Percentage-of-completion method

'Percentage of completion (PoC) is an accounting method of work-in-progress evaluation, for recording long-term contracts. GAAP allows another method of revenue recognition for long-term construction contracts, the completed-contract method.

When to use

The accounting for long term contracts using the percentage of completion method is an exception to the basic realization principale. It is based on determining the revenues based on the costs incurred so far. The percentage of completion method is used when:

• Collections are assured
• The accounting system can:

1. Estimate profitability
2. Measure progress toward completion.

Losses are recognized in the year when they are discovered, the same way as for the completed contract method. The balance sheet presentation is the same as in the completed contract method.

Formulas used

Revenues and gross profit are recognized each period based on the construction progress-in other words, the percentage of completion. construction costs plus gross profit earned to date are accumulated in an inventory account (construction in process, also called construction in progress), and progress billings are accumulated in a contra inventory account (billing on construction in process).

Although the formula for recognizing income in the current period can vary, a widely accepted one is as follows:

$Inc_{k}=[{\frac {\sum _{i=1}^{m}Costs_{i}}{\sum _{i=1}^{N}E(Costs_{i})}}\cdot [\sum _{i=1}^{N}Revenues_{i}-\sum _{i=1}^{N}E(Costs_{i})]]-\sum _{i=1}^{m-1}Inc_{i}.\,$

where... $m=\,$ the number of periods lapsed since the inception of the contract.

$N=\,$ the expected length of the contract.

$k=\,$ the current period.

Examples

For example lets say our total estimated cost for the contract is $10,000 and our contract value is $12,000. We know that project will be completed in 4 years. Now after first year we see that total cost incurred in first year is $3,000. So according to PoC method- Cost percentage = 3000/10000 = 30% So we will recognize 30% revenue in first year's income statement.

Income statement of AnantPurohit corporation Pvt. Ltd. for the year ended on xx/yy/zzzz

Sales	3,600 (30% of 12,000)
Cost of goods	3,000
Profit	600

from next year, some more complicated part enters in the game Lets say after completion of the second year, our expected cost changed to 11,000 and our cost to date is 5,500 then percentage completed = 5,500/11,000 = 50% Revenue to be recognized = (50% of 12,000) – 3,600 (previously recognized) = 2,400

Income statement of AnantPurohit corporation Pvt. Ltd. for the year ended on xx/yy/zzzz+1

Sales	2,400
Cost of goods	2,500 (5,500 till date – 3,000 last year)
Loss	100

Now let's say for the next year, our total cost estimation is increased to 15,000 due to increases in raw material and labor costs. So we know that we are going to incur a loss of 3000 at the end of contract period. For third year our cost to date reaches 10,500 so according to Poc- Percentage completion = 10,500/15,000 = 70% Revenue = 70% of 12,000 – previously recognized = 8,400 – 6,000 = 2,400 However, because we are going to have a total loss of 3,000 on the contract, we must recognize the total loss in the period it is estimated. As a result, our Cost of goods will be 5,900 (total loss recognized because of 500 profit recognized in previous periods [3,500] + Sales [2,400]); we reached this inductively by figuring the Sales and the Loss before the Cost of goods.

Income statement of AnantPurohit corporation Pvt. Ltd. for the year ended on xx/yy/zzzz+2

Sales	2,400
Cost of goods	5,900
Loss	3,500

In final year, our cost is 4,500 and revenue is 3,600. But we record only 3,600 in Cost of goods because we already recognized the total loss in the last period.

Sales	3,600
Cost of goods	3,600
Profit/loss	0

Total Profit/Loss from the contract = 600-100-3,500= 3,000 Net Loss

External links

• Percentage-Of-Completion Method at Answers.com