Each business is required to choose an accounting method to report income and expenses. It is important to fully understand the chosen method, as each differs, especially concerning taxes. Once selected, the method cannot be changed without special permission from the Internal Revenue Service.
Revenue Recognition for Projects
The percentage-of-completion and completed contract methods are often seen in construction companies, engineering firms and other businesses that operate on long-term contracts for large projects. Since income and expenses are often deferred during work on these long-term projects, companies seek to defer tax liabilities as well. Both the percentage-of-completion and completed contract methods allow for such tax deferral.
Completed Contract Revenue Recognition
The completed contract method 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. Though a construction company may enjoy a break from income 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, but tax laws can and do change from year to year. If perhaps tax rates were increased 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. The completed contract method, however, is still the most conservative accounting method for companies working on long-term contracts.
Still, it’s recommended to only use this method when the project completion date is unknown or may be changed.
Percentage-of-Completion Revenue Recognition
With some variations on the completed contract method, the percentage-of-completion method affords similar tax deferral benefits with less risk for fluctuation and a more frequent reporting of revenues and expenses. Using this method, the business 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. For example, if a construction company is building a 10-story office complex that is under contract at a sales price of $4 million and the company estimates the total cost to build at $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 and 40% of the $3 million in expenses for a current gross profit of $400,000, or ($4 million x 0.4) - ($3 million x 0.4).
While the completed contract method is the best option for income tax deferral, the percentage-of-completion method must be used if revenues and costs of a project can be reasonably estimated and the parties involved are expected to be able to complete all duties.