What is the Percentage of Completion Method?
The percentage of completion method is an accounting method in which the revenues and expenses of long-term contracts are recognized as a percentage of the work completed during the period. This is in contrast to the completed contract method, which defers the reporting of income and expenses until a project is completed. The percentage-of-completion method of accounting is common for the construction industry, but companies in other sectors also use the method.
Understanding the Percentage of Completion Method
The percentage of completion method of accounting requires the reporting of revenues and expenses on a period-by-period basis, as determined by the percentage of the contract that has been fulfilled. The current income and expenses are compared with the total estimated costs to determine the tax liability for the year. For example, a project that is 20% complete in year one and 35% complete in year two would only have the incremental 15% of revenue recognized in the second year. The recognition of income and expenses on this work-in-progress basis applies to the income statement, but the balance sheet is handled the same way as the completed contract method.
There are two main conditions for the use of the percentage of completion method. First, collections by the company must be reasonably assured; second, the company must be able to reasonably estimate costs and the rate of project completion.
- The percentage of completion method reports revenues and expense in terms of the work completed to date.
- This method can only be used if payment is assured and estimating completion is relatively straightforward.
- The percentage of completion method has been misused by some companies to boost short-term results.
Examples of the Percentage of Completion Method
The percentage of completion accounting method is commonly used by construction firms that are contractors for buildings, energy facilities, public sector infrastructure and other long-term physical projects. It has also been used by defense contractors (think nuclear submarines or aircraft carriers) and software developers whose projects represent a multi-year commitment of resources. For software developers, the product must be a significant custom-designed project for a client.
Fluor Corporation, a global engineering and construction firm, provides details about its use of the percentage of completion method in its 10-K filing under "Note 1 - Major Accounting Policies" of the notes to the consolidated financial statements. An analyst would learn that changes to total estimated contract costs or losses, if any, are recognized in the period in which they are determined by the company. Income recognized in excess of billed amounts is booked as a current asset under "contract work in progress" and billed amounts to clients in excess of income recognized to date are booked as a current liability under "advance billings on contracts."
Potential for Abuse of the Percentage of Completion Method
Percentage of completion method is vulnerable to abuse by unethical companies. Those who wish to engage in creative accounting can easily move around income and expenses from one period to another period, or understate or overstate amounts. This game would not be sustainable, however, as Toshiba Corp. discovered in 2015. The infrastructure unit of the Japanese conglomerate understated operating costs by approximately 152 billion yen ($1.2 billion) between 2008 and 2014. Shortly after the scandal broke, the CEO was forced to resign, and half the Board of Directors stepped down.