The term percentage-of-completion method refers to an accounting approach that recognizes revenues and costs associated with long-term projects. The percentage-of-completion method allows companies to record revenues as progress is made toward completion of the project. A cost-to-cost calculation is typically used as the basis for determining the completion percentage.
Using a cost-to-cost method, the following calculation is used to determine the completion percentage:
Percent Complete = Cost Incurred to Date / Total Cost Estimate
The current period revenue to be recognized during production would then be:
Current Period Revenue = (Percent Complete x Total Contract Revenue) - Revenue Recognized in Prior Periods
The FASB Concept Statement No. 5 states that companies cannot recognize revenues as being earned until they are realized or realizable, and the company has substantially completed what it needs to do in order to be entitled to payment. Revenue can be recognized at the point of sale, before, and after delivery, or as part of a special sales transaction.
Long-term projects oftentimes require the buyer to make payments as certain milestones are reached. This is a common arrangement in the construction and other heavy equipment industries that might involve customized projects or products that can take years to complete or build.
The percentage-of-completion method recognizes revenues and costs each accounting period as the project progresses. Companies that use this method believe that waiting until a project is complete before recognizing the potential revenues associated with the project misaligns costs and revenues. The biggest hurdle to this approach is the ability to accurately determine the percentage of a long-term project that is complete.
The cost-to-cost method is one of the more popular approaches to solving this problem. This method first determines the percentage of the project that is complete using a ratio of the costs incurred to date to the total project costs. This value is then applied to the total revenue associated with the project.
Company A has contracted with Company Z to upgrade their customer information system. The total value of the contract with Company Z is worth $22 million, and the project is expected to take three years to complete. Company Z's internal estimate indicates the project will cost $15 million to complete. The first milestone payment from Company A does not occur until nine months into the project, but Company Z would like to recognize revenue on their income statement in their next annual report. At that point in time, Company Z would have expended $5 million in costs.
Using the percentage-of-completion method, the percentage complete would be:
= $5 million / $15 million, or 33% complete
The current period revenue would then be calculated as:
= 33% x $22 million
= $7.26 million
Note: Since this is the initial determination of revenue, there is no need to adjust this value for prior periods.