Completed Contract Method

Definition

The completed contract method is an accounting method used to recognize revenue and expenses for long-term contracts. Under this method, a company does not report any revenue or expenses related to a contract until the contract is fully completed and the product or service is delivered to the customer.

5 Must Know Facts For Your Next Test

1. The completed contract method is commonly used for long-term contracts where the outcome of the contract is highly uncertain until the very end.
2. Under this method, a company does not report any revenue or expenses related to a contract until the contract is fully completed and the product or service is delivered to the customer.
3. The completed contract method results in lumpy or uneven revenue and profit recognition, as all revenue and profit are recorded at the end of the contract.
4. This method is simpler to apply than the percentage of completion method, as it does not require estimates of the contract's progress or percentage of completion.
5. The completed contract method is generally used when a company cannot reliably estimate the total costs or total revenue of a long-term contract.

Review Questions

• Explain how the completed contract method differs from the percentage of completion method in recognizing revenue and expenses for long-term contracts.
  • The key difference between the completed contract method and the percentage of completion method is the timing of revenue and expense recognition. Under the completed contract method, a company does not report any revenue or expenses related to a long-term contract until the contract is fully completed and the product or service is delivered to the customer. In contrast, the percentage of completion method recognizes revenue and expenses proportionally as the project progresses, based on the estimated percentage of completion. The completed contract method results in lumpy or uneven revenue and profit recognition, while the percentage of completion method provides a more gradual and consistent recognition of revenue and expenses over the life of the contract.
• Describe the circumstances in which a company would choose to use the completed contract method over the percentage of completion method for long-term contracts.
  • Companies typically choose to use the completed contract method when the outcome of a long-term contract is highly uncertain until the very end. This is often the case for contracts where the total costs or total revenue cannot be reliably estimated. The completed contract method is simpler to apply than the percentage of completion method, as it does not require ongoing estimates of the contract's progress or percentage of completion. Additionally, the completed contract method may be preferred when a company wants to avoid recognizing revenue and profit prematurely, which can happen with the percentage of completion method if the estimates of completion prove to be inaccurate. However, the completed contract method can result in more volatile or uneven financial reporting, as all revenue and profit are recorded at the end of the contract.
• Analyze the potential impact of a company's choice between the completed contract method and the percentage of completion method on its financial statements and key financial ratios.
  • The choice between the completed contract method and the percentage of completion method can have a significant impact on a company's financial statements and key financial ratios. The completed contract method results in lumpy or uneven revenue and profit recognition, as all revenue and profit are recorded at the end of the contract. This can lead to greater volatility in the company's reported earnings and cash flows, which may affect its stock price and investor perceptions. Additionally, the completed contract method can result in lower current assets and higher current liabilities on the balance sheet, as the company defers the recognition of revenue and expenses until the contract is completed. This can impact the company's liquidity ratios, such as the current ratio and quick ratio. In contrast, the percentage of completion method provides a more gradual and consistent recognition of revenue and expenses over the life of the contract, which can lead to smoother financial reporting and potentially higher current assets and lower current liabilities. The choice of method can also impact the company's profitability ratios, such as the profit margin and return on assets, depending on the relative timing of revenue and expense recognition.

Related terms

Revenue Recognition: The accounting principle that determines when a company should record revenue from the sale of its goods or services.

Percentage of Completion Method: An alternative accounting method that recognizes revenue and expenses proportionally as a project progresses, rather than waiting until the project is complete.

Long-Term Contracts: Contracts that extend over multiple accounting periods, such as construction projects or large-scale service agreements.