If your business handles projects that take longer than a year to complete, you’ll need the “percentage-of-completion” method to recognize the associated revenue.
Let’s get into how and why to do this.
Percentage-of-completion vs. completed contract
Individuals and businesses who perform work on long-term contracts—like developers, engineering firms, creative agencies, and homebuilders—typically report financial performance with one of the two following methods:
- Percentage-of-completion: Revenue recognition is tied to the incurrence of job costs.
- Completed contract: Revenue and expenses are recorded upon completion of the contract terms.
Per U.S. Generally Accepted Accounting Principles (GAAP), companies that can make a “sufficiently dependable” estimate must use the more complicated percentage-of-completion method.
Those who use this method for reporting typically use the same method for taxes, as well.
However, the federal tax code makes an exception for certain small contractors with average gross receipts of less than a certain amount over the previous three years.
For 2023, this amount is $29 million, and the number is adjusted annually for inflation.
Estimating percentage-of-completion
Typically, companies that use the percentage-of-completion method report income sooner than those that use the completed contract method.
To estimate how much of a project is complete, companies usually compare the actual costs incurred to their total expected cost. Job cost allocation policies, change orders, and changes in estimates can complicate the process.
As an alternative, some companies choose to estimate the percentage completed via an annual completion factor.
In either scenario, the IRS requires detailed documentation to support estimates used in the percentage-of-completion method.
Balance sheet impacts
If your company uses the percentage-of-completion method, you’ll see an impact on your balance sheet.
You’ll report an asset for costs in excess of billings if you underbill customers based on the percentage of costs incurred. On the other hand, you’ll report a liability for billings in excess of costs if you overbill based on the costs incurred.
Imagine you’re working on a two-year projected valued at $1 million. You incur half of the expected costs in Year 1 ($400,000) and bill the customer $450,000. From a cash perspective, it appears as if you’re $50,000 ahead because you’ve collected more than the costs you’ve incurred. In reality, you’ve underbilled based on the percentage of costs incurred.
At the end of Year 1, you would have reported $500,000 in revenue, $400,000 in costs, and an asset for costs in excess of billings of $50,000. However, if you’d billed the customer $550,000, you’d report a $50,000 liability for billings in excess of costs.
Questions? Smolin can help.
The percentage-of-completion method can be complicated. Still, if your estimates are reliable, this method provides a more accurate picture of the financial performance of your long-term contracts.
If you’d like extra help navigating the percentage-of-completion method and interpreting the insights it provides, contact the helpful team at Smolin.