Completed Contract Method - Explained
What is the Completed Contract Method?
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Table of ContentsWhat is the Completed Contract Method (CCM)?How does the Completed Contract Method (CCM) Work?How Completed Contract Method Works (Example)When to use a Completed Contract MethodAdvantages of a Completed Contract MethodDisadvantages of a Completed Contract MethodAcademic Research on Completed Contract Method
What is the Completed Contract Method (CCM)?
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. Another term for the completed contract method is the contract completion method.
How does the Completed Contract Method (CCM) Work?
The completed-contract method is most popular in the construction industry. Why most contractors prefer this method is that it fits well with short-term contracts as well as projects involving residential construction. It is also simple and that the contractor is in a position to delay tax liability reporting until the project is complete. Users of the competed contract method use it to recognize all project-related revenue and profits upon project completion. The method works the same as the percentage of completion method, and its results are the same. The only difference is that the completed contract method recognizes revenues and expenses only at the end of the project. Before project completion, this method usually has no useful information to the reader, especially on the financial statements.
How Completed Contract Method Works (Example)
Lets assume that John works for XYZ Construction Company. He has been able to bid for a contract from ABC organization. The organization wants some of its office space to undergo renovation. XYZ believes that if given the contract, they will be able to complete the project in 7 months' time. Now, when ABC is dealing with a short-term project, it uses the completed contract method of revenue recognition. In the contract, the organization has given an offer of $5 million that is willing to pay ABC once they complete the project. However, the estimated costs are $4.5 million. XYZ took 8 months to complete the project instead of 7 months. Upon completion, the organization paid XYZ Construction Company $5 million. However, not that the actual total cost for the project was $4.5 million. So, since XYX was able to complete the project successfully, the revenue that John will recognize in this case is $5 million, including the constructions actual cost of $4.5 million. So, if John was to state his correct income, it will be $5 million. Note that if in this contract the percentage of the completed method was the one being used, the company would have been forced to make some adjustments to entries to rectify the extended month and the extra costs.
When to use a Completed Contract Method
Contractors handling short-term projects prefer using the completed contract method. Short-term contracts refer to those contract that lasts less than a year. Where a contract lasts for over a year, then the percentage of completion method will instead be used. According to IRS, long-term construction contracts should use the percentage of competition methods. However, there are exemptions in this condition. For instance, you do not have to use the percentage of completion method when dealing with:
- Home construction contracts
- Small contractor contract
The two requires that the estimation period of completion be two years, and the annual gross receipts of the contractor do not surpass $25M over the past three years. In case a contractor qualifies for this exception, then he or she can opt for the contract completion method instead. Also, contractors may use the completed contract method under the following circumstances:
- When there is difficulty in estimating the actual costs of the contract
- When the projects require a short duration
- When a company has numerous ongoing projects, and they are regularly completed each year
- Where are hazards that are likely to interfere with project completion
Advantages of a Completed Contract Method
Using the completed contract method has the following advantages:
- Reporting of revenue is not based on the estimates but rather on the actual results
- There is a tax deferment. The IRS allows the contractor to defer taxes until the ongoing project comes to completion.
- It helps in reducing fluctuation costs related to the long-term projects
- The contractor is motivated to complete the project earlier than the agreed time. Note that the actual time taken to complete the project does not in any way affect the value of compensation. So, even if the contractor manages to complete the project before the stated deadline, he or she will still be paid as per the agreement.
- A contractor may get more net income if he or she chooses to use a completed contract method.
Disadvantages of a Completed Contract Method
The completed-contract method also comes with certain disadvantages. Some of them include the following:
- The contractor cannot recognize the income within the earning period. The situation is likely to create an additional tax liability for the contractor. The reason is that for tax reporting purposes, the entire project revenue has to occur within one period
- In a completed contract method, a contractor will not qualify for any extra compensation if he or she completes the project past the agreed time
- The completed-contract method is mostly used in home construction projects or small projects that are a short time
- When it comes to the completed contract method, the information in the books and records is usually not clear
- In case of any losses in the course of project implementation, then the deduction of such losses can only happen upon project completion