The Percentage of Completion Method is an accounting technique used for long-term contracts, recognizing revenues and expenses based on the work completed during the period. This article explains the method, its application, and potential misuse, using real-world examples.
What is the Percentage of Completion Method?
The Percentage of Completion Method (PCM) is an accounting approach that recognizes revenues and expenses on long-term contracts according to the percentage of work completed within a given period. In contrast to the Completed Contract Method, which defers income and expenses until project completion, PCM offers a more periodic assessment of financial performance. While commonly associated with the construction industry, other sectors also employ this method.
PCM is a valuable accounting technique used to gauge the financial progress of long-term projects. By recognizing revenues and expenses as a project advances, it provides a more accurate reflection of a company’s financial health. The Completed Contract Method, on the other hand, defers the reporting of income and expenses until a project reaches its completion, which may not be suitable for businesses with extended contracts.
Understanding the Percentage of Completion Method
PCM requires businesses to report revenues and expenses on a period-by-period basis, based on the percentage of contract completion. The income and expenses are compared with total estimated costs, influencing tax liabilities for the year. For instance, if a project is 20% complete in the first year and 35% complete in the second year, only the additional 15% of revenue is recognized in the second year. The balance sheet treatment is similar to the Completed Contract Method.
This method ensures a more accurate representation of a company’s financial situation, which is crucial for both internal and external stakeholders. It offers insights into the progress of projects and allows for timely adjustments in financial reporting. By assessing income and expenses in this manner, businesses can plan for tax liabilities more effectively.
Conditions for using PCM
Two primary conditions must be met for using the Percentage of Completion Method. First, the company must have a reasonable assurance of collections. This means that the company should be confident in its ability to collect payments for the work completed. Second, the company must be capable of reasonably estimating costs and project completion rates. This requirement ensures that the company can make accurate predictions about the project’s progress and costs.
These conditions are essential to maintain the integrity of financial reporting. Without a reasonable assurance of collections and the ability to estimate costs accurately, the use of PCM may not be appropriate.
Examples of the Percentage of Completion Method
PCM is commonly employed by construction firms involved in long-term projects such as building, energy facilities, and public infrastructure. It’s also utilized by defense contractors and software developers for projects requiring multi-year commitments. For software developers, the project must be custom-designed for a client.
For example, Fluor Corporation, a global engineering and construction firm, provides insights into its use of PCM in its 10-K filing under “Note 1 – Major Accounting Policies” of the notes to the consolidated financial statements. In this document, analysts can learn that changes to total estimated contract costs or losses are recognized in the period in which they are determined by the company. Income recognized in excess of billed amounts is booked as a current asset under “contract work in progress,” and billed amounts to clients in excess of income recognized to date are booked as a current liability under “advance billings on contracts.” This example illustrates the practical application of PCM in a real-world business context.
Potential for abuse of the Percentage of Completion Method
PCM is susceptible to abuse by unethical companies. Some may manipulate income and expenses to understate or overstate financial results across different periods. However, such practices are not sustainable, as demonstrated by Toshiba Corp.’s 2015 scandal when it understated operating costs by approximately 152 billion yen ($1.2 billion) between 2008 and 2014, leading to the resignation of the CEO and half the Board of Directors.
It’s important to highlight that while PCM is a valuable accounting method, its integrity relies on ethical practices. Unethical manipulation can lead to severe consequences, damaging a company’s reputation and leading to legal actions. Companies should use PCM responsibly and transparently to provide accurate financial information to stakeholders.
The bottom line
The Percentage of Completion Method is a vital tool for businesses, especially those engaged in long-term contracts. It offers a more accurate and periodic assessment of financial performance compared to the Completed Contract Method. By understanding the conditions for its use and the potential for misuse, companies can make informed decisions when implementing this method. It’s crucial to use PCM ethically and responsibly, ensuring the accuracy and transparency of financial reporting, which ultimately builds trust among stakeholders.
Here is a list of the benefits and drawbacks to consider.
- Periodic financial assessment
- Accurate income recognition
- Relevant for long-term projects
- Potential for manipulation
- Not suitable for all industries
- Complex accounting requirements
Frequently asked questions
How does the Percentage of Completion Method work?
PCM recognizes revenues and expenses based on the percentage of work completed within a specific period. This allows for a more accurate reflection of financial performance on long-term contracts.
Which industries commonly use the Percentage of Completion Method?
The construction industry, defense contractors, and software developers working on extended projects are among the key users of PCM.
What are the conditions for using PCM?
PCM requires reasonable assurance of collections and the ability to estimate costs and project completion rates with reasonable accuracy.
Can PCM be manipulated for financial gain?
Yes, unethical companies may attempt to manipulate PCM to boost short-term results, but such practices are typically unsustainable and can lead to legal consequences.
Why is accurate income recognition important in long-term contracts?
Accurate income recognition helps maintain transparency and fairness in financial reporting, which is crucial for stakeholders and investors.
- Percentage of Completion Method tracks financial performance on long-term contracts based on the work completed in a specific period.
- Two key conditions for using PCM are reasonable assurance of collections and the ability to estimate costs and project completion rates accurately.
- It is commonly used in the construction industry, defense contracting, and software development for extended projects.
- PCM can be manipulated by unethical companies but is not a sustainable practice.
- Accurate income recognition is essential for transparency and stakeholder trust.
View Article Sources
- 26 CFR § 1.460-1 – Percentage of completion method – Legal Information Institute
- 26 CFR § 1.460-4 – Percentage of Completion Method; Alternative Conditions – Cornell Law School
- Unearned Revenue Definition – SuperMoney