Table of Contents
- When to use the completed-contract method
- Effects of the completed-contract method on financial statements
Completed-contract method is a revenue recognition method in which the company does not recognize revenue and profits until the contract is complete. This method is common in long-term contracts such as construction, which often face uncertainties associated with raising funds. Furthermore, companies will defer their tax obligations for the coming period until the contract is completed.
The contract is completed when all parties agree, and the company sends or submits the results to the contractor. As compensation, the company receives payment.
When to use the completed-contract method
Under US GAAP and IFRS, companies can use this method when results cannot be measured reliably. However, both differ in recognizing revenue and expenses related to the contract.
In US GAAP, during the construction process, the company does not recognize revenues or expenses. They will realize both when the contract is substantially completed.
Then, how does the company recognize it in the financial statements? The company accumulates billing and related costs in the balance sheet, namely on the construction-in-progress account.
US GAAP also allows the use of this method for non-long-term contracts. So, for example, contracts and construction are completed in the same period; for instance, in one year, this method will be the same as the percentage completion method.
Furthermore, under IFRS, the company recognizes revenue equal to costs incurred during the period. Therefore, the company does not report profits during the contract.
Let’s take a simple case. The company obtained a building construction contract worth Rp400 for two years. The company estimates the construction costs to reach Rp300. Assume, the company incurs a cost of Rp220 in the first year and Rp80 in the second year.
Let’s discuss the impact one by one under US GAAP and IFRS accounting standards.
In the income statement, the company does not recognize revenues or expenses in the first year. There were no additional retained earnings (and total equity).
On assets, cash decreases by Rp220 in the first year because the company spends it on construction costs. To keep the financial position balanced, the company reports a construction-in-progress account of Rp220.
In the second year, the company receives cash payments for Rp400. Under U.S. GAAP, it reports revenue and expense of Rp400, resulting in a profit of Rp100. Total equity increases Rp100 as a result of an increase in retained earnings.
On assets, the company eliminates the construction-in-progress account. The actual cash outflow in the second year is IDR80. If it is added to the previous year’s cash of minus Rp220 and the cash payment of Rp400, the company’s cash position (and total assets) increases by Rp100 in the second year.
In the first year, the company reported revenues and expenses as much as construction costs incurred, which amounted to Rp220. And the company’s profit is zero. In the second year, the company reports the remaining revenue of Rp180, and the expense of Rp80, generating a profit of Rp100.
Meanwhile, in both years, the recognition of cash position and construction-in-progress accounts is the same as the US GAAP standard.
Effects of the completed-contract method on financial statements
What are the company’s advantages when using this method? Both under IFRS and GAAP, companies postpone tax obligations during the contract because they do not report profits.
Furthermore, the method allows companies to avoid estimation errors as in the percentage completion method. The company does not need to estimate construction costs. These costs will be seen at the end of the contract as in US GAAP or incurred during construction as in IFRS.
However, under the GAAP method, the income statement may see a sudden surge in revenue and expenses, especially if the company completes a large number of contracts in the same period. Because it recognizes both revenue and expenses at the end of the contract. That will produce sharp balance sheet fluctuations.
Conversely, the revenue and expense trends will be smoother under IFRS. Because this standard allows companies to recognize revenues and expenses during the construction period.