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.
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What is the completed contract method?
The completed contract method of accounting is the practice of deferring all revenue, expenses, and gross profits until the completion or substantial completion of the project. This is a more straightforward and conservative approach than other accounting methods. It will still yield the same results as the commonly used percentage of completion method, except that revenue recognition comes at the end of the project.
For a deep dive on the percentage of completion:
How does the completed contract method work?
This method requires contractors to use a separate, dedicated balance sheet to record their expenses and revenues. Once the project is finished, the billings and costs will be pushed to their income statement. Even if payment is received through progress billings, those will not be factored into the final income statement until the end of the project. But, if the contractor becomes aware that the contract will end in a loss, it should be recorded on the income statement as soon as possible.
A simplified example:
XYZ, Inc. is a construction company who entered into a contract for $100,000 in August of 2018. The job will be completed in July of 2019, costing $75,000. The $100k of revenue and $25k of profit won’t be recognized until 2019, despite the costs incurred in 2018.
As an additional bonus, this method eliminates the problem of estimating errors that can occur using the percentage of completion as a guidepost. There’s no need to estimate costs when using the completed contract method since those costs are readily apparent at the end of the contract.
When to use it
The IRS requires that all long-term construction contracts use the percentage of completion method. However, there are two exceptions: home construction contracts, and the small contractor contract exception. This requires that the contract is estimated to be completed within two years, and the contractor’s annual gross receipts don’t exceed $25M over the previous three years (this was raised from $10M in 2018).
If a contractor falls under this exception, they can opt out and use the contract completion method. Contractors tend to favor this method when the actual contract costs are hard to estimate, the project is short, or the company has a number of ongoing projects that contracts are finished regularly each year.
Choosing an accounting method in the construction industry is no easy task. Each company has its own unique challenges and demands. Contractors should think carefully about their long term business goals and tax liabilities before choosing. Here are two of the biggest factors construction businesses might want to consider when assessing the completed contract method of accounting.
One of the main advantages of the completion method is the deferral of taxes. Since the construction company doesn’t claim any revenue until the completion of the contract, the tax liability is deferred to the end of the tax year.
This can also backfire if a construction business isn’t careful. If the company is expecting tax breaks, those will also be deferred until the end of the contract. This could cause a massive impact on the business’ working capital and cash flow.
Unstable bottom lines
Another risk using this system is that a contractor may have multiple contracts ending at the same time. This can cause a significant fluctuation of expenses and revenue in the balance sheet. To those outside the company, this could be seen as a sign of inconsistency and risk, which can make securing bonding or acquiring financing particularly tricky.