Completed contract method definition
/What is the Completed Contract Method?
The completed contract method is used to recognize all of the revenue and profit associated with a project only after the project has been completed. This method yields the same results as the percentage of completion method, but only after a project has been completed. Prior to completion, this method does not yield any useful information for the reader of a company’s financial statements.
When to Use the Completed Contract Method
The completed contract method is used when there is uncertainty about the collection of funds due from a customer under the terms of a contract. Since revenue and expense recognition only occurs at the end of a project, the timing of revenue recognition can be both delayed and highly irregular. Given these issues, the method should only be used under the following circumstances:
When it is not possible to derive dependable estimates about the percentage of completion of a project; or
When there are inherent hazards that may interfere with completion of a project; or
When contracts are of such a short-term nature that the results reported under the completed contract method and the percentage of completion method would not vary materially.
Advantages of the Completed Contract Method
There are several advantages associated with using the completed contract method, which are as follows:
Income tax deferral. The delay in income recognition associated with the completed contract method allows a business to defer the recognition of related income taxes. This defers the payment of cash to a later period, thereby giving the company the use of that cash in the meantime.
Simplifies revenue recognition. Because all revenue recognition is done at the conclusion of a project, the completed contract method allows you to avoid estimating project progress, the amount of work completed, or the percentage of costs incurred.
Reduces complexity. Because revenue recognition is delayed until the end of a project, the completed contract method reduces the complexity of the accounting work required for a project. This is quite useful when a contractor does not have a large accounting staff, and especially when they are not highly trained in the complexities of contract accounting.
Avoids premature profit recognition. When there are substantial uncertainties related to a project, using the completed contract method eliminates the risk of recognizing profits prematurely, when there may actually be no profit at all, or perhaps a loss.
Disadvantages of the Completed Contract Method
The completed contract method creates several disadvantages for financial reporting and performance analysis, which are as follows:
Distorted financial results during the contract period. Revenue and profit are not recognized until the project is completed, even though work may occur over multiple reporting periods. This can make financial statements appear unusually weak during the construction phase and unusually strong when the contract is finished.
Reduced transparency for financial statement users. Investors and lenders may find it difficult to assess the progress or profitability of long-term contracts. Because results are deferred, the financial statements do not reflect the economic activity occurring during the contract period.
Potential tax volatility. Income is recognized in a single period when the contract is completed, which can cause large fluctuations in taxable income. This timing issue may result in uneven tax obligations and less predictable tax planning outcomes.
Related AccountingTools Courses
Auditing Construction Contractors
Accounting for the Completed Contract Method
If a contract is being accounted for under the completed contract method, record billings issued and costs incurred on the balance sheet during all periods prior to the completion of the contract, and then shift the entire amount of these billings and costs to the income statement upon completion of the underlying contract. A contract is assumed to be complete when the remaining costs and risks are insignificant.
If there is an expectation of a loss on a contract, record it at once even under the completed contract method; do not wait until the end of the contract period to do so. Recording losses at once represents the most conservative form of accounting, ensuring that financial statement users are aware of problems as soon as they arise.
Example of the Completed Contract Method
Logger Construction Company is building housing for a disaster relief agency, and is doing so at great speed, so that displaced citizens can move in as soon as possible. Logger’s management expects that the entire facility will be complete in just two months. Given the short duration of the project, Logger elects to use the completed contract method. Accordingly, Logger compiles $650,000 of costs on its balance sheet over the period of the project and then bills the customer for the entire $700,000 fee associated with the project, recognizes the $650,000 of expenses, and recognizes a $50,000 profit.
FAQs
How is tax reporting affected by the completed contract method?
Under the completed contract method, taxable income from a contract is recognized only when the contract is finished. Revenue and related costs are deferred until completion, which can delay tax liability. This method may improve short-term cash flow but can result in large taxable income in the completion year.