Completed Contract Method of Accounting
The fundamental principles of the accounting include accrual and matching concept. Both principles are used in determining the accounting period. It is necessary to determine the accounting period because of recognition of revenue and expenses is based on this classification. This ultimately leads in preparation of financial statements that are true and fair, and gratis from objects error. According to the income recognition principle, revenues are documented when they are comprehended or are realizable, and when you earn them no matter when the cash is actually received.
Completed contract method of accounting is a method based on revenue recognition. This method is applicable for the lasting contracts, i.e., contracts spanning over more than one accounting period. In this method, the total contract revenue and the related costs incurred in the performance are recognizable in the period in which the contract is actually completed. This means that revenues, cost and gross profits are not recognized until the contract is fully completed. Therefore, if a company has adopted the completed contract method of accounting, its profits and costs until the final year will be shown as zero. However, the losses will be incorporated in full immediately due to conservatism constraint of the method. Therefore, the company will show $0 on the income statement until the final year.
This method of revenue recognition is not generally used in the common practice due to its limitations and conservative approach. However, there are some circumstances when it becomes a better option to use this method. This method should only be used when the agreement engages tremendously high risks. If there is a risk of breach or the contract is too big compared to the normal ones, then it is better to use this method instead of percentage-of-completion. Companies also use this method when percentage-of-completion method is not applicable.
Although, the completed contract method of accounting does not reproduce the incomes, costs, gross profits and expenses in the period in which they are incurred, it has its obvious tax benefits. This method allows the companies to defer their tax accountability to the upcoming periods.