Percentage-of-Completion Capitalization is an accounting method used predominantly in long-term project work, like in construction or large-scale manufacturing projects. Under this model, costs are capitalized and revenues are recognized proportionately with the completion of the project.
How It Works
Determining Completion Percentage
The percentage-of-completion method typically uses one of the following methods to estimate the completion percentage:
- Cost-to-Cost Method:
$$ \text{Percentage Complete} = \left( \frac{\text{Total Costs Incurred to Date}}{\text{Estimated Total Costs}} \right) \times 100 $$
- Efforts-Expended Method: This method is based on the proportion of effort expended in relation to the total effort expected.
- Units-of-Delivery Method: Here, the project is divided into measurable units, and completion is determined based on the number of units delivered compared to the total number of units.
Capitalizing Costs
Under this method, costs incurred are not immediately expensed. Instead, they are capitalized as assets in progress, reflecting the work done. As the project progresses towards completion, these costs are systematically transferred to expense accounts.
Revenue and Expense Recognition
Revenues and expenses are recognized based on the completion percentage and the stage of the project. This recognition allows for a more accurate reflection of both the costs and the revenue associated with a period.
Types of Projects Using Percentage-of-Completion Capitalization
- Construction Projects: Buildings, roads, bridges, etc.
- Shipbuilding: Large maritime vessels.
- Aerospace: Aircraft and spacecraft projects.
- Software Development: Large-scale software systems.
Special Considerations
Contract Modifications
Adjustments must be made for contract modifications that change the scope, pricing, or completion date of the project.
Estimation Uncertainties
Applicability
The method is particularly useful where the project’s outcome can be reliably estimated. It provides a more realistic view of ongoing projects by capturing the financial implications as they occur, making it a valuable tool for management decision-making.
Historical Context
The percentage-of-completion method has been largely guided by standards such as U.S. GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards). This method arose from the need to provide a fair representation of a company’s financial status over long periods of project work.
Comparisons
Completed-Contract Method
Unlike the percentage-of-completion method, the completed-contract method recognizes revenues and associated costs only once the project is completed. This can lead to large variabilities in financial reporting periods, making the percentage-of-completion method preferable in most cases for ongoing projects.
Cost Recovery Method
This method involves recognizing profit only when recovered costs exceed the expenses, which is more conservative compared to the percentage-of-completion method.
Related Terms
- Work-in-Progress (WIP): A term related to projects still under construction.
- Construction-in-Progress (CIP): A specific example of WIP, often used in real estate and large infrastructure projects.
- Revenue Recognition: The principle governing the timing of revenue recognition from sales or services.
Frequently Asked Questions
Q1: What are the main benefits of the percentage-of-completion capitalization method?
A1: It provides ongoing visibility into the project’s financial status, aligning revenues and expenses with actual progress, which aids in better management decisions and financial transparency.
Q2: What are the challenges with this method?
A2: The primary challenge is the accurate estimation of total project costs and progress, which can lead to necessary adjustments and corrections.
References
- Financial Accounting Standards Board (FASB). “Codification Topic 605 - Revenue Recognition.”
- International Financial Reporting Standards (IFRS). “IAS 11 - Construction Contracts.”
- Accounting textbooks and professional publications detailing best practices in project accounting.
Summary
Percentage-of-Completion Capitalization is a sophisticated accounting method that ensures the financial reporting of long-term projects aligns with their actual progress. By capitalizing costs based on completion percentage, it provides a balanced reflection of both revenues and expenses, making it a more accurate and informative method than other project accounting alternatives.
For anyone involved in long-term projects, especially in construction, real estate, and large-scale manufacturing, understanding and implementing this accounting method can lead to better financial transparency and more informed decision-making.
