The percentage-of-completion method is an accounting technique used to recognize revenue and expenses from long-term contracts based on the proportion of work completed during a tax year. This method contrasts with the completed-contract method, where income and costs are recognized only upon the contract’s completion.
Key Concepts and Terminology
Long-Term Contracts
A long-term contract refers to any contract for the manufacture, building, installation, or construction of property that is not completed within the same tax year as its commencement.
Gross Revenue
Gross revenue is the total amount generated from the contract before any costs or expenses are subtracted.
Look-Back Rule
The look-back rule mandates taxpayers to recompute their prior-year tax liabilities when the contract is completed to correct differences between the estimated and actual costs.
Detailed Explanation
Calculating the Percentage of Completion
- Identify Contract Costs: Sum all costs allocated to the contract and incurred before the tax year’s close.
- Estimate Total Costs: Calculate the total estimated costs necessary to complete the contract.
- Determine Completion Percentage: Use the formula:
$$ \text{Percentage of Completion} = \frac{\text{Costs Incurred}}{\text{Total Estimated Costs}} \times 100 $$
- Apply to Gross Revenue: The derived percentage is then applied to the gross revenue of the contract to ascertain the portion to include in taxable income.
Example
Assume Company A enters a contract with a total projected cost of $1,000,000. By the end of the tax year, the company incurs $400,000.
- Completion Percentage:
$$ \frac{\$400,000}{\$1,000,000} \times 100 = 40\% $$
- Revenue Recognition: If the total contract value is $1,200,000, 40% of this, which equates to $480,000, will be included in taxable income for the year.
Special Considerations
Advantages
- More accurate reflection of the financial performance over the life of the project.
- Helps in smoothing income and expenses over multiple periods.
Disadvantages
- Requires significant estimation and judgment, potentially leading to inaccuracies.
- More complex and time-consuming compared to other methods.
Historical Context
The percentage-of-completion method has its roots in the construction and manufacturing industries, where projects span multiple fiscal periods. This method aligned revenue recognition more closely with the progress of the work rather than deferring it.
Applicability
- Primarily utilized in construction, engineering, and large-scale manufacturing industries.
- Suitable for projects with predictable costs and timelines.
Comparisons to Other Methods
Completed-Contract Method
- Revenue and expenses are recognized only upon contract completion.
- Simpler but may lead to large income fluctuations between years.
Accrual Method
- Revenue and expenses are recognized when earned or incurred, regardless of actual cash flow.
Related Terms
- Percentage-of-Completion Capitalization: Costs are sometimes capitalized based on completion percentage.
- Revenue Recognition Principle: Framework for recognizing revenue in financial statements.
- Deferred Revenue: Money received for goods or services yet to be delivered.
FAQs
What industries typically use the percentage-of-completion method?
How does the look-back rule impact the percentage-of-completion method?
What are the key advantages of using the percentage-of-completion method?
References
- Financial Accounting Standards Board (FASB) guidelines
- Internal Revenue Service (IRS) publications on long-term contract accounting
- Generally Accepted Accounting Principles (GAAP)
Summary
The percentage-of-completion method is a vital accounting technique used predominantly in industries with long-term projects. It offers an enhanced view of ongoing project performance by accounting for revenues and costs proportionate to the work completed. Despite its complexity, the method provides significant insight and smoother financial tracking, supporting better strategic and operational decision-making.
