A Guide to the Percentage of Completion Method for Contractors
For most working taxpayers, accounting for income is as simple as keeping a record of W2 documents they receive from their employer. If you run your own business, you must keep up with costs and received income for sales of products or services. A service provider records income as soon as a sale is complete. However, in the construction industry, this isn't always possible. That’s where the percentage of completion for contractors comes in.
Construction projects often take months or years to complete. If the contractors working those jobs only record income for completed projects, personal and business income appears sporadic and unsuccessful. Instead, the IRS requires contractors to report income as a project progresses to indicate a steady income flow. The process used for this accounting technique is called the percentage of completion (POC) method.
Can Contractors Wait Until a Project Is Complete to Report Income?
Determining income for a project that isn't complete isn't without flaws. It requires foresight and many calculations that include materials and labor completed in the past and how much of the project is incomplete. With this in mind, accounting would be much easier for contractors who simply report income after the project is complete.
This may seem like an easy solution. But the IRS requires businesses to recognize revenue in the period in which they earned it. Contractors and subs who aren't waiting for years to get paid can't wait for years to report income. The only exception is small contracts that companies will complete within two years. To meet this exception, contractors must be considered a small business that has grossed $25 million or less over the past three years, and the project must be completed within two years. Contractors who can't meet these criteria must report income during the project.
How to Use the Percentage of Completion Formula
Distilling a partially completed project into accurate, reportable figures can feel like a mathematical feat when so many variables are involved. If the total estimated cost of a project is $100,000, that figure includes supplies and labor. This means you can calculate the percentage completed on a project using more than one indicator. You can calculate the percentage of completion for contractors by using costs, units, or labor hours. No matter what method you choose, it's important to be consistent.
For the sake of simplicity and the use of firm numbers, most contractors use costs to calculate POC. Units can only be utilized in projects when a specific number of units is required. You can also calculate labor hours using estimated hours of labor on the job or machine hours.
To calculate POC using costs, you must divide the total costs to date by the total estimated costs of a project. Let's look at that $100,000 project. If the costs to date equals $40,000, the POC is as follows: 40,000 ÷ 100,000 = 0.4 or 40%. If the contract is for $125,000, $50,000 can be included in the income statement.
Similarly, if the total estimated labor hours for a project is 5,000 and 1,250 are completed, you can calculate POC as follows: 1,250 ÷ 5,000 = 0.25, or 25%. For the same $125,000 contract, you can list $31,250.
Why the Percentage of Completion Formula Gets Complicated
Once you have the POC formula in place, filling out the income statement should be a breeze. Unfortunately, like all matters of construction billing and invoices, there can be complications with the POC. Change orders and slow payments are common factors in the construction industry. These issues can mean your percentages fail to add up, which results in overbilling, underbilling, or other inaccuracies.
Recognizing Change Orders
People create emergency change orders throughout a project. Unfortunately, the accounting team might not receive notification as quickly as the contractors. When builders execute change orders before accountants include them in the project's costs, it appears like they're overbilling the project. Even if the numbers match up in the future, the current accounting period will reflect inaccurate losses.
It's impossible to predict the frequency of change orders. But staying on top of changes is essential to the proper accounting procedures of your company. Making sure change orders accurately go into the system will provide an accurate estimate of costs and avoid incidents of overbilling.
When Estimates Fail to Equal Payments
Estimated costs are essential to the inner workings of a long-term project. In order for contractors to obtain supplies and complete a job, they use a variety of documents to track the costs of the entire job as it progresses. But suppliers, contractors, and subs might be working with different aspects of the same project. So the paper trail doesn't always add up to the money in the account.
The percentage of completion equation allows contractors to report income for completed work. However, it can also mean using unpaid invoices to calculate the costs. Reporting income when you have uncollected payments paints an inaccurate picture of your company's income. It can also lead to cash flow problems. To avoid spending cash you don't actually have, it's important to find a way to streamline your construction billing process for the most up-to-date numbers and receipt of payment on time.
How Construction Billing Software Leads to More Accurate POC Calculations
Using the percentage of completion formula in construction requires the routine input of specific data from several sources. This leaves considerable room for error and inaccuracies due to missing paperwork and late payments. Construction billing software should address issues that cause inaccuracies and slow down the billing process. It can also help you import the data you need for accurate percentage of completion calculations.
Construction billing software from Flashtract provides general contractors with control over unapproved change orders and the ability to electronically sign documents when and where they are. Additionally, the ability to send automated reminders for billing documents and payments keeps everything up to date. Your company's bank account can more easily match your calculations. A streamlined billing process with the help of customizable software means you can improve your billing process. You can also seamlessly integrate accounting payment statements into your routine.