Construction projects can take years to finish, but accountants often don’t have time to consistently prepare financial documents such as income statements. While it’s possible to defer revenue recognition until project completion (known as the completed contract method, or CCM), spreading it out using the percentage of completion (POC) method is more common within construction, tech, and similar industries.
The POC method to recognizing revenue considers the revenue and expenses of long-term projects compared to the amount of work completed as the project progresses. POC is essential in the construction industry, as waiting years to recognize revenue may defy Generally Accepted Accounting Principles (GAAP) and lead to more confusion and potential for errors.
Let’s unpack POC in construction to easily recognize revenue in the correct period and maintain legal compliance with ASC 606 and GAAP. From calculation methods to common challenges and case studies, here’s your comprehensive guide to this essential accounting method.
What Is the Percentage of Completion Method?
The POC method tells us how to calculate revenue recognition for extended contracts. It measures the percentage of work you’ve completed against the total amount for the entire project.
This approach gives a clearer picture of your business’s financial health. When you use it, your balance sheet will not only reflect the contract costs incurred up until that point but also include the percentage of project revenue you’ve earned—even if you haven’t fully realized it in your account yet.
In comparison, under Completed Contract Method—one of the other ASC 606 revenue recognition examples—revenue isn’t recognized incrementally; instead, revenue is deferred until you finish the job. This form of completion accounting leads to a financial snapshot where:
- Your business has accrued a host of expenses
- You haven’t recorded any revenue
- You debit contracts in progress (CIP) until you finally receive payment
While this model doesn’t require you to estimate project costs (as you’ll simply tally them at the end), it leads to a less clear and less desirable depiction of your financial health.
In turn, most construction companies opt for the accrual accounting approach of POC, which can be calculated with the formula:
POC = (Costs incurred to date / total estimated costs) * 100
To find the revenue recognized via the POC approach, calculate this percentage and apply it to the total transaction price of your contract.
Importance of the Percentage of Completion Method in Construction
The POC approach gives your company and its interested parties a more accurate snapshot of your current finances. As long as you can reasonably expect to receive payment for the work you’ve completed (i.e., the customer isn’t going bankrupt or defaulting on their debts), including that income on your balance sheet is perfectly acceptable. It can be desirable, and often, it makes all the difference between a black or red financial statement.
POC also helps you better manage your cash flow because, as just noted, it’s not permissible to include revenue on your financial statements unless you have a reasonable expectation of receiving it. If everything proceeds as planned, you can include partial revenue on your statements instead of conservatively putting it off until the project is completed. Alternatively, if you suspect you may not be paid in full, omitting that period’s revenue prevents premature recognition.
Furthermore, as you can see from these ASC 606 revenue recognition examples, POC aligns with ASC 606’s and GAAP’s rateable criteria for revenue recognition. Since POC averages total contract costs over time and recognizes revenue when the customer receives the benefits of your work (i.e., partial completion of their project), it’s a defensible and effective recognition method for most construction companies. However, as always, you should consult your auditors to help determine the best revenue recognition method your company should use.
How to Calculate Percentage of Completion
You can actually use three techniques to recognize revenue using POC. To start, tally up your total revenue for a project. Then, select one of the three methods for calculating costs:
- The cost-to-cost method: This is the basic POC calculation we’ve already covered and is used when a company inserts its own expenses into the formula POC = (Costs incurred to date / total estimated costs) * 100.
- The efforts-expended method: This approach compares the amount of effort you’ve expended to date (generally measured in total estimated labor hours or machine hours) to the total necessary for the project.
- To calculate it, use the formula POC = (Effort expended to date / estimated total effort) * 100.
- To calculate it, use the formula POC = (Effort expended to date / estimated total effort) * 100.
- The units-of-delivery method: This method uses a concrete, measurable factor (such as the number of apartments completed in a building) to assess progress on your project.
- To add it up, insert your own progress into the formula: POC = (Number of units delivered to date / estimated/contracted total number of delivered units) * 100.
Cost-to-Cost Example: Let’s envision a four-year project worth $10,000,000 and plug it into these formulas to see POC calculations in action. Let’s start with the Cost-to-Cost method and assume $5,000,000 in total project costs, of which the company has incurred $1,250,000 to date:
- POC = (Costs incurred to date / total estimated costs) * 100
- POC = (1,250,000 / 10,000,000) * 100
- POC = 0.25 * 100
- POC = 25
To find the amount of revenue to report in this period, simply multiply the total contract value by the POC: $10,000,000 * 25% = $2,500,000.
Effort-Expended Example: Now, let’s use the same contract value but use the effort-expended formula and assume 2,500 of 10,000 labor hours have been completed:
- POC = (Effort expended to date / estimated total effort) * 100
- POC = (2,500 / 10,000) * 100
- POC = 0.25 * 100
- POC = 25%
Units-of-Delivery Example: And when we multiply our original $10,000,000 contract value by that 25%, we once again come to revenue of $2,500,000 for the period. The same can be surmised using the Units-of-Delivery Method if we assume 250 units out of 1000 completed:
- POC = (Number of units delivered to date / estimated total number of delivered units) * 100
- POC = (250 / 1,000) * 100
- POC = .25 * 100
- POC = 25%
Of course, 25% of $10,000,000 is $2,500,000—or the amount of revenue to report for the period. Despite this easy-to-follow example, the total revenue recognized in each accounting period won’t necessarily be the same with different POC formulas. Be sure to pick the most applicable method that best represents your current finances.
Challenges and Considerations
Despite complying with GAAP, helping you manage your cash flow, and accurately representing your business’s finances, the POC method isn’t without its issues. Some of the most common roadblocks companies face when implementing POC include:
- Difficulties estimating costs: It can be difficult to detach an accurate idea of your ongoing expenses from the total cost of your project. You may have bought materials you won’t use for several accounting periods, prepaid labor contracts, or incurred other overarching bills that cloud your current expenditure.
- Changes in the project: Delays beyond your control may extend your project deadline, forcing you to add more labor hours to your total. Unforeseen circumstances could require you to increase your initial quote, changing the total cost of the project. These and similar events can affect your POC and forecasted revenue, making it increasingly difficult to determine an accurate figure to recognize at different points in your project.
- Administrative effort: Tracking percentage of completion requires many variables to be consistently tracked and reported in order to effectively calculate the true percentage complete. Tracking hours, costs, or units may require additional systems in place to consistently be able to report on these metrics.
Best Practices for Using the Percentage of Completion Method
Perhaps the most important practice in POC calculation is consistently updating your cost estimates and project progress. Keep a constant running total of these two figures. You’ll be able to recognize revenue at the drop of a hat rather than sifting through material recipients and contract totals during tax or audit season.
To keep these figures updated, however, you’ll need to maintain a clear, open line of communication between project managers and your accounting team. Every time they approve a material purchase or add labor hours, it needs to be recorded and added to your ongoing totals.
Relying on accounting software such as RightRev can be a huge time saver as it supports POC and other revenue recognition methods. Manual book entries are slow and tedious, and human error is possible. RightRev recognizes revenue in real-time, so your POC calculations are consistently up-to-date and accurate.
Industry Applications and Case Studies
Business was booming for Blue Gilia Construction—so much so that they reported 116% POC on a key project during a singular year of work. Knowing what we now do about the POC method, it’s clear that 116% was an impossibility.
However, their problem wasn’t with POC but with their reporting process. Too many costs were slipping through the cracks, being reported twice, or otherwise being erroneously recognized. To clean up their unkempt books, revenue recognition professionals suggested several changes to their accounting process, including:
- Having all relevant teams meet to evaluate their accounting processes and strengthen the company’s internal controls
- Reviewing their performance obligations and original contract with each instance of revenue recognition to minimize errors
- Getting written documentation and authorization for each expenditure that falls outside the original scope of the contract
Any company practicing POC can benefit from following these procedures. Accurate POC recognition hinges on reliable data, and when you’re reporting 116% of your project as completed over a single year, it’s obvious something is amiss in your calculations.
Don’t make the same mistake as Blue Gilia—use a trustworthy, robust accounting automation solution from the start when calculating POC.
Leverage RightRev for Quicker, Easier POC Calculations
If you’re involved in construction or similar industry where singular projects often take multiple years to complete, the POC method of revenue recognition is an effective, legally defensible accounting method technique that accurately and favorably represents your books. POC in construction is essential, as it helps you better manage your cash flow, gauge your completion progress, and adhere to GAAP and ASC 606.
Think critically about your current accounting methods, and consider whether POC could benefit your business. If so, try RightRev to make the entire process of POC calculation far faster and easier.
RightRev allows you to instantly and accurately recognize revenue for an entire accounting period using POC or a variety of other methods. This helps remove the stress, tedium, and manual mistakes from your bookkeeping process.
Request a demo of RightRev today—rapid, reliable revenue recognition is right around the corner.
As always, we recommend consulting with your auditors to determine the best revenue recognition method to use.
