Percentage of Completion vs Completed Contract: What’s the difference?

31 Maggio 2023

If these requirements cannot be met then it is recommended to proceed with the completed contract method. The company will report its revenue of $1 million to recognize the two payments for $500,000 that the customer made at the end of the six-month and one-year milestones. The completed contract accounting method is frequently used in the construction industry or other sectors that involve project-based contracts. However, in a construction setting, the percentage of completion method will serve as your best bet for staying GAAP compliant when accounting for long-term projects. Most trade contractors can choose to get by with the cash basis of accounting. It’s relatively easy to implement and gets the ball rolling with tracking cash flow.

Instead, revenue and expenses can be reported after the project’s completion.
Unless you were a CPA in a past life, this means you need to hire an accountant to manage this for you.
The completed contract method of accounting records all revenue earned on the project in the period when a project is done.
In this case, however, Build-It should be able to finish the property and turn it over to another buyer.

Choosing an accounting method in the construction industry is no easy task. 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. As the contract progresses, the revenues & expenses are accumulated in the balance sheet until the last day of contract completion. It is only after the completion of the contract that the figures are moved from the balance sheet to the profit & loss account. You can observe from the above reading that the disadvantages of this method are more than the advantages.

Despite some pitfalls, cash basis and completed contract can be a significant tax deferral and cash flow strategy for the small contractor. While the resulting tax deferral is temporary in nature, the benefit can turn out somewhat ‘quasi-permanent’ as it extends and fluctuates over many years. However, because of this it is essential that the contractor at both the CFO/controller and owner level are continuously aware of the ongoing planning and considerations necessary for the long-term. Without this, it becomes easier for management to lose sight of the timing and margins of current ongoing work, versus the immediate tax liability and cash needs related to earnings on prior work. It is therefore important that management develops a consistent way to monitor this off-balance sheet deferred liability as a step in their ongoing process. Other types of construction contracts qualify for the completed contract method if they satisfy the general CCM requirements.

Exempt Percentage of Completion Method

Finally, the cash basis of accounting isn’t allowed under GAAP or IFRS (more on this in the next section). Below we’ll take a look at the four most common methods in construction accounting. We’ll start with a breakdown of cash basis vs. accrual accounting before looking toward the more specialized revenue recognition methods known as percentage of completion and completed contract. Using the completed contract method, the taxpayer does not recognize revenue until the contract is completed and accepted by the customer. 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. There should be no terms in the contract with the only purpose of deferring tax.

Before tax reform, the law defined a ‘small contractor’ as having average gross receipts from the preceding three years under $10 million.
A long-term contract is defined as any contract to manufacture, build, or install or construct property that is not completed within the tax year the contract is entered into.
The reason is that the recognition of such revenue happens only after the completion of the project.
This is huge for job costing since you can look at the true profitability of a specific time period.
However, despite its benefits, below are three pitfalls that should not be overlooked when considering converting to a cash or completed contract method for tax reporting purposes.

The Completed Contract Method of revenue recognition is normally only used in the short-term. For example, projects that last less than a year are considered short-term. It is anything over a year, then most firms prefer the percentage of completion method because it paints a more realistic picture in the long term.

Requirements for the Completed Contract Method

When choosing the method to use, it is important to pick the method that could create the best tax deferral. The revenue recognition standards that ASC 606 introduced changed the equation slightly for contractors reporting under U.S. This is because instead of looking at contract completion, ASC 606 looks at the completion of performance obligations. And a single contract may include one or multiple performance obligations.

Example of the Completed Contract Method

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. In other words, you can acknowledge that you’ll pay this money later, but you can account for it right away.

Advantages and Disadvantages of the Completed Contract Method

By deferring the recognition of revenue and expenses until the end of the project, the company might put itself at risk of higher tax liabilities. For example, let’s say a project is estimated to take three years to complete and tax laws change, leading to an increase in the business tax rate. The tax liability would be higher under the completed contract method versus using the percentage of completion approach since some of the revenue would have already been recognized. The completed-contract method is an accounting concept that enables a business or a taxpayer to delay income reporting until the contract is complete. Even if the contractor receives payment during project implementation, he or she can still delay the reporting of such revenue. The reason is that the recognition of such revenue happens only after the completion of the project.

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. In addition to the completed contract method, another way to recognize revenue for a long-term contract is the percentage of completion method. The two revenue recognition methods are commonly seen in construction companies, engineering companies, and other businesses that mainly generate revenue on long-term contracts for projects.

The percentage of completion method must be used if the revenues and costs of a project can be reasonably estimated and the parties involved are expected to be able to complete all duties. Further, this method is vulnerable to fraud and underreporting of a milestone period, so accounting practices must be closely reviewed. Instead, you’ll wait until the end of the six months as soon as you complete the contract. Only upon substantial completion will you recognize the revenue and expenses from this project. The completed contract method has a similar setup to the percentage of completion method. However, it’s best used for small jobs that are relatively short-term or when a project brings an inherent risk to job completion beyond what is typical.

While there are exceptions where cash basis is okay, accrual is a reliable option for companies of any size. Similarly, percentage of completion is always a trustworthy option for long-term https://personal-accounting.org/completed-contract-method-of-revenue-recognition/ projects. In addition, one of the main functions of GAAP is to create a level playing field for auditors or lenders looking to compare financial results against benchmarks.

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If the specifics of your contract allow you to do so, then the completed contract method is technically plausible. One of the most significant advantages of percentage of completion is that you can get a view on profitability before the job is complete. Another benefit is that you don’t have to wait until the end of a project to receive payment. Additionally, you can avoid a heavy cost hit at the start of the job since you won’t need to front the entire project as you’ll be receiving payment along the way as you progress through the job. If you can handle your cash flow tactfully, you can keep dollars flowing in without waiting for everything to wrap up.

Under this method, retainage payable is also not recognized—so that should be considered when evaluating whether this method is appropriate. The first exemption available to taxpayers is the “small contractor’s exemption.” To qualify for this exemption, the taxpayer’s AAGR for the past three years must be below $10 million. The taxpayer must also assume that the contract can be completed in 24 months or less. There’s no more Jones Realty to take control of the performance obligation — or to pay them! Avoiding “phantom revenue” from this situation is one reason why it’s good they don’t record their collections as income right away. In this case, however, Build-It should be able to finish the property and turn it over to another buyer.