Measuring Progress: The Percentage of Completion Method
When recognizing revenue over time, companies must estimate their progress. There are two primary ways to do this:
- Output-based estimates: Measuring progress based on the proportion of goods or services transferred (e.g., units produced).
- Input-based estimates: Measuring progress based on the effort expended relative to the total expected effort.
The most common input-based method is the cost-to-cost ratio. This method calculates the percentage of completion by dividing the costs incurred to date by the total estimated costs of the project.
Percentage of Completion=Total Estimated Project CostsTotal Costs Incurred to Date
Once the percentage is determined, the revenue recognized for the period is calculated by multiplying that percentage by the total contract price.
Revenue Recognition Upon Completion
In some scenarios, or under different accounting choices for certain contract types, revenue is recognized only when the contract is finished. Under this "point in time" approach, the company does not report any gross profit on the income statement until the final obligation is met. While this is simpler, it can lead to "lumpy" financial statements where a company appears to have no profit for years, followed by a massive spike in the final year.
Accounting for Costs and the Balance Sheet
To manage the financial records of a long-term project, companies use specific accounts to track progress and billing.
Construction in Progress (CIP)
Construction in Progress (CIP) is an asset account, similar to work-in-process inventory in manufacturing. It accumulates all costs incurred on the project, including direct materials, labor, and allocated overhead.
Billing and Balance Sheet Presentation
As the project moves forward, the company sends invoices to the customer. These are recorded in a Billings on Construction Contract account, which acts as a contra account to CIP.
The presentation on the balance sheet depends on the net relationship between CIP and Billings:
- Contract Asset: If CIP > Billings, the net amount is reported as a current asset (often called "Construction in progress in excess of billings").
- Contract Liability: If Billings > CIP, the net amount is reported as a current liability (often called "Billings in excess of construction in progress").
Exam Tip: Always check if the net balance is a debit or a credit. A debit balance in the net CIP/Billings account is an asset; a credit balance is a liability.
Handling Long-Term Contract Losses
One of the most critical rules in long-term contract accounting involves unexpected losses. If, at any point, the total estimated costs of a project exceed the total contract price, the project is expected to result in a loss.
The Conservatism Principle: A projected loss on the entire project must be recognized in full in the period in which the loss becomes evident, regardless of whether the company is using the "over time" or "upon completion" method.
For example, if a company realizes in Year 2 that a project will lose $200,000 in total, they cannot wait until Year 3 to report it. They must immediately recognize enough loss to ensure the total reported loss matches the $200,000 projection.
Worked Example: Loss Recognition
Consider a project where:
- Total Contract Price: $5,000,000
- Year 1 Costs: $1,500,000
- Year 2 Costs: $1,260,000
- Year 3 Costs: $2,440,000
- Total Actual Costs: $5,200,000
Because total costs ($5.2M) exceed the price ($5M), a total loss of $200,000 is expected. If the company was recognizing revenue over time, they would adjust their Year 2 revenue and costs to reflect this reality immediately, ensuring the cumulative loss matches the current estimate.
