The percentage of completion (POC) calculation has traditionally been considered the best recognition of progress toward completion of a contract. The POC can be computed with factors other than costs, such as labor hours or labor costs or machine hours. Also, the costs can be total contract costs or a specific limited type of costs, such as direct costs only.

The POC is simply a ratio of one factor, such as contract costs incurred, to the total estimated amount of that factor at the completion of the contract, such as total estimated costs.

The computed ratio is applied to the total estimated revenue on the contract for the amount of the contract revenue to recognize.

If another factor is used, such as labor hours, then the POC would be calculated with labor hours incurred in the numerator and total estimated labor hours in the denominator.

Challenges
The revenue and gross profit of a contractor using the POC can be manipulated. The total contract revenue often changes during the performance of the contract with change orders. While most contractors will wait for a signed change order to recognize the changed contract amount, GAAP permits the use of the estimated contract amount for the POC calculation.

Another critical estimate is the total contract costs at completion of the contract. With so much of the financial statement revenue, gross profit and equity based on estimates, accuracy is impossible and manipulation is always a concern.

The most solid number used in the calculation of the POC is the contract costs incurred, but that amount is an accumulation that can vary from contract to contract. The concrete and steel may be relatively easy to identify and correctly classify to a contract, but the soft costs (e.g., labor burden, insurance and equipment) and the allocated indirect costs can be challenging to reasonably allocate on a consistent basis.

Current Numbers and Estimates
GAAP requires that estimates be updated as necessary prior to any calculation of the POC for GAAP financial statements. If contract profit is slipping, a natural tendency is to use the older, more optimistic estimates and hope that better production effort will make up the profit fade prior to contract completion, or postpone the financial reporting of the slippage or loss.

Noodling the Numbers
Also, a contractor may try to offset the financial reporting of fade on one contract with the profit on another one. While trying to cover one problem, a second is created. Rather than just properly reporting fade on the first contract, fade is also created on the second. And to make matters worse, sometimes this rolling of problems from one contract to another, over time, over several contracts, may culminate with a very bad loss on the final contracts.

One of contractors’ favorite calculations to make a loss contract look better is to use a lower estimated cost to complete than what the contractor reasonably knows or expects. This may be apparent when the under-billings—the asset calculation of the POC—are larger than expected or larger than typical for the contractor. Because the contractor will bill generally close to actual production, but the POC calculation shows that the contract is farther along than it actually is, the under-billings will be exceptionally large. Large under-billings, without an explanation to support the amount, are often the first sign of profit fade. For example, if the contract is actually about 50 percent done but the POC computes to 60 percent complete, that difference may be caused by additional costs incurred that are not recognized in the total estimated costs.

Costs to Include in the POC
The costs to include in the numerator of the calculation may not include all the costs incurred and, at the same time, may include some costs that the contractor has not yet booked.

A common challenge is what, if anything, to include as costs incurred if the material has not been installed in the building or bridge or whatever is being constructed. If the uninstalled materials are specially fabricated for that contract, it is customary to include those costs, but an option to not include those costs is available if the contractor believes they may skew the POC to represent more progress than actual. If the material is generic (e.g., sheets of plywood that have not been installed), then the rules require those costs to be eliminated from the numerator in the calculation of the POC.

A general contractor may have a subcontractor that bills slowly, but has performed the work, so the general contractor will include that work in its billing to the owner. The numerator of the POC ratio is supposed to include costs incurred. While that usually includes costs on the general contractor’s books, in this example, the subcontractor’s unbilled work should be included in the calculation because the cost has been incurred.

The flip side of that subcontractor billing also can be a challenge. What if the subcontractor has billed the general contractor for work that has not been done yet? Should that billing be in the numerator of the POC ratio? This should not be a POC calculation challenge, but is a clue to a systemic control problem of the general contractor. If that question arises, it should be addressed with a review of the controls because that billing by the subcontractor should not be entered into the general contractor’s books until the work has been done and approved. With proper controls in place, this question should never arise.

Red Flags
Internally, the subjective estimates from superintendents and project managers should serve as a reality crosscheck for the POC calculation. For example, if the calculation shows the job to be 80 percent complete, but the project manager says it is only 50 percent complete, it is time to dive into the individual cost detail to see what has exceeded the budget and how much of a loss the job will eventually create. On the other hand, if the project manager says the job is 80 percent complete, but the POC computes to 50 percent, then the construction financial professional has to look at the estimates and the recorded costs to see what has been omitted and why there is such a big difference in the objective calculation and the subjective evaluation of actual performance.

Externally, financial statement users look at the individual POC calculation on each contract, both currently and historically, for consistency of estimating, production and reporting with the tracking of the over-billings or under-billings on individual jobs and for the company as a whole. If there is a pattern of unexplained job fade from prior financial reporting, the current financials will surely be discounted for a lack of credibility for an expected deficiency in estimating or production.

The POC calculation and the related over-billing and underbilling amounts on the balance sheet are essential to proper financial reporting but have a unique complexity that require a close look at the results of the calculation for both contract management and proper financial reporting.

Alan Clark is a partner at Smith, Adcock and Company LLP, Atlanta. For more information, email aclark@smithadcock.com.