Percentage of Completion vs. Completed Contract: An Overview
Each business is required to choose an accounting method to report income and expenses. It is necessary to fully understand the chosen method, as each differs, especially concerning taxes. Once selected, the method cannot be changed without special permission from the Internal Revenue Service (IRS).
The percentage of completion and completed contract methods are often used by construction companies, engineering firms, and other businesses that operate on long-term contracts for large projects. Since income and expenses are often deferred during work on these long-term projects, companies seek to defer tax liabilities as well. Both the percentage of completion and completed contract methods allow for such tax deferral.
- The completed contract method for the revenue recognition of a project is often the best option for income tax deferral.
- The risks associated with completed contract accounting include increases in tax rates and missing tax incentives.
- 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.
- Percentage of completion may shield companies from fluctuations and make it easier to show revenue.
Percentage of Completion
The percentage of completion method allows for the recognition of revenues, expenses, and taxes during the period that a contract is being executed. Through frequent reporting, percentage reporting reduces the risk of fluctuations while affording tax deferral benefits.
A company using this method may arrange milestones throughout the building process or estimate the percentage of the project completed. As long as particular amounts of income and expenses can be attributed to each completed part, whether via percentage calculation or defined milestones, the activities are reportable.
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.
For example, a construction company is building a 10-story office complex that is under contract at a sales price of $4 million. The company estimates its total cost to complete the structure will be $3 million. So, at any given point in the construction process, it can report completion by percentage.
Therefore, if the project is deemed to be 40% complete, the business would report 40% of the $4 million project revenue ($4 million x 0.4). The firm will also report 40% of the $3 million in expenses ($3 million x 0.4). This calculation will result in a current gross profit of $400,000 ($4 million x 0.4) – ($3 million x 0.4).
The completed contract method (CCM) of accounting considers all income and expenses directly related to a long-term contract as received when work is completed. The date of completion is spelled out in the contract and is often months or even years away from the date work begins.
Though a construction company may enjoy a break from taxes during the working phase—and sometimes may even qualify for certain tax incentives in the meantime—this method can be a riskier way to account for operations.
For example, if a contract is set for completion in five years, the business may not incur taxes on that project’s income during that time. However, tax laws can and do change from year to year. If tax rates were to increase during that period of five years, the company faces paying higher taxes than it would have if reporting occurred sooner in the process.
Under the completed contract method it is not necessary to estimate the costs of the project as all of the costs are known at the time the project is completed. This prevents inaccurate estimates, which can be costly.
Furthermore, if a business seeks outside investors, it can be challenging to prove to them the value of the company during times of little-to-no incoming revenues. Still, even with these risks, the completed contract method is the most conservative accounting method for companies working on long-term contracts.
The percentage of completion method is viewed as a continuous sale. As such, it is considered that both the buyer and the seller have enforceable rights. The buyer carries the right to implement specific performance requirements in the contract while the seller has the right to ask for payments based on fulfilling these requirements.
There are typically three requirements that must be in place to proceed with a percentage of completion method. These are a contract that specifies the milestones and payments, assurance that a buyer can ensure payment, and that a seller can ensure completion. If these requirements cannot be met then it is recommended to proceed with the completed contract method.