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How to Use Percentage-of-Completion Accounting

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How to Use Percentage-of-Completion Accounting

In the simplest sense, a ratio of the percentage of completion is determined and applied to the expected gross profit on the contract to determine the gross profit and revenue to be recognized in the financial statements.


By Steve Maltzman November 30, 2002
Percentage of completion accounting | Sketches of graphs and charts | Image by Pathdoc/Stock.Adobe.com
Image by Pathdoc/Stock.Adobe.com
This article first appeared in the PB December 2002 issue of Pro Builder.

Jones Builders just obtained a contract for $500,000 to build a home for Mr. & Mrs. Smith. Jones estimates his total cost on the job to be $400,000. During the first month of the job, the following transactions occur:

  1. Cash of $10,000 is paid for permits, fees and other startup costs.
  2. An invoice is received from the excavation subcontractor for $10,000.
  3. The first progress billing is prepared for $60,000.

If the above transactions were the only ones Jones Builders had for the month, its income statements under each accounting method would look like this:

 

 
Cash
Accrual
Completed
Contract
% of
Completion
Revenue
$0
$60,000
$0
$25,000
Costs
10,000
20,000
0
20,000
Gross Profit
$(10,000)
$40,000
$0
$5,000

Under the accrual method, revenue earned equals the amount invoiced on the first progress billing ($60,000). Revenue under the percentage-of-completion method was computed as follows:

  1. Calculate what percentage of the job is complete.
  2. Calculate the amount of revenue to be earned.

  3. Costs to date / total estimated costs = % complete
    $20,000 / $400,000 = 5% complete


    Contract amount x % complete = revenue earned
    $500,000 x 5% = $25,000

By examining the four income statements, you see that the percentage-of-completion method best reflects the company's revenue, costs and gross profit for the period. If the president of Jones Builders received an accrual-basis statement, he might think the company is really prospering (the job is only 5% complete, and the company already made $40,000).

However, this statement does not give a true picture of the company's profitability as of the end of the month. Because the job was only 5% complete, only 5% ($5,000) of the total projected gross profit ($100,000) has been earned.

However, the costs and revenues calculated in this method are at best still estimates of the job's true outcome. For this reason, care should be taken when determining job progress.

Mechanics of Percentage-of-Completion Accounting

In the simplest sense, a ratio of the percentage of completion is determined and applied to the expected gross profit on the contract to determine the gross profit and revenue to be recognized in the financial statements.

Two typical methods of measuring the percentage of completion are:

  • The cost-ratio method, which uses the ratio of actual contract costs incurred during the reporting period to total estimated contract costs.
  • The effort-expended method, which uses the ratio of some measure of the work input during the reporting period, such as labor hours, machine hours or material quantities, to the total units of that measure of work required to complete the contract. This method assumes that profits on the contract are derived from the contractor's efforts rather than from the acquisition of materials or other tangible items.

Many other techniques will be found in practice, including combinations of the above, or the application of these methods to different phases and cost codes of the same contract.

For a remodeler, the most important subsidiary ledger is job cost, which accumulates the costs for each job. The sum of the costs entered in this ledger must agree with the general ledger for a variety of reasons:

  • When jobs cross year-ends, the job-cost subsidiary ledger survives the closing of the books for the year and is the only record covering the entire life of the job.
  • It is the only reliable way of actually keeping track of cost on a job because it is controlled by the general ledger's balancing system (part of internal control).

Under the percentage-of-completion method, all cost and progress billing against a contract are accumulated in revenue and cost accounts of the general ledger and the job-cost ledger until the period in which the contract is completed, at which time the costs and billings are transferred to income and expense accounts and the job's subsidiary record is closed out.

At the end of the accounting period, an adjusting journal entry must be prepared to adjust the revenue recognized on jobs that are in progress based upon the estimated percentage of job completion as of that date. That journal entry is reversed on the first day of the next reporting period.

In computing percentage of completion, only four items need to be pulled from your job-cost accounting records.

  • Cost to date = total costs incurred on the job from inception through the end of the accounting period.
  • Billings to date = total billings (draws) taken on the job from inception through the end of the accounting period.
  • Current contract = original contract plus change orders executed through the end of the accounting period.
  • Total estimated costs = current estimate of total anticipated costs on the job. This estimate should be updated to account for any projected budget overruns or underruns as well as include estimated costs on all change orders included within the current contract amount.

The mechanics of making the adjusting entry consist of the following:

  • The amount of revenue to be recognized for the period is computed by multiplying the completion percentage (determined by whatever method is appropriate for the contract) by the current contract amount. Using the cost-ratio method (the simplest to use), completion percentage is computed by dividing total estimated costs by costs to date.
  • The revenue to be recognized for the period is subtracted from the revenue posted to the job-revenue account (billings to date). This difference is posted to either Account 248, Billings in Excess of Costs, or Account 126, Costs in Excess of Billings.

Dr. Sales (Revenue)
   Cr. Billings in Excess of Cost

When billings exceed revenue recognized, or

Dr. Costs in Excess of Billings
   Cr. Sales (Revenue)

When revenue recognized exceeds billing.

Steve Maltzman is president of Steve Maltzman & Associates, which provides financial and business management services exclusively for the construction industry. 

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