Definition
The Completed Contract Method is a concept in accounting used primarily for long-term projects. It recognizes and records the income and expenses related to a particular project only after the project is fully completed. This approach contrasts with the Percentage of Completion Method, which records costs and revenues progressively as the project advances.
Key Takeaways
- The Completed Contract Method is an approach to accounting for long-term contracts, usually in the construction industry, where revenues and expenses are recognized only when the contract is fully completed.
- This accounting technique mitigates the risk of premature revenue recognition which could distort the financial condition of the business when contracts take an extended period to complete or have uncertain outcomes.
- While this method can provide a more accurate depiction of a company’s financial health at the end of the contract, it may not reflect the “economic reality” during the contract period, as it omits the ongoing financial activities related to the contract.
Importance
The Completed Contract Method is significant in finance as it provides a way to recognize and report income and expenses related to a long-term contract.
In this method, revenue, costs, and profit associated with a contract are recognized only after the contract is fully completed.
This implies that, even if payments are received or expenses incurred during the term of the contract, they won’t be recorded until the project is concluded.
This method is crucial, especially in industries like construction or research and development, where projects last over multiple periods, as it helps control the possible distortion of financial results that could occur from recognizing revenue or expenses prematurely.
Explanation
The Completed Contract Method (CCM) serves a special purpose in the realm of accounting, especially given its unique application in the management of long-term construction contracts. The basic purpose behind this accounting strategy is the deferral of tax liabilities, until the completion of the contract, providing a significant advantage to contractors in terms of cash flow and tax management.
It allows them to avoid declaring profits on a plan that could potentially end up in losses, thereby improving financial safety and stability. It allows businesses to correctly match revenues with expenses during the tax year in which a long-term project is completed.
Moreover, CCM is often used when the outcome of a project is uncertain, whereas in other accounting methods, the outcome may need to be estimated. The uncertainty associated with revenue and expense recognition in projects is significantly reduced with the completed contract method.
In practice, a project running over multiple years won’t have its profit or loss recognised until the job is wholly finished. Therefore, it is primarily used as a protective measure in the construction industry and other sectors involving long-term contracts against possible financial inconsistencies and uncertainties in project outcomes.
Examples of Completed Contract Method
The completed contract method is a finance term commonly used in accounting, particularly by businesses that engage in long-term projects. It allows companies to postpone their profit recognition until a project is completely finished. Here are three real-world examples of the completed contract method:
Construction Industry: A construction company constructs a large building, such as a shopping mall or an office complex, over a period of few years. Even though the company receives payment installments during the construction phase, it only recognizes the entire project revenue and associated costs upon completion of the project, under the completed contract method.
Shipbuilding Industry: A ship manufacturer building a cruise liner would use the completed contract method. The company would only record the profits after completing the ship even though payments may be received during the construction period.
Aerospace Manufacturing: An aerospace company contracted to build a new aircraft might only recognize profits upon delivery of the completed aircraft to the purchaser, using the completed contract method. In this scenario earnings emerge all at once, after typically substantial levels of expenses have been disbursed over multiple periods, when the asset is finally delivered. Remember, the completed contract method is particularly useful for companies that undertake large, long-term projects where the final outcome is uncertain.
FAQs on Completed Contract Method
What is the Completed Contract Method?
The Completed Contract Method is an approach used in accounting, particularly in construction businesses, where the revenue and profits associated with a specific contract are recognized only after the contract has been fully completed.
When is the Completed Contract Method used?
This method is commonly used when there is uncertainty of the project completion and its associated costs, or when it is difficult to measure the progress of the contract accurately.
What are the benefits of the Completed Contract Method?
The primary benefit of the Completed Contract Method is that it avoids recognizing any profit on a long-term contract until the contract is complete, thereby mitigating the risk of future unforeseen costs eroding the anticipated profit.
What is an example of the Completed Contract Method in use?
Consider a construction company that has entered into a contract to build a commercial property. Under the Completed Contract Method, the revenues and expenses related to this project would not be recognized until the project is fully complete, regardless of when payments from the property owner are received.
How does Completed Contract Method differ from the Percentage of Completion Method?
Unlike the Percentage of Completion Method where revenues, costs, and profits are recognized periodically based on the progress of the contract, the Completed Contract Method recognizes these only after the contract has been fully completed.
Related Entrepreneurship Terms
- Progress Payments
- Contract Revenue
- Contract Costs
- Recognized Profits
- Billings and Cash Receipts
Sources for More Information
- Investopedia: This well-respected site is known for its in-depth articles on numerous topics in finance and investing, including the completed contract method.
- Accounting Tools: This resource provides a lot of accounting definitions and explanations, possibly including detailed information about the completed contract method.
- IAS Plus: A service by Deloitte, IAS Plus provides up to date information on international financial reporting, which likely includes information on various accounting methods.
- American Institute of CPAs: As the world’s largest member association representing the accounting profession, the AICPA’s website is a promising place to look for information about the completed contract method.
