The percentage of completion method is a revenue recognition accounting concept that evaluates how to realize revenue periodically over a long-term project or contract. Revenue, expenses, and gross profit are recognized each period based on the percentage of work completed or costs incurred.
Understanding the Percentage of Completion Method
The percentage of completion method falls in line with IFRS 15, which indicates that revenue from performance obligations recognized over a period of time should be based on the percentage of completion. The method recognizes revenues and expenses in proportion to the completeness of the contracted project. It is commonly measured through the cost-to-cost method.
There are two conditions to use the percentage of completion method:
Collections by the company must be reasonably assured.
Costs and project completion must be reasonably estimated.
In the cost-to-cost approach, the percentage of completion is based on the costs incurred to the estimated total cost to complete the project. Therefore, the equation for the cost-to-cost estimate of percentage completion is:
An example is provided below to clarify the cost-to-cost approach.
Example of the Cost-To-Cost Approach
StrongBridges Ltd. was awarded a $20 million contract to build a bridge. The estimated time to complete the project is three (3) years, with an estimated cost of $15 million. Assuming that the cost estimates do not change, the project is expected to generate $5 million in profit. The following is a schedule on the project:
Costs Incurred are the costs incurred to build the bridge as estimated by the company’s engineer.
Billings are the amount of money StrongBridges Ltd. billed for the construction of the bridge. Billings amount is set by the contract.
Cash Collected is the amount of money StrongBridges Ltd. received for the construction of the bridge. The variation in billings and cash collected is due to timing differences.
% Completed is determined by the percentage completion formula.
For the schedule above, revenues recognized under the percentage of completion method:
Year 2008: 33% completed. Revenue recognized = 33% x $20 million (contract price) = $6,600,000
Year 2009: 47% completed. Revenue recognized = 47% x $20 million (contract price) – $6.6 million (previously recognized) = $2,800,000
Year 2010: 100% completed. Revenue recognized = 100% x $20 million (contract price) – $6.6 million – $2.8 million (previously recognized) = $10,600,000
Total Revenue = $20,000,000
Costs recognized under the percentage of completion method:
Year 2008: $5,000,000
Year 2009: $2,000,000
Year 2010: $8,000,000
Total Cost = $15,000,000
Profit recognized under the percentage of completion method:
Year 2008: $6,600,000 – $5,000,000 = $1,600,000
Year 2009: $2,800,000 – $2,000,000 = $800,000
Year 2010: $10,600,000 – $8,000,000 = $2,600,000
Gross Profit = $5,000,000
Journal entries for the example above would be as follows:
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