We know that when the goods or services are transferred continuously, and the customer has control over the goods or services transferred to date, it means that performance obligations are satisfied over time. Accordingly, revenue should be recognized over time by measuring progress towards complete satisfaction of the performance obligation.
Percentage of completion method is a method for accounting of revenues and related expenses of long-term contracts where the performance obligations are satisfied over time. Percentage of completion method, also known as POC method is commonly used in the construction industry, however, it can be used in any other industry as well, where there are long-term contracts, and the performance obligations are satisfied overtime.
Following steps are followed to account for the revenues and expenses in an accounting period under the POC method:
- Percentage of completion (POC) of the contract is calculated (Either using input method or output method).
- POC is multiplied with the contract price to calculate cumulative revenues earned till date.
- Revenues recognized in previous periods are deducted from cumulative revenues till date to work out the revenue for the current accounting period.
- POC is multiplied with the total budgeted costs of the contract to calculate the cumulative costs incurred till date.
- Costs expensed in previous periods are deducted from the cumulative costs incurred till date to work out the cost of sales for the current accounting period.
For onerous contracts, the above steps are modified, and the expected loss of the contract is recorded as expense immediately in the period in which the contract becomes onerous (loss making).
We know that in accounting, examples are the best way to understand a topic, so let’s look at the following example to develop a better understanding of the POC method.
Example – POC method
A construction company is awarded a contract for the construction of a building for a total contract price of $1,200,000. The company started construction work in March 20X1. Following additional information is available.
- Total budgeted costs of the contract are $900,000
- Costs incurred till 31 December 20X1: $200,000
- Costs incurred till 31 December 20X2: $600,000
- The company uses input method to calculate the progress of the contract.
Calculate the revenues and cost of sales to be included in the income statements of the company for the years ended 31 December 20X1 and 20X2.
Example – POC method with onerous contract
Let’s take the data from the above example and amend it a little bit. Suppose that after year 20X1, the operational department came up with an issue that their estimate of budgeted costs missed a few things, and the revised budgeted cost of the contract is $1,300,000. The contract price agreed was $1,200,000 and the company cannot withdraw from the project as it will be detrimental to its reputation. The company therefore expects a loss of $100,000 from this contract.
Now, calculate the revenues and cost of sales to be included in the income statements of the company for the years ended 31 December 20X1 and 20X2.