Percentage of completion: revenue on long contracts
How a contractor recognises revenue on a long contract by percentage of completion, and how work in progress and advance billings appear in its books.
By Achekam · · 5 min read · For Construction businesses in South Africa, Nigeria, Kenya
A contractor building a school over eighteen months sends progress invoices whenever the client's quantity surveyor values the work. Some months the invoice runs ahead of the work actually done, because the contract allowed an advance or front-loaded preliminaries. Other months the work runs ahead of the invoice, because a valuation was delayed or a variation is still being agreed. If the books simply treat each invoice as that month's revenue, the income statement goes up and down with the paperwork rather than with the building.
The percentage of completion method exists to fix that. It ties revenue to the progress of the work, not the timing of the invoices. This article explains how it works, when it can be used, how the gap between revenue and billing appears in the books, and why it needs a careful review every month.
Revenue by stage of completion
Investopedia explains that the percentage of completion method recognises revenue and expenses each period according to how much of a long-term contract is complete. Its example: a project that is 20% complete at the end of year one and 35% complete at the end of year two recognises only the additional 15% of revenue in year two.
The alternative Investopedia describes is the completed contract method, which defers results until the project is finished. For a contractor with a few large jobs, that would mean years with almost no revenue followed by a year with a great deal, which tells the directors, the bank and the tax authority very little about how the business is actually doing.
Investopedia's guide to the percentage of completion method walks through the method, its conditions and its risks.
The two conditions
The method is not available on every contract. Investopedia says two conditions must be met: the company's collections must be reasonably assured, and it must be able to reasonably estimate both the costs and the rate of project completion.
In construction terms, the first condition asks whether the client can and will pay. The second asks whether the contractor has a reliable cost-to-complete and a sound way of measuring progress, such as costs incurred against total expected costs, or surveyed quantities against the bill of quantities. A job with no credible budget, or a client in financial distress, fails one or the other.
Work in progress and advance billings
Because revenue follows progress and invoices follow the contract's payment terms, the two rarely match. The difference has to sit somewhere on the balance sheet.
Investopedia uses Fluor Corporation's disclosures to show how. Income recognised in excess of the amounts billed is carried as a current asset, described as contract work in progress. Amounts billed in excess of the income recognised are carried as a current liability, described as advance billings on contracts.
| Situation | Balance sheet | Meaning |
|---|---|---|
| Work done ahead of billing | Current asset: contract work in progress | Revenue earned, not yet invoiced |
| Billing ahead of work done | Current liability: advance billings | Invoiced, not yet earned |
Your accountant will present these balances in the terms of the reporting framework the business uses, but the logic is the same.
When estimates change
Estimates on a long contract will change. Investopedia notes from Fluor's accounting policies that changes to total estimated contract costs or losses are recognised in the period in which the company determines them. A contractor does not go back and restate earlier months when the cost-to-complete rises; it adjusts in the month it finds out. And if the revised estimate shows the whole contract will make a loss, that loss is a matter for immediate attention.
Why the method needs a firm review
The method relies on judgement: how complete is the job, and what will it cost to finish? Investopedia warns that it is open to manipulation, citing Toshiba's infrastructure unit, which understated operating costs by approximately 152 billion yen ($1.2 billion) between 2008 and 2014.
A contractor does not need to be a listed company to fall into the same trap on a smaller scale: an optimistic cost-to-complete in a tight month makes the job look more profitable and the month look better. The guard is a review by someone other than the person who prepared the figures:
- Is the percentage complete supported by a survey, a valuation or a cost report?
- Has the cost-to-complete been rebuilt from the remaining work, not just the unspent budget?
- Do the work in progress and advance billing balances agree to the contract schedules?
- Have changes in estimates been explained?
Month-end journals per contract
The percentage complete is worked out in the contract schedules your quantity surveyor and accountant keep. Achekam's books carry the results.
Customer invoices are created as drafts that can be changed or deleted, and issuing one takes the next number in its sequence and posts it to the ledger as debtors, sales and output VAT. That is the billing side, and it should follow the contract's payment terms.
The adjustment from billing to earned revenue is a manual journal. Each business has its own ledger with a standard chart of accounts, and accounts can be added, so add accounts for contract work in progress and for advance billings. At month end, post a journal per contract that moves revenue between sales and the right balance sheet account. Achekam refuses a journal that does not balance or that is dated in a closed month, and corrects a posted journal only by a reversal.
Then close the month. Months can be soft-closed, hard-closed and locked; a closed month refuses postings from every source, and reopening a hard close needs a second approver. Closing after the journals are reviewed keeps the reported revenue from being quietly adjusted later.
For agreeing the last valuation with the client, see reconciling the final account; for advances paid at the start of a contract, read setting off an advance payment.
Revenue that follows the building, reviewed every month, gives a contractor accounts it can actually manage by.
General guidance only, not advice on your own circumstances. Tax and payroll rules change: check the current position with the authority or your adviser.
