Legal Definitions - percentage-of-completion method

The percentage-of-completion method is an accounting technique primarily used for long-term contracts where the work spans multiple accounting periods. Instead of waiting until the entire project is finished to record all revenue and expenses, this method allows businesses to recognize a portion of the total contract revenue and associated costs as the work progresses. This approach provides a more accurate representation of a company's financial performance over time by matching the income earned with the expenses incurred during each period of the project.

Here are some examples to illustrate this method:

• Example 1: Commercial Building Construction

  Imagine a construction company, "Skyline Builders," is contracted to build a new office tower for $100 million. The project is expected to take three years to complete. Using the percentage-of-completion method, Skyline Builders would not wait until the tower is fully built and handed over to recognize all $100 million in revenue. Instead, at the end of each fiscal year, they would assess the percentage of the project that has been completed. If, after the first year, their engineers certify that 30% of the work is done (based on costs incurred, materials used, and labor expended), Skyline Builders would recognize $30 million (30% of $100 million) in revenue and a corresponding percentage of the total estimated project costs in their financial statements for that year. This provides investors and stakeholders with a clearer picture of the company's ongoing profitability during the multi-year construction period.

• Example 2: Custom Software Development

  Consider "InnovateTech Solutions," a company hired to develop a complex, custom enterprise resource planning (ERP) system for a large client. The contract is for $5 million and is projected to take two years, involving several distinct development phases (e.g., requirements gathering, module coding, integration, testing). InnovateTech Solutions would use the percentage-of-completion method. As they complete and deliver specific modules or reach predefined milestones, they would calculate the percentage of the overall project completed. For instance, if after 12 months, the core modules are coded and accepted by the client, representing 60% of the total estimated effort and cost, InnovateTech would recognize $3 million (60% of $5 million) in revenue and the related development expenses for that year. This method accurately reflects the value created and the resources consumed as the software project progresses.

• Example 3: Specialized Manufacturing of Industrial Equipment

  A company called "Precision Robotics" receives a contract to design and build a highly specialized, custom-made robotic assembly line for an automotive manufacturer. The contract value is $20 million, and the project involves extensive design, fabrication, assembly, and testing over an 18-month period. Precision Robotics would apply the percentage-of-completion method. As they complete the design phase, procure specialized components, fabricate custom parts, and begin the assembly process, they would periodically assess the completion status. For example, if after nine months, all design work is finalized, 70% of the components are fabricated, and 40% of the assembly is complete, they might determine the project is 50% complete overall. They would then recognize $10 million (50% of $20 million) in revenue and the corresponding costs in their financial reports for that period, rather than waiting until the entire robotic line is installed and operational at the client's factory.