Percentage of Completion vs. Completed Contract: What’s the Difference?

Each business is required to choose an accounting method to report income and expenses. Two options that cater to businesses working on long-term projects, such as construction and engineering firms, are the percentage of completion method and the completed contract method.

The percentage of completion method recognizes income and expenses gradually as determined by the percentage of the contract that has been fulfilled, whereas the completed contract method defers the reporting of income and expenses until the project is complete. The difference between the two, therefore, is the timing of income and expense recognition, with each method offering pros as well as cons.

Key Takeaways

• 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 can be used if the revenues and costs of a project can be reasonably estimated and the parties involved are 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 of completion method 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.

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.

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).

Special Considerations

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 two requirements that must be in place to proceed with a percentage of completion method:

1. A contract that specifies the milestones and payments.
2. Assurance that a buyer can ensure payment, and that a seller can ensure completion.

If these requirements cannot be met, it is recommended to proceed with the completed contract method.

Important

Once an accounting method is selected, it cannot be changed without special permission from the Internal Revenue Service (IRS).

Completed Contract

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.

Example

A company is hired to construct a building for $2 million. The project is expected to take three years to complete and cost the company $1 million.

Under the completed contract method, no income ($2 million) or expenses (estimated to be $1 million) will be recorded and reported to the IRS from this project until it is complete in three years time, assuming everything runs on schedule. Once the building has been constructed and all the payments have been made, the company will declare and record its earnings and costs.

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.

Special Considerations

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.

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.

What Is the Principal Disadvantage of Using the Percentage of Completion Method?

The percentage of completion method can be complicated. It relies on estimates, and measuring the percentage of completion of a project isn’t always straightforward as there could be delays or a need for changes.

Does GAAP Allow the Percentage of Completion Method?

Yes, generally accepted accounting principles (GAAP) recognize and accept the percentage of completion method as a valid way to record income and expenses. However, the Financial Accounting Standards Board (FASB) has placed various conditions and restrictions on its use to prevent poor bookkeeping and companies using it to boost short-term results. GAAP also allow the completed contract method.

What Is the Abuse of the Percentage of Completion Method?

Since the percentage of completion method relies on estimates, it can be abused by companies. With this method, it is possible to move income and expenses from one period to another, understating or overstating amounts in order to manipulate financials and tax obligations.

The Bottom Line

The percentage of completion method and completed contract method are two different accounting methods mainly used by construction companies and other firms that work on long-term projects. With the former, income and expenses are recorded gradually as various milestones of the contract are met. With the latter, all revenue and expense recognition is deferred until the work is finished and the contract completed. Choosing which accounting method is best depends on the company’s needs and whether the requirements of the percentage model can be met.