Revenue Recognition: Percentage of Completion Method
Percentage of completion method is a basis for revenue recognition in long-term construction contracts which span over more than one accounting periods. In case of long-term contracts, accountants need a basis to apportion the total contract revenue between the multiple accounting periods. Percentage of completion method provides one of those bases, other being full-contract method.
It determines revenue recognized in one accounting period in accordance with the following formula:
|=||Percentage of Work Completed in the Period|
|Total Contract Value|
Total contract value is the total revenue from the long-term contract.
Percentage of work completed is the proportion of work completed in a period to total work for the contract. It is usually estimated using the following formula:
|Percentage of Work Completed|
|=||Expenditures Incurred from Inception to Date|
|Total Estimated Costs for the Contract|
Expenditures incurred from inception to date represent costs incurred from the start of the project to the date of estimation.
Total estimated expenditures for the contract represent the total budgeted cost for the project. It includes costs that have been incurred to date and costs that are expected to be incurred in future periods.
There is another method for estimating percentage of completion called survey method which is based on the physical progress of the contract. Under this method engineers and other experts observe the activities and determine their judgment of the percentage of work completed.
Construction Inc. is engaged in constructing a massive bridge in Wonderland. The contract is worth $200 million and the company is expected to complete it in 3 years. In Year 1 the company has incurred an amount of $50 million on the contract and the engineers estimate that in the next 2 years the company is expected to expend $110 million more. Based on the physical progress of the project the engineers also estimate that 40% of the work has been carried out.
Under the survey method the engineers have provided their judgment of the percentage of work completed and it is 40%.
Based on costs incurred to date and total costs the percentage of completion comes out to be:
Percentage of work completed = $50 million ÷ ($50 million + $110 million) = 31.25%.
Total costs include costs incurred to date and costs expected to be incurred over the remaining period.
Based on the percentage of completion calculated using cost date we determine than revenue of $62.5 million has been earned (31.25% multiplied by $200 million total contract value). On the other hand based on the engineer's survey the revenue recognized should be $80 million (40% multiplied by $200 million).
Written by Obaidullah Jan, ACA, CFA