Long-term Contract Accounting for Construction Projects: An Introduction to Financial Discipline

Long-term contract accounting is a crucial aspect of financial management for construction projects in the US market. It involves the recognition and reporting of revenue, expenses, and profits over the duration of a long-term construction contract. This financial discipline is essential for ensuring accurate financial reporting, managing project profitability, and making informed business decisions.

In this article, we will explore the two main methods of accounting for long-term construction contracts – the Percentage of Completion Method (POC) and the Completed Contract Method (CCM). We will discuss the advantages and disadvantages of each approach, examine recent changes in revenue recognition standards, and explore best practices for optimizing long-term contract accounting processes.

Key Takeaways

• Long-term contract accounting is a critical financial discipline for construction projects in the US market.
• It involves the recognition and reporting of revenue, expenses, and profits over the duration of a long-term construction contract.
• The two main methods of accounting for long-term construction contracts are the Percentage of Completion Method (POC) and the Completed Contract Method (CCM).
• Choosing the appropriate accounting method is essential for accurate financial reporting, managing project profitability, and making informed business decisions.
• Organizations should follow best practices for optimizing long-term contract accounting processes, including record-keeping, documentation, internal controls, and compliance with industry standards and regulations.

Understanding Long-term Construction Contracts

Long-term construction contracts are agreements between a contractor and a customer for the construction of a specific asset, such as a building, road, or bridge. The contract’s duration typically spans several accounting periods, and the total revenue and cost associated with the contract will be recognized over the contract’s life.

These contracts are prevalent in the construction industry, with many firms relying heavily on them for revenue growth. However, accounting for long-term contracts is complex, and proper accounting is crucial to ensure accurate financial reporting.

There are two primary methods of accounting for long-term construction contracts: the Percentage of Completion Method (POC) and the Completed Contract Method (CCM).

The POC method recognizes revenue and expenses based on the progress of the contract. The percentage of the contract that is complete is determined by comparing the total costs incurred to date against the estimated total costs of the project.

The CCM method defers recognition of revenue and expenses until the project is substantially completed. Under this method, all costs incurred during the construction process are capitalized, and no revenue is recognized until the project is completed or substantially complete.

Choosing the appropriate accounting method is vital and depends on the nature and circumstances of the contract. The method selected will impact the timing of revenue and cost recognition, profit margin calculations, and taxation.

Key Characteristics of Long-term Construction Contracts

Before diving into the accounting methods for long-term contracts, it is essential to understand the key characteristics that set them apart from other types of contracts:

• Long-term contracts span multiple accounting periods with a duration of over one year,
• The project’s total revenue and cost are recognized over the contract’s life,
• Project progress can be measured in various ways, including physical completion, labor hours, or costs incurred, and
• The contract includes provisions for change orders, variations, and potential claims.

Understanding these key characteristics is crucial for choosing the appropriate accounting method and ensuring accurate financial reporting for long-term construction contracts.

Method 1: Percentage of Completion Method (POC)

The Percentage of Completion Method (POC) is a widely used method for accounting long-term construction contracts. It recognizes revenue and expenses as work progresses on the project, based on the percentage of completion. Under this method, revenue and expenses are recorded each period based on the proportion of the project completed compared to the total project.

POC can provide a more accurate representation of the financial position of a company during a project’s life cycle. It also helps to identify any potential risks and ensure the project stays on track.

There are two ways to calculate the percentage of completion – the cost-to-cost method and the surveys method. The cost-to-cost method is the most commonly used method and is based on the relationship between costs incurred and the total estimated cost of the project. On the other hand, the surveys method is based on surveys of work completed to date, as a percentage of the total work required.

Using POC can be beneficial for companies that have a long-term contract with a client, as it allows for better management and tracking of project costs and revenue. However, there are some drawbacks to this method. It may require more record-keeping and additional administrative work, and it may not be suitable for projects with a high level of uncertainty or those that have significant changes in scope or the contract price.

Key Principles and Guidelines for POC Accounting

There are several key principles and guidelines that companies should follow when using POC for long-term contract accounting:

• Revenue and expenses should be recognized based on the proportion of work completed
• The percentage of completion should be based on reliable estimates of progress
• Costs should be accumulated and allocated to the project based on the stage of completion
• Any expected loss on the project should be recognized immediately
• Changes in estimates should be reflected in the period in which the changes are identified

Adhering to these principles and guidelines can ensure that companies using POC for long-term contract accounting report accurate and reliable financial information.

“POC can provide a more accurate representation of the financial position of a company during a project’s life cycle.”

Method 2: Completed Contract Method (CCM)

The Completed Contract Method (CCM) is another method of accounting for long-term construction contracts, which defers the recognition of revenue and expenses until the project is substantially completed. The CCM is a suitable accounting method when an organization cannot reliably measure the progression of the project. According to the Financial Accounting Standards Board (FASB), a contract is completed if the related work has been finished, and the customer has either accepted the work or taken control of the asset.

The CCM is ideal when a project’s costs cannot be estimated accurately, or the project is in its early stages and lacks significant milestones. This method is also common in situations where the project’s scope or its duration is subject to change, and the contract is ambiguous. Under the CCM, revenue and expenses are recognized once the project is complete.

Conditions and Criteria for Applying the Completed Contract Method

• The outcome of a contract cannot be reliably estimated
• The contract’s duration is expected to exceed one year
• Significant changes in the project’s scope or costs may occur
• The method must be used consistently across the organization

Using the CCM may result in a more straightforward accounting process. However, it may also lead to a delay in recognizing revenue, which may impact an organization’s financial statements’ comparability. Since revenue and expenses are only recognized when the project is complete, the income statement will not reflect the project’s profitability until the end of the contract.

One advantage of CCM is that it enables companies to accurately identify the total project costs and potential profits upfront. However, if the project results in a loss, this method can adversely impact an organization’s financial performance, as the entire loss must be recognized once the project is finished.

It is worth noting that the CCM is not consistently allowed across all jurisdictions or countries, as it is dependent on their respective accounting standards. Therefore, organizations should consult with their accountants or tax advisors before adopting this method of accounting.

Advantages and Disadvantages of POC and CCM

When it comes to long-term contract accounting, organizations have two primary options: the Percentage of Completion Method (POC) and the Completed Contract Method (CCM). Each method has its advantages and disadvantages, and choosing the right one depends on a variety of factors.

Advantages of POC

The main advantage of using the Percentage of Completion Method is that it provides a more accurate picture of project progress and financial performance over time. This is because revenue and expenses are recognized based on the percentage of the contract that has been completed, rather than waiting until the project is complete to recognize them. This method is particularly useful in industries where projects are typically long-term and have many different stages.

POC accounting also allows for earlier revenue recognition, which can improve cash flow and help organizations meet financial targets. This is because revenue is recognized as work is completed, rather than waiting until the project is complete.

Disadvantages of POC

One of the main disadvantages of using the Percentage of Completion Method is that it requires a significant amount of estimation and judgment. The percentage of completion must be estimated, and any changes in estimates must be reflected in the financial statements. This can make the accounting process more complex and time-consuming.

Another potential disadvantage of POC accounting is that it may not be suitable for all types of projects. For example, if a project has only a few stages, or if progress is difficult to measure, it may be difficult to apply POC accounting accurately.

Advantages of CCM

The Completed Contract Method is simpler than the Percentage of Completion Method, as revenue and expenses are recognized only when the project is complete. This can make the accounting process more straightforward and reduce the risk of errors or misstatements in financial statements.

CCM accounting is also useful in situations where the outcome of a project is uncertain, as it allows organizations to defer recognition of revenue and expenses until the project is substantially complete.

Disadvantages of CCM

One of the primary disadvantages of using the Completed Contract Method is that it can delay revenue recognition, which may negatively impact cash flow and make it more difficult to meet financial targets. In addition, CCM accounting may not provide an accurate picture of project progress and financial performance until the project is complete, which could be a significant disadvantage for some organizations.

Ultimately, organizations must weigh the advantages and disadvantages of each method and choose the one that is most appropriate for their specific circumstances. By carefully considering these factors, organizations can ensure accurate financial reporting and better manage the financial aspects of their long-term construction contracts.

Changes in Revenue Recognition Standards

The accounting landscape for long-term contracts is constantly evolving, and one of the most significant changes in recent years has been the introduction of new revenue recognition standards. In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers, which replaced existing revenue recognition guidance and created a single revenue recognition model across all industries.

The new standard aims to simplify the accounting for revenue recognition and provide more useful disclosures to users of financial statements. It requires organizations to identify the performance obligations in a contract, determine the transaction price, allocate that price to the performance obligations, and recognize revenue when the performance obligations are satisfied.

For long-term construction contracts, the new standard may impact the timing and amount of revenue recognition. Under the old guidance, some organizations may have recognized revenue using the Completed Contract Method (CCM), which defers recognition until the project is substantially completed. However, under the new guidance, organizations may be required to use the Percentage of Completion Method (POC), which recognizes revenue and expenses based on the progress of the contract.

Organizations should carefully assess the impact of the new revenue recognition standards on their long-term contract accounting practices. They may need to update their systems and processes to capture the required data and implement new accounting policies and controls. It is also crucial to ensure compliance with the new standards and provide transparent and informative disclosures to stakeholders.

Accounting for Losses on Long-term Contracts

Long-term construction projects may incur losses due to a variety of reasons, such as unforeseen costs, delays, or errors in estimates. As such, it is essential to account for these losses properly to accurately reflect the financial performance of the contract and the overall financial position of the organization.

The accounting treatment for losses on long-term contracts depends on the accounting method used. Under the Percentage of Completion Method (POC), losses are recognized as soon as they are anticipated, and the total estimated loss is immediately recognized in the financial statements. On the other hand, under the Completed Contract Method (CCM), losses are not recognized until the project is substantially completed, and the total loss is recognized in one go.

It is important to note that the accounting treatment for losses affects not only the income statement but also the balance sheet. Losses reduce the value of the contract asset and, in some cases, may lead to the recognition of a liability. Organizations must also disclose the nature and extent of any losses in the notes to their financial statements.

Accounting for losses on long-term contracts requires the use of professional judgment and estimation techniques. Organizations should develop and maintain internal control systems to monitor the progress of their contracts, identify potential losses, and update their estimates regularly. This process will help ensure that financial reporting is accurate, reliable, and consistent.

In conclusion, accounting for losses on long-term contracts is a critical aspect of financial reporting for construction projects. Organizations must choose the appropriate accounting method and ensure that their internal control systems are robust enough to identify and account for potential losses. Failure to do so may result in inaccurate financial statements, loss of investor confidence, and potential legal and regulatory implications.

Tax Implications of Long-term Contract Accounting

Long-term contract accounting has significant implications for taxes in the United States. The accounting method used can impact the timing of revenue recognition for tax purposes, affecting the amount of taxable income reported in a given year. It is critical for organizations to understand the tax implications of their accounting method and manage their tax liabilities effectively.

The Percentage of Completion Method (POC) and the Completed Contract Method (CCM) have different tax implications. Under POC, revenue and expenses are recognized based on the estimated progress of the contract, which can result in earlier revenue recognition than under CCM. This early recognition can lead to higher taxable income in earlier years, resulting in higher tax liabilities. Under CCM, revenue and expenses are deferred until the project is substantially completed, resulting in lower taxable income in earlier years.

However, it is important to note that CCM may result in greater tax liabilities in the year of completion, as all revenue and expenses are recognized at that time. Organizations must evaluate their specific circumstances and consult with tax professionals to determine the best accounting method for their tax situation.

Additionally, changes in revenue recognition standards, such as the recent adoption of ASC 606, can impact tax liabilities for long-term contracts. Organizations must ensure compliance with the new standards while managing their tax liabilities effectively.

In conclusion, long-term contract accounting has significant tax implications for organizations in the United States. It is crucial to carefully evaluate the tax implications of the chosen accounting method and manage tax liabilities effectively to avoid any adverse effects on financial performance.

Best Practices for Long-term Contract Accounting

Long-term contract accounting can be complex and challenging, but with the right practices, organizations can optimize their processes and improve financial reporting accuracy. Here are some best practices to consider:

• Documentation: Proper documentation is crucial in long-term contract accounting. Organizations should maintain detailed records of contract terms, progress, and costs. They should also ensure that contracts are properly reviewed and approved before execution.
• Internal controls: Robust internal controls can help prevent errors and fraud in long-term contract accounting. Organizations should establish clear procedures for contract execution, progress monitoring, and invoicing. They should also implement segregation of duties and regular audits to ensure compliance.
• Industry standards: Compliance with industry standards and regulations is essential in long-term contract accounting. Organizations should stay up to date with the latest standards, such as the FASB Revenue Recognition Standard, and ensure that their accounting practices align with these guidelines.
• Specialized software: Using specialized software can streamline long-term contract accounting processes and reduce errors. These tools can automate calculations, generate reports, and provide real-time visibility into contract progress and financial performance.
• Training and education: Proper training and education can help ensure that staff members understand the principles and guidelines of long-term contract accounting. Organizations should invest in ongoing training to keep their teams up to date with the latest developments and best practices in the field.

By following these best practices, organizations can improve their long-term contract accounting processes and ensure accurate financial reporting for construction projects.

Conclusion

Long-term contract accounting is a critical discipline for construction projects in the US market. Proper accounting for long-term contracts is essential for accurate financial reporting and contract profitability.

Choosing the Appropriate Method

Organizations must choose the appropriate accounting method based on their specific circumstances. While the Percentage of Completion Method (POC) and Completed Contract Method (CCM) are the two predominant methods for long-term contract accounting, organizations should consider the advantages and disadvantages of each method before making a decision.

Compliance with Regulations

It is also essential for organizations to stay up-to-date with regulatory changes that may impact long-term contract accounting. Compliance with industry standards and regulations is crucial to ensure accurate financial reporting and avoid potential legal issues.

Best Practices

To optimize their long-term contract accounting processes, organizations should implement best practices such as maintaining accurate and complete documentation, establishing internal controls, and regularly reviewing financial statements. By following best practices, organizations can minimize errors and ensure compliance with regulations.

In conclusion, long-term contract accounting is a complex but necessary discipline for construction projects. With the appropriate accounting method, compliance with regulations, and implementation of best practices, organizations can effectively manage their financial reporting and ensure project profitability.