Percentage of Completion method and Installment Sales method are both methods of recognizing revenue. Percentage of completion method focuses on construction companies recording profits, while the installment sales method focuses on businesses who sell merchandise on account and are paid back in equal payments through a contractual obligation, almost like a lease.
Percentage ofCompletion method is
one of the trickiest revenue valuation methods. This method is commonly used to
account for construction contracts. Since construction projects usually take
multiple years to finish and construction companies are obligated to report
some of the construction expense to match the current year’s income due to the
matching principle, the percentage of completion method is implemented. The
biggest advantage of the percentage of completion method is that it accurately
reports the amount of revenue earned and expenses incurred on the financial
statements.
Example:
Adequate Disclosure takes on a construction project that is estimated to cost $300,000 to complete, and will bring $700,000 in revenue. This project will take approximately 2 years to complete.
Year 1:
Step 1: $700,000 – $300,000 = $400,000
Step 2: $140,000/$300,000 = 47%
Step 3: 47% x $400,000 = $188,000 (Revenue Earned this year)
Year 2
Step 1: $700,000 - $300,000 = $400,000
Step 2: $140,000 + $115,000 = $255,000/$300,000 = 85%
Step 3: 85% x $400,000 = $340,000
Step 4: $340,000 – $188,000 (Revenue Earned in Year 1) = $152,000(Revenue Earned this year)
Installment Sales Accounting Method:
This method of recognizing revenue is used when collectability is uncertain. This method recognizes income in in the periods of collection rather than the period of sale. It is convenient because it follows the matching principle and the accrual method of accounting. Companies that use this method defer income until the actual collection of cash.
Example:
Adequate Disclosure has the following information at the year end of 2011.
Calculate the gross profit earned and also deferred gross profit.
Gross Profit Earned:
$50,000 - $$25,000 = $25,000/$50,000 = 50%
50% x 30,000 = $15,000
Deferred Gross Profit:
$25,000 – $15,000 = $10,000