When accounting for the revenues and costs recognized on long-term construction-type contacts, there are two main methods
When accounting for the revenues and costs recognized on long-term construction-type contacts, there are two main methods: the completed-contract method and the percentage-of-completion method. We will unpack what both of these methods entail, when to use, how to calculate, and what financial statement implications come with them.
Under the completed-contract method, recognition of revenues, costs, and profits from the construction contracts are deferred until the contract has been fulfilled.
The completed-contract method is best suited for projects where costs and progress are difficult to estimate, many small jobs are ongoing simultaneously, and the duration of these jobs is short.
Recognition of revenues, job costs, and profits are deferred until the year the job is completed. In the meantime, costs and billings reside capitalized on the balance sheet.
An advantage of using the completed-contract method from a tax standpoint is their deferral until the year of job completion. However, if the contractor expects a period of rising tax rates, this method would mean the contractor takes a larger tax hit at the end (in the tax year with the higher rate) than recognizing a portion of those profits earlier (in tax years where the rates are lower).
In contrast to the completed-contract method, the percentage-of-completion provides that revenues, costs, and gross profits be recognized through the income statement as the project is being completed instead of all at the end.
This method would be used for jobs when collections are assured, profitability can be estimated, and progress towards completion can be measured.
As the costs for each contract are incurred, the contractor is essentially working towards the goal of completing the contract…and reaching their estimate of total costs for the job.
A contract for $4million has total estimated costs of $3.75million, and an estimated profit of $250k. During year one, the contractor incurs $375k in costs, the estimate of total costs remains unchanged, and the contractor determines that the project is 10% complete. For year one, they recognize $400k in revenue (10% of the contract), the $375k in costs, resulting in recognition of $25k in profit from this job.
Depending on how/when the contractor bills, at the end of the year they may record 1) an asset when billings on uncompleted contracts are less than the income earned to date, or 2) a liability when billings are greater than the income earned on uncompleted contracts on the balance sheet.
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