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what are the two basic methods of accounting for long-term construction contracts

Of course, strictly selling and general and administrative expenses would not be applied to contract costs. Amounts representing construction activity would be allocated to the construction contracts based on an appropriate driver, such as direct labor and/or equipment hours, direct labor costs, direct material costs, etc., in a systematic and rational manner. The completed-contract method recognizes revenue upon completion of the contract; the percentage-of-completion method recognizes revenue over the life of the contract. Percentage of completion method is vulnerable to abuse by unethical companies.

In contrast, the percentage of completion method is similar to accrual in that it recognizes revenue earned during the contract period. Payment is made based on completing project milestones or predetermined dates, i.e. a weekly or monthly schedule. The milestones can be broken down into percentages of completion in order to determine the potential revenue separate from the total gross profit. By the end of the project, each small percentage will add up to the full 100% for payment.

What are the Main Construction Accounting Methods?

We can help you determine if adopting one of these available methods would be a good move for your company. Now that the contractor has determined that PC is most appropriate method of accounting, the next step is to correctly determine the extent of progress toward completion of the contract. In the second part of this blog I will discuss the methods most commonly used to determine the extent of completion on a particular contract. What are the two basic methods of accounting for long-term construction contracts? Indicate the circumstances that determine when one or the other of these methods should be used. Construction accounting has its own set of unique rules for both generally accepted accounting principles and taxes.

what are the two basic methods of accounting for long-term construction contracts

The method of accounting will depend on the types of contracts the contractor works on. For example, a contractor will be using the POC method for non-exempt long-term contracts, completed contract method on home construction contracts, and accrual less retainage on short-term contracts. After all of the above steps are completed, it is now time to compute the percentage of completion.

Controlling costs with construction accounting

Although the accrual method of accounting more closely aligns with GAAP, some contractors prefer the cash method because the recognition of income and expenses aligns with cash flow. As a taxpayer in the construction industry, there are various accounting methods to choose from that will have an impact on tax-related cash flow over the life of your business. It is important for contractors to be aware of the methods and together with their tax advisors, determine which method best suits their business need and growth goals. Completed contract method allows taxpayers to defer the taxes in the year in which the contract is completed. However, the expenses directly related to the jobs are also deferred until the end when the contract is completed.

what are the two basic methods of accounting for long-term construction contracts

The IRS sees many abuses in this area, where either construction contracts are improperly classified as home construction contracts or the date of completion is extended by contrivance. One common maneuver that contractors use to defer taxes is to construct many houses on a large residential plot, while delaying the completion of common improvements, such as roads and sewage, as long as possible. Therefore, the contractors argue, the construction of any one home is not complete until all the common improvements have been finished. However, the IRS is taking the position that a home construction contract is considered completed when it is sold. Other types of construction contracts qualify for the completed contract method if they satisfy the general CCM requirements.

What is the Right Construction Accounting Methods?

With PCM, continuous payment is made in installments whenever certain goals are met, such as the foundation being completed or siding being finished. A major drawback of this method is that, at the end of the day, a company might pay revenue taxes without having actually collected the cash. This unearned revenue is also known as deferred revenue for this reason. After estimating the amount of variable consideration within the transaction price, the entity then must apply the constraint on variable consideration concept.

Construction CPAs and accounting software can help streamline your accounting methods to ensure compliance. The ASU includes new comprehensive disclosure requirements that are expected to provide users of financial statements with detailed information on an entity’s contracts with customers. The enhanced disclosure requirements will provide more information that enables “users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers.” In current US GAAP there are frequent inconsistencies in the revenue recognition requirements for specific transactions. Over the years the Boards have issued industry specific guidance which has resulted in different accounting for economically similar transactions to respond to these inconsistencies. The primary objective of the Boards’ joint revenue project was to clarify the principles for recognizing revenue and to develop converged standards under US GAAP and IFRS.

Financial Performance

However, expense recognition, which can reduce taxes, is likewise delayed. From the client’s perspective, the CCM allows for delayed cash outflows and ensures the work is fully performed and received before any payment is made. Accrual accounting is typically the most common method used by businesses, such as large corporations. However, some small businesses use the cash method, which is also called cash-basis accounting. The completed contract method does not require the recording of revenue and expenses on an accrued basis. Instead, revenue and expenses can be reported after the project’s completion.

Under the accrual basis of accounting, revenue is recognized when a performance obligation is satisfied and expenses are recognized when incurred, without regard to the time of the receipt or payment of cash. Income is recognized periodically on the basis of the percentage of the job completed rather than only when the entire job is completed. It recognizes revenues, costs, and gross profit as a company makes progress toward completion on a long-term contract during the accounting periods. By raising thresholds to $25 million ($27 million in 2022), the TCJA allowed more construction businesses to use the cash method of accounting and the completed contract method for long-term contracts if they so choose. These options may create tax deferral opportunities for construction contractors.