Knowledge Base - Financial Tools
Use Percentage of Completion to Recognize Revenue
One of the basic tenets of accounting is the proper matching of Revenue and Expense. To accomplish this, there are four basic ways to record accounting information. Here we will focus on the Percentage of Completion method.
Before we drill down, let’s review the four methods.
- CASH – Report revenue when cash is received and expenses when paid. Does not consider when revenue is earned or when costs are incurred. Mainly useful for tax reporting.
- ACCRUAL – report revenue when earned and expenses when incurred. Records receivables and payables to address the timing difference from cash. This is the most common method of accounting.
- COMPLETED CONTRACT – Typically used by contractors or manufacturers for large projects. Revenues and expenses are not recorded on the income statement until the whole job is complete. During the job, receipts from the customer are recorded in a customer deposit liability account and costs are recorded in a work-in-process inventory account. While this methodology is useful for tax reporting, it does not give a good picture of how the company is doing on an interim basis.
- PERCENTAGE OF COMPLETION – Another method of accounting for large jobs. Costs are recorded as incurred. Revenue is recorded monthly based on an evaluation of progress on open jobs. For large jobs this is the preferred method because it give the most accurate picture of how the company is performing on a month to month basis.
Percentage of Completion – The Concept:
- Revenue is determined each month based on the costs that have been incurred.
- During the month, billings are recorded as normal to Income and Accounts Receivable.
- During the month, costs are recorded as normal to the appropriate expense accounts.
- For each job, a Cost % is calculated based on the ratio of the current total cost estimate to the sales amount.
- The Cost % is used to calculate the amount of revenue to be recognized based on the total cost incurred to date on a job.
- If the contract sales amount is $1,000 and the estimated cost is $500, the Cost % would be 50%.
- If at the end of month one, $200 of costs has been incurred, you would calculate the revenue to be recognized by dividing the $200 by 50%. This would indicate $400 of revenue should be recognized in that month.
Percentage of Completion – The Mechanics:
- To implement Percentage of Completion Accounting you need to add two Balance Sheet accounts to your General Ledger:
- Excess of Costs over Billings – an asset.
- Excess of Billings over Earned Income – a liability.
- The above accounts are used to record the difference between revenue to be recognized and the actual billings to the customers.
- A Construction Accounting System will be able to produce a report listing all of the information needed to adjust your accounts at month end. If you do not have such a system, you will need to set up an Excel spreadsheet for that purpose. An example of a month end Schedule of Contracts in Progress is included below.
- At the end of each month using the Schedule of Contracts in Progress, a comparison of costs and billings to date is made. This review results in calculating the entry needed to adjust Earned Revenue to the appropriate amount based on the costs that have been incurred to date. This entry would utilize one of the two balance sheet accounts mentioned above, depending on whether the actual billings to date “exceed” or are “less than” the amount earned to date.
It is important to periodically re-evaluate the expected total cost of a job so that “excess’ profit is not recognized early in the job with resulting losses reported as the job nears completion.
In some cases it may be appropriate to allocate and report profit by major component of a large project. For example, if you earn 40% profit on labor but only 10% on material, component reporting would prevent over reporting profit early in the job on the material which is typically front loaded.