Percentage of completion vs completed contract

A job that starts in March and finishes in September crosses months, quarters and sometimes a year end. Somebody has to decide how much of its profit belongs to each of those periods — and the answer changes what your financial statements say, what a surety sees, and in some cases what you are taxed on.

That decision is the revenue recognition method. There are two that matter to contractors, and the difference between them is simply when the profit shows up.

Percentage of completion

Profit is recognized as the work happens. Each period you calculate how far along the job is and recognize that share of the contract’s revenue and profit.

The usual way to measure progress is cost-to-cost: costs incurred to date divided by the total costs you now expect. A job that has consumed 40% of its expected costs is treated as 40% complete, so 40% of its contract value is earned.

This is the method behind a WIP schedule, and it is what sureties and banks expect to see from a contractor of any size.

What it gives you: financial statements that describe the business as it is actually running. Revenue appears in the periods when the work was done, and a job going wrong shows up while it is still going wrong.

What it demands: an honest estimate of total cost, updated every period. The method is only as good as that estimate, which is why under-billings and fade are the first things an experienced reader checks.

Completed contract

Profit is recognized when the job finishes. Costs and billings accumulate on the balance sheet while the job runs, and the entire profit lands in the period it completes.

What it gives you: simplicity, and a legitimate deferral — profit on a job that straddles a year end falls into the later year.

What it costs you: statements that describe nothing useful month to month. A quarter with three finishing jobs looks spectacular; the quarter before it, when all the work happened, looks like a loss. For a business with long jobs, this makes the monthly P&L close to unreadable — and makes it very hard to notice a job failing until it is over.

Which one applies to you

Two separate questions, often confused:

For your tax return, the method is substantially constrained by rules — the length of your contracts, the size of your business measured over recent years, and the type of work (home construction gets different treatment). Those thresholds are indexed and have moved, so the current ones belong to your CPA rather than to a web page. Ask them which methods you are permitted to use and which they recommend.

For your management and reporting books, you have more freedom, and for most contractors with jobs running longer than a month the answer is percentage of completion. It is the only one that tells you anything in the month the work is being done. It is also what a surety will ask for, whatever your tax return says — see getting bonded.

Keeping tax-basis and management-basis views of the same year is normal and not duplicate bookkeeping: it is one set of job costs, reported two ways.

The number everything depends on

Under percentage of completion, one input decides whether any of it is true: the estimated cost to complete.

If a project manager leaves that estimate where it was at the bid, costs to date keep rising against a stale total and the job looks further along than it is. Revenue gets recognized early, profit appears that has not been earned, and the correction lands in a later period as fade.

Updating the estimate every month, from people who know the job, is the whole discipline. The books supply costs to date; only the field can tell you what is left.

The two balance sheet lines

Percentage of completion produces two lines that confuse contractors the first time they see them:

• Billings in excess of costs and estimated earnings — you have billed more than you have earned. A liability: you owe that work.
• Costs and estimated earnings in excess of billings — you have earned more than you have billed. An asset, and often a sign you are behind on billing.

Both come straight off the WIP schedule, and reading them is covered in WIP schedules: over-billing and under-billing explained.

If your jobs are short

A service company whose jobs start and finish the same week does not need any of this. Cash or accrual basis with a receivables report answers the same questions. The methods above start to matter when jobs regularly span month ends — see cash basis vs accrual for contractors.

Related

• AIA billing and pay applications
• Construction bookkeeping, step by step
• The bank asked for financial statements

General information, not tax or accounting advice. Which methods you may use for tax depends on current thresholds and your situation — your CPA decides that.