Updated July 15, 2023
Definition of Completed Contract Method
Completed contract method is a method of contract accounting used in industries that are involved in a long-term type of contracts, wherein the profits are booked only after the contract is completed & it results in 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.
Explanation
- 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 recognized) once certain milestones are achieved in the long-run contract. Here, we are talking about the complete postponement of revenue and 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 a 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, tunnels, 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 made, and in-between, advances are taken from a customer. Still, nothing is recorded in books, even if cash or any other asset is exchanged.
- Everything gets postponed until the contractor finishes off the contract & gets confirmation from the customer.
- Only after the customer has approved the contract does the 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
Examples of completed contract methods are given below:
A company has received a contract to construct a tunnel. The estimated time of completion of the contract is 3 years, with the following details:
| Contract Price | $2,00,00,000 |
| Estimated Price Required (years) | 3 |
| Estimated Cost of contract | $ 1,40,00,000 |
| Estimated Profits | $60,00,000 |
Solution:
| Particulars | Years | ||
| 2017 ($) | 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 |
Explanation
- You can observe NIL tax liability in the years 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 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 is 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 contract completion period.
- 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 have difficulty getting those estimates due to the complexity. In such a situation, the contractor may also prefer going for the completed contract method.
- The most logical method is the percentage of completion method. So, the country’s laws may require the contractor to follow the percentage completion method subject to a 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 get 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
- Whenever costs are incurred (for example, labor 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 recognized in books of accounts:
| Sales Deferred Account (Debit) | XXXXX |
| Revenue Account (Credit) | XXXXX |
- When a project is completed & expenses are recognized 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.
Advantages
- 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 cash flow point of view. No revenue means no profit & no profit means no liability to pay tax.
- This shorter window gives buffer time to the 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.
Disadvantages
- The biggest disadvantage is uneven revenues or the results of the entity’s operations.
- 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.
- The contract may be 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 cash flow at the time of tax payment.
- 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 in a single year, the financial picture will be untidy & the analyst may observe huge fluctuations. This shows inconsistency in the contract.
Conclusion
As the contract progresses, the revenues & expenses are accumulated in the balance sheet until the last day of contract completion. It is only after the completion of the contract that 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.
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