Percentage-of-Completion Revenue Recognition
Percentage-of-completion accounting recognizes revenue on a long-term project gradually, in proportion to how much of the work is actually done, rather than waiting until the entire contract is finished.
Prerequisites: Revenue Recognition
Some contracts — building a bridge, constructing a plant, developing custom software — span years. Percentage-of-completion accounting recognizes a slice of the total contract revenue and profit each period, in proportion to how much of the work has actually been completed, rather than recognizing nothing until the entire project is delivered at the end.
Percentage-of-completion recognizes revenue as , so a project 40% of the way through its estimated costs books roughly 40% of its expected revenue and profit that period, matching income to the work actually performed rather than to the delivery date.
Why it exists
Waiting until the very end of a multi-year contract to book any revenue would make a company's income statement look artificially lumpy and uninformative — several years of real activity followed by one giant revenue spike. Recognizing revenue as work progresses gives a truer picture of the economic activity happening each period, as long as costs and progress can be reliably estimated.
Worked example
A construction firm signs a $10 million contract expected to cost $8 million to complete. By the end of year one, it has incurred $2 million of costs — 25% of the estimated total. It therefore recognizes 25% of the $10 million contract value, or $2.5 million, as revenue for the year, and $2 million of costs, for a reported gross profit of $500,000, even though the project won't be delivered to the customer for another two years.
The whole method rests on cost estimates that can be wrong or manipulated — underestimating total costs makes a project look further along (and more profitable) than it really is, which is why sudden, large revisions to a project's estimated total cost are a red flag worth investigating in the footnotes.
Further reading
- FASB ASC 606, Revenue from Contracts with Customers