08. Long-Term Contracts: Percentage of Completion Method

By Jay

Percentage of Completion Method.

The percentage of completion method is used to recognize revenue over time for long-term contracts under ASC 606 if one of the criteria for over-time revenue recognition is met.

🔹 ASC 606 & Long-Term Contracts

Revenue is recognized over time if any of the following apply:

  1. Customer simultaneously receives and consumes benefits.
  2. Performance creates/enhances an asset that the customer controls.
  3. The asset has no alternative use, and the entity has an enforceable right to payment for performance completed to date.

Construction and production contracts often fall under the third criterion.

🔹 Measuring Progress Toward Completion

Two main methods:

1. Input Method

Progress measured based on inputs used:

  • Costs incurred to date ÷ Total estimated costs
  • Labor hours worked
  • Materials consumed

📌 Example:
If total estimated costs = $1,000,000, and $400,000 is incurred by year-end:
Progress = 40% → Recognize 40% of transaction price.

2. Output Method

Progress measured based on results delivered:

  • Units delivered
  • Milestones achieved
  • Surveys of performance

📌 Output methods must faithfully depict performance and should be supported by observable evidence.

🔹 Percentage of Completion Table

Assumptions:

  • Contract Price: $3,000,000

  • Estimated Total Costs: $2,100,000

  • Project Duration: 3 years

  • Cost Incurred per Year:

    • Year 1: $500,000
    • Year 2: $800,000
    • Year 3: $800,000
    • (Total = $2,100,000)

  • Annual Billings to Customer:

    • Year 1: $600,000
    • Year 2: $1,200,000
    • Year 3: $1,200,000

  • Cash Collected:

    • Year 1: $500,000
    • Year 2: $1,100,000
    • Year 3: $1,400,000
ItemYear 1Year 2Year 3
Cost to Date$500,000$1,300,000$2,100,000
Estimated Costs to Complete$1,600,000$800,000$0
Estimated Total Cost$2,100,000$2,100,000$2,100,000
% Complete23.8%61.9%100%
Cumulative Revenue Recognized (CIP)$714,000$1,857,000$3,000,000
(Revenue from Prior years)-$714,000$1,857,000
= Revenue Current Year$714,000$1,143,000$1,143,000
(Cost This Year)$500,000$800,000$800,000
= Gross Profit This Year$214,000$343,000$343,000

Billings

ItemYear 1Year 2Year 3
Cumulative Billings$600,000$1,800,000$3,000,000
Cash Collected(Cumulative)$500,000$1,600,000$3,000,000
CIP – Billings$114,000$57,000$0
→ ClassificationUnbilled CIPUnbilled CIPNone

📌 CIP – Billings > 0 → Construction in Progress in Excess of Billings (Unbilled Revenue)
📌 CIP – Billings < 0 → Billings in Excess of Construction in Progress (Overbilled Revenue)
📌 CIP – Billings = 0 → No adjustment needed

🔹 Journal Entries (Simplified)

💡 Standard accounts used:

Construction in Progress (CIP): inventory asset

Construction Expense: recognized cost of construction

Construction Revenue: revenue recognized

Accounts Receivable / Cash: billings or collections

Billings on Construction Contract: contra-CIP account

Year 1

  1. To record construction costs incurred

    Construction in Progress (CIP)     500,000  
    Cash / A/P / Materials Inventory     500,000

  2. To record progress billings to customer

    Accounts Receivable                  600,000  
    Billings on Construction Contract     600,000

  3. To record cash collected from customer

    Dr. Cash                               500,000  
    Cr. Accounts Receivable                500,000

  4. To recognize revenue and gross profit

    Dr. Construction Expense               500,000  
Dr. Construction in Progress (CIP)     214,000  
    Cr. Construction Revenue               714,000

Year 2

  1. To record construction costs incurred

    Construction in Progress (CIP)     800,000  
    Cash / A/P / Materials Inventory     800,000

  2. To record progress billings to customer

    Accounts Receivable                1,200,000  
    Billings on Construction Contract   1,200,000

  3. To record cash collected from customer

    Dr. Cash                             1,100,000  
    Cr. Accounts Receivable              1,100,000

  4. To recognize revenue and gross profit

    Dr. Construction Expense               800,000  
Dr. Construction in Progress (CIP)     343,000  
    Cr. Construction Revenue              1,143,000

Year 3

  1. To record construction costs incurred

    Construction in Progress (CIP)     800,000  
    Cash / A/P / Materials Inventory     800,000

  2. To record progress billings to customer

    Accounts Receivable                1,200,000  
    Billings on Construction Contract   1,200,000

  3. To record cash collected from customer

    Dr. Cash                             1,400,000  
    Cr. Accounts Receivable              1,400,000

  4. To recognize revenue and gross profit

    Dr. Construction Expense               800,000  
Dr. Construction in Progress (CIP)     343,000  
    Cr. Construction Revenue              1,143,000

  5. To close project-related accounts upon completion

    Dr. Billings on Construction Contract   3,000,000
    Cr. Construction in Progress (CIP)       3,000,000

Year-End Balance Sheet Adjustments

At the end of each year:

  • If CIP > Billings:

    Construction in Progress (Asset) - Unbilled Revenue

  • If Billings > CIP:

    Liability: Billings in Excess of Construction in Progress

✅ By end of Year 3, CIP = Billings = $3,000,000, so no remaining asset or liability.

🔹 Contract Asset vs. Liability

  • Contract asset: If revenue recognized > billings
  • Contract liability: If billings > revenue recognized

🔹 Accounting for Contract Losses (Crucial for Exam)

The CPA exam frequently tests how to handle losses. There are two scenarios.

1. Overall Loss on the Contract

This occurs when the new estimated total costs exceed the total contract price.

  • GAAP Rule: If a contract is projected to have an overall loss, the entire estimated loss must be recognized immediately in the period the loss becomes apparent.

  • Example Scenario: Assume at the end of Year 1, management revises the total estimated project cost from $2,100,000 to $3,100,000. The contract is now unprofitable.

    • Contract Price: $3,000,000
    • New Estimated Total Costs: $3,100,000
    • Total Estimated Loss: ($100,000)

  • Year 1 Calculation & Journal Entry:

    1. Recognize the Entire Loss Now: The full $100,000 loss must be booked in Year 1.
    2. Calculate Revenue: The percentage of completion is based on the new cost estimate.
      • % Complete = $500,000 (Cost to Date) / $3,100,000 (New Est. Total Cost) = 16.1%
      • Revenue to Recognize = 16.1% * $3,000,000 = $483,000
    3. Calculate Gross Profit/(Loss) for the Period:
      • Gross Loss = $483,000 (Y1 Revenue) - $500,000 (Y1 Costs) = ($17,000)
    4. Journal Entry to Recognize Revenue and Total Loss: 
      Dr. Construction Expense          500,000
Dr. Loss on Long-Term Contract    100,000  // Recognizes the entire estimated loss
    Cr. Construction Revenue                483,000
    Cr. Construction in Progress            117,000  // Plug figure to balance
      This entry recognizes the revenue for the period and the entire future loss, crediting CIP for the total amount ($17,000 current loss + $100,000 total loss provision adjustment, simplified here).

2. Current Period Loss on a Profitable Contract

This occurs when the costs for a single period are higher than the revenue recognized in that same period, but the overall project is still expected to be profitable. This is handled by the normal journal entry.

  • Example: A project has a gross profit of $50,000 in Year 1 but a gross loss of ($10,000) in Year 2. The entry in Year 2 would simply result in a credit to CIP, reducing its balance.

🔹 Handling Changes in Cost Estimates (Prospective Application)

The exam will often include scenarios where cost estimates change for a contract that remains profitable.

  • GAAP Rule: Changes in accounting estimates are handled prospectively. You do not restate prior periods. You use the new, revised estimate to calculate progress from that point forward.

  • Example Scenario: Assume at the end of Year 2, management revises the total estimated cost from $2,100,000 to $2,200,000. The contract is still profitable.

    • Contract Price: $3,000,000
    • New Estimated Total Costs: $2,200,000
    • Cost to Date (at end of Y2): $1,300,000

  • Year 2 Recalculation:

    1. New % Complete: $1,300,000 (Cost to Date) / $2,200,000 (New Est. Total Cost) = 59.1%
    2. Cumulative Revenue to Recognize: 59.1% * $3,000,000 = $1,773,000
    3. Revenue for This Year (Year 2): $1,773,000 (New Cumulative) - $714,000 (Y1 Revenue) = $1,059,000
    4. Gross Profit for This Year (Year 2): $1,059,000 (Y2 Revenue) - $800,000 (Y2 Costs) = $259,000

🔹 Key FAR Exam Tips

✅ Know when to apply the percentage-of-completion method under ASC 606 (i.e., when control transfers over time).

✅ Master the immediate recognition rule for overall contract losses. This is a high-frequency test topic.

✅ Be able to calculate % complete and recognized revenue, especially when total cost estimates change (prospective application).

✅ Understand all related journal entries (costs, billings, collections, revenue/profit recognition, and the final closing entry).

✅ Differentiate between a Contract Asset (CIP > Billings) and a Contract Liability (Billings > CIP) and how they are presented on the balance sheet.