Applying the percentage of completion method in M&A transactions

Once selected, the method cannot be changed without special permission from the Internal Revenue Service (IRS). By nature, percentage of completion allows project managers to accurately evaluate projects for each individual phase of a project. This helps to identify operational bottlenecks such as cash flow issues or labor inefficiencies, clearly showing cash requirements throughout the job. When change orders are included and estimates change as the project goes along, calculating the percentage complete can get complicated. Because income recognition is based on a percent of the revised contract for each project, it’s important that contractors enter change orders into the system as soon as they are approved.

When revenue figures don’t quite match up with what’s already been billed, it can result in major cash flow problems. Percentage of completion (POC) is an accounting method used to recognize revenues and expenses based on the percent of work done. In essence, costs and revenues are determined by how far along you are on the job. First, take an estimated percentage of how close the project is to being completed by taking the cost to date for the project over the total estimated cost. Then multiply the percentage calculated by the total project revenue to compute revenue for the period. Then derive the construction income by subtracting the cost from the period revenue.

Income Recognition

Using the percentage of completion method, it’s almost as if you have a scoreboard to keep track of all the progress made so far. Each phase of the job is a possession, and the project timeline is like the game clock. This standardized approach of POC keeps you in the know so you can quickly tell where you stand in any given quarter and what adjustments need to be made before you head into the next one.

This progress percentage is then used to determine how much revenue you can recognize and how much expense you can deduct in the current year. This method is based on the ratio between the cost incurred to date on the contract to the total estimated project cost. If the cost of raw materials has not been taken into use until the end of the period, then it should not be considered when calculating the percentage of completed contracts. However, while FASB and IASB have placed certain requirements on how you can recognize revenue, the IRS allows for different methods, including the percentage of completion method. Accurately calculating your revenue in the correct accounting period will ensure that your tax liabilities are properly represented. The percentage of completion accounting method is commonly used by construction firms that are contractors for buildings, energy facilities, public sector infrastructure, and other long-term physical projects.

Different methods to calculate the percentage of completion

Experienced tax professionals track regulations, policies and legislation to help translate changes. Stay updated on tax planning and regulatory topics that affect you and your business. Getting these foundations right is key to leveraging percentage-of-completion successfully. Double Entry Bookkeeping is here to provide you with free online information to help you learn and understand bookkeeping and introductory accounting.

The percentage of completion method calculates the cumulative amounts at the end of each period. The adjustments needed for the period are found by taking the difference between the amounts calculated for the current period less the amounts calculated from the previous period. Note that the same answer could be arrived at by applying the percentage completion to the estimated total income from the project. The degree to which a project is completed can be calculated using the percentage of completion formula. XYZ Ltd. took a contract to build an airport at a contract price of $125 million. This would mean that only 25% of the contract was completed in the second year, and revenues relating to that 25% of work should be recognized for the current period.

Utilizing a Construction Percentage-of-Completion Spreadsheet

The billing discrepancies probably arose as the managers billed before the end of the month and estimated the percentage of completion as of the billing date rather than the actual month-end. Doing so improves the consistency of the percentage of completion results over time. The ability to create dependable contract estimates may be impaired when there are conditions present that are not normally encountered in the estimating process.

The balance sheet presentation is the same as in the completed contract method. 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 percentage of completion calculation example engineers and other experts observe the activities and determine their judgment of the percentage of work completed. The percentage of completion method spreads tax liability out over multiple years and helps free up cash flow.

It’s not something we see often, but it’s good to know this approach exists if you ever find yourself in a similar situation. The financial stability of construction firms often hinges on their ability to effectively manage costs, a key factor in keeping projects within budget and securing profitability. Although many construction clients make these determinations on an annual basis, it is preferable to do it more frequently, such as on a monthly basis. This allows for estimates to more closely approximate actual results and enables more useful planning and budgeting. For example, missing change orders are easier to discover with more frequent WIP report preparation. Don’t make this more complicated than it has to be by using spreadsheets to keep tabs on billing.

• In this method, we replace the costs incurred and estimated costs with efforts expended till now and total expected efforts for the contract.
• This is where percentage of completion (POC) accounting can be extremely helpful.
• To calculate the percentage of completion for a project, there are three indicators contractors can use.
• With a basic understanding of the three most common methods, let’s look at a detailed percentage of completion example using the cost-to-cost method.
• Revenues also need to be systematically recognized each period based on the updated % complete figures.

In addition, it’s compatible with generally accepted accounting principles (GAAP), as these principles require that you recognize revenue in the period it was earned. As such, Seller’s obligations under the contract are terminated and income or expense is recognized on the contract. The completion of work is measured by the percentage of efforts expended till date as compared to estimated total effort expected to be expended for each contract.