Accountants CPA Hartford
William Brighenti, Certified Public Accountant
Certified QuickBooks ProAdvisor
Office Address:  46 Mildrum Road, Berlin, Connecticut 06037-2423      Phone:  (860) 828-3269      Email:  [email protected]
New Britain
The Percentage-of-Completion Method of Accounting for Long-Term Construction Contracts
According to ARB No. 45 and SOP 81-1
by William Brighenti, Certified Public Accountant, Certified QuickBooks ProAdvisor

Accountants CPA Hartford, LLC: William Brighenti, Certified Public AccountantAlthough there was never an individual FASB (Financial Accounting Standards Board’s Statement) or APB (Accounting Principles Board’s Opinion) on the accounting for construction contractors, for decades three publications issued by the AICPA (American Institute of Certified Public Accountants) have constituted GAAP (Generally Accepted Accounting Principles) for construction accounting:
  1. ARB (Accounting Research Bulletin) No. 45:  Long-Term Construction-Type Contracts (1955);
  2. SOP (Statement of Position) 81-1:  Accounting for Performance of Construction-Type and Certain Production-Type Contracts (1981);
  3. AICPA Audit and Accounting Guide, Construction Contractors.
These pronouncements permitted the use of two different accounting methods for the treatment of construction contracts:
  1. Completed Contract;
  2. Percentage of Completion.
The completed-contract method recognizes revenue upon completion of the contract; the percentage-of-completion method recognizes revenue over the life of the contract. 

The two methods should not be used for the same circumstances as acceptable alternatives from which contractors are free to choose as suits them.  The percentage-of-completion method ordinarily is to be used for the accounting of long-term construction contracts except in two situations:
  1. Where reasonably reliable estimates cannot be made; or
  2. Where the results of using the completed-contract method do not differ materially from those obtained by using the percentage-of-completion method.
It is ordinarily presumed that virtually all contractors are capable of making reasonably reliable estimates, otherwise their companies would not be going concerns.  SOP 81-1 states:

For entities engaged on a continuing basis in the production and
delivery of goods or services under contractual arrangements and for whom
contracting represents a significant part of their operations, the presumption
is that they have the ability to make estimates that are sufficiently dependable
to justify the use of the percentage-of-completion method of accounting.
Persuasive evidence to the contrary is necessary to overcome that presumption.
The ability to produce reasonably dependable estimates is an essential element
of the contracting business. Accordingly, entities with significant contracting
operations generally have the ability to produce reasonably dependable estimates
and for such entities the percentage-of-completion method of accounting is
preferable in most circumstances.

Consequently, the burden of proof rests upon the contractor to justify its use of the completed-contract method for long-term construction contracts, since SOP 81-1 clearly specifies a preference for the percentage-of-completion method for the accounting of construction contracts.  Moreover, SOP 81-1 does not excuse the unsophisticated contractor from being required to employ its methodolgy for the recognition of revenue on long-term construction contracts.   Contractors who have “informal estimating procedures” resulting in “poorly documented estimates and marginal quality field reporting and job costing systems”—and who are, therefore, unable to estimate given levels of total contract revenue and total contract costs—would be required then to produce “ranges” of amounts of estimated revenues and costs and therein select the most conservative, if not the most likely,  value.  If they are still unable to estimate total contract costs, then the contractor would be required to estimate total contract costs equivalent in value to total contract revenues, yielding a zero estimate of profit, until results can be more precisely estimated, at which time a change in accounting estimate would be disclosed. 

In essence, SOP 81-1 concludes that if the contractor’s estimates are sufficient to justify one’s bids on contracts, then they “should be regarded as reasonably dependable” enough to justify the use of the percentage-of-completion method of accounting.  In other words, meeting the exception for not using the percentage-of-completion method based on an inability to make reasonably reliable estimates would be extremely rare.

On the other hand, attempts to meet the second exception in order to avoid using the percentage-of-completion method of accounting for long-term construction contracts would be absurd, if not a waste of time.  In order to substantiate that the results of using the completed-contract method would not differ materially from those obtained by using the percentage-of-completion method, by implication a contractor would have to compute the results under both methods, or pay one’s auditor to do so, and then compare the results.  Of course, the question is if the results did not differ materially, why on earth would one incur this additional expense of time and money just to employ the completed-contract method for financial statement purposes.

Unless the contracts were unenforceable, pending litigation, or involved properties subject to condemnation or expropriation, it would be advisable to save money and headaches and use the percentage-of-completion method.  Otherwise, “specific, persuasive evidence” to the contrary would be required to justify the use of the completed-contract method, while the probability of providing such evidence would be rare given the nature of circumstances required to substantiate its use.  Moreover, even though both methods would be required to recognize a loss on a contract in the period in which it became anticipated, the percentage-of-completion method would more than likely enhance a contractor’s financial picture rather than impair it, since it ordinarily offers the prospect of income recognition over the periods of construction.

For most contractors, the real problem with using the percentage-of-completion method is that it is not an easy method to implement and maintain on the books.  Even the most sophisticated and expensive construction accounting software will necessitate considerable judgment and some adjusting journal entries—if not a complete export of a report into Excel—in order to produce accurate financial reports based on its methodology.

Contributing to the problem of reporting revenue in accordance with the percentage-of-completion method of accounting is the fact that the contractor’s books typically are kept and maintained on a basis of accounting facilitating the preparation of its tax returns and not the percentage-of-completion method of accounting.  For many small contractors, that often means the books—particularly in QuickBooks—are kept on the cash basis of accounting, recognizing revenues when payments are received and expenses when bills are paid.  Of course, the cash basis of accounting may have little relevance to the actual revenues earned and the corresponding expenses incurred.  Other contractors possessing a little more accounting savvy sometimes will use the accrual method of accounting on their books even though their tax returns are prepared on the cash basis of accounting, recording revenue when invoices or AIA requisitions are submitted and expenses when bills are received.

Although the percentage-of-completion method of accounting is not cash basis accounting, it is also not accrual accounting as most users know it and as most contractors customarily maintain their accounting records:  that is, it is not simply recognizing revenue when an invoice is submitted, and recognizing expense when a bill is received.  Contractors are notorious for “frontloading” requisitions in order to assist in the financing of construction.  Similarly, invoices from subcontractors and vendors for work or products provided may not strictly apply to the period in question, since such may have been paid for, purchased or invoiced but not yet performed or installed.  As a result, in the everyday books of contractors, revenues and the corresponding expenses of generating those revenues rarely reflect the actual percentage of work accomplished during the accounting period in question, unless, of course, billings are strictly based on the actual work completed and expenses reflect precisely all of the actual work undertaken and installed to-date.

In short, whether contractors employ cash or accrual basis accounting in their normal day-to-day accounting activities, they ordinarily will have to adjust their records at year-end to reflect the actual work completed during the year in order to comply with the requirements of the percentage-of-completion method of long-term construction contracts. 

First, the contractor would need to ensure that all expenses had been accrued for all work undertaken prior to the end of the period.  Failure to do so would impair the results obtained from implementing the percentage-of-completion method since the cost-to-cost method of the percentage-of-completion method—the most widely used method of determining the percentage of completion of contractual work—determines the percentage of completion by dividing the total costs to-date of work undertaken on a contract by the total estimated costs of the contract.  This percentage is then applied to the contract’s value or expected gross profit to arrive at the requisite adjustment to revenues.  Thus, if all costs were not included, the percentage of completion would understate completion and result in less income being recognized.

Second, and equally as important, the contractor would need to ensure that all relevant direct and indirect costs and expenses of construction have been appropriately applied to construction contracts.  The omission of this step could have serious ramifications on the revenues recognized under the percentage-of-completion method of accounting for construction contracts for the same reason as mentioned above.  In addition to direct materials, direct labor, subcontract, and other direct costs, generally accepted accounting principles require the inclusion of indirect overhead expenses in contract costs.  But determining which indirect costs and the amount to apply to contract costs is not as straightforward as applying materials, direct labor, subcontract, and other direct costs since considerable judgment may be involved.

For the sake of simplicity and expediency, it is often recommended that contractors, where permitted, capitalize the same indirect costs in the same amounts on financial statements as reported on tax returns.  For the most part, there are only a few indirect costs that would necessitate different treatment for capitalizing contract costs on tax returns as opposed to financial statements:
  1. Of course, tax depreciation would be reported on tax returns and book depreciation on financials; hence, relevant book depreciation would be capitalized in preparation of the application of the percentage-of-completion method.
  2. Although contract-related research and development expenses would require capitalization on tax returns, GAAP would not permit such treatment on financial statements.
  3. Except for the above two mentioned expenses, virtually all of the other contract-related expenses would be eligible for similar treatment on the tax returns as on the financial statements, including the following, which many contractors might overlook:
    1. Contract administrative expense
    2. Officer salaries
    3. Administrative support departments
    4. Pensions and profit sharing
    5. Rework, scrap, and spoilage
    6. Successful bidding expense
    7. Engineering and design
    8. Storage, handling, purchasing, and related costs
  4. Of course, the following indirect costs would also be capitalized on tax returns and financial statements:
    1. Rent of construction equipment and facilities
    2. Repairs of construction equipment and facilities
    3. Maintenance
    4. Utilities
    5. Tools
    6. Supplies
    7. Inspection, quality control
    8. Indirect labor salaries and wages
    9. Payroll taxes
    10. Fringe benefits
    11. Workers’ compensation insurance
    12. Liability insurance
    13. Certain taxes
By doing such, the amount of work involved in the conversion of financial records to tax return information would be minimized, and the methodology of allocating these indirect costs to individual contracts would be more systematic and rational, objectives which FASB has traditionally endorsed for all accounting methodology.

Third, any mixed indirect overhead costs would need to be first decomposed into that amount representing construction work and that representing strictly selling and general administrative work.  Of course, strictly selling and general and administrative expenses would not be applied to contract costs.  Amounts representing construction activity would be allocated to the construction contracts based on an appropriate driver, such as direct labor and/or equipment hours, direct labor costs, direct material costs, etc., in a systematic and rational manner. 

Fourth, after all expenses had been recorded and accrued, and all direct and indirect costs had been applied to contracts, it is time review and update total estimated costs for all open contracts.  Total estimated costs, or more precisely, total estimated costs to complete, is a significant variable in the process of determining income earned and is thus a significant factor in accounting for contracts.  Ideally, this process should involve all members of the construction team, including the controller, project accountants, engineers, project managers, superintendents, foremen, et al.  Because conditions change daily and change orders modify total estimated costs, this critical step should be undertaken on a frequent basis:  if not weekly, then monthly.  Again, failure to do so will distort operating results, since total estimated costs to complete may often be understated, in turn leading to an overstatement of revenues from the application of the cost-to-cost measure of the percentage of completion.

After all of the above steps are completed, it is now time to compute the percentage of completion.  As previously mentioned, the degree of completion of construction is typically estimated by dividing the total construction costs incurred to-date by the total estimated costs of the contract, or job.  However, other rational and systematic measures of progress toward completion may be employed if appropriate and justifiable, “having due regard to the work performed”.  For example, physical measures of output completed, material quantities, labor dollars, hours of labor, equipment, and/or subcontractors, etc., may be appropriate as long as the measures reasonably reflect the degree of completion in the given circumstances.

Once the particular measure of completion is determined, then the percentage of completion can be calculated:

Percent complete = Total measure to-date / Total estimated measure

Using the cost-to-cost measure, the percentage of completion is calculated as follows:

Percent complete = Total construction cost to-date / Total estimated costs of contract

Then total estimated revenues or gross profit is then multiplied by this percentage of completion to derive the total revenues or gross profit that have been earned to date:

Gross profit to date = Percent complete X Total estimated gross profit

An example of the computation and the respective journal entries can be found in a companion article on the subject:  The Percentage-of-Completion Method by William Brighenti, Certified Public Accountant.  As one can see, the percentage-of-completion method is presently the preferred accounting method of revenue recognition of long-term construction contracts.  Only under rare circumstances would the completed-contract method be employed.  Although conceptually the percentage-of-completion method is not difficult to understand, care must be exercised in its implementation.  Contractors are often careless in accruing all construction costs, including indirect overhead expenses, to contracts, and of failing to update total estimated construction costs, which are subject to constant change and revision given the difficulty of foreseeing all future conditions and including all relevant variables.  With the involvement of all members of the construction team and particularly of a trained accountant in construction accounting, the degree of difficulty in its implementation should be significantly reduced.

This article is provided for informational purposes and is not intended to be construed as legal, accounting, or other professional advice.  For further information, please consult appropriate professional advice from your attorney and certified public accountant. 

Have a tax, a QuickBooks, or an accounting question?  Please feel free to submit it under "Comments" on our blog, Accounting, QuickBooks, and Taxes by William Brighenti, Certified Public Accountant, Accountants CPA Hartford, LLC.  For information and assistance on any tax, QuickBooks, or accounting issue, please visit our website:  Accountants CPA Hartford, LLC. Please visit our sister website, Intense Flavors, and see how you can have a gourmet meal on us when we do your accounting, QuickBooks, and taxes.

If and only to the extent that this publication contains contributions from tax professionals who are subject to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, the publisher, on behalf of those contributors, hereby states that any U.S. federal tax advice that is contained in such contributions was not intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose.  The above tax advice was written to support the promotion or marketing of the accounting practice of the publisher and any transaction described herein.  The taxpayer recipients of this offering memorandum should seek tax advice based on their particular circumstances from an independent tax advisor.

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