Generally accepted accounting principles, or GAAP, require businesses to recognize revenues in a way that matches closely with expenditures and accrue those revenues within the same accounting period as the expenses. The installment method and percentage-of-completion method are each revenue recognition structures specifically designed for businesses that operate under contract on large projects. Some examples include construction companies, real estate developers and engineers, as each generally works on large-scale projects that take months or even years to complete. For investors, understanding these two methods is essential when determining profitability and sustainability of these types of companies.
The installment method is suitable for construction companies, especially for homebuilders, as they routinely make contracts to build and only receive some revenues before and during the project, with the majority of the revenue received at completion. Meanwhile, costs add up, and building materials must be paid along the way regardless of revenues received. To claim the expenses incurred, there must be revenues to match. For example, if a home is to be built at a contracted price of $300,000, with the builder’s cost at $200,000, the builder might accept a $5,000 down payment.
The builder calculates the gross profit for the entire transaction, then applies that proportionately to the revenues as they are received. For the first month, in which the $5,000 down payment was received, the builder would take his gross profit percentage of 67 percent ($200,000/$300,000) and record the down payment as $3,350 ($5,000 x 0.67) gross profit; however, this method can overstate gross profits if the final payment is not received. This is because all calculations assume the entire sales price will be collected.
The percentage-of-completion method is also commonly seen with builders, although generally for those with much longer-term contracts for huge projects such as the construction of an office building. In this method, revenues and expenses are recorded based on how much work has been completed. Thus, the requirements for using this method are that the project be easily identifiable by stages of completion and that specific costs be attributed to each stage. The company then reports earnings using an estimated total cost against incurred expenses or distinguish milestones, such as how many floors are completed.
For example, using the milestone approach, in building a 10-story office building, the contractor determines the cost per floor at $100,000. Then, the company calculates revenue and expenses for each completed floor. If the sale price of the building is $5 million, and four floors have been completed, this is calculated as $1.25 million of revenue and $400,000 in expenses for a gross profit of $850,000. For the cost approach, the builder determines the estimated gross profit for the project to be $4 million. With the building 40 percent complete, and $400,000 in expenses, the revenues can be accrued as $1.6 million ($4 million x 0.40). Like the installment method, the percentage-of-completion method can overstate gross profit if expenses are contributed to work before it is actually completed.