What Is Completed Contract Method?
The completed-contract method is one where the business entity decides to postpone its revenue and profit recognition until the project is completed or finished. Usually, business organizations adopt such methods when they are doubtful about recovering their debts.
It is the concept in accounting for revenue recognition wherein all the revenues and the profits associated with the project are to be recognized only when the project has been finished or completed. Mainly this method is followed if a company is still determining the dues collection from the customer under the contract.
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Completed Contract Method Explained
In the completed contract method accounting, all the revenues and costs accumulate on the balance sheet until the project’s completion and delivery to the buyer. Once the project is delivered to the buyer, the items in the balance sheetItems In The Balance SheetAssets such as cash, inventories, accounts receivable, investments, prepaid expenses, and fixed assets; liabilities such as long-term debt, short-term debt, Accounts payable, and so on are all included in the balance sheet. are then moved to the income statement. It is used by the company when unpredictability prevails concerning collecting the funds from customers.
If the company is expecting to incur the loss on the contract, it is to be recognized as and when such expectation arises. Under the completed contract approach, companies must report the cost and revenue incurred based on the actual results. Therefore, it helps the company avoid the errors that can be caused when estimation is made on various aspects, like in the case of the percentage completion method.
The yield in this method is the same as that of the percentage completion methodPercentage Completion MethodThe percentage of completion method is an accounting method for recognizing revenue and expenses for long-term projects that span over more than one accounting year. The revenue is recognized yearly as a percentage of work completed during that year. Revenue to be recognized = (Percentage of Work Completed in the given period) * (Total Contract Value) . However, in the completed contract method, the yield will be considered only after completing the project.
Before completing the project, this method provides no useful information to the users of thefinancial statements of the companyFinancial Statements Of The CompanyFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels..
However, because of this delay in completed contract method revenue recognition, the business will be allowed to defer recognition of the related income taxes. If the company expects a loss on the contract, it will be recognized when such an expectation arises. Therefore, the company should realize the same before the end of the contract period.
Let us look at a completed contract method example to understand the concept.
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 a 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 incurredCost IncurredIncurred Cost refers to an expense that a Company needs to pay in exchange for the usage of a service, product, or asset. This might include direct, indirect, production, operating, & distribution charges incurred for business operations. in the project is $700,000, and the fee to be received from 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. Then, after that, the company has to bill the customer an entire $750,000 fee associated with the project. So, finally, recognize a profit of $50,000 and an expense of $650,000. The above completed contract method example clearly shows the process.
- The completed contract method accounting results in deferred tax liabilityDeferred Tax LiabilityDeferred tax liabilities arise to the company due to the timing difference between the accrual of the tax and the date when the company pays the taxes to the tax authorities. This is because taxes get due in one accounting period but are not paid in that period. as it requires paying taxes on the income earned only after the completion of the project. This payment of tax deferment and corresponding tax benefitTax BenefitTax benefits refer to the credit that a business receives on its tax liability for complying with a norm proposed by the government. The advantage is either credited back to the company after paying its regular taxation amount or deducted when paying the tax liability in the first place. deferment can have a negative or positive effect on the working capital. Therefore, contractors must analyze the implications of the completed contract method for tax before using the technique.
- Under the completed contract method, revenue recognition and expense recognition are done only when the project is completed; the revenue recognition timing will get delayed and 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
- If the contracts are undertaken are short-term, and the results that will arise are expected not to vary if any of the methods among contract methods or percentage completion methods are used.
- 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 deferredTaxes As The Taxes Are DeferredDeferred Tax is the effect that occurs in a firm as a result of timing differences between the date when taxes are actually paid to tax authorities by the company and the date when such tax is accrued. Simply put, it is the difference in taxes that arises when taxes due in one of the accounting period are either not paid or overpaid. by the contractor until the completion of the project.
- The completed-contract accounting method helps reduce the cost fluctuations associated with long-term projects. This method also motivates the contractor to apply cost and time-saving methods to complete the project as the contractor’s compensation does not change with the actual time taken to finish the project.
- Compared to the completion method’s percentage, higher net income is generally reported in the completed contract method.
- 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. If the project takes a longer time to complete than the anticipated time, the contractor is also not entitled to receive any extra compensation.
- The completed-contract method can be used only for 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.
Completed Contract Method Vs Percentage Of Completion
Both completed contract method and percentage of completion method is used by many companies across sectors to report the income and expenses. But let us understand the difference between them.
- The completed contract method for tax payment is helpful if the company wants to defer the income tax payment. In contrast, the percentage of completion is helpful because it helps companies shield themselves against economic and market fluctuations.
- The former may result in the entity not being able to get the tax benefits and face rise in tax rates but the latter does not have any such problems.
- Completed contact does not need to estimate the project cost but percentage of completion can be used only if the cost of project is estimated and parties can honour the contact on time.
This article has been a guide to what is Completed Contract Method. We explain it with example & differences with percentage of completion method. You may learn more about finance from the following articles –