The percentage of completion method is an accounting practice in which the revenues and expenses of long-term contracts are recognized as a percentage of the work completed during a period. This is quite different from the completed contract method, which defers the reporting of income and expenses until a project is completely finished. While primarily used in the construction industry, this method finds its applictions in various sectors beyond construction.
Key Takeaways
- The percentage of completion method reports revenues and expenses in relation to work completed to date.
- This method can be leveraged only if payment assurance and estimation of project completion are straightforward.
- It has been misused by some companies to temporarily boost their financial standings.
Understanding the Percentage of Completion Method
The method entails periodical reporting of revenues and expenses based on the degree of contract fulfillment. The current income and expenses are compared with the estimated total costs to determine the annual tax liability. For instance, if a project is 20% complete in year one and progresses to 35% in year two, only the incremental 15% of the revenue will be recognized in the second year. While the income statement follows a work-in-progress approach, the balance sheet operates similarly to the completed contract method.
To utilize the percentage of completion method, two main conditions must be met: collections by the company must be reliably assured, and the company must be able to reasonably estimate costs and project completion rates.
Real-World Applications
This accounting method is commonly employed by construction firms dealing with buildings, energy facilities, and public sector projects. It also extends to defense contractors handling extensive projects, such as nuclear submarines or aircraft carriers, and software developers creating significant custom-designed projects for clients.
For instance, Fluor Corporation, a global engineering and construction firm, elaborates on its use of the percentage completion method in its financial reports. Changes in total estimated contract costs or losses are recognized during the period in which the changes occur. Income recognized in excess of billed amounts is logged as a current asset, whereas amounts billed to clients in excess of recognized income are recorded as current liabilities.
Potential for Misuse
The percentage of completion method can be exploited by unethical companies for creative accounting, allowing them to manipulate income and expenses between periods to deceive stakeholders. This practice, however, is not sustainable. A notable example is Toshiba Corp., which, between 2008 and 2014, understated operating costs by approximately 152 billion yen ($1.2 billion). The fallout from this scandal resulted in the resignation of the CEO and the departure of half the Board of Directors.
Related Terms: completed contract method, revenue recognition, current income, tax liability, creative accounting.
