Knowing the percentage of completion approach is essential for precise financial management. This revenue recognition technique gives your financial statements clarity, accuracy, and compliance by bringing revenue and expenses into line with the status of your projects. In this article, we’ll break down the benefits of the percentage of completion method, walk through the calculations, and explain how it can improve your business’s bottom line.
What is the Percentage of Completion Method?
The percentage of completion method is an accounting approach that allocates revenue and expenses to a project in proportion to its completion. Unlike the completed contract method, which defers revenue and expense recognition until the project is fully completed, this method ensures that income is reported gradually as work progresses.
The percentage of completion method example, if your team has completed 50% of a project, the same percentage of revenue and expenses will be recognized in your financial statements. When working on long-term contracts that span months or years, this approach is especially advantageous.
Why is the Percentage of Completion Method Important
Construction projects often span months or even years, involving complex financial arrangements such as milestone payments, subcontractor costs, and material expenses. The percentage of completion method simplifies these complexities by aligning financial reporting with the actual progress of a project. This dynamic approach is more reflective of the project’s financial health than static alternatives like the completed contract method. Here’s a closer look at its key advantages:
Improved Financial Accuracy
By tying revenue and expenses directly to the percentage of work completed, this method eliminates guesswork and ensures that your financial statements provide an accurate snapshot of profitability at any given time. For example, if a project is halfway done, your books will show 50% of the revenue and associated costs, offering a realistic view of performance.This helps you determine which projects are achieving profit projections and which could need revisions, which is very useful when managing numerous projects at once.
Manage Your Business Cash Flow
Cash flow can make or break a construction business, and the percentage of completion method helps stabilize it by recognizing revenue in proportion to the work completed. Unlike the completed contract method, where revenue is delayed until project completion, this approach allows contractors to invoice for progress, keeping funds flowing consistently. For instance, recognizing partial revenue throughout a year-long project can help contractors better manage payroll, purchase materials, and address unforeseen expenses without resorting to high-interest financing.
Better Compliance
Compliance with accounting standards like Generally Accepted Accounting Principles (GAAP) is critical, especially for companies seeking financing or undergoing audits. The percentage of completion method aligns with these standards, ensuring that your financial records are not only accurate but also audit-ready. This compliance builds trust with banks, investors, and regulatory bodies. In addition, it helps positioning your company as a reliable and well-managed business.
Transparency for Stakeholders
For construction companies, keeping stakeholders informed is essential. The method fosters transparency by providing clients with up-to-date financial insights into project progress. For example, if a stakeholder requests a financial summary midway through a project, you can provide accurate, data-driven reports that reflect both progress and profitability. This transparency builds trust and strengthens relationships with key stakeholders, ultimately leading to more opportunities.
How to Calculate the Percentage of Completion Method
The percentage of completion method relies on two commonly used techniques for measuring progress: the cost-to-cost method and the efforts-expended method. Here’s a detailed explanation of both:
Cost-to-Cost Method
This calculating percentage completion compares the costs incurred to date with the total estimated costs of the project to calculate the percentage of completion. It is widely favored in construction accounting for its simplicity and direct correlation to expenses.
Formula: Percentage Completed = Costs Incurred to Date / Total Estimated Costs
Example: Imagine you’re working on a $1,000,000 construction project. By the end of the first quarter, you’ve incurred $500,000 in costs. Using the formula:
Percentage Completed = $500,000 / $1,000,000=50%
This means 50% of the project’s revenue and expenses can be recognized in your financial statements.
Efforts-Expended Method
This method measures project progress based on efforts such as labor hours, machine hours, or units of work completed. It’s particularly useful for projects where cost may not accurately reflect progress, such as those involving high-value materials or equipment.
Example: If a project is estimated to require 10,000 labor hours and 4,000 hours have been completed, the percentage of completion is:
Percentage Completed = 4,000 Hours / 10,000 Hours= 40%
Both methods are valid and offer flexibility depending on the nature of your project. However, the cost-to-cost method is more commonly used because it aligns closely with construction expenses, making it easier to track and report.
Common Questions About the Percentage of Completion Method
1. Is the Percentage of Completion Method Mandatory for Construction Businesses?
Not always. For smaller projects or businesses that prefer simpler accounting, the completed contract method might suffice. However, if your contracts exceed a year or involve significant resources, the percentage of completion method is often recommended for compliance and accuracy.
2. What Are the Risks of Using This Method?
While this method improves accuracy, it depends heavily on reliable estimates. Overestimating or underestimating costs can skew financial data. Working with professional construction accounting services helps mitigate these risks.
3. How Does the Percentage of Completion Method Impact Taxation?
Revenue recognized incrementally affects your taxable income. With proper planning, you can leverage construction tax strategies to optimize your tax liability.
Benefits of Percentage Completion Method
Revenue Recognition in Real Time: Helps construction businesses identify financial trends as projects progress.
Simplified Progress Billing: Ties financial recognition to project milestones, making invoicing more straightforward.
Supports Loan and Bond Approvals: Accurate revenue tracking enhances your credibility with lenders and surety bond providers.
Facilitates Job Cost Tracking: Aligns with software like QuickBooks, Sage, and Buildertrend to improve financial oversight.
Final Thoughts
For construction companies, the completion methods percentage is revolutionary. By accurately tracking revenue and expenses, you can maintain financial transparency, improve cash flow management, and stay compliant with GAAP standards. If you're struggling with implementing this method or need help with bookkeeping, reach out to professionals like us. At Construction Cost Accounting (CCA), we specialize in construction bookkeeping and accounting for many construction businesses from all over the world. Whether it’s applying the percentage of completion method, managing job cost tracking, or ensuring compliance, we’re here to support your business’s success.
What’s your biggest challenge with construction accounting? Let us know in the comments below or contact us directly for personalized advice!
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