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
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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.
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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
### How does the percentage-of-completion method recognize revenue?
- [x] Based on the percentage of contract completion
- [ ] When the contract is awarded
- [ ] Upon contract completion
- [ ] At the beginning of the project
> **Explanation:** The percentage-of-completion method recognizes revenue throughout the life of the project based on the actual work completed, providing a more accurate reflection of financial performance.
### What industries commonly use the percentage-of-completion method?
- [x] Construction and engineering
- [ ] Retail
- [ ] Pharmaceuticals
- [ ] E-commerce
> **Explanation:** Construction and engineering projects often span over multiple years, making the percentage-of-completion method suitable for matching income with incurred expenses over time.
### What rule must be followed when using PCM to ensure accurate tax reporting?
- [ ] Last-In, First-Out Rule
- [ ] Matching Principle
- [x] Look-Back Rule
- [ ] Future Earnings Rule
> **Explanation:** The Look-Back Rule ensures any discrepancies in estimated vs. actual costs are accounted for by recomputing prior years' tax liabilities once the contract is completed.
### Can software development projects use the percentage-of-completion method?
- [x] Yes
- [ ] No
- [ ] Only for projects longer than five years
- [ ] Only for government contracts
> **Explanation:** Yes, software development projects can use the percentage-of-completion method if they span more than one fiscal year, ensuring revenue is matched with work completed.
### What percentage completion does a project have if $200,000 out of estimated $400,000 total costs are incurred?
- [ ] 25%
- [x] 50%
- [ ] 75%
- [ ] 100%
> **Explanation:** The project is 50% complete if $200,000 total costs are incurred out of an estimated $400,000, indicating that half of the project's tasks have been finished.
### How are revenue and expenses recognized in the completed-contract method?
- [ ] As and when costs are incurred
- [ ] At project milestones
- [ ] Upon contract completion
- [x] Only when the entire contract is completed
> **Explanation:** In the completed-contract method, revenues and expenses are recognized only upon the project's completion, differing from PCM which recognizes them throughout the project lifespan.
### What is a key advantage of the percentage-of-completion method?
- [ ] Simple bookkeeping
- [x] Matches revenue with work completed
- [ ] Immediate full revenue recognition
- [ ] Deferred revenue until completion
> **Explanation:** The key advantage of PCM is matching revenue with the work completed at various stages of a project, offering a more accurate financial picture over time.
### When comparing actual costs against estimated costs, what does a higher completion percentage indicate?
- [ ] The project is behind schedule
- [ ] Increased profit margins
- [ ] Decreased project expenses
- [x] More of the project has been completed
> **Explanation:** A higher completion percentage suggests that more of the project tasks have been accomplished relative to initial cost estimates.
### How does the PCM help in financial reporting for long-term contracts?
- [ ] Revenues are understated
- [x] Income is recognized proportionately as costs are incurred
- [ ] Expenses are recorded only after completion
- [ ] Gains are deferred until the final period
> **Explanation:** PCM aids financial reporting by recognizing income proportionately with costs incurred, aligning revenue recognition with the progressive completion of a project.
### Why is retrospective tax liability adjustment necessary in PCM?
- [ ] To overestimate current period revenues
- [x] To ensure previous years' income aligns with actual project completion
- [ ] For simplifying tax calculations
- [ ] To defer taxable income
> **Explanation:** Retrospective adjustments ensure that any discrepancies between estimated and actual costs reflect true project completion, ensuring accurate historical income reporting.
Thank you for exploring the intricacies of the Percentage-of-Completion Method. Continue to enhance your accounting proficiency with dedicated studies and practical assessments!
