Completed Contract Method
It is a method that is used when there is uncertainty about getting paid by the customer under the contract terms
What Is The Completed Contract Method?
The Completed Contract Method (CCM) is used when there is uncertainty about getting paid by the customer under the contract terms. It is mainly designed for any business that engages in long-term contracts.
This could be companies that build things, like construction or engineering firms, or those that make software. Since the money and expenses are only counted at the end of the project, when it comes to timing, it can be both delayed and irregular.
The Percentage of Completion Method is the most commonly used. It helps figure out how much money is entering and exiting a company treasury during the execution of the project.
It recognizes profit and losses for a project in each accounting period while the entity is still working on the project. It's like using a ruler to measure and guess how much of the project is finished.
Key Takeaways
- The completed contract method allows all revenues from a project to be deferred until the completion of the project.
- When it is hard to estimate the completion of a project, or when we have small and tricky projects, we tend to use the completed contract method.
- Tax liabilities are postponed using this method, which is the main advantage of using the CCM.
Understanding Completed Contract Method
The percentage of completion method works well when it's possible to estimate the project's completion stages or at least guess the remaining costs as the project goes on.
However, it's not good when there's a lot of uncertainty about how much the project is done or how much it will cost to finish.
Sometimes, unusual conditions like an unenforceable contract, legal problems, or property disputes can make it hard to estimate accurately, so there are several risks in the percentage of completion methods.
For example, what they say is happening with the money isn't exactly what's going on at the construction site.
This can be a problem because the money they think they have earned or spent might be different from what's happening on the project.
Hence, using this method can be tricky because it relies on estimates, and if the estimates are not updated when things change, it can cause problems with the money. It's like ensuring the money in the books matches the situation at the construction site.
That’s how the completed contract method differentiates itself and sets it apart from the percentage of completion method by recognizing all the money and profit for a project only after it's finished.
It gives the same results as the Percentage of Completion Method, but only after the project is done. Before that, it doesn't give useful information for a company's financial statements. It doesn't rely on estimates or assumptions.
Instead, it provides specific and highly accurate results, ensuring that both parties in the contract avoid losses.
When to use the completed contract method?
You might wonder when using the completed contract method in accounting is okay. Well, it's a bit different from the usual way of keeping track of money, and there are some special situations where it makes sense. These are:
1. Project Completion Uncertainty
Imagine the contractor is not sure when the project will really be finished. In situations like this, when there's uncertainty about when everything will be done, using the completed contract method is allowed.
2. Short and Tricky Projects
If a project is really short, like just 2 or 3 months, and it doesn't make sense to figure out the progress every month, the contractor might choose the completed contract method. It's a quick and practical way to handle the money for these kinds of projects.
3. Complex Estimates Trouble
In cases where projects are intricate and obtaining accurate estimates from experts is challenging, the completed contract method may be chosen as a more feasible option to navigate the financial intricacies.
4. Legal Requirements and Exceptions
Usually, the percentage of completion method is the normal and logical way to do things. Laws in the country might say that contractors should use this method, but there are some exceptions.
For example, the IRS (which is like the tax authority) allows the completed contract method in specific situations.
The IRS says it's okay to use the completed contract method in two special cases:
- If the contractor is building a house.
- If the contractor is small, meaning they finish projects within 2 years and make less than or equal to $25 million every year for the past three years.
So, there are times when using the completed contract method is fine, especially when things are a bit uncertain or tricky.
Completed Contract Method Advantages
Some of the advantages of this method are:
- Knowing the Real Results: The good thing about this method is that the construction worker knows exactly how well the project is doing, not just what they thought in the beginning.
- Delaying Tax Payments: Another good part is that they don't have to pay taxes until they make money. This means that if a project does not yield a profit, the business is not obligated to pay taxes, providing financial flexibility.
- Time to Manage Money: This method also gives the construction worker some extra time to figure out how to spend their money wisely. It's like a little break to plan their expenses better.
- Better Understanding of Profits: If construction workers use this method for all their projects, they can see exactly how much money they're making. It's like having a clear picture of their profits in real-time.
- Less Guesswork: Unlike other methods, this one saves the construction worker from making big guesses at the end of the year. They don't have to guess how much money they made; they can use the real numbers.
Completed Contract Method Disadvantages
The disadvantages of the method are:
- Uneven Money Coming In: One significant disadvantage is the uneven flow of money. This can confuse people who read the financial statements. They might think it's risky to invest in such a company.
- Confusing Accounting: This method doesn't follow the usual ways of keeping track of money. The construction worker doesn't know if the project is making money or not right now because they're not using the regular methods.
- Messy Finances for Long Projects Long-term projects can result in messy financial records. The lack of clarity in accounts during extended projects may make it difficult to determine whether the project is generating profits or incurring losses.
- Problems with Losses: Even if the construction worker knows a project is losing money, they can't use that loss to balance out gains from other projects until the losing project is done. It's like having to wait to fix money problems.
- Big Changes in One Year: The worst part is if all the projects are finished in one year, the financial picture looks messy. People might see big ups and downs, but it looks bad. It's like the construction workers are not consistent in how they handle projects.
Using this method might affect how much money a business has on hand and its ability to operate. It can also make a business's profits go up and down a lot, which makes it hard to get support from financial partners or bond with others.
IRS regulations on Completed Contract Method
The Internal Revenue Service (IRS) functions as the tax collection agency for the U.S. federal government. It is tasked with gathering federal taxes and managing the Internal Revenue Code, the primary set of laws governing federal taxation.
Operating as part of the Department of the Treasury, the IRS is overseen by the Commissioner of Internal Revenue, appointed to a five-year term by the President of the United States.
The IRS has several responsibilities, including aiding taxpayers with tax-related matters, investigating and resolving cases of incorrect or deceptive tax filings, and supervising different benefit programs, such as the Affordable Care Act.
The IRS recommends using the percentage of completion method for long-term construction or manufacturing projects. However, there are two exceptions for construction projects: home construction contracts and small contracts.
To qualify for the completed contract method, the project should be estimated to finish in under two years, and gross receipts for the past three years should not exceed $25 million (increased from $10 million in 2018).
If a project doesn't meet the exceptions or if the revenues are too high, contractors have the option not to use the completed contract method.
Contractors often prefer the completed contract method when it's tough to estimate the actual costs of a project. It's also favored when managing multiple projects simultaneously or when a project is short-term.
Using the completed contract method means your yearly revenues, profits, and expenses won't be shown during the project period; therefore, you can defer your tax liability to a later time. In other words, you pay taxes, which greatly benefit our business.
This is why contractors in the manufacturing and construction sectors with yearly revenues averaging less than $10 million can choose the completed contract method as their accounting technique.
When using this method, you'll make journal entries similar to the percentage of completion method, but you won't recognize revenue or gross profit until the contract project is finished.
This means your revenue and expense accounts won't show the transactions related to that specific contract while it's still ongoing.
Percentage of Completion Contract Method Vs Completed Contract Method — Example
Matta Construction Company has a contract to construct a $1,000,000 highway. The contract is to start on May 2, 2021, and be completed in December 2023.
Percentage of Completion Contract Method
The first method used will be the percentage of completion method:
| 20X1 | 20X2 | 20X3 | |
|---|---|---|---|
| Cost to date | $200,000 | $500,000 | $800,000 |
| Estimated costs to complete | $550,000 | $300,000(we can have more cost through the project) | - |
| Progress billings during the year | $175,000 | $340,000 | $485,000 |
| Cash collected during the year | $140,000 | $300,000 | $560,000 |
Balance sheet entries:
| Record Cost of Construction: | 20X1 | 20X2 | 20X3 |
|---|---|---|---|
| Construction in process | $200,000 | $300,000 | $300,000 |
| Material cash payable | $200,000 | $300,000 | $300,000 |
| To record process billing: | |||
| Amounts receivable | $175,000 | $340,000 | $485,000 |
| Billings on construction | $175,000 | $340,000 | $485,000 |
| To record cash collection: | |||
| cash | $140,000 | $300,000 | $560,000 |
| Amounts receivable | $140,000 | $300,000 | $560,000 |
Income Statement entries+Closing
| To recognize revenue and profit | 20X1 | 20X2 | 20X3 |
|---|---|---|---|
| Construction in Process Profit | $66,667 | $58,333 | $75,000 |
| Construction expenses | $200,000 | $300,000 | $300,000 |
| Construction revenues | $266,667 | $358,333 | $375,000 |
| Record completion of contract | |||
| Billing on construction | - | - | $1,000,000 |
| Construction in Process | - | - | $1,000,000 |
Completed Contract Method
Using the completed contract method, we will get :
Income Statement entries+Closing
| To recognize revenue and profit | 20X1 | 20X2 | 20X3 |
|---|---|---|---|
| Construction in Process Profit | - | - | $200,000 |
| Construction expenses | - | - | $800,000 |
| Construction revenues | - | - | $1,000,000 |
| Record completion of contract | |||
| Billing on construction | - | - | $1,000,000 |
| Construction in Process | - | - | $1,000,000 |
Considerations on the completed contract method
As the contract moves forward, all the money coming in and going out is kept track of in the balance sheet until the very end of the project. It's only after everything is finished that the numbers are shifted from the balance sheet to the profit and loss account.
After looking at the information provided, it's clear that this method has more drawbacks than benefits.
The percentage of completion method is preferred to better understand the contract's financial status. This method is widely followed in accounting standards, tax laws, and other regulations.
Completed Contract Method FAQs
Companies might delay reporting income and expenses until after a contract is finished by using the (CCM), an accounting approach.
Under CCM accounting, even if cash payments were made or received during the contract period, revenue and costs are not recorded on an organization's income statement.
According to the completed contract method of revenue recognition, a concept in accounting, all project-related revenue and profit are recognized only once the project is completed.
The completed contract approach defers contract revenue instead of the percentage of completion technique, which records expected revenue in each quarter depending on the contract's completion percentage.
The realization of associated costs and expenses is not delayed, not even by the completed contract approach.
The construction business is the only one that uses the completed contract method of accounting (CCM).
Due to its ability to allow taxpayers to postpone the recognition of income and expenses until the year that a contract is concluded, it is widely regarded as the ideal way of accounting.
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