Question

Edward Foster is a building contractor. He and his customer have agreed that he will submit a bill to them when he is 25 percent complete, 50 percent complete, 75 percent complete, and 100 percent complete. For example, he has a $200,000 room addition. When he has completed 25 percent, he will bill his customer $50,000. The problem occurs when he is 40 percent complete, has incurred expenses but cannot yet bill his customer. How can his revenue and expenses match? Discuss several ways that Edward's accountant could solve this problem. What accounts would be used?

Answer 1

1) Percentage of Completion Method

The percentage of completion method for recognizing revenue is typically used in large or long-term projects. Firms that provide construction services, engineering services or other services with long projects are most likely to use this method. Providers of these services need to be able to demonstrate that they are generating revenue even though projects are not yet complete.

The percentage of completion method may only be used if both of the following requirements are met:

There is a long-term contract in place that is enforceable by law.
The project is set up in a way that allows for the percentage of completion to be estimated in order to allocate both revenue and expenses.

The percentage of completion method can be computed in two ways:

Revenue may be recognized at specific milestones. For a building, that could be a specific number of square feet, or a web design firm may have milestones of a specific number of pages for a website.
The percentage of completion may also be calculated based on cost. For example, if a firm expects costs to total $1,000,000 and they have incurred $300,000 in cost, the project would be seen as 30 percent complete.

While this revenue recognition method provides an alternative for long-term contracts, revenues may be overstated if the timing for expenses and completion of work are not properly aligned.

2) Completed Contract Method

When the completed contract method is used, revenue is recognized only once the project is complete and the contract is fulfilled. This method applies to both revenue and expenses. The only time this revenue recognition method is used is when the requirements of the percentage of completion method are unable to be met. For example, if a contract is not enforceable or if completion percentage cannot be calculated.

Since revenues are not recognized until a project is complete, the completed contract method runs the risk of under-reporting revenue at the time it is earned and overstating revenue once it is recognized.

3) Sales Basis Method

With the sales basis revenue recognition methods, revenue is recorded at the time of sale. Sale is defined as the period of time where goods and services change hands, which may or may not be at the same time as payment.

For example, if a customer makes payment before they receive delivery of the product, the revenue isn’t recognized until the product is delivered.

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