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The Percentage-of-Completion Method
The percentage-of-completion method is generally the required method of financial and tax accounting of larger construction companies for long-term contracts. Its justification relies largely on the matching principle in accounting, where revenues and expenses are matched in the applicable accounting period. The percentage-of-completion method attempts to recognize revenues and gross profit in the applicable periods of construction, and not soley in the period when the construction has been completed, as in the completed contract method. The degree of completion of the construction, i.e., the percentage-of-completion, is typically estimated by dividing the total construction costs incurred to date by the total estimated costs of the contract, or job.
% complete = Total construction costs to date/Total estimated costs of contract
Total estimated revenues or gross profit is then multiplied by this percentage of completion to derive the total revenues or gross profit that have been earned to date.
Gross profit to date = % complete X Total estimated gross profit
The journal entry required to recognize the current year's revenues or gross profit is the difference between total revenues or gross profit earned to date less revenues or gross profit recognized in prior years.
Current year's gross profit = Gross profit to date - Gross profit in prior years
To illustrate the accounting under the percentage-of-completion method of constructing accounting, assume the following:
Contract = $100,000 Total estimated costs = $80,000 Year 1 costs = $20,000 Year 1 billings = $30,000 Year 2 costs = $40,000 Year 2 billings = $50,000During year 1, costs are accumulated in an asset account typically entitled Construction in Process (CIP):
Construction in Process 20,000 Accounts Payable (or Cash) 20,000During year 1, billings are posted to a contra account to Construction in Process, often entitled Progress Billings:
Contracts Receivable 30,000 Progress Billings 30,000To compute the percentage of completion, one divides the costs to date by the total estimated costs:
% complete = 20,000/80,000 = 25%
Of course, total estimated gross profit is merely the difference between the contract price less total estimated costs:
Total estimated gross profit = 100,000 - 80,000 = 20,000
Gross profit to date is computed multiplying the percent complete by the estimated gross profit:
Gross profit to date = 25% X 20,000 = 5,000
The following journal entry is made to reflect the gross profit, revenues and expenses on the contract for year 1:
Construction in Process 5,000 Construction Expenses 20,000 Construction Revenues 25,000For year 2, gross profit is derived as follows:
% complete = 60,000/80,000 = 75%
Current year's gross profit = 75% X 20,000 - 5,000 = 10,000
And the following journal entry is made to reflect the gross profit, revenues and expenses on the contract for year 2:
Construction in Process 10,000 Construction Expenses 40,000 Construction Revenues 50,000Of course, the above illustration is a very simplified example of the percentage-of-completion method ignoring many events, including change orders, changes in estimates, and the like.
