What is the Completed Contract Method?
The completed-contract method is one of the methods where the business entity decides to postpone its revenue and profit recognition till the time the project is completed or finished and usually business organizations adopt such methods when they are doubtful about the recovery of their debts.
It is the concept in accounting for the revenue recognition wherein all the revenues and the profits associated with the project is to be recognized only when the project has been finished or completed. Mainly this method is followed if a company is uncertain about the dues collection from the customer under the contract.
- The yield in this method is the same as that of the percentage completion method. However, in the completed contract method, the yield will be considered only after the completion of the project.
- Before the completion of the project, this method provides no useful information to the users of the financial statements of the company.
- However, because of this delay in the income recognition business will be allowed to defer recognition of the related income taxes.
- In case the company is expecting loss on the contract, then it is to be recognized as and when such expectation arises. The company should not wait till the end of a period of the contract for recognizing the same.
Let’s say the company opts to account for the contract received by it as per the completed contract method. Then it has to compile all costs on the balance sheet for the project before the completion of the contract. And then bill the entire fee from a customer in the income statement once the underlying contract is completed. A contract thus is assumed as completed once the remaining costs and the risks of the project are insignificant.
Completed Contract Method Example
XYZ Construction Company is provided with the contract to build a warehouse for the Strong Product Ltd. company on an urgent basis as the company doesn’t have its warehouse to keep the products. Management of XYZ expected to complete the entire project in 3 months, and for that, they decided to adopt the completed contract method.
The total cost incurred in the project is $700,000, and the fee that is to be received from the Strong product Ltd. is $750,000. So, XYZ Construction Company has to consider the cost of $700,000 on the balance sheet for the project. After that, the company has to bill the customer an entire $750,000 fee, which is associated with the project. Finally, recognize a profit of $50,000 and an expense of $650,000.
Advantages
- The principal advantage is that the revenue reported is based on the actual results and not based on the estimates.
- Deferment of taxes as the taxes are deferred by the contractor until the completion of the project.
- The completed-contract method of accounting helps to reduce the cost fluctuations associated with the long term projects. This method also motivates the contractor to apply cost and time-saving methods for the completion of the project as the compensation of the contractor does not change with the actual time taken to finish the project.
- As compared to the percentage of completion method, higher net income is generally reported in the completed contract method.
Disadvantages
- The main disadvantage of this method is that the contractor does not necessarily recognize the income in the period it is earned. As a result, there is a possibility that additional tax liability can be created as the whole project revenue will occur in a single period for tax reporting.
- In the completed contract method of accounting, there is a disadvantage to the investor that if the project takes a long time to complete than the anticipated time, then also the contractor is not entitled to receive any extra compensation.
- The completed-contract method can be used only by the home construction projects or other small projects. Long term contractors always prefer a percentage of completion method.
- The clear information on the operations is not shown in the records and books.
- If there is a loss during the completion of the project, then such losses are deductible only after project completion.
Important Points
- The completed-contract method results in deferred tax liability as it requires paying taxes on the income earned only after the completion of the project. This payment of tax deferment and corresponding tax benefit deferment can have a negative or positive effect on the working capital. Therefore, contractors are required to analyze the implications of taxes before using the completed contract method.
- Since the recognition of the revenue and expense is done only when the project gets completed, so the revenue recognition timing will get delayed and will be highly irregular. Thus, this accounting should be used only if any of the below-mentioned situations prevails:
- Where there prevail the inherent hazards which may interfere with the project completion
- When dependable estimates required for using the project’s percentage of completion are hard to derive
- In case the contracts undertaken are of short term nature and the results that will arise are expected not to vary if any of the methods among contract method or percentage completion method is used.
Conclusion
As per the completed contract method of accounting, all the revenues and costs accumulate on the balance sheet until the project completion and delivery to the buyer. Once the project is delivered to the buyer, the items in the balance sheet are then moved to the income statement. It is used by the company when unpredictability prevails with respect to the collection of the funds from customers.
In case the company is expecting to incur the loss on the contract, then it is to be recognized as and when such expectation arises. Under the completed contract approach, companies have to report the cost and revenue incurred based on the actual results. It helps the company in avoiding the errors which can be caused when estimation is made on various aspects like in case of the percentage completion method.
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