Accounting Methods for Long-Term Contracts: Completed Contract Method, Percentage of Completion Method

Before that, it doesn’t give useful information for a company’s financial statements. Hence, using this method can be tricky because it relies on estimates, and if the estimates are not updated when things change, it can cause problems with the money. It’s like ensuring the money in the books matches the situation at the construction site. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Below, we’ll break down each of these methods taking a deeper look at how they operate in a construction or specialty trade setting.

Impact on the Chart of Accounts

Once Build-It Construction completes the contract, they may finally move these onto the income statement. To clear the full contract amount from Progress Billings, they’ll perform a debit, then credit revenue. To recognize the costs of the contract, they’ll credit Construction in Progress and debit their expenses.

Who Should Use Percentage of Completion vs Completed Contract?

For example, the IRS (which is like the tax authority) allows the completed contract method in specific situations. Usually, the percentage of completion method is the normal and logical way to do things. Laws in the country might say that contractors should use this method, but there are some exceptions. It recognizes profit and losses for a project in each accounting period while the entity is still working on the project.

Accounting Methods for Long-Term Contracts: Completed Contract Method, Percentage of Completion Method

Completed-contract-method projects also must be completed under a specified timeframe. Of course, that doesn’t mean the contractor who uses the completed contract method doesn’t get paid. They’ll continue to bill and receive payment, much like they would under a different revenue recognition method.

• However, some small businesses use the cash method, which is also called cash-basis accounting.
• Completed homes are recorded as inventory – once the home is sold the sales price is recorded as revenue and the construction costs are removed from inventory and recorded as expenses.
• Except for home construction contracts, CCM can only be used by small contractors for contracts with an estimated life that does not exceed 2 years.
• Total revenue and total gross profit recorded under both the methods are same.

If your construction company isn’t careful, however, this technique can backfire. Expected tax breaks, for instance, will also be deferred to the next season when the project ends. In the construction sector, selecting an accounting technique for projects is no mean task. There isn’t any particular advantage to using it long-term that we can point to from a contractor’s perspective. Over the following months, you’ll buy materials, schedule and pay your crew, and deal with suppliers. You may even receive partial payment or reimbursement for parts of the project.

• Accrual accounting is typically the most common method used by businesses, such as large corporations.
• Completed contract accounting is best suited to short term contracts that last under one year.
• This calculation will result in a current gross profit of $400,000 ($4 million x 0.4) – ($3 million x 0.4).
• Here’s how we advise our construction clients on project revenue reporting methods.

Percentage of Completion-Capitalized Cost Method

In this scenario, you would record the $1,000 of expenses on the day you incurred them. And record the $2,000 in revenue the following week when payment is finally received. In order to use CCM, the project must completed contract method example be completed in less than two years, primarily because the IRS doesn’t want you to defer tax indefinitely. But if the project timeline, as noted in the contract, is less than two years, CCM can be used.

Everything You Need To Build Your Accounting Skills

The completed contract method is one of the most popular accounting methods in the construction industry. It’s the preferred method for short-term contracts and residential projects because of its simplicity and the ability to shift costs and tax liability to the end of the project. The completed contract method has advantages, but it comes with risk as well. Using CCM accounting can help avoid having to estimate the cost of a project, which can prevent inaccurate forecasts. Also, since revenue recognition is postponed, tax liabilities might be postponed as well. From the client’s perspective, the CCM allows for delayed cash outflows and ensures the work is fully performed and received before any payment is made.

Total revenue and costs recognized over the life of the contract were the same under either method. ABC Co. enters into a two-year contract with DEF Township to build a bridge. The contract states that ABC Co. will receive $25 million for this project. Estimated costs under the PCM will be $18 million, for an estimated profit of $7 million. While both methods have advantages and disadvantages, the CCM is more advantageous if annual cash flow is a concern. The PCM may be preferable when the company’s books are expected to be reviewed regularly by external parties over the contract’s life.