Q: I’ve heard that percent-complete accounting produces more accurate results for longer-term contracts than cash and accrual methods. What are some other advantages of percent-complete accounting?
A: Let’s take these advantages one at a time.
Greater Accuracy, YES!
For many remodelers, money comes in or is invoiced at a different pace than costs are recognized. This can create a see-saw effect on each month’s gross profit for each job. Percentage-of-completion (POC) accounting adjustments provide more accurate results, especially for jobs that stretch across month-ends, because the adjustments are designed to match the income you recognize on your books to the costs you have incurred on that job to date.
Why Cash and Accrual Results Don’t Show True Monthly Job Profits
To see what I mean, look at this example. Let’s say that you’ve created the following estimate for a new job that’s going to last approximately four months:
Now, let’s jump to your accounting records at the end of the first month’s entries. Look at the wildly varying results that you could get if you use the cash or accrual methods:
Wow! These two methods show a difference of $15,000 ($10,000 profit? Or $5,000 loss? Or are they both wrong?) Well, from a management perspective, the cash basis is misleading because it looks like you’ve “earned” $10,000 (67% gross profit). You know that doesn’t reflect your true profitability because that’s simply the amount of cash that’s traded hands. You still have vendors to pay. And 67% gross profit? This job is just not on track to earn that much, is it?
The accrual basis results aren’t really useful either. It looks like you’re losing lots of money on this job ($5,000 or a minus-20% gross profit margin). But that’s not right because you did a good job of estimating this job, and you know you’ll make money by the time it’s finished. The $5,000 loss for this month not only doesn’t feel right, it looks downright discouraging.
Of course, you could probably make some “mental modifications” for the first month. But when you get to the second and third months, things start getting a bit more complicated, and results can swing from positive to negative from one month to the next. Using either the cash or accrual method, you won’t know how things are going on this job until you get to the end.
Then, if you stop to consider that these inaccuracies can repeat themselves for each of the jobs that you currently have in production, it’s easy to see that, using either method, you will never know how profitable you really are at the end of any given accounting period -- month, quarter, or year-to-date. That’s a tough way to run a business.
How Do Percentage-of-Completion Adjustments Bring Sanity to Your Results?
To make the POC adjustment, do the following:
- Compare this job’s actual cost to date (as shown on your job cost report) against your estimated costs and compute the cost booked as a percentage of estimated cost.
- Multiply that percentage against your estimated income to match income proportionally to costs.
- Make a temporary entry to adjust your income up (or down) to keep your income aligned with costs.
Let’s apply these steps to the accrual-based income example:
- The accrued costs incurred to date on this job are $30,000. This is equal to 42.86% (rounded) of our anticipated costs of $70,000.
- According to the POC approach, we should show 42.86% of the total anticipated revenue on our books: 42.86% of $100,000 = $42,860.
- We have invoiced the client, according to our contract, $25,000 thus far. So, we make a temporary entry of $17,860 to increase our income on this job up to the $42,860.
Accounting note: The other side of this income adjustment goes to a balance sheet account typically called “under-billings” (or “overbillings” if income needs to be decreased). After the adjustment to income, our gross profit for this job at the end of the first month looks like this:
Now we’re talking! Our net income for the month should not be $10,000 (as shown in the cash method), or ($5,000) as shown in the accrual method. Instead, it should be the $12,860 as shown above. That’s $2,860 more than shown using the cash method, and $17,860 more than shown using the accrual method.
Estimated Income and Costs Can Change Over Time
Be sure to adjust your initial estimated income and costs for change orders, as well as for known budget overruns or known savings each month. Use the adjusted numbers for calculations to keep your financial results synchronized between estimated costs and actual costs.
If you don’t do this, you may end up seeing a significant variance in dollars and gross profit in the final month of the job’s life, which defeats what you’re trying to accomplish with the percentage-of-completion entries in the first place.
In addition to providing an up-to-date, accurate picture of gross profit, other benefits of the POC accounting method arise from preparing the information needed for the entries. This includes:
- The need to prepare real cost estimates. Believe it or not, some companies simply prepare income estimates for customers, but not cost estimates for internal use. Preparing cost estimates sets the stage for being able to review Estimated vs. Actual Cost variance reports -- a necessity for monitoring job costs and keeping them under control.
- Tracking and entering change orders (both additional costs and income) into the accounting system (or POC spreadsheet) on a monthly basis. This process helps to keep these critical money-robbers from disappearing into the mist.
- Finding and including known life-to-date cost overruns or savings into the calculations helps you become more aware of, and stay on top of, changing profit margins as they occur. There’s no need to wait until the end of the job to see how the financial results shake out.
- A good POC worksheet will also help to show remaining income to be earned, helping you anticipate future earnings from jobs in process.
The Case for Percentage-of-Completion Entries
Most business management experts agree that you can only improve what you can measure, and that the process of (accurate) measurement, in and of itself, almost always brings about change and improvement.
Implementing POC procedures and gathering the required information should certainly help you to manage more efficiently and achieve greater profitability.
Click on this link for more specific instructions for percentage-of-completion accounting entries (suitable for accounting or bookkeeping staff using QuickBooks).
--Diane Gilson ([email protected]) created the accounting firm of Info Plus(+) Accounting in 1994 with the intent of providing current and future-oriented management accounting services to small- and medium-size businesses. Since the firm’s inception, Diane has worked exclusively in QuickBooks -- a powerful, flexible, multifunctional software accounting system currently used by 70% to 85% of small- to medium-size businesses in the U.S. She is a Certified QuickBooks Advanced Professional Advisor and Certified QuickBooks Enterprise ProAdvisor (through Intuit), and a Certified QuickBooks consultant (through the Sleeter Group Consultants Network).