For example, let’s say a project is estimated to take three years to complete and tax laws change, leading to an increase in the business tax rate. The tax liability would be higher under the completed contract method versus using the percentage of completion approach since some of the revenue would have already been recognized. The percentage of completion method is a revenue recognition accounting concept that evaluates how to realize revenue periodically completed contract method formula over a long-term project or contract. Revenue, expenses, and gross profit are recognized each period based on the percentage of work completed or costs incurred. Below we’ll take a look at the four most common methods in construction accounting. We’ll start with a breakdown of cash basis vs. accrual accounting before looking toward the more specialized revenue recognition methods known as percentage of completion and completed contract.
Once they do, their costs and income will shift from the balance sheet to their income statement. The company would recognize 20% of the total estimated revenue and expenses for the contract based on the units delivered. Each method of the percentage of completion method has its specific application depending on the project’s characteristics and contract terms. Accounting professionals must choose the most appropriate percentage of completion method to recognize revenue and comply with applicable accounting standards. Of course, reporting income means nothing if you aren’t collecting payments. Regardless of the accounting method your construction business is using, it’s important to take steps to secure your payments on every project.
Pros and cons of accrual basis accounting
In the construction industry, your best bet is to use percentage of completion. While there are exceptions where cash basis is okay, accrual is a reliable option for companies of any size. Similarly, percentage of completion is always a trustworthy option for long-term projects.
Contractors often prefer the completed contract method when it’s tough to estimate the actual costs of a project. It’s also favored when managing multiple projects simultaneously or when a project is short-term. Construction in Process and Progress Billings will continue to accrue until the project wraps up. Once Build-It Construction completes the contract, they may finally move these onto the income statement. To clear the full contract amount from Progress Billings, they’ll perform a debit, then credit revenue. To recognize the costs of the contract, they’ll credit Construction in Progress and debit their expenses.
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Because you’ll be recording income and expenses in separate accounting periods, making it extremely challenging to understand your true financial position. Finally, the cash basis of accounting isn’t allowed under GAAP or IFRS (more on this in the next section). The percentage of completion method provides a truer financial picture for construction firms with jobs spanning multiple periods. By recognizing revenues and expenses throughout a project, it avoids the lumpiness issues of alternative accounting methods.
Under the completed contract method, contractors can defer taxes until the ongoing project is contractually complete. Instead, you’ll wait until the end of the six months as soon as you complete the contract. Only upon substantial completion will you recognize the revenue and expenses from this project. One of the most significant advantages of percentage of completion is that you can get a view on profitability before the job is complete. Another benefit is that you don’t have to wait until the end of a project to receive payment. Additionally, you can avoid a heavy cost hit at the start of the job since you won’t need to front the entire project as you’ll be receiving payment along the way as you progress through the job.