Percentage-of-Completion Method

An accounting method used to report income from long-term contracts based on the percentage of contract completion during the tax year.
On this page

Definition

The Percentage-of-Completion Method (PCM) is an accounting technique used to report income from long-term contracts, reflecting the extent of completion of a contract during a particular tax year. This method allocates costs incurred up to the end of the tax year proportionally to the estimated total costs of the entire contract. The same percentage is then applied to the gross revenue from the contract to determine the taxable income for that year. Taxpayers employing PCM must also adhere to the Look-Back Rule for recomputing previous years’ tax liabilities.

Examples

  1. Construction Projects: A construction company engages in a two-year contract worth $2 million. By the end of the first year, it has incurred $1 million in costs out of an estimated total cost of $1.5 million. The completion percentage is approximately 66.67%, and the company must recognize that percentage of the contract revenue ($2 million * 66.67% = $1.33 million) as income for the first year.

  2. Software Development: A software company embarks on a long-term project worth $500,000. By the end of the second year, it has spent $300,000, with total projected costs of $400,000. This yields a completion percentage of 75%, recognizing 75% of the contract revenue ($500,000 * 75% = $375,000) as income over the two years.

Frequently Asked Questions

Q1: What contracts are eligible for the percentage-of-completion method?

  • A1: Generally, long-term contracts, such as construction, engineering, and software development, which span more than one year, can utilize the PCM.

Q2: What is the Look-Back Rule?

  • A2: The Look-Back Rule is a corrective measure requiring the recomputation of income from prior years based on the actual percentages of completion once the contract is finalized. This ensures accuracy in the reported taxable income.

Q3: How does PCM differ from the Completed-Contract Method?

  • A3: While PCM recognizes revenue throughout the life of a project, the Completed-Contract Method records all costs and revenues only upon project completion.
  • Long-Term Contracts: Agreements extending beyond a single fiscal year for delivering goods or services, often used in construction and manufacturing projects.
  • Gross Revenue: Total income from sales before any deductions such as expenses or taxes.
  • Look-Back Rule: A tax provision obligating the recomputation of earlier tax returns to align taxable income with actual project outcomes upon completion.

Online References

Suggested Books for Further Studies

  • “Financial & Managerial Accounting for MBAs” by Peter D. Easton et al.
  • “Revenue Recognition: Principles and Practices” by Steven M. Bragg
  • “Wiley IFRS Interpretation and Application” by PKF International Ltd

Fundamentals of the Percentage-of-Completion Method: Accounting Basics Quiz

Loading quiz…

Thank you for exploring the intricacies of the Percentage-of-Completion Method. Continue to enhance your accounting proficiency with dedicated studies and practical assessments!

Percentage-of-Sales Method
Percentage-of-Completion