Completed contract method

What Is Completed Contract Method?

The completed contract method (CCM) is an accounting approach within the broader category of accounting methods that defers the recognition of all revenues and expenses associated with a long-term contract until the entire project is substantially finished. Unlike methods that recognize income progressively, the completed contract method records all financial outcomes—such as the gross profit or loss—only in the period when the contract reaches completion. This approach is primarily used in industries with long-term contracts, such as construction and manufacturing, where project durations span multiple accounting periods.

History and Origin

Prior to the enactment of Internal Revenue Code (IRC) Section 460, taxpayers had more flexibility in choosing between the completed contract method and the percentage of completion method for long-term contracts. The completed contract method was historically a permissible accounting choice under Treasury Regulation §1.451-3. Howe³⁵ver, the Tax Reform Act of 1986 significantly changed the landscape for long-term contract accounting. Congress generally mandated the use of the percentage of completion method for most long-term contracts, aiming to better match revenue and expenses over the life of a project.

Des³⁴pite this shift, certain exceptions were retained, allowing the completed contract method to remain a viable option for specific types of contracts. For instance, the Internal Revenue Service (IRS) continues to permit the completed contract method for certain small construction contracts and home construction contracts, recognizing the unique nature and challenges in accurately estimating progress on such projects.

³¹, ³², ³³Key Takeaways

• The completed contract method defers the recognition of revenue, expenses, and profit until a contract is fully completed.
• It is primarily used for long-term contracts in industries like construction and manufacturing.
• Under U.S. tax law, the completed contract method is permitted for specific types of contracts, such as small construction contracts and home construction contracts, under exceptions to IRC Section 460.
• A key advantage of the completed contract method is its simplicity and the tax deferral it offers until the project's completion.
• A potential drawback is the uneven reporting of income, which can lead to significant fluctuations in taxable income from year to year.

Formula and Calculation

The completed contract method does not involve a periodic formula for calculating revenue or profit during the life of the contract, as it defers all revenue recognition until completion. Instead, costs incurred and any billings or cash received are accumulated on the balance sheet as assets (Construction in Progress) and liabilities (Progress Billings or Deferred Revenue) until the contract is finished.

Upo²⁹, ³⁰n completion, the total contract price and all accumulated allocable costs are recognized on the income statement. The gross profit (or loss) is then calculated as:

Here:

• Total Contract Revenue represents the final, agreed-upon price for the completed contract.
• Total Allocable Contract Costs include all direct costs and indirect costs properly attributable to the contract. These costs are subject to specific cost accounting rules, as outlined by the IRS.

Interpreting the Completed Contract Method

Interpreting financial performance under the completed contract method requires a long-term perspective. Since no income or expense is recognized until project completion, interim financial statements may not reflect the economic reality of ongoing work. For example, a company with several large, multi-year projects might show little to no revenue or profit for several years, followed by a significant surge in income when those projects are completed.

Use²⁸rs of financial statements, such as investors or lenders, must understand that the reported figures under this method do not provide a real-time indication of a company's operational performance during the life of a contract. Instead, the focus shifts to the company's backlog of unfinished contracts and the ultimate profitability of completed projects. This²⁷ method prioritizes certainty of outcome over interim performance reporting.

Hypothetical Example

Consider "BuildWell Construction," a company specializing in custom home construction, which qualifies for the small contractor exemption. On January 1, 2024, BuildWell signs a contract to build a custom home for $1,000,000, with an estimated completion time of 18 months.

• Year 1 (2024): BuildWell incurs $400,000 in construction costs. They bill the client $350,000 through progress payments. Under the completed contract method, BuildWell does not recognize any revenue or expenses on its income statement for 2024. The $400,000 in costs is recorded as an asset (Construction in Progress), and the $350,000 billed is recorded as a liability (Progress Billings) on the balance sheet.
• Year 2 (2025): The home is completed on June 30, 2025. BuildWell incurs an additional $450,000 in costs, bringing the total costs to $850,000 ($400,000 + $450,000). The remaining $650,000 of the contract price is billed. In 2025, upon completion of the contract, BuildWell recognizes the full $1,000,000 in revenue and the total $850,000 in costs on its income statement.
  • Revenue: $1,000,000
  • Cost of Goods Sold: $850,000
  • Gross Profit: $150,000

In this example, the entire profit of $150,000 is recognized in 2025, the year the contract was completed, rather than being spread across 2024 and 2025.

Practical Applications

The completed contract method finds its most common application in the construction industry, particularly for smaller contractors or those undertaking projects with short durations or significant uncertainties. The Internal Revenue Service (IRS) outlines specific criteria under which this method is permissible for tax purposes, primarily for contracts that are exempt from the general requirement to use the percentage of completion method. These exemptions typically include home construction contracts and other construction contracts expected to be completed within two years by a taxpayer whose average annual gross receipts for the three preceding taxable years do not exceed a certain inflation-adjusted threshold (e.g., $31 million for tax year 2025).

Thi²⁵, ²⁶s method allows companies to delay the reporting of taxable income until the project's conclusion, which can provide a significant tax deferral benefit. Howe²³, ²⁴ver, this benefit comes with the trade-off of potentially lumpy earnings reported for financial reporting purposes. IRS Publication 538, "Accounting Periods and Methods," provides guidance on various accounting methods, including the completed contract method, and the requirements for their consistent application.

²¹, ²²Limitations and Criticisms

Despite its simplicity and potential for tax deferral, the completed contract method has several limitations and faces criticism. A primary critique is that it does not provide an accurate representation of a company's financial performance during the life of a long-term contracts. Since all revenue and expenses are recognized only at completion, interim income statements may show no profit or loss, even if substantial work has been performed and costs incurred. This can lead to significant fluctuations in reported income from one accounting period to another, making it difficult for stakeholders to assess ongoing operational efficiency or financial health.

Fur¹⁹, ²⁰thermore, the completed contract method is generally considered less transparent than the accrual method or the percentage of completion method because it defers the recognition of economic activity. This can hinder comparability between companies using different accounting methods. While the completed contract method simplifies the cost accounting process by eliminating the need for interim estimates of completion, it also means that potential losses on a contract must be recognized immediately when they become apparent, even if the project is not yet complete. This immediate recognition of expected losses, while deferring revenue, can further distort financial results.

¹⁷, ¹⁸Completed Contract Method vs. Percentage of Completion Method

The completed contract method (CCM) and the percentage of completion method (PCM) are two distinct approaches to revenue recognition for long-term contracts, primarily used in industries like construction. The key difference lies in when revenue and expenses are recognized.

C⁸onfusion often arises because both methods apply to similar types of contracts. However, the choice between the two, particularly for tax purposes, depends on factors such as the size of the contractor, the duration of the project, and the nature of the contract, as dictated by tax regulations like the Internal Revenue Code Section 460.

FAQs

What types of businesses typically use the completed contract method?

The completed contract method is primarily used by businesses involved in long-term contracts, such as construction companies, shipbuilding firms, and manufacturers of large, custom-ordered goods. It is particularly common for smaller contractors or those engaged in home construction contracts, as they may be exempt from the general requirement to use the percentage of completion method for tax purposes.

###⁷ How does the completed contract method affect a company's financial statements?
Under the completed contract method, during the progress of a contract, costs incurred and payments received are recorded on the balance sheet as assets and liabilities, respectively. There is no impact on the income statement until the contract is fully completed. Upon completion, the total revenue and all associated costs are recognized, leading to the entire profit or loss appearing in the financial statements for that single period.

###⁶ Can any company use the completed contract method for tax purposes?
No, not every company can use the completed contract method for tax purposes. Under U.S. tax law (Internal Revenue Code Section 460), the percentage of completion method is generally required for most long-term contracts. However, exceptions exist for certain construction contracts, such as those performed by "small contractors" (those with average annual gross receipts below a specific threshold) and home construction contracts. Comp⁴, ⁵anies must meet specific criteria outlined by the IRS to qualify for using the completed contract method.

What are the main benefits of using the completed contract method?

The main benefits of using the completed contract method are its simplicity and the resulting tax deferral. It is simpler because it eliminates the need for complex interim calculations and estimates of project completion. For tax purposes, it defers the recognition of taxable income until the project is finished, which can be advantageous for managing tax liabilities.

###³ What happens if a loss is anticipated on a contract using the completed contract method?
Even under the completed contract method, if a loss on a contract is anticipated, it must be recognized immediately in the period it becomes apparent. This is a conservative accounting principle designed to prevent overstating assets and ensure that expected losses are accounted for promptly, even if the project is not yet complete.¹, ²