Reporting income or expenses can be postponed using an accounting technique known as the complete contract method. It’s a common revenue recognition practice for businesses that undertake construction contracts, short projects, and manufacturing sectors.
Contractors can either report revenues when projects are done when they bill and when their invoices are fully paid. The first option of reporting on completion of the contract means that your business’s revenues will only be recognized once the contract is fully complete.
A preferred accounting method for residential projects and other short-term contracts is that the completed contract method features simplicity due to the shifting of liability.
Defining the completed contract method
When there is unpredictability in determining when a client is going to pay, contractors use the completed contract method of accounting. Since it’s easy to ascertain that a project has been finished, all costs are calculated at the end of the contract.
This method allows businesses to defer all expenses and revenue recognition until the completion of a contract. Costs are not estimated beforehand, since progress may involve many small projects taking place simultaneously.
Completed contract accounting is best suited to short term contracts that last under one year. For longer contracts, suppliers and contractors prefer the percentage of completion technique.
Since revenue reporting is postponed, tax liabilities are also deferred — sort of. The reduction of your business tax rates with expense recognition is also delayed.
The radical balance sheet and financial statement fluctuations experienced from the surge of contracts finishing simultaneously is one downside of the completed contract method.
A stock analyst looking at your business’s books can flag it as an investment risk due to your balance sheet’s inconsistency.
What is required of contractors using the completed contract method?
A contractor using the completed contract method is required to use a dedicated balance sheet to record their revenues and expenses. Costs and other billings are pushed to their separate income statement once the project is completed.
Your yearly income statement will not factor in your business’s investment in that project. Such costs will feature in the next year’s revenue report.
If a contractor expects the project to end in a loss, an income statement record is made as soon as they become aware.
If my company, Scribe Construction, enters into a contract in august 2020 for $100,000, I expect to complete it in July 2021. Using the completed contract method, I won’t declare my costs of $75,000 and a profit of $25,000 until 2021.
This is despite the costs I incur in 2020.
A bonus of using the completed contract method of accounting is that error estimation is not necessary. Costs will be readily apparent at the end of the project.
When should you use the completed contract method?
The percentage of completion method is advocated for by the IRS for long term construction or manufacturing contract projects. In construction specifically, there are two exceptions to this rule.
- Home construction contracts
- Small contracts
Requirements for contractors using the completed contract method include an estimated project completion date of fewer than two years. The contractor should also not have gross receipts that exceed $25 million for the preceding three years.
In 2018, this figure was raised from $10 million.
If your project does not qualify for the completed contract exception, or your gross revenues are excessive of the limit, you can opt-out of this method.
When actual contract costs are not easy to estimate, contractors, favor the completed contract accounting method. Other favorable instances include when you have a number of projects ongoing simultaneously and when your project period is short.
The completed-contract method will not reflect your yearly revenues, profits, or expenses in the period they’re incurred or earned. Deferral of tax liability to future time is one significant tax advantages that can benefit your business.
Manufacturer and construction sector contractors that average less than $10 million in yearly revenues can elect to have the completed contract method as their accounting technique.
You shall make journal entries that are similar to when you are using the percentage of completion method. However, your entries will have an absence of revenue or gross profit recognition during the time the contract project is ongoing.
All your revenue or expenses accounts will not reflect the transactions that relate to that contract.
Looking at the point in time transfer and ASC 606
For contractors reporting tax obligations under General Accepted Accounting Principles or US GAAP standards, change the completed contract equation slightly.
With ASC 606, this standard applies to performance obligation as opposed to contract completion.
Your company may be running a contract with more than one performance obligation, and revenue is recognized when the transfer of control happens.
For instance, a construction company builds a project on its land, aiming to sell to a customer once the project is completed. Using the completed contract of revenue recognition, the construction firm owns all costs until the project is transferred to its customer upon completion.
This transfer of control may happen at a single point in time or over an extended duration. In any case, the transfer of control is dictated by your contract’s language, not by how you want to recognize revenue.
For performance obligations under ASC 606, conditions that must be met for a contractor to recognize revenue include;
- There is no consumption of benefit from the customer until the end of the project.
- Enhancing or creating an asset that’s under your control as a contractor
- If the project falls through, you will still be able to utilize the asset without ceding your enforceable right to be paid.
Considerations for your business when choosing the completed contract method
In the construction sector, selecting an accounting technique for projects is no mean task. Each project will have its demands and challenges.
Tax liabilities alongside long-term business goals must be part of your considerations when choosing a revenue recognition method.
Two of the main benefits for contractors selecting to report with the completed contract method include;
Deferment of tax
The deferral of taxes is one of the main advantages of using the completed contract method of revenue recognition.
As the contractor won’t claim any revenue until the project is completed, tax liabilities are also deferred to the next tax season.
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.
Your business’s cash flow and working capital can be impacted negatively by deferred tax breaks.
Bottom line instability
If you are undertaking multiple contracts and using the completed contract method for all, there will be fluctuations in revenue and expenses on your balance sheet. Unstable bottom lines can be perceived as signs of risks or inconsistencies.
This can make acquiring financial partners or securing bonding particularly tricky.
Final thoughts on the completed contract method
The completed-contract method gives hope to contractors after the changes in guidance for revenue recognition. The gist remains to hold off revenue reporting and tax obligations until payment is assured, similar to the procedures of point in time recognition under ASC 606.
Performance obligations are looked at by ASC 606 as opposed to contracts under completed contract accounting. Ensuring that your contract provides appropriate conditions for the transfer method ensures that you also take advantage of the tax deferral benefits.
Consult with your project-specific CPA when selecting or choosing the pertinent revenue recognition method. The best accounting procedure is the one that suits both the purposes of reporting and tax while offering an accurate picture of your business’s financial health.