Definition of Completed Contract Method
Completed contract method is a method of contract accounting, used in the industries which are involved in the long term type of contracts, wherein the profits are booked only after the contract is completed & it results into the postponement of income & expenses till the completion of the contract since the same is not recorded as per the progress of the contract till date.
- As the name suggests, the “completed” contract method refers to 100% completion & not stage-wise. This method relates to the accounting system followed by the contractor.
- Some contractors may follow a proportionate contract method (or percentage of completion method) wherein accounting is done (i.e. income & expenses are recognised) once certain milestones are achieved in the long-run contract. Here, we are talking about the complete postponement of revenue as well as expenses until the contract is completed.
- So, this method follows neither the cash system of accounting nor the accrual system of accounting. It works in its different style.
- This results in postpone of revenue, which ultimately results in the postponement of taxes as per the contractor’s convenience.
- This mostly observed method in long-term contracts such as the construction of dams, rivers, bridges, tunnel, etc., which takes more than a year.
How Does It Work?
- A contract is executed between the customer & contractor.
- The contractors start working on the project.
- Material is received, purchases are made, payments are done, in-between advances are taken from a customer, but nothing is recorded in books even if cash or any other asset is exchanged.
- Everything gets postpone until the contractor finishes off the contract & gets confirmation from the customer.
- Only after the customer has approved the contract, contractor records the accounting in its books of accounts.
- After the recording of transactions, the tax implications are addressed.
- Contractors use this method only when there is uncertainty about the completion of the contract.
- This method saves on the efforts to make estimates as at the close of the accounting year.
Example of Completed Contract Method
Example of completed contract method are given below:
A company has received a contract to construct a tunnel. The estimated time of completion of contract is 3 years, with following details:
|Contract Price||$ 2,00,00,000|
|Estimated Price Required (years)||3|
|Estimated Cost of contract||$ 1,40,00,000|
|Estimated Profits||$ 60,00,000|
|2017 ($)||2018 ($)||2019 ($)|
|Work in Progress (Debit)||50,00,000||20,00,000||70,00,000|
|Accounts Payable (Credit)||-50,00,000||-20,00,000||-70,00,000|
|Accounts Receivables (Debit)||60,00,000||60,00,000||80,00,000|
|Sales Deferred Account (Credit)||-60,00,000||-60,00,000||-80,00,000|
|Bank Account (Debit)||50,00,000||80,00,000||70,00,000|
|Accounts Receivables (Credit)||-50,00,000||-80,00,000||-70,00,000|
|Accounts Payable (Debit)||40,00,000||60,00,000||40,00,000|
|Bank Account (Credit)||-40,00,000||-60,00,000||-40,00,000|
|Sales Deferred Account (Debit)||–||–||2,00,00,000|
|Revenue Account (Credit)||–||–||-2,00,00,000|
|Material Costs (Debit)||–||–||50,00,000|
|Labour Costs (Debit)||–||–||70,00,000|
|Miscellaneous Costs (Debit)||–||–||20,00,000|
|Work in Progress (Credit)||–||–||-1,40,00,000|
|(Profits) / Loss||–||–||-60,00,000|
|Tax Liability @ 20%||–||–||-12,00,000|
- You can observe that there is NIL tax liability in the year 2017 & 2018. But tax liability is $ 12 lakhs in the year 2019.
- The cash flow left with the company is $ 30 lakhs in 3 years of operations. So, it can pay $ 12 lakhs from that amount.
- It has only $ 18 lakhs left in its hand as against $ 60 lakhs of profit.
When to Use It?
- The recognition of revenue & expenses is done only when the project gets completed. Hence, the accounting happens to be irregular in the case of the completed contract method of accounting.
- Thus, such a method is allowed in exceptional circumstances as explained below:
- The contractor observes some inherent problems or deadlocks in the contract & he is uncertain about the exact period of completion of a contract.
- The contracts require a shorter period of time for completion (say 2-3 months) & month-to-month percentage completion appears illogical. In such situations, the contractor may prefer for completion contract method.
- In some contracts, there are estimates required from experts. However, the contractor may face some difficulty in getting those estimates due to the complexity involved. In such a situation as well, the contractor may prefer going for the completed contract method.
- The most logical method is the percentage of completion method. So, the laws of the country may require the contractor to follow the percentage completion method subject to few exceptions.
- IRS has allowed two situations wherein the contractor can prefer the completed contract method.
- One is the construction of any residential building & the second is where the contractor is treated as a small contractor. Small contractor means contracts gets completed within 2 years & his gross annual receipts are less than or equal to $ 25 million in all of the three previous years relevant to the current year.
Journal Entries of Completed Contract Method
- Every time when costs are incurred (for example, labour costs, materials costs, etc.), the following entry is recorded:
|Work in Progress (Debit)||XXXXX|
|Accounts Payable (Credit)||XXXXX|
- When progress billing is made to the customer:
|Accounts Receivables (Debit)||XXXXX|
|Sales Deferred Account (Credit)||XXXXX|
- When the amount is received from a customer:
|Bank Account (Debit)||XXXXX|
|Accounts Receivables (Credit)||XXXXX|
- When liabilities are settled through payment to various vendors or employees:
|Accounts Payable (Debit)||XXXXX|
|Bank Account (Credit)||XXXXX|
- When a project is completed & sales are recognised in books of accounts:
|Sales Deferred Account (Debit)||XXXXX|
|Revenue Account (Credit)||XXXXX|
- When a project is completed & expenses are recognised in books of accounts:
|Material Costs (Debit)||XXXXX|
|Labour Costs (Debit)||XXXXX|
|Miscellaneous Costs (Debit)||XXXXX|
|Work in Progress (Credit)||XXXXX|
In case the contracts undertaken are of a short term nature and the results that will arise are expected not to vary if any of the methods.
Some of the advantages are given below:
- The easiest advantage is that the contractor knows the actual results of the contract & not the estimated results, which usually happens in the case of the percentage completion method.
- Deferment of tax liability is the biggest advantage from the cashflow point of view. No revenue means no profit & no profit means no liability to pay tax.
- This shorter window gives buffer time to contractor to manage his cash budgeted expenses.
- If the contractor follows this method for all his projects, he gets a better picture of his profits & his analysis will be based on real-time figures.
- As against the percentage completion method, this method saves efforts to make lumpsum estimates at the end of the accounting year. Estimates are usually reversed in the next year & actual entries are passed. Thus, the efforts are saved.
Some of the disadvantages are given below:
- The biggest disadvantage is uneven revenues or results of operations of the entity.
- This unevenness creates doubts in the mind of the readers of financial statements. An analyst may also term investment in such companies as “risky”.
- This method follows neither of the accounting systems (i.e. cash or accrual).
- The contractor is unaware whether the contract is profitable as of today or not since none of the usual accounting methods is followed.
- It may happen that the contract is completed in the 2nd year, but the contractor already receives all the money & the tax is higher due to higher profits. He may or may have cashflow at the time of payment of tax.
- This method is untidy in the case of long-term contracts.
- This method reflects the ambiguity in the accounts.
- Even if the contract is aware of the losses in any particular contract, he can set off such loss against profits from other contracts only when this loss-making contract is completed.
- The biggest disadvantage is that if all the contracts finish off in a single year, the financials picture will be untidy & the analyst may observe huge fluctuations. This shows inconsistency in the contract.
As the contract progresses, the revenues & expenses are accumulated in the balance sheet till the last day of completion of a contract. It is only after completion of the contract when 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. Thus, if you want a better picture of the contract status, the percentage completion method of accounting is upheld in all accounting standards, tax laws, etc.
This is a guide to the Completed Contract Method. Here we also discuss the definition and how does it work? Along with advantages and disadvantages. You may also have a look at the following articles to learn more –