KEY TAKEAWAYS
- The percentage of completion method recognizes income as a project progresses using milestones.
- Completed contract method reports income only once the project is finished.
- The percentage of completion method mitigates revenue fluctuation risks for long-term projects.
- The completed contract method can defer tax liabilities, but risks changes in tax rates over time.
- The choice between methods depends on contract requirements and company needs.
Key Differences Between Percentage of Completion and Completed Contract Methods
Businesses that work on projects lasting months or even years need to understand how long-term accounting works. Industries, such as construction and engineering, rely on these accounting methods to accurately track progress and revenue over time. Choosing the right approach can affect financial reporting, tax obligations, and overall financial health. Each method comes with its own advantages and drawbacks, so the best choice depends on a company’s project structure, cash flow needs, and reporting goals.
Understanding the Percentage of Completion Method
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, the percentage of completion method reduces the risk of fluctuations while affording tax deferral benefits.1
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.2
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:34
- A contract that specifies the milestones and payments.
- 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.
Example
Assume that a construction company builds 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).
IMPORTANT
Once an accounting method is selected, it cannot be changed without special permission from the Internal Revenue Service (IRS).5
Exploring the Completed Contract Method
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.6 The CCM should
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.7
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.
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.
TIP
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.
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.8
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.
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.
Is the Percentage of Completion or Completed Contract Method Better?
This depends, but the percentage of completion method is generally considered to be better when dealing with long-term contracts. That's because the income and expenses are spread out over the course of the project, which makes a company's profitability more accurate. The completed contract method, on the other hand, waits until the project is completed. This can lead to skewed financial figures because income and expenses are accounted for once a project is completed.
The Bottom Line
The percentage of completion and completed contract methods are used by companies with long-term projects. Each offers distinct trade-offs. The percentage of completion method records revenue as work is completed, with up-to-date reporting. But it requires detailed cost estimates and impacts taxes over time. The completed contract method defers all revenue and expenses until completion, simplifying accounting while delaying financial visibility and tax recognition. The best method depends on a company’s estimating capabilities, tax strategy, and reporting needs.