Since construction projects take a lot of time and even run from a few months to several years, it becomes hard to track a company's performance using traditional accounting practices. Recording all the income generated when the project is already completed distorts financial reports and makes it tough to determine the real financial state of the firm. The Percentage of Completion Method allows to solve the problem of income recognition through its recording as the project proceeds.
This blog will explain the method of percentage of completion calculation, the reasons behind the necessity of an accurate cost estimation and job costing, the common errors businesses commit, and the importance of trustworthy PCM reports.
Understanding the Percentage of Completion Method and Why It Matters
For long-term construction projects, the need for financial reporting must take into consideration the progress made to date, as opposed to deferring this process until the end of the project period. This is the reason why the Percentage of Completion approach has been favored by most businesses for accounting purposes.
How the Percentage of Completion Method Calculates Revenue
Under the Percentage of Completion Approach, the revenue is recorded according to the percentage of costs incurred to the estimated total cost of the whole project. Since the construction process goes on and the expenses are increasing day by day, the companies will record their revenues in accordance with that progress.
For instance, if there is a construction company that enters into an agreement for $1 million and its total estimated cost is $750,000, then the completion of 50% of the estimated cost of the project can give rise to the recording of 50% of the total contract revenue.
Why Long-Term Contracts Require Progressive Revenue Recognition
A project does not have to run through a number of years for it to be accounted for using Percentage of Completion accounting services. There may be situations whereby projects start in one fiscal year but end up in another and, as such, there is need for PCM.
This is to avoid situations whereby income statements may not reflect much revenue earned from the project even when a lot of work is already done in the construction process.
How PCM Improves Financial Visibility
Revenue recognition during the entire period of a project gives management the ability to understand profitability and cash flow and to see how each project affects the company financially. It is not necessary to wait until the contracts are completed for business leaders to see how projects affect the company’s finances.
The process of recognizing revenue will improve budgeting, planning, and forecasting since companies will be able to make business decisions based on current financial information.
Why Accurate Cost Estimates and Job Costing Drive Successful Financial Reporting
The accuracy of Percentage of Completion Method hinges to a great extent on how good are the estimations for projects undertaken. Any small mistake at the estimation stage might lead to serious consequences as regards recognizing revenues and calculating profits.
Estimated Costs and Contract Value Form the Foundation
There are two figures that define the application of PCM: the total value of the contract and the cost to complete the project. The values defined the percentage of completion of the project, influencing the amount of revenue, gross profit, contract assets, and contract liabilities.
When any of these two figures is wrong, all the calculations become meaningless. Small inaccuracies can lead to significant discrepancies in reporting, which means that the estimates have to be regularly reviewed.
Managing Change Orders and Cost Overruns
There is very little likelihood that construction work will go ahead according to plan. Changes in site conditions, changes in the design, changes in the cost of materials, and requirements from the customer often lead to changes orders that affect the cost of the project and contract income.
A proper recording of the change orders ensures that the contract income is properly recorded. But in situations where the overages in the cost of construction cannot be recouped from the clients, then the company should anticipate loss of income from the project.
Job Costing Creates Better Business Decisions
Although most firms start using job costing in order to meet their accounting obligations, its true benefits can be seen in business management. Through thorough job costing, firms are able to contrast their cost estimates with real costs incurred and find out which type of project is profitable.
Using past data on projects, a contractor can make better predictions about his/her business. By studying completed projects, the contractor will learn important information on labor efficiency, materials consumption, subcontracting, and overheads.
Comparison: Accurate vs. Poor Percentage of Completion Reporting
|
Accurate PCM Practices |
Poor PCM Practices |
|---|---|
|
Reliable revenue recognition |
Misstated financial results |
|
Updated project estimates |
Outdated cost assumptions |
|
Consistent job costing |
Inconsistent expense tracking |
|
Better cash flow forecasting |
Unexpected financial surprises |
|
Strong lender confidence |
Reduced financing opportunities |
|
Improved bidding accuracy |
Repeated estimating mistakes |
Building Stronger Financial Performance Through Reliable PCM Reporting
Apart from compliance with regulations, the Percentage of Completion Method ensures proper financial management and better relations with financiers, bonding firms, investors, and owners of projects. Firms which keep accurate records of their work in progress enjoy a competitive advantage over others in the construction sector.
Common Mistakes That Create Audit Problems
Inconsistency in scheduling of work in progress is an issue that auditors commonly face. An example of inconsistency in the reported revenues from one period to another without any justifiable reason is a problem that may arise. This indicates either accounting mistakes or even fraudulent alterations in the historical accounting information.
Other examples include projects missing from the WIP schedule, having more than 100% of completion percentage, negative completion percentage, or even allocating expenses to wrong projects.
Why Banks, Bonding Companies, and Clients Depend on PCM
Percentage of Completion reporting is highly essential in the assessment of construction firms by financial institutions. Lenders look at financial reports when assessing the risk in giving loans, and surety firms examine the profitability and backlog of projects in the company before giving out performance bonds.
Contracting organizations are also required to provide financial reports to the government departments and project owners for the evaluation of their financial capacity before awarding the contract to them.
Best Practices for Successful Percentage of Completion Accounting
The successful adoption of PCM entails continuous monitoring rather than annual corrections. It is recommended for organizations to continuously assess their estimated project costs, adjust their contract prices based on approved change orders, reconcile their work-in-progress schedules with accounting data, and record the details of job costing for each of their projects.
Those organizations that see PCM as a continuous management process and not only as a necessary requirement manage to have more profitable projects, better cash flow management, better financial reporting, and increased assurance from creditors and bondholders and customers.
PCM is highly crucial in construction accounting because of its ability to match income recognition with actual progress. With precise cost estimations, proper job costing, and efficient reporting on work-in-progress, a company can create financial statements that are useful in business decisions.
Businesses which adopt the PCM process go beyond satisfying the accounting requirements. These businesses become transparent, profitable through proper analysis, and in good relations with banks and bond companies.
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