Completed-Contract Method

Definition

The term completed-contract method refers to an accounting approach that delays the recognition of revenues and costs associated with long-term projects.  The completed-contract method allows companies to accumulate revenues and costs on the balance sheet, but no charges or credits appear on the income statement until the project is completed and delivered to the buyer.

Explanation

The FASB Concept Statement No. 5 states that companies cannot recognize revenues as being earned until they are realized or realizable, and the company has substantially completed what it needs to do in order to be entitled to payment.  Revenue can be recognized at the point of sale, before, and after delivery, or as part of a special sales transaction.

Long-term projects oftentimes require the buyer to make payments as certain milestones are reached.  This is a common arrangement in the construction and other heavy equipment industries that might involve customized projects or products that can take years to complete or build.

The completed-contract method accumulates revenues and costs on the balance sheet until the project is delivered to the buyer.  When that occurs, the balance sheet items are moved to the income statement.  The completed-contract approach allows companies to report these costs and revenues based on actual results, while avoiding the estimating errors that can occur when using the percentage-of-completion method.

While the completed-contract method eliminates the possibility of a distorted income statement, it's thought to misrepresent the company's actual performance if the long-term project spans multiple accounting periods.  The calculation of revenues and costs recorded on the balance sheet would be identical to those flowing to the income statement under the percentage-of-completion method.

Example

Company A has contracted with Company Z to upgrade their customer information system.  The total value of the contract with Company Z is worth $22 million and the project is expected to take three years to complete.  Company Z's internal estimate indicates the project will cost $15 million to complete.  The first milestone payment from Company A does not occur until nine months into the project, but Company Z would like to recognize revenue on their balance sheet in the next annual report.  At that point in time, Company Z would have expended $5 million in costs.

Using the completed-contract method, the percentage complete would be the same as that calculated under the percentage-of-completion approach:

= $5 million / $15 million, or 33% complete

The current period accounts receivable would be calculated as:

= 33% x $22 million
= $7.26 million

The journal entries to record these transactions on the balance sheet would then be:

  Debit Credit
Unbilled Revenue in Excess of Cost   $2,260,000
Inventory:  Construction in Progress   $5,000,000
Unbilled Revenue $7,260,000  

Note:  Since this is the initial determination of revenue, there is no need to adjust this value for prior periods.  All of the above accounts are found on the balance sheet.

Related Terms

revenues, revenue recognition principle, revenue recognition: before delivery, revenue recognition: point of sale, revenue recognition: during production, percentage-of-completion method