Understanding the Percentage-of-Completion Method for Long-Term Contracts

Revenue recognition is a critical aspect of accounting, particularly in the context of long-term contracts. In this expanded explanation, we will explore the percentage-of-completion method, which is employed by companies for recognizing revenue over time, especially in construction and similar long-term projects. Understanding this method is essential for applying effective accounting practices and meeting relevant financial reporting standards.

Revenue Recognition Over Time

Under certain circumstances, companies recognize revenue over time rather than at a single point in time when the contract is completed. This approach is particularly relevant for long-term construction contracts, which often have significant durations and complex deliverables.

The percentage-of-completion method allows companies to recognize revenue incrementally as they fulfill their contractual obligations. This is particularly useful for projects that span multiple accounting periods, enabling a more accurate reflection of earnings in relation to ongoing efforts.

Criteria for Recognizing Revenue Over Time

A company may recognize revenue progressively if it meets at least one of the following three criteria:

Simultaneous Benefit: The customer simultaneously receives and consumes the benefits of the seller’s performance. For instance, in a construction project, the client might occupy an area of the building while construction is ongoing.
Creation of Assets: The company’s performance enhances or creates an asset (e.g., work in process) that the customer controls as it is developed. This is often applicable in the construction of bespoke infrastructure.
No Alternative Use: The performance does not result in an asset with alternative use, combined with one of the following conditions:

The completed work so far does not require substantial re-performance by another company if it were to finish the project.
The company has the right to payment for the work performed to date and expects to complete the contract as promised.

If any of these criteria are met, companies can recognize revenue over time, provided they can reasonably estimate their progress toward fulfilling their performance obligations.

Measuring Progress Toward Completion

One of the most common methods to measure progress toward completion is the cost-to-cost basis. This input measure involves assessing the proportion of costs incurred to date relative to the total estimated costs of the project.

Example: Hardhat Construction Company

Consider the example of Hardhat Construction Company, which is contracted to construct a bridge valued at £4,500,000, with an estimated total cost of £4,000,000. The contract starts in July 2019, with completion expected in October 2021. Over the construction period, the company will track costs and recognize revenue based on the percentage of completion derived from the costs incurred.

Illustrative Data

The following illustration summarizes the projected costs incurred and the revenue recognized over the project duration:

Year 2019: Initial costs and revenue recognition based on early progress.
Year 2020: Continued cost accumulation and adjustment of estimated costs affecting revenue recognition.
Year 2021: Final stages of construction, culminating in the completion of revenue recognition.

Financial Statement Presentation

The percentage-of-completion method affects how companies present their financial statements. The construction in process account will reflect the cumulative revenues recognized, costs incurred, and any gross profit attributable to the ongoing work. It is vital for stakeholders to see a clear picture of a company’s financial health, particularly in long-term contracts where the timing of revenue recognition can significantly impact reported results.

Specific illustrations highlight how the financial statements would differ year by year, ensuring that earnings accurately represent the operational performance and progress of the undertaken projects. These illustrations play a crucial role in showing stakeholders the anticipated versus actual financial outcomes across the contract duration.

Conclusion

The percentage-of-completion method is a vital accounting approach for long-term contracts. By understanding and applying this method, companies can ensure accurate revenue recognition aligned with the progression of their projects. This method not only aids in compliance with accounting standards but also provides valuable insights into a company's performance over time, enabling better financial planning and decision-making. As businesses continue to engage in long-term projects, mastering this method will remain essential for accounting professionals.

Example of Percentage-of-Completion Method Progress Chart

Percentage-of-Completion Method for Revenue Recognition

Percentage-of-Completion Method for Revenue Recognition