Introduction
The percentage of completion method is a popular accounting method used to recognize revenue over time as a project progresses. It is commonly used in industries such as construction, engineering, and software development, where projects can take months or even years to complete. In this blog post, we will discuss what the percentage of completion method is, how it works, and provide examples of how it is used in practice.
What is the Percentage of Completion Method?
The percentage of completion method is an accounting method used to recognize revenue over the duration of a long-term project. The method is based on the concept of measuring progress toward completion of a project by comparing the total costs incurred to date with the total estimated costs for the entire project. The percentage of completion is then calculated by dividing the total costs incurred to date by the estimated total costs for the project.
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How Does the Percentage of Completion Method Work?
The percentage of completion method works by recognizing revenue and expenses based on the percentage of the project that has been completed. Under this method, revenue and expenses are recognized proportionally over the duration of the project based on the percentage of completion. The percentage of completion is calculated using the following formula:
Percentage of completion = Total costs incurred to date / Estimated total costs for the project
Once the percentage of completion is calculated, revenue and expenses are recognized based on that percentage. For example, if a construction project is estimated to cost $1,000,000 and $500,000 of costs have been incurred to date, the percentage of completion would be 50%. If the total contract price for the project is $2,000,000, revenue would be recognized for 50% of that amount, or $1,000,000.
Example of the Percentage of Completion Method in Practice
Let’s consider an example of how the percentage of completion method works in practice. A construction company is building a new office building for a client. The contract price for the project is $5,000,000, and the estimated total costs for the project are $4,000,000. At the end of the first year, the company has incurred costs of $1,500,000.
To calculate the percentage of completion, the company would divide the total costs incurred to date by the estimated total costs for the project:
Percentage of completion = $1,500,000 / $4,000,000 = 37.5%
Based on this percentage of completion, the company would recognize revenue of $1,875,000 for the first year of the project. This revenue would be calculated by multiplying the total contract price of $5,000,000 by the percentage of completion of 37.5%.
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Advantages of the Percentage of Completion Method
The percentage of completion method has several advantages over other accounting methods. One of the main advantages is that it provides a more accurate representation of the revenue and expenses associated with long-term projects. By recognizing revenue and expenses over the duration of the project, the method takes into account the actual progress of the project and the costs associated with that progress.
Another advantage of the percentage of completion method is that it allows for more accurate forecasting of future revenue and expenses. By tracking the progress of a project and recognizing revenue and expenses over time, the method can provide more accurate projections of future revenue and expenses.
Limitations of the Percentage of Completion Method
While the percentage of completion method has several advantages, it also has some limitations. One of the main limitations is that it requires accurate estimates of the total costs for a project. If the estimated costs are inaccurate, the percentage of completion and the revenue and expenses recognized based on that percentage will also be inaccurate.
Another limitation of the percentage of completion method is that it requires ongoing monitoring of the progress of a project. If the progress of a project is not accurately tracked, the percentage of completion may be misstated, resulting in inaccurate revenue recognition. This can be particularly challenging in industries where project completion is subject to delays or changes in scope.
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Furthermore, the percentage of completion method can be complex to implement and may require significant accounting expertise. It requires careful record-keeping and monitoring of costs and progress to accurately calculate the percentage of completion and recognize revenue and expenses accordingly.
Despite these limitations, the percentage of completion method remains a widely used accounting method in industries that involve long-term projects. It provides a more accurate representation of the revenue and expenses associated with a project, and can help companies forecast future revenue and expenses more accurately.
Summary
The percentage of completion method is an accounting method that is commonly used in industries such as construction, engineering, and software development. It recognizes revenue and expenses based on the percentage of completion of a long-term project, and provides a more accurate representation of the actual progress of a project than other accounting methods. While the method has some limitations, it remains a popular choice for companies involved in long-term projects. By carefully monitoring progress and accurately calculating the percentage of completion, companies can more accurately forecast future revenue and expenses and make better-informed decisions about their projects.