The Percentage of Completion Method (PCM) is an accounting technique used primarily for long-term contracts such as construction projects. This method allows for the recognition of revenues, expenses, and profits in proportion to the work completed on the project.
Formula and Calculation
To calculate the percentage of completion, the following formula is commonly used:
Revenue and Expense Recognition
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Recognizing Revenue: Revenue is recognized based on the percentage of the project that is completed during the accounting period.
$$ \text{Revenue Recognized} = \text{Total Contract Value} \times \text{Percentage of Completion} $$ -
Recognizing Expenses: Similar to revenues, expenses are also recognized in line with the percentage of work completed.
$$ \text{Expenses Recognized} = \text{Total Estimated Costs} \times \text{Percentage of Completion} $$
Types of Projects Suitable for PCM
- Construction Projects: Typically extended over multiple years.
- Large Manufacturing Contracts: Including military and aerospace projects.
- Software Development: When the development period spans over several accounting periods.
Special Considerations
- Accuracy of Estimates: The accuracy of reported figures heavily depends on reliable estimates of total costs and project progress.
- Continuous Review: Estimates should be reviewed periodically and adjusted as necessary, reflecting any changes in project scope or cost accruals.
- Compliance with GAAP and IFRS: PCM is recognized under Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) but requires thorough documentation and justification.
Example Scenario
Calculation Example
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Project Background: A construction company has a $10 million contract to build a commercial building. Halfway through the project, $4 million has been spent, and the total estimated cost is $8 million.
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Calculations:
$$ \text{Percentage of Completion} = \frac{4,000,000}{8,000,000} = 50\% $$$$ \text{Revenue Recognized} = 10,000,000 \times 0.50 = 5,000,000 $$$$ \text{Expenses Recognized} = 8,000,000 \times 0.50 = 4,000,000 $$Thus, the company would recognize $5 million in revenue and $4 million in expenses.
Historical Context
The concept of PCM dates back to the early 20th century as large-scale construction projects necessitated a more accurate reflection of ongoing work in financial records. Over time, PCM has become an integral part of accounting standards and practices for many industries engaged in long-term contracts.
Applicability
- Financial Reporting: Ensures timely and proportional recognition of revenues and expenses.
- Project Management: Facilitates tracking project progress and financial health consistently over time.
- Stakeholder Communication: Provides transparency and regular updates to stakeholders on project performance.
Comparisons with Completed Contract Method (CCM)
- PCM reports revenues and expenses as work progresses.
- CCM defers recognition until the project is fully completed.
Related Terms
- Completed Contract Method (CCM): An alternative method recognizing revenue only once the entire contract is completed.
- Cost-To-Cost Method: A variation where revenue is recognized based on the ratio of costs incurred to total estimated costs.
FAQs
Q1: What are the key benefits of using PCM?
Q2: What are the risks associated with PCM?
References
- Generally Accepted Accounting Principles (GAAP)
- International Financial Reporting Standards (IFRS)
- Financial Accounting Standards Board (FASB)
Summary
The Percentage of Completion Method offers a balanced approach to accounting for long-term contracts, reflecting ongoing project progress. Through careful estimation and regular review, PCM ensures that financial statements provide a true and fair view of a company’s performance and financial position over extended periods. This method is crucial for industries where project timelines extend over multiple fiscal periods, promoting transparency and accuracy in financial reporting.
