Percentage-Of-Completion Method of Accounting
The fundamental accounting principle contains accrual and matching concept, which are used in the revenue recognition principle for the determination of the accounting period. The determination of the accounting period is necessary as it helps in proper allocation of revenue and expenses to their respective accounting period. Revenue recognition principle states that revenue is acknowledged when they are apprehended and earned no matter when the cash is actually received.
Percentage-of-completion method of accounting is based on the revenue recognition principle that provides with a framework on how to recognize revenue and expenses in the accounts of the company. The percentage-of-completion method is generally required method for the bigger construction companies for the financial accounting and taxation purposes. These companies use this method for the long-term contracts. This method’s justification relies on the matching principle in accounting, according to which it is necessary to match the revenue and expenses in the valid accounting time. This method recognizes the revenues, costs and gross profits as they are incurred in the applicable period and not solely in the period in which the contract has been completed, as in the completed contract method. As the name of the method suggests, the degree of completion of the work is allocated to it related period.
In order to estimate the degree upon the completion of the work, you can divide the total construction incurred to the date with the total estimated costs of the contract.
Percentage of work completed = total construction costs/ total estimated cost of contract.
This percentage of the work completed can then be used to determine the total amount of revenue or gross profits that are to be allocated to this period by multiplying it with the total estimated revenues or gross profits.The journal entries of the percentage-of-completion method are the same to that of a completed contract method. However, in percentage-of-completion method, you need to post entries for the transactions allocated to the current period. Therefore, if 30% of the building is completed in the current year, the construction company can recognize 30% of the profit in the current period. This continues for whole life of the contract until the contract is completed. On the completion, the adjusting entries are passed to adjust the differences.