Should Your Business Apply Percentage of Completion Accounting Methods
Preface: Percentage of completion accounting is necessary for large contractors. The following details specific instances requiring percentage of completion accounting and the methodology.
Percentage-of-completion (PCM) method of accounting is required for construction businesses with $10m or greater of revenue. The $10m threshold is considered to be the IRS definition of a large contractor. However, any contractor with contracts that have completion duration beyond two years need apply percentage of completion to long duration contracts.
So what is percentage-of-completion method (PCM) and how does it work? PCM accounting is a method with income recognition of construction revenue as the construction project progresses; not when completed (completed contract method) or as billed (accrual method), or as cash received (cash method). Here is how PCM works. A specific $3m construction project, with an estimated cost of $2.8m, may be overbilled. Percentage of completion method accumulates costs in a construction in progress (CIP) account as a debit, and a credit of accounts payable or cash. Let’s look at an example: say at 50% of a specific project’s completion the construction in progress account (current accumulated construction cost) has a balance of $1.5m from materials and labor. Say the progress billings (invoiced balance on project) are $1.8m. These progress billings, are posted to a contra account called contracts receivable (a debit balance of $1.8m on the balance sheet), and progress billings accounts ($1.8 as a credit on the balance sheet).
To calculate percentage of completion method on a specific contract, as the accountant deems material, you first multiply the percent of the project complete by the gross profit (example for this specific contract, a gross profit of $3m revenue – $2.8m cost = $200,000), so the estimated current period gross profit is 50% * $200,000 = $100,000. Let’s look at how the pre-adjusted numbers of $1.8m in progress billings, as outlined above, and $1.5m of cost from the construction in progress account are adjusted.
The journal entry to post $100,000 of revenue to the income statement for this specific construction project would be to credit construction in process for $1.4m = 50% of $2.8m (this account would already have a pre-adjusted debit balance of $1.5 from accrued costs), and debit to the construction expense accounts for $1.4m (cost of goods sold) on the income statement. This adjusts for costs of the construction project with a credit to balance sheet, debit to income statement.
To post the revenue, 50% of the billings would be debited for $1.5m (50% of $3m) from progress billings (a pre-adjusted credit balance of $1.8 from accrued invoices),) and a credit to construction revenues of $1.5 on the income statement. Now the income statement would show $1.5m of revenue and $1.4m of cost of goods sold, for a gross profit on the specific construction contract for $100,000 ($1.5m-$1.4m). Your general and administrative expense would be deducted from the $100,000. After these journal entries you would have on your balance sheet, a construction in progress balance remaining of $100,000 (the $1.5m debit [period accrued costs] – 1.4m credit [PCM adjustment]) and a $300,000 balance of progress billings (the $1.8m [period accrued billings] – $1.5m [PCM adjustment]).
The difference between PCM accounting and say accrual accounting is as follows. For accrual method accounting your revenue would be the $1.8m of billings – $1.5m of cost, or $300,000; more tax now, and a loss of $100,000 in the next period. PCM is only $100,000 of evenly recognized net income . No skewed income statements, or analytical inquires on swings in profitability; quality accounting. This is an example only, and actual PCM accounting will result in varying taxable balances.
Summary
Percent of completion can become complex when you have 10, 20 or more projects in the in-construction phases. If you are a large contractor it is important to use the percentage of completion method for accounting. You are considered a large contractor if your prior 3 year revenue average exceeds $10m. This article is written to help you appreciate the importance of PCM in your business if applicable. To apply percentage of completion method to your business will require accounting expertise, such as qualified internal staff, or a CPA. If you are a developing, or large, contractor, and have additional questions on percentage of completion methods, contact your CPA.