Whatever industry you are in, your business is required to choose an accounting method to report income and expenses. In construction, the percentage of completion and completed contract methods are often used by contracts since they often work on long-term contracts for large projects. Once you’ve chosen the method, it can’t be changed without special permission from the Internal Revenue Service (IRS). Therefore, it’s crucial to fully understand the chosen method to stay on top of tax compliance.
Let’s go into detail with each revenue recognition method and learn the difference between the percentage of completion and the completed contract method.
The Percentage of Completion Method (PCM)
The percentage of completion method allows for the periodical recognition of revenues, expenses, and taxes according to the percentage of the work completed during the period. Since the expense and revenue are reported frequently during the project execution, this accounting method can reduce the risk of fluctuations while affording tax deferral benefits.
PCM must be used if the revenues and costs of a project are reasonably estimated and the parties involved are expected to be able to complete all duties according to the contractual obligations. If these conditions have not been met, then the completed-contract method should be a better option.
Also, you have to closely review the construction bookkeeping practices to ensure the accuracy of cost reporting that is attributed to each completed part or defined milestone.
>> More: Construction Bookkeeping 101
The Completed Contract Method (CCM)
The completed-contract method allows deferring all income and expenses directly related to a long-term contract until work is completed. The day of completion is spelled out in the contract.
This construction revenue recognition method is often the best option for income tax deferral. For example, if a contract is set for completion in two years, you may not incur taxes during this period until it is completed. However, tax laws can be changed from year to year, you can face the risk of increases in tax rates and missing tax incentives. In other words, if the tax rates were to increase during that period of two years, you have to pay higher tax than it would have if reporting occurred sooner in the process.
Furthermore, if you’re looking for investors or creditors, it can be challenging to prove the real value of your company since revenues on ongoing projects have not yet been recorded.
Percentage of Completion vs Completed Contract: What’s the Difference?
Before exploring the difference, it should be emphasized that the total profit on the construction project is the same under both methods. Also, the percentage of completion and completed contract methods allow contractors to defer tax liabilities.
The biggest difference method is simply a question of timing - the completed contract method defers the entire profit until completion while the percentage method recognizes profit little by little over time.
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