The Percentage of Completion Method Explained: A Practical Guide for Contractors
The percentage of completion method is one of the most common approaches in construction accounting, and with good reason too. This method provides the most accurate way to track and measure revenue earned on long-term contracts. Your financial statements reflect economic reality throughout the project lifecycle. The IRS generally requires contractors to use this approach for long-term construction projects. Understanding percentage of completion accounting is essential because it affects everything in revenue recognition and cash flow management. This piece will walk you through what the percentage of completion method is and how to calculate percentage of completion method using the proven formula. We’ll also cover the difference between percentage of completion vs completed contract approaches and how to handle percentage of completion journal entries correctly.
What is the Percentage of Completion Method?
Percentage of Completion Accounting Basics
The percentage of completion method is a revenue recognition accounting concept that assesses knowing how to realize revenue periodically over a long-term project or contract. We recognize revenue, expenses and gross profit in each period based on the percentage of work completed or costs incurred rather than waiting until project completion.
This method falls in line with IFRS 15, which indicates that revenue from performance obligations recognized over a period of time should be based on the percentage of completion. The approach recognizes revenues and expenses in proportion to the contracted project’s completeness.
Two conditions must be met before you can use percentage of completion accounting. Collections by the company must be reasonably assured. Costs and project completion must be reasonably estimated. This method cannot be properly implemented without reliable estimates of total project costs and knowing how to accurately measure work progress throughout the contract period.
The cost-to-cost approach is how the percentage of completion method is measured most often. This calculation bases the percentage of completion on the costs incurred relative to the estimated total cost needed to complete the project. Three fundamental components drive this method: the total contract price (the agreed-on amount the customer will pay), total estimated costs (the company’s projection of all costs) and costs incurred to date (the actual expenses incurred up to the current point).
Percentage of Completion vs Completed Contract Method
The completed contract method defers the recognition of both revenue and expenses until the project is completed. This approach can obscure a company’s financial performance during long-term projects and potentially lead to less accurate interim financial statements, though it is simpler.
Think about a construction company working on a three-year, $10 million project. The company would show no revenue for the first two years with the completed contract method, even though it’s actively working and incurring costs, then recognize all $10 million in the third year. The company would recognize revenue proportionally as work progresses with percentage of completion accounting.
When to Use This Method
The percentage of completion method is especially suitable for companies working on long-term projects with identifiable stages or milestones. This method is standard in industries like construction (building construction, infrastructure projects and civil engineering), manufacturing (large-scale manufacturing projects with extended production cycles) and engineering (projects with design, development and construction). Defense contractors working on multi-year commitments, such as nuclear submarines or aircraft carriers, also use this method. The product must be a significant custom-designed project for a client for software developers.
How to Calculate Percentage of Completion Method
The Cost-to-Cost Formula
The cost-to-cost method calculates completion by comparing costs incurred to date against total estimated costs. The formula: Percent complete = Total costs to date ÷ total estimated costs. To name just one example, if you’ve incurred $400,000 in costs on a project with estimated total costs of $800,000, the calculation shows the project is 50% complete ($400,000 / $800,000 x 100).
Three components drive this calculation: total contract price (the agreed amount), total estimated costs (projected costs for completion), and costs incurred to date (actual expenses up to the current point). The cost-to-cost approach assumes construction costs are the contract’s primary driver and therefore provide the most accurate way to measure progress.
Revenue Recognition Calculation
Once you determine the percentage complete, apply it to the total contract price to calculate cumulative revenue to date. The formula: Revenue Earned to Date = Percent Complete x Total Contract Price. A project that is 50% complete with a contract value of $120,000 would record revenue of $60,000.
Subtract previously recognized revenue to determine current period revenue for subsequent periods. A project that reaches 35% completion in year two after being 20% complete in year one recognizes only the additional 15% revenue in the second year.
Work in Progress (WIP) Schedule
A WIP schedule tracks four components: contract price (including change orders), total estimated cost of construction, costs of construction to date, and progress billings. The schedule calculates whether a project is overbilled or underbilled using this formula: Overbilling or Underbilling = Revenue Earned to Date – Progress Billings.
A positive value represents underbilling, meaning you’ve earned more revenue than billed. This appears on the balance sheet as an asset. A negative value represents overbilling and is recorded as a liability because you’ve billed in advance for work yet to be performed.
Percentage of Completion Method Example
Think about a $20 million bridge construction contract with estimated costs of $15 million over three years. Year one saw costs incurred of $5 million, making the project 33% complete ($5 million / $15 million). Revenue recognized equals 33% x $20 million = $6.6 million. The gross profit for year one is $6.6 million – $5 million = $1.6 million.
Year two brought costs incurred totaling $2 million additional, bringing cumulative costs to $7 million, or 47% complete. Revenue recognized for year two is $2.8 million (47% x $20 million – $6.6 million previously recognized).
Percentage of Completion Journal Entries and Financial Reporting
Recording Revenue and Expenses
Journal entries under percentage of completion accounting involve three core accounts: Construction in Progress (asset account), Construction Revenue (income statement account), and Billings on Construction in Progress (liability account). Costs get debited to Construction in Progress as they accumulate. Revenue recognition happens through debiting Construction in Progress for gross profit and Construction Expenses for costs incurred, while crediting Construction Revenue for the earned amount. Progress billings are recorded by debiting Accounts Receivable and crediting Billings on Construction in Progress.
Overbilling vs Underbilling
Overbilling occurs when billings exceed recognized revenue and creates a current liability on the balance sheet. Underbilling happens when earned revenue surpasses billings and gets recorded as a current asset. Income recognized beyond billed amounts appears as ‘contract work in progress’ (current asset), while billed amounts exceeding recognized income show as ‘advance billings on contracts’ (current liability).
Balance Sheet and Income Statement Impact
Revenue and expenses appear on the income statement based on completion percentage. The balance sheet reflects overbillings as liabilities and underbillings as assets. This treatment will give revenue that matches actual work performed rather than billing amounts.
GAAP and IRS Requirements
GAAP mandates percentage of completion accounting for long-term contracts under ASC 606. The IRS requires this method for contractors unless they qualify for the small contractor exception: average gross receipts of $25 million or less over three years (adjusted to $29 million for 2023) and contracts completed within two years.
Risks and Challenges with Percentage of Completion
Estimation Accuracy Issues
Estimating costs requires subjective judgment. This creates risk for unintentional errors and intentional manipulation. Small inaccuracies in projected costs can substantially affect reported revenue, distorting financial results and damaging credibility with lenders or stakeholders. Understated projected costs may cause revenue to be overstated early in projects, only to reverse later. The consequences can be severe. Toshiba Corp. understated operating costs by about $1.20 billion between 2008 and 2014. The CEO was forced to resign and half the Board of Directors had to step down.
Change Order Management
Change orders complicate percentage of completion accounting substantially. Income recognition ties to updated contract values and cost estimates. Contractors must revise budgets and forecasts as soon as changes are approved. The percentage complete becomes accurate if change orders are entered promptly into the system. Delays in recording changes distort the completion percentage and lead to overstated or understated revenue.
Cash Flow Disconnects
Revenue recognized under percentage of completion accounting is different from actual cash collected. You may show strong earnings while facing cash constraints due to billing timing or delayed payments. Billings that exceed recognized revenue (overbilling) will make it hard to cover remaining costs as projects continue. The opposite scenario, underbilling, means you’ve completed work but haven’t requested payment. You’re forced to finance projects using your own capital.
Ethical Considerations and Compliance
The method is vulnerable to manipulation by those engaging in creative accounting. They can shift income and expenses between periods with ease. Common abuses include cost shifting between projects and front-loading profits. Booking costs outside POC calculations to maintain project profitability artificially is another abuse. Red flags include stable profit margins that stay consistent during fluctuating costs, proportionally low risk contingencies, and poorly documented processes.
Conclusion
The percentage of completion method provides the most accurate financial picture for long-term construction projects. In fact, becoming skilled at this approach helps you recognize revenue proportionally, maintain compliance with GAAP and IRS requirements, and make better business decisions throughout project lifecycles.
In spite of that, success depends on accurate cost estimation and diligent tracking. We recommend implementing reliable WIP reporting systems and reviewing your estimates often. Correct application of this method will help you learn more about project profitability and strengthen your financial position with stakeholders.
Key Takeaways
The percentage of completion method is essential for contractors managing long-term projects, providing accurate financial reporting and regulatory compliance while requiring careful implementation.
• Use cost-to-cost formula for accurate tracking: Calculate completion percentage by dividing costs incurred to date by total estimated project costs to recognize revenue proportionally.
• Required for most contractors by IRS: Companies with average gross receipts over $29 million (2023) must use this method for contracts extending beyond two years.
• Monitor overbilling vs underbilling carefully: Track whether billings exceed earned revenue (liability) or earned revenue exceeds billings (asset) to maintain healthy cash flow.
• Accurate cost estimation is critical: Small errors in projected costs can materially distort revenue recognition, making reliable budgeting and change order management essential for success.
• Implement robust WIP reporting systems: Regular work-in-progress schedules help track contract price, estimated costs, actual costs, and progress billings to ensure compliance and profitability.
This method transforms how contractors view project profitability by matching revenue recognition with actual work performed, providing stakeholders with a clearer picture of financial performance throughout the construction lifecycle.
FAQs
Q1. Is the percentage of completion method still allowed for contractors? Yes, the percentage of completion method is still allowed and widely used in construction accounting. In fact, it’s the standard approach for long-term construction projects and is required by both GAAP under ASC 606 and the IRS for most contractors, unless they qualify for the small contractor exception.
Q2. Does the IRS require contractors to use the percentage of completion method? Yes, the IRS generally requires contractors to use the percentage of completion method for long-term construction contracts. The requirement applies unless you qualify for the small contractor exception, which is available to companies with average gross receipts of $29 million or less (2023 adjusted amount) over three years and contracts completed within two years.
Q3. How do you calculate the percentage of completion for a construction project? To calculate the percentage of completion, divide the total costs incurred to date by the total estimated costs for the entire project. This gives you the completion percentage. Then multiply this percentage by the total contract amount to determine how much revenue you should recognize. For example, if you’ve spent $400,000 on a project with estimated total costs of $800,000, the project is 50% complete.
Q4. What is the difference between overbilling and underbilling in percentage of completion accounting? Overbilling occurs when progress billings exceed recognized revenue, creating a liability on your balance sheet because you’ve billed for work not yet performed. Underbilling happens when earned revenue surpasses billings, appearing as an asset because you’ve completed work but haven’t yet requested payment. Both situations impact cash flow and should be monitored carefully.
Q5. What are the main risks of using the percentage of completion method? The primary risks include estimation accuracy issues, where small errors in projected costs can materially distort revenue recognition, and cash flow disconnects between recognized revenue and actual cash collected. Additionally, the method requires careful change order management and is vulnerable to manipulation through creative accounting practices if proper controls aren’t in place.
