The percentage of completion method is used to calculate the amount of revenue and therefore income that can be recognized by a business on long-term construction project. The method is in accordance with the matching or accruals concept of accounting, and ensures that the costs incurred on the project are matched to the revenues arising from that project.
In summary the method calculates the percentage completion of the project by taking the ratio of costs incurred to date to the total estimated costs, and applies that percentage to the estimated total revenue arising from the project.
Percentage of Completion Method Calculation
The degree to which a project is completed can be calculated using the percentage of completion formula.
For example, if the estimated total costs for a long term project are 40,000 and the costs incurred to date are 9,000, then the percentage of completion is calculated as follows:
Percentage completion = Costs to date / Estimated total costs Percentage completion = 9,000 / 40,000 Percentage completion = 22.5%
Having calculated the percentage of completion, the next step is to apply this percentage to the estimated total revenue from the project.
Suppose in the above example, the project had total estimated revenues of 120,000, then using then percentage of completion method, the revenue to recognize is calculated as follows:
Revenue recognized = % of completion x Total estimated revenue Revenue recognized = 22.5% x 120,000 Revenue recognized = 27,000
The income recognized can now be calculated as follows:
Income recognized = Revenue recognized - Costs to date Income recognized = 27,000 - 9,000 Income recognized = 18,000
Note that the same answer could be arrived at by applying the percentage completion to the estimated total income from the project.
Estimated total income = Estimated revenue - Estimated costs Estimated total income = 120,000 - 40,000 Estimated total income = 80,000 Income recognized = % of completion x Total estimated income Income recognized = 22.5% x 80,000 Income recognized = 18,000
Percentage of Completion Method Accounting
To show how the percentage of completion method is used in practice consider the following example.
Suppose a business has a long term construction project and has incurred costs to date of 300. The following double entry bookkeeping entry would be made.
|Construction in progress||300|
The construction in progress account sometimes referred to as the construction in process account or abbreviated to CIP account, is a current asset balance sheet account and represents the cumulative costs plus income recognized to date on the project. The account is similar in nature to the work in process account used to accumulate inventory job costs.
If the estimated total costs of the project are 1,000, and the estimated total revenue from the project is 2,500, then the percentage of completion method formula can be used to calculate the revenue recognized to date as follows:
Percentage completion = Costs to date / Estimated total costs Percentage completion = 300 / 1,000 Percentage completion = 30% Revenue recognized = % of completion x Total estimated revenue Revenue recognized = 30% x 2,500 Revenue recognized = 750 Income recognized = Revenue recognized - Expenses Income recognized = 750 - 300 Income recognized = 450
The income recognized (450) is now included in the income statement by posting the revenue and expenses with the following journal:
|Construction in progress||450|
The effect of this journal is to include an amount equal to the income recognized to date as a debit to the construction in progress account. The balance on the construction in progress account is now 750, representing costs of 300 plus income recognized to date of 450, which is also the amount of recognized revenue.
Next Accounting Period
In the next accounting period, the process is repeated. Suppose the total costs incurred are now 650, the percentage of completion method is again used to calculate the income recognized to date as follows:
Percentage completion = Costs to date / Estimated total costs Percentage completion = 650 / 1,000 Percentage completion = 65% Revenue recognized = % of completion x Total estimated revenue Revenue recognized = 65% x 2,500 Revenue recognized = 1,625 Income recognized = Revenue recognized - Expenses Income recognized = 1,625 - 650 Income recognized = 975
The percentage of completion method calculates the cumulative amounts at the end of each period. The adjustments needed for the period are found by taking the difference between the amounts calculated for the current period less the amounts calculated from the previous period.
Adjustment = Current period amount - Previous period amount Cost adjustment = 650 - 300 = 350 Revenue adjustment = 1,625 - 750 = 875 Income adjustment = 975 - 450 = 525
Construction in Progress Journals
The bookkeeping journals to post these amounts to the construction in progress account are as follows:
|Construction in progress||350|
|Construction in progress||525|
The effect of this journal is to include an amount equal to the income recognized for the period as a debit to the construction in progress account. The balance on the construction in process account is now the revenue recognized of 1,625 (300 + 450 + 350 + 525) which again represents the cumulative costs plus income recognized to date.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.