Percentage of Completion Method
Small business owners know how vital accurate accounting is. When you can confidently keep up your accounting books and know how much money is in your accounts at all times, you'll find it easier to understand how to invest to grow your business. You'll also have a better grasp of how your business strategies work and your overall financial health.
As you begin to learn about small business accounting, you'll see there are a few accounting methods that you can use to manage your books. One method is known as the percentage of completion (POC) method. We'll review how to use this particular accounting method so that you can determine if it will work well for you and your business's needs. Here's what you need to know.
What Is the Percentage of Completion Method?
The percentage of completion method helps demonstrate the revenue your business has generated and the expenses it has incurred throughout the completion of a long-term contract, which can help predict tax liabilities for the year. This method of accounting and revenue recognition generally works best for business models that focus on long projects and can provide reasonable estimates of job costs and revenue at different points in a project.
For example, consider the construction accounting needs of a company awarded a contract to construct a new office building. The project is expected to take four years and cost $6 million. The estimated cost for the company to build the building will be $4 million.
Therefore, the company can estimate that after each year, it will complete about 25% of the project. Thus, the business will have spent $1 million in construction and collected about $1.5 million from the client. This means that the business owners can list their yearly profits at $500,000 for each year.
The company's certified public accountant (CPA) or chief financial officer (CFO) can then use this contract value to clearly report their earnings on the long-term project. This can provide guidance for tax purposes before project completion.
Percentage of Completion Method vs. Completed Contract Method
The percentage of completion method and the completed contract method both provide a means of managing the accounting balance sheet and financial statements for long-term contracts. However, as discussed, the percentage of completion method estimates the revenue and cost of the project for a particular accounting period throughout the contract. On the other hand, the completed contract method only considers the revenue and costs of the contract when the job is finished.
With the first method, the company will note its revenue with the Internal Revenue Service (IRS) throughout the project. This can consistently demonstrate the business's cash flow instead of having periods of no apparent income followed by large influxes. With the second, the business won't have to pay taxes or note revenue until the end of the project with the final income statement, which could be months or years away.
Who Uses the Percentage of Completion Method?
Under generally accepted accounting principles (GAAP), the percentage of completion method is generally used by those who work with primarily long-term contracts, such as contractors and construction companies. The method allows them to keep accurate records of their profits and revenue throughout the construction project.
The IRS does place some limitations on the types of accounting methods that different types of businesses can use. Some important rules to note are:
- A company that has more than $1 million in annual revenue must use accrual-based accounting.
- Firms in the construction industry that have contracts longer than two years must use the percentage completion method.
- The completed contract method can only be used by small contractors (who have less than $25 million in receipts over the previous three years) and who have small projects (that will be completed in less than two years). Both of these factors must be met to use the completed contract method.
- Residential contractors, under the "home construction contract" in Section 460(e)(5)(A) of the tax code, also have more flexibility with using the completed contract method.
How Do You Calculate Percentage of Completion?
Businesses interested in using the percentage of completion method will find there are a few options for calculating this accounting measure. It's important as you begin to calculate your percentage of completion that you are mindful of GAAP and International Financial Reporting Standards (IFRS) guidelines. These two sets of accounting rules aim to make accounting books transparent around the world so that people can easily understand how accounts are maintained and the financial health of businesses.
There are three main strategies that businesses can use to calculate the percentage of completion method. They each have different benefits and drawbacks depending on the type of contract you have signed and the end-product you produce. We'll review each so that you can determine the strategy that will work best for you, your business, and your contract.
The cost-to-cost method is one of the most commonly used calculations by those who use this system of accounting. With this method, the business compares the costs that it has already encountered and compares that total to the total costs expected for the job. The business will determine the percentage of the project completed by dividing the costs incurred by the job thus far by the total amount of projected costs.
In other words, it uses the following formula:
|Percentage of Work Completed|
For example, if a business has a project that will cost $20,000 by the end of the project, and the business owner has already spent $4,000, they will find the percentage of work completed by dividing $4,000 by $20,000. This will give them 20% as the percentage of work completed.
This number can then be used to find the recognized revenue thus far. If that same project is expected to bring the business $30,000, multiplying $30,000 by 20% will give the business $6,000. In other words, the estimated revenue on the project thus far is $6,000.
Efforts Expended Method
The efforts expended method calls for businesses to measure their work product based on the amount of effort their business expends. For example, they might determine effort by calculating the estimated number of work hours or machine hours required to complete the project. Some will also use this method to calculate the effort expended based on the amount of materials used to generate the products for the project.
For example, if you have a project that you estimated will take 30,000 manual labor hours, and you have completed 10,000 hours thus far, you will divide 10,000 by 30,000 to get 33% of the project completed.
To determine your estimated revenue, you can multiply the 33% by the total revenue expected from the project.
The output method looks at the amount of product produced as a part of the project and how that compares to the expected amount of product to be produced.
For example, if you promised to produce 20,000 units of a particular customized pen for another business and have already delivered 10,000 units, you would divide 10,000 by 20,000. This would tell you that you have delivered 50% of the expected project.
Knowing that you have completed 50% of the work can then help you calculate the estimated amount of revenue you should have generated thus far as well.
Let Skynova Help You Manage Your Small Business Accounting
Managing challenging accounting situations, such as long-term construction contracts, can inspire businesses to learn more about the different types of accounting. As a result, they can find easier ways to navigate those situations as a taxpayer while also investing in their business. For many businesses, the percentage of completion method will work well.
When it comes to managing your accounting for your small business, Skynova is here to make the entire process more simple and straightforward. With accounting software and other software products that can help manage a variety of accounting methods, along with business templates to streamline payments, Skynova can help you confidently move forward with your accounting.
Notice to the Reader
The content within this article is meant to be used as general accounting guidelines and may not apply to your specific situation. Always consult with a professional accountant to ensure you're meeting accounting standards.