Percentage of Completion Method Defined With Examples

Long-term contracts present distinct revenue recognition challenges, particularly in industries such as construction and engineering where projects can span multiple accounting periods. The percentage of completion method (PCM) addresses these challenges by allowing businesses to recognize revenue and expenses incrementally as work progresses. While updates to Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) have refined how companies implement PCM-style recognition, the concept remains vital for the accurate financial reporting of complex, long-term projects.

What Is the Percentage of Completion Method?

PCM is an accounting method that allows companies to recognize revenue and expenses in stages, as a long-term project progresses, rather than waiting until project completion. Financial performance is reported based on the proportion of work completed during each accounting period to reflect the company’s ongoing financial position and performance.

While the specific rules of PCM have been updated under GAAP ASC 606 and IFRS 15, which introduced a five-step model for revenue recognition, the underlying principle of recognizing revenue over time for certain long-term contracts remains. PCM in its traditional sense may still be used by some private companies and smaller contractors not required to follow GAAP or IFRS, though many are still required to or choose to do so for various reasons (stakeholder or investor requirements, for instance).

In any case, effective implementation of PCM or its modern variants hinge on a company’s ability to make reliable estimates of total project costs and accurately measure work progress throughout the contract period.

Key Takeaways

• PCM is an accounting technique used primarily for long-term contracts to recognize revenue and expenses as a project progresses.
• By aligning revenue recognition with actual project progress, PCM offers a clearer picture of a company’s economic reality than its counterpart, the completed contract method.
• Current GAAP and IFRS standards no longer explicitly accept PCM, though its underlying principles remain relevant.
• PCM can still be used by certain private companies that aren’t required to follow GAAP or IFRS.
• PCM requires reasonable assurance of payment collection and reliable estimates of costs and project completion rates.

Percentage of Completion Method Explained

Unlike its counterpart approach, the completed contract method (CCM)—which defers all revenue recognition until project completion—PCM provides a more dynamic and accurate financial picture throughout the project’s life cycle. This incremental recognition aligns more closely with the economic reality of long-term projects and offers advantages over CCM, such as smoother earnings patterns.

PCM relies on three fundamental components:

• Total contract price: The agreed-on amount the customer will pay upon the project’s successful completion.
• Total estimated costs: The company’s projection of all costs associated with completing the contract.
• Costs incurred to date: The actual expenses the company has incurred up to the current point.

These components form the basis for calculating the percentage of completion and the amount of revenue to be recognized in each accounting period, but specific calculations and methods for determining the percentage of completion can vary.

Percentage of Completion Method Example

To illustrate how PCM works, consider a construction company working on a $1,000,000 project expected to take two years to complete.

If the company estimates total project costs to be $800,000 and incurs $400,000 in costs during the first year, the project is considered 50% complete ($400,000 / $800,000), based on the cost-to-cost method of determining the percentage complete (more on this later).

Using that percentage, the company would recognize 50% of the total revenue for the first year—$500,000 ($1,000,000 × 50%)—and match it with the related expenses incurred. This calculation aligns revenue recognition with project progress, reflecting the portion of the total contract value earned based on work completed.

In the second year, assuming the project is completed as estimated, the company would recognize the remaining 50% of revenue ($500,000) and the remaining costs.

Percentage of Completion Method Journal Entries

PCM requires specific journal entries to accurately reflect the financial progress of long-term projects. These entries ensure that revenue and expenses are properly matched to reflect project progress and comply with construction accounting standards. Key accounts typically include “Construction in Progress” (an asset account), “Construction Revenue” (an income statement account), and “Billings on Construction in Progress” (a liability account).

PCM Example Journal Entry

Using our previous example of the $1,000,000 construction project, at the end of Year 1:

• Total project costs are estimated at $800,000.
• Costs incurred in Year 1 are $400,000.
• The company billed the client $500,000 and so far has collected $450,000 (with the remaining $50,000 an outstanding accounts receivable balance).

Calculating Percentage of Completion

When using PCM, companies typically choose from three primary approaches to calculate the completion percentage: cost-to-cost, efforts expended, or units of delivery. Each method has its strengths and is suited to different types of projects.

• Cost-to-cost approach:

  The cost-to-cost approach calculates completion by comparing the costs incurred to date against the total estimated costs for the entire project. This method is widely used because costs are often a reliable indicator of progress. However, it requires accurate cost tracking and regular updates to estimates to ensure precision.

Percentage of completion = (Costs incurred to date / Total estimated costs) x 100

If $400,000 has been spent out of an estimated $800,000 total cost, the project would be considered 50% complete ($400,000 / $800,000 x 100).

• Efforts expended calculation:

  The efforts expended calculation measures completion based on labor hours worked or machine hours used compared to the total estimated hours required for the project. This method is particularly useful when labor or effort is closely tied to progress but may not account for cost fluctuations or delays effectively.

Percentage of completion = (Labor hours to date / Total estimated labor hours) x 100

If a team has worked 1,200 hours out of an estimated 2,400 hours needed to complete a project, it would be considered 50% complete (1,200 / 2,400 x 100).

• Units of delivery method:

  The units of delivery method calculates completion based on physical outputs delivered compared to total expected outputs. This approach works well when deliverables are uniform and measurable, but it may not account for variations in complexity or cost between units.

Percentage of completion = (Units delivered / Total units in contract) x 100

If a construction company is building 10 identical houses under one contract and has completed five houses so far, the project would be considered 50% complete (5 / 10 x 100).

What’s the Difference Between the Percentage of Completion Method vs. Completed-Contract Method?

CCM is an alternative to PCM, under which companies defer all revenue recognition until a project is fully completed, regardless of the work performed or costs incurred during the contract period. Although this approach might seem simpler—waiting until everything is finished to record revenue and expenses—it can create significant fluctuations in reported income and may not accurately reflect a company’s ongoing financial performance.

Consider a construction company working on a three-year, $10 million project.

• Using CCM, the company would show no revenue for the first two years, even though it’s actively working and incurring costs. It would then recognize all $10 million in the third year. This approach can create misleading financial statements and make it difficult for stakeholders to assess the company’s true financial health.
• Using PCM, the company would recognize revenue proportionally as work progresses—perhaps $3 million in the first year, $4 million in the second, and $3 million in the final year—to provide a more accurate picture of the company’s ongoing operations. However, with PCM, companies need to regularly reassess their estimates of total contract costs and revenues, which can lead to adjustments in recognized revenue and profit margins over the life of the project.

Like PCM, CCM remains an option for companies not beholden to GAAP. But it’s important to note that ASC 606 and IFRS 15 use “point-in-time” recognition for those cases where revenue isn’t recognized over time. Historically, PCM has been the preferred method for most long-term contracts because it offers a more accurate representation of a company's financial position over time. While the current standards don’t explicitly use the terms PCM or CCM, the underlying concepts are still relevant:

• “Over time” recognition in current standards often aligns with situations where PCM would have typically been used.
• “Point-in-time” recognition may be used in scenarios where CCM might have been applied in the past.
• The choice between these approaches depends on specific criteria outlined in the standards.

Percentage of Completion Risks and Potential for Abuse

PCM, while widely used, carries inherent risks that can have significant implications for companies and their stakeholders. These risks became starkly evident in the 2015 Toshiba scandal, in which misuse of PCM led to understated operating costs by approximately $1.2 billion over seven years.

To improve financial reporting consistency and reduce the potential for similar situations, accounting standard-setters have implemented more stringent guidelines. The Financial Accounting Standards Board and the International Accounting Standards Board teamed up to introduce ASC 606 and IFRS 15, respectively, which address many of the vulnerabilities associated with PCM. Clearer criteria for performance obligations and progress measurements provide a more robust framework for revenue recognition, while enhanced disclosure requirements improve transparency.

However, private companies not bound by these standards still face significant challenges when implementing PCM:

• Estimation errors: Inaccurate estimates can lead to significant misstatements of revenue and profit. As projects progress, initial estimates may prove to be overly optimistic or pessimistic.
• Cost shifting: Inappropriate allocation of costs between projects can distort the true financial performance of each project.
• Front-loading of profits: Early recognition of disproportionate profits can misrepresent financial performance and potentially erode stakeholder trust if actual figures diverge from initial estimates.
• Cash flow misalignment: Revenue recognition may not align with cash inflows, potentially leading to liquidity issues.
• Audit challenges: Verifying the accuracy of completion percentages and cost estimates can be difficult for auditors, increasing the risk of undetected misstatements.

To mitigate these risks, companies using PCM should implement strong internal controls, robust cost estimation systems, and standardized progress measurement methodologies. Integrated project management and accounting software can also help improve the accuracy and consistency of PCM calculations.

Cloud-Based Accounting Software for Construction

Managing long-term projects and implementing PCM can be challenging without the right tools. NetSuite Construction ERP streamlines accounting processes and guarantees accurate financial reporting thanks to real-time project tracking that allows companies to monitor costs, revenue, and project progress as they happen—in turn, facilitating more accurate PCM calculations. And, by natively integrating project management with accounting functions, the enterprise resource planning system consistently updates financial data across all departments to reduce discrepancies and enhance efficiency.

NetSuite Construction ERP can also automate complex revenue recognition calculations, minimizing the risk of human error and saving valuable time. Customizable reporting features allow businesses to generate tailored reports that meet specific industry requirements, providing stakeholders with clear insights into the financial health of their projects.

At its core, PCM helps businesses accurately reflect their financial position when managing long-term contracts. Whether companies follow the traditional PCM approach or newer GAAP/IFRS standards, the fundamental goals remain the same: to align revenue recognition with actual project progress, provide a clearer picture of a company’s economic reality, enable more informed decision-making, and maintain stakeholder confidence.

Percentage-of-Completion Method FAQs

Is the percentage of completion method GAAP-compliant?

The percentage of completion method was fully GAAP-compliant under ASC 605 but has since been replaced by “over time” recognition under current GAAP standards (ASC 606). ASC 606 does not refer to “percentage of completion” by name, but the underlying principle remains valid. Companies following GAAP must meet specific criteria to recognize revenue over time, including reasonable assurance of collectability and the ability to make reliable estimates.

Does the IRS require a percentage of completion method?

Unless the taxpayer meets the small contractor exception, any non-home construction contract not completed within the same taxable year it is entered into is subject to PCM. More information can be found in Internal Revenue Code Section 460.

How is the percentage of completion method applied to service contracts?

Historically, the PCM has been widely applied to long-term service contracts, particularly in industries such as consulting, software development, and professional services. While the traditional PCM approach is no longer explicitly used under current accounting standards (ASC 606 and IFRS 15), the concept of recognizing revenue over time for service contracts remains relevant. Today it’s applied in five steps:

1. Identify the contract with the customer.
2. Identify the performance obligations.
3. Determine the transaction price.
4. Allocate the transaction price.
5. Recognize revenue.

In step five, companies measure progress using input methods (e.g., costs incurred) or output methods (e.g., milestones achieved). This often results in a revenue recognition pattern similar to the old PCM but within the framework of current standards.