The Percentage of Completion Method (POC) is a fundamental accounting technique primarily used by businesses handling long-term contracts, such as construction, engineering, or software development firms. This method allows companies to recognize income and expenses gradually, in proportion to the contract’s progress, rather than only reporting financial results upon project completion. It provides a more accurate reflection of a company’s financial activity and taxable income year over year.
Why the Percentage of Completion Method Matters
For projects that span multiple tax years, such as constructing a building over two years, traditional accounting methods that recognize income only at the end can create significant fluctuations in reported earnings and taxes owed. The IRS requires or permits the use of the Percentage of Completion Method for many long-term contracts to provide clearer financial transparency and align revenue with actual work performed and costs incurred. This approach is detailed in IRS Publication 538, which covers accounting periods and methods.
How the Percentage of Completion Method Works
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Estimate Total Project Revenue and Costs: The business begins by determining the total expected contract revenue and the estimated total costs to complete the project.
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Measure Project Completion Percentage: Typically, the percentage of completion is calculated by dividing costs incurred to date by the total estimated costs. For example, if $500,000 has been spent out of an expected $2 million, the project is 25% complete.
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Recognize Proportional Revenue and Expenses: The accounting records recognize 25% of the total contract revenue and related expenses during the current accounting period.
This method ensures income recognition matches the work progress, smoothing out earnings and tax liabilities across multiple periods.
Examples of Use
- Construction companies: Building infrastructure like roads, bridges, or commercial buildings over several years.
- Engineering and architectural firms: Managing multi-year design and development projects.
- Custom software developers: Engaged in large, extended contracts where deliverables and payments are phased.
IRS Requirements and Guidelines
The IRS generally mandates the Percentage of Completion Method for contracts that extend beyond 12 months when the total contract value exceeds $25 million, with some exceptions for smaller contractors who may opt for the Completed Contract Method (CCM). Choosing the right accounting method depends on your business size and contract specifics.
Best Practices
- Maintain accurate and up-to-date cost tracking: Regularly revise cost estimates and project progress to avoid inaccurate income reporting or unexpected tax bills.
- Engage with a qualified CPA: Tax rules for long-term contracts and revenue recognition are complex. Professional advice helps maintain compliance and optimize tax outcomes.
- Avoid switching methods without IRS approval: Consistency in your chosen accounting method is critical to avoid penalties.
Common Missteps
- Applying the method to short-term contracts, which is inappropriate.
- Underestimating costs leading to premature income recognition.
- Switching between the Percentage of Completion and Completed Contract methods improperly.
Percentage of Completion vs. Completed Contract Method
| Aspect | Percentage of Completion | Completed Contract |
|---|---|---|
| Income Recognition Timing | Throughout the project as work progresses | Only at project completion |
| Financial Reporting | Provides smoother, accurate revenue allocation | Income reported in lump sum at end |
| IRS Usage Requirement | Required for large, multi-year contracts | Allowed for smaller contracts or shorter projects |
| Tax Payment Timing | Taxes paid yearly based on progress | Taxes deferred until project completion |
| Record-Keeping Complexity | Requires detailed documentation and updates | Simpler record-keeping |
Understanding this method can help businesses involved in complex projects better manage financial reporting and tax obligations.
For detailed IRS guidance, see IRS Publication 538. You can also learn more about related accounting methods such as the Completed Contract Method and Accrual Method on FinHelp.
This method may seem complex, but it allows businesses engaged in long-term contracts to align income recognition closely with actual work accomplished, offering a realistic financial picture for management, investors, and tax authorities alike.
