There are two methods of accounting for most construction contractors; Percentage of Completion (POC) and Completed Contract (CCM). Percentage of completion is the method utilized most by contractors. But why? What are the benefits of POC? Let’s find out!
Percentage of Completion of Method Project Accounting (POC)
POC requires the reporting of revenues and expenses on a period-by-period basis, calculated based on the percentage of the contract that has been fulfilled. The POC method should be used when collections by the company are reasonably assured and the company is reasonably able to estimate the costs and the rate of project completion.
There are various methods that can be used to measure the rate of completion; units completed, incremental milestones, cost ratio, experience, and weighted or equivalent units. One of the most common measurement methods used is cost ratio. In order to calculate the percent complete using cost ratio, divide actual costs incurred to date for the contract by the total estimated costs (actual/estimated). This is your percent complete. The amount of revenue recognized on a contract would be the total contract amount multiplied by the percent complete. If you have already billed some of this contract, you would adjust revenue for the difference between the billings and the revenue that should be recognized. If revenue is greater than the billings; increase revenue for the difference. The offset would be an unbilled asset typically called Costs in Excess of Billings. If billings are greater than the revenue that should be recognized, you would decrease revenue. The offset would be a deferred revenue account called Billings in Excess of Costs.
Completed Contract Method of Project Accounting (CCM)
A contractor can use an alternate method to recognize revenues and expenses on contracts – the Completed Contract Method (CCM). CCM can be used when costs are difficult to estimate or there are many small short-term jobs where the results reported under the CCM and the POC would not vary materially. The CCM recognizes revenue only when the contract is substantially completed.
While a job is in progress, all costs are capitalized to an asset on the balance sheet, Construction in Progress. When a contract is invoiced, the billings are posted to a liability account, Progress Billings. These amounts are accumulated until the contract is complete. Once the contract is complete, the costs are expensed and the progress billings are taken into revenue.
Why is POC better for construction?
POC accounting method is often used by construction companies to keep track of their projects. POC is preferred over the CCM because it provides a more realistic view of the company’s true financial status especially when their contracts are more long-term. This is because income and gross profit are recognized as the contract progresses, as opposed to the CCM which only recognizes income and expense when a contract is substantially complete.
To illustrate the benefits of POC method accounting for construction projects, let’s look at XYZ, Inc.’s fictional Contract 123. Here is a snapshot of Contract 123 after three months of work on the project have been completed. The original contract was for $500,000, and XYZ estimated its total costs on the project to be $400,000, generating an estimated $100,000 in gross profit.
Without the benefit of the POC accounting method, the owner of XYZ, Inc. might mistakenly believe that Contract 123 is going to surpass all of the estimates and be hugely profitable. Since the project’s start, XYZ has spent just $60,000 while billing its client $120,000. You could see how XYZ’s owner might be thinking to himself, “cha-ching!” He originally thought that XYZ was going to clear $100,000 and at the end of month three, and XYZ already has $60,000 in the bank! According to this mistaken premise, the owner might assume that Contract 123 is on track to already exceed the gross profit estimates. Additionally, the owner might also incorrectly assume that Contract 123 is 24% completed based on billings to date ($120,000 / $500,000).
But, these would be a grave mistakes because the percentage completed is not based on how much has been billed, it’s based on how much has been spent. That means that Contract 123 isn’t 24% complete at the end of month three; it’s actually just 15% complete ($60,000 in actual costs/$400,000 in estimated).
Based on the contract being 15% complete, revenue that should be recognized under POC is $75,000. XYZ, Inc. has overbilled its client on Contract 123 by $45,000 (actual billings of $120,000 less the recognized revenue to date of $75,000). And furthermore, that $60,000 sitting in XYZ’s bank account? Only $15,000 of that is actually gross profit.
Under US generally accepted accounting principles, POC is the preferred method of accounting for long-term contracts. Because revenues and expenses are recognized over the life of the contract rather than the end of it, POC creates a more accurate view of contract finances and progress. It also enables companies to better manage their cash flow. If used correctly and conservatively, the POC method should be a tremendously valuable tool to help keep contract finances – and the overall health of the company – on track.
If you would like more information on this topic, please contact Janet Stafiej, CPA at 314-576-1350 or firstname.lastname@example.org.