Long-Term Contract Accounting
The construction industry differs from other industries such as manufacturing because contracting has certain distinct traits from an accounting perspective. For example, construction is project-based, meaning that every construction project is treated as unique and as a short-term profit center, in contrast to some other businesses which treat entire divisions or businesses as profit centers. Construction contractors also have decentralized production and long-term contracts.
Construction contracts are often longer than other business deals such as auto dealerships whose contract is complete once the transaction is. Due to construction having long and seasonal production cycles, production contracts can last years and include multiple extended payments. Contract terms can allow 30, 60 or even 90 days to pay invoices, with retainage withheld and disputes delaying payment longer. These contracts are known as long-term contracts and there are different types of accounting methods for them.
What is a Long-Term Contract?
A long-term contract is a contract that overlaps financial reporting periods or tax years. This definition creates a clear separation between small-time tasks and construction sites that require a large amount of planning. The details in the projects are important, if a contract only covers a few days of work but those days pass over into a new year, then that project is now considered long-term.
Percentage of Completion Method (PCM)
The method most commonly used for long-term contracts is the percentage of completion accounting method. Under the percentage of completion method, the contractor will determine revenue to be recorded based on the size of the total contract, by calculating labor and costs incurred to date as a percentage of the expected total costs of the project. This method is required under U.S. generally accepted accounting principles (GAAP) and is often required for income tax returns.
The percentage of completion method is considered to recognize revenue as it is earned, which is based on performing the work, rather than when the contract permits billing or when the customer pays. This is dependent on significant estimates, specifically the expected total cost of a project which frequently fluctuates over the course of the project as tasks within the project may take less or more labor than initially budgeted. Thus, for proper financial reporting, it is crucial for contractors to regularly review their calculations of revenue recognized on current projects, often called work-in-process schedules or contracts-in-progress schedules.
Exceptions
For income tax reporting, the percentage of completion method does not apply to:
- Small construction contracts which fall under small contractor exceptions and additional laws made for contractors below a certain level of income.
Completed Contract Method (CCM)
In contrast to the percentage of completion method, the completed contract method defers all revenue and expense recognition until the completion of a contract. While the completed contract method is not GAAP, this method of accounting can be used for income tax reporting in certain cases and is helpful when there is unpredictability in the project’s total costs or completion date. For example, if a project is subject to potential hazards that might delay its completion, or if a contract has a short-term end date and most of the revenue is likely to be recognized when the project is completed, this accounting method would work best. For income tax purposes, when permitted, contractors may prefer to delay project profit recognition until completion of the project, which is accomplished under the CCM.
Most long-term contracts are handled through the percentage of completion method but in certain situations, the completed contract method may be permitted for income tax purposes. If you have any questions about which accounting method is best for your company, consult your Brown Plus advisor.