IAS recognizes the percentage-of-completion method as the only valid method of accounting for construction contracts. Under an earlier version of IAS 11, both the percentage-of-completion method and the completed-contract method were recognized as being acceptable alternative methods of accounting for long-term construction activities. The principal concern of accounting for long-term construction contracts involves the timing of revenue (and thus profit) recognition. Construction contract revenue may be recognized during construction rather than at the completion of the contract. This “as-earned” approach to revenue recognition is justified because under most long-term construction contracts, both the buyer and the seller (contractor) obtain enforceable rights. The buyer has the legal right to require specific performance from the contractor and, in effect, has an ownership claim to the contractor’s work in progress. The contractor, under most long-term contracts, has the right to require the buyer to make progress payments during the construction period. The substance of this business activity is that a continuous sale occurs as the work progresses.
Strength and Weakness Of the Percentage Completed Method
The completed-contract method makes the most sense when the costs and revenues associated with a project cannot be reasonably tracked, or when there is some uncertainty regarding either the addition of costs to the project or the receipt of payments from the customer.
This approach does not, however, reveal the earning of any revenue on the financial statements of a construction company until its projects are substantially complete, giving the reader of its financial statements very poor information about its ability to generate a continuing stream of revenues (except for projects of such short duration that they will be initiated and completed within the same accounting period).
Consequently, the percentage-of-completion method is the preferred method in jurisdictions that allow the use of both methods.
How to Make the “Percentage-of-Completion Method” Works
Here I outlined some critical point to be taken care to make the use of the percentage-of-completion method works:
1. The Percentage Of Income Associated with The Project – Under the percentage-of-completion method, a percentage of the income associated with a project is recognized in proportion to the estimated percentage of completion of the project. An approach under the completed-contract method is to wait until a construction project has been completed in all respects before recognizing any related revenue. The completed-contract method is not in accordance with IFRS, but this is an allowable method of accounting for long-term construction contracts in the United States, Canada, and Japan—and the only method permitted in Germany.
2. The Expenses – Under the percentage-of-completion method, accounting must be performed for each project, in which the entity accumulates all project-related expenses. At the end of each reporting period, the budgeted gross margin associated with each project is added to the total expenses accumulated in each account and subtracted from the accumulated billings to date. If the amount of expenses and gross profit exceeds the billings figure, then the company recognizes revenue, matching the difference between the two figures. If the expenses and gross profit figure are less than the amount of billings, the difference is stored in a liability account.
3. Construction in Progress (CIP) Asset – Under the percentage-of-completion method, the accounting staff creates a new asset construction-in-progress (CIP) account to accumulate costs and recognize income. When the CIP exceeds billings, the difference is reported as a current asset. If billings exceed CIP, the difference is reported as a current liability. Where more than one contract exists, the excess cost or liability should be determined on a project-by-project basis, with the accumulated costs and liabilities being stated separately on the statement of financial position. Assets and liabilities may not be offset unless a right of offset exists. Thus, the net debit balances for certain contracts should not ordinarily be offset against net credit balances for other contracts. An exception may exist if the balances relate to contracts that meet the criteria for combining.
4. The Contract Cost – Under the percentage-of-completion method, income should not be based on advances (cash collections) or progress (interim) billings. Cash collections and interim billings are based on contract terms that do not necessarily measure contract performance. Costs and estimated earnings in excess of billings should be classified as an asset. If billings exceed costs and estimated earnings, the difference should be classified as a liability. Contract costs are comprised of costs that are identifiable with a specific contract, those that are attributable to contracting activity in general—and can be allocated to the contract—and those that are contractually chargeable to a customer. Generally, contract costs would include all direct costs, such as direct materials, direct labor, and direct expenses, as well as any construction overhead that could specifically be allocated to specific contracts. Contract costs can be broken down into two categories:
(1). Costs Incurred To Date : The costs incurred to date include pre-contract costs and costs incurred after contract acceptance. Pre-contract costs are costs incurred before a contract has been entered into, with the expectation that the contract will be accepted and these costs will thereby be recoverable through billings. Pre-contract costs include costs of architectural designs, costs of learning a new process, cost of securing the contract, and any other costs that are expected to be recovered if the contract is accepted. Contract costs incurred after the acceptance of the contract are put toward the completion of the project, and are capitalized in the construction-in-progress (CIP) account. The contract does not have to be identified before the capitalization decision is made; it is only necessary that there be an expectation of the recovery of the costs. Once the contract has been accepted, the pre-contract costs become contract costs incurred to date. Nevertheless, if the pre-contract costs are already recognized as an expense in the period in which they are incurred, they are not included in contract costs when the contract is obtained in a subsequent period.
(2) Estimated Costs to Complete: Estimated costs to complete are the anticipated costs required to complete a project at a scheduled time. They would be comprised of the same elements as the original total estimated contract costs and would be based on prices expected to be in effect when the costs are incurred. The latest estimates should be used to determine the progress toward completion.
Timing for Revenue Recognition
Under the percentage-of-completion method, revenues are recognized based on the stage of completion of a contract. The standard recognizes that the stage of completion of a contract may be determined in many ways and that an entity uses the method that measures reliably the work performed. The standard further stipulates that depending on the nature of the contract, one of these three methods may be chosen:
- Cost-to-cost Method (The proportion that contract costs incurred bears to estimated total contract cost)
- Survey of Work Performed Method
- Completion of a Physical Proportion of Contract Work (also called units-of-work performed) method. Note: Progress payments and advances received from customers often do not reflect the work performed.
Each of these methods of measuring progress on a contract can be identified as being either an input or an output measure. The input measures attempt to identify progress in a contract in terms of the efforts devoted to it. The cost-to-cost method is an example of an input measure.
Under the cost-to-cost method, the percentage of completion would be estimated by comparing total costs incurred to date to total costs expected for the entire job. Output measures are made in terms of results by attempting to identify progress toward completion by physical measures. The units of work-performed method is an example of an output measure. Under this method, an estimate of completion is made in terms of achievements to date, but it is not considered to be as reliable as input measures.
When the stage of completion is determined by reference to the contract costs incurred to date, the standard specifically refers to certain costs that are to be excluded from contract costs. Examples of such costs are:
- Contract costs that relate to future activity (e.g., construction materials supplied to the site but not yet consumed during construction)
- Payments made in advance to subcontractors prior to performance of the work by the subcontractor
Under the cost-to-cost method, we measure the percentage of completion by dividing the total amount of costs incurred to date by the total estimated project cost. This method works well only if the total estimated project cost is revised regularly to reflect the most accurate cost information. Also, it tends to result in proportionately greater amounts of revenue recognition early in a project, since this is when most of the material-related costs are incurred. A more accurate way to calculate the percentage of completion when there are large up-front materials costs is to include the materials costs only when the aspects of the project in which they are used are completed.
Example of the Cost-to-cost Method
The Lie Dharma Putra Construction (LDPC) is building a hotel and has elected to purchase the materials for the air-conditioning system, costing $200,000, at the beginning of the project. The total estimated project cost is $2 million and the amount billable to the customer is $2.5 million. After one month, LDPC has incurred a total of $400,000 in costs, including the air conditioning equipment. This is 20% of the total project cost, and would entitle LDPC to recognize $500,000 of revenue (20% of $2.5 million). However, because the air-conditioning equipment has not yet been installed, a more accurate approach would be to exclude the cost of this equipment from the calculation, resulting in a project completion percentage of 10% and recognizable revenue of $250,000. The resulting journal entry would be:
[Debit]. Costs and estimated earnings in excess of billings = $125,000
[Credit]. Contract revenues earned = $125,000
The trouble with these methods is that one must have good cost tracking and project planning systems in order to ensure that all related costs are being properly accumulated for each project, and that cost overruns are accounted for when deriving the percentage of completion. For example: If poor management results in a doubling of the costs incurred at the halfway point of a construction project—from $5,000 up to $10,000—this means that the total estimated cost for the entire project (of $10,000) would already have been reached when half of the project had not yet been completed. In such a case, one should review the remaining costs left to be incurred and change this estimate to ensure that the resulting percentage of completion is accurate.
If the percentage-of-completion calculation appears suspect when based on costs incurred, one can also use a percentage of completion that is based on a Gantt chart or some other planning tool that reveals how much of the project has actually been completed. For example: If a Microsoft Project plan reveals that a construction project has reached the 60% milestone, then one can reasonably assume that 60% of the project has been completed, even if the proportion of costs incurred may result in a different calculation.
Costs that may be included in the construction-in-progress account include direct labor, materials, and overhead related to the project. Expenses included in overhead should be consistently applied across multiple projects, as should the method of applying overhead to jobs; this keeps one from arbitrarily shifting overhead expenses between project accounts.
If the estimate of costs left to be incurred plus actual costs already incurred exceeds the total revenue to be expected from a contract, then the full amount of the difference should be recognized in the current period as a loss, and it should be presented on the statement of financial position as a current liability. If the percentage of completion method has been used on the project, then the amount recognized will be the total estimated loss on the project plus all project profits previously recognized. If, after the loss estimate has been made, the actual loss turns out to be a smaller number, the difference can be recognized in the current period as a gain.
Example of Project Loss Recognition
The LDPC Construction Company’s cost accountant has determined that its construction of a new office building will probably result in a loss of $80,000, based on his most recent cost estimates. The company uses the percentage-of-completion method, under which it had previously recorded gross profits of $35,000 for the project. Thus, the company must record a loss of $115,000 in the current period, both to record the total estimated loss and to back out the formerly recognized profit. The entry is:
[Debit]. Loss on uncompleted project = $115,000
[Credit]. Estimated loss on uncompleted contract = $115,000
If costs are incurred prior to the signing of a project contract, these costs must be charged to expense at once rather than storing them in the construction-in-progress account as an asset. It is not allowable to shift these costs retroactively from an expense account into the construction-in-progress account.