Preface: Construction contract accounting can get complicated, and the IRS allows taxpayers various methods to account for it. This blog will look at the completed contract method of accounting. The completed contract method is a method of accounting for long-term contracts; this blog assesses both advantages and disadvantages of the accounting method.
Construction Finance with Completed Contract Accounting
Credit: Jacob M. Dietz, CPA
How does it work?
The completed contract method of accounting records the income and related costs of a contract in the accounting period in which it is completed. For example, suppose ABC Construction, LLC begins building a house addition on 9/1/17. ABC completes the job on 2/1/18. The total contract price is $200,000, and the total contract costs are $190,000. The taxpayer would wait until 2018 to include the $200,000 in income, and to deduct the $190,000.
What are some disadvantages?
A disadvantage of this method is that income can potentially be grouped into one year, which could throw the taxpayer into a higher bracket and phase them out of deductions and credits. For example, if a big job was started in July of 2016, and finished in January of 2017, then potentially 1 ½ years of revenue could be reported in 2017. 2016 would have less income. Specific tax circumstances vary, but these swings could hurt the taxpayer.
Furthermore, some lenders may request tax returns to grant credit. If the most recent year happens to have low income because a large contract was not completed, then the lender may be less likely to grant credit.
The taxpayer must track the revenue and contract costs per contract for this method to work. Contractors should track this anyway for financial management purposes, but it does take time. It would likely take more time to adjust the books appropriately for the completed contract method than for accrual or cash basis methods.
What are some advantages?
So why would anyone want to use the completed contract method? Perhaps the number one reason is tax deferral. Using the earlier example, suppose ABC Construction, LLC has a $200,000 project started in 2017 but not finished until 2017, the company expects to earn a profit. The completed contract method allows the taxpayer to defer that income until the next year.
Although the completed contract method naturally causes swings in revenue based on when jobs are completed, this method reports the cost of the contract in the same period as the revenue. If applied appropriately, the taxpayer’s gross profit may swing, but the gross profit percentage should not experience the wild swings that can come from getting contract costs in a different period than contract revenue. Also, the taxpayer doesn’t need to worry if billings don’t match the costs for financial management purposes. Both the billings and costs of the contract will be deferred until the contract is finished. If using the accrual or cash method, and if the billings are not in line with the costs, then income skews. The skewed numbers make it harder to understand the company’s profitability.
The taxpayer doesn’t even need to track the percentage of completion for financial reporting purposes, except possibly towards the end. (If it is 95% done, and the owner starts using the building, then it can be considered completed.) Avoiding the percentage of completion calculation simplifies the accounting and potentially reduces the risk of errors. The taxpayer doesn’t need to worry about entering the correct estimated cost to complete, or if change orders increased anything. The taxpayer, however, still needs to track the contract costs and billings related to the project to keep them off the profit and loss statement until completion.
As you read down the blog, did any of the advantages or disadvantages stick out to you? If you meet the IRS qualifications, various contract accounting methods are available for you. There may not be one right answer. Consider both the pros and cons, and discuss with your accountant which method makes the most sense for your business.