Contract Completion Method: Definition, Computation, and Its Consequences
In the world of long-term contracts, particularly construction projects, the method used for revenue recognition can significantly impact a company's financial reporting. This article delves into the differences between the Completed-Contract Method under US GAAP (ASC 606 and previous standards) and IFRS (IFRS 15), focusing on construction projects.
Overview of Completed-Contract Method
The completed-contract method is a revenue recognition method used for long-term contracts where the outcome is uncertain. Revenue and profit are recognized only when the contract is substantially complete.
US GAAP (ASC 606 and Previous Standards)
Under US GAAP, the completed-contract method is generally not the preferred method for recognizing revenue in long-term contracts. Instead, ASC 606 emphasizes recognizing revenue when performance obligations are satisfied, which often leads to using the percentage-of-completion method or other methods for construction projects. However, in cases where the completed-contract method is used, it is typically applied when the outcome of the contract is highly uncertain.
IFRS (IFRS 15)
IFRS 15, similar to ASC 606, emphasizes recognizing revenue when performance obligations are met. However, IFRS might allow for greater flexibility in certain scenarios due to its broader framework.
Key Differences
- Point of Revenue Recognition: While both standards now emphasize recognizing revenue when performance obligations are satisfied, IFRS may allow for a more cautious approach in certain scenarios, focusing on when it is nearly certain that the customer will not redeem or return goods/services.
- Disclosure Requirements: Both ASC 606 and IFRS 15 require detailed disclosures to ensure transparency. However, IFRS might provide more flexibility in how these disclosures are presented due to its broader guidelines.
- Industry-Specific Provisions: IFRS does not allow for LIFO inventory valuation, which can affect construction companies' financial reporting if they hold inventory for long-term projects. US GAAP provides this option.
Construction Projects
In construction, the percentage-of-completion method is more commonly used under both US GAAP and IFRS. This method recognizes revenue as the project progresses, based on the percentage of completion. However, the completed-contract method is applied when the outcome of the contract is highly uncertain. The main difference lies in the detailed application and flexibility allowed under IFRS compared to the more structured approach of ASC 606.
For instance, consider a construction project with a contract worth Rp400, spanning two years, with estimated costs of Rp300. If the costs incurred in the first year are Rp220 and Rp80 in the second year, under US GAAP, the company does not recognize revenues or expenses in the first year. In the second year, under US GAAP, the company reports the remaining revenue of Rp180, and the expense of Rp80, generating a profit of Rp100. Under IFRS, in the first year, the company reports revenues and expenses as much as construction costs incurred, which amounted to Rp220. In the second year, the company recognizes revenue equal to costs incurred during the period, resulting in a revenue of Rp100 and an expense of Rp80, also generating a profit of Rp100.
In summary, while both standards have converged significantly with ASC 606 and IFRS 15, differences remain in flexibility, disclosure requirements, and industry-specific provisions. Construction companies must carefully apply these standards to ensure compliance and accurate financial reporting.
It's essential to note that both under IFRS and GAAP, companies postpone tax obligations during the contract because they do not report profits. The revenue and expense trends will be smoother under IFRS because this standard allows companies to recognize revenues and expenses during the construction period. Under US GAAP, companies can use the completed-contract method when results cannot be measured reliably. In the second year, the company eliminates the construction-in-progress account. The total equity increases Rp100 in the second year as a result of an increase in retained earnings.
Lastly, when adding the cash payment of Rp400, the company's cash position (and total assets) increases by Rp100 in the second year. US GAAP allows the use of the completed-contract method for non-long-term contracts as well. The income statement may see a sudden surge in revenue and expenses, especially if the company completes a large number of contracts in the same period under US GAAP. Under IFRS, this surge is avoided due to the recognition of revenues and expenses during the construction period.
Investing in construction projects under US GAAP (ASC 606 and previous standards) may require a different approach compared to IFRS (IFRS 15), as the former generally prefers the percentage-of-completion method over the completed-contract method, especially when the outcome of the contract is less uncertain. On the other hand, the completed-contract method, while less common under US GAAP, can be applied in cases where the outcome is highly uncertain.
When it comes to business finances, the choice between these standards can significantly impact the financial reporting and cash flow of construction companies. For instance, under IFRS, revenues and expenses can be recognized during the construction period, resulting in smoother revenue and expense trends, while under US GAAP, revenues and expenses are typically recognized only when the contract is substantially complete, which could lead to sudden surges in reported income.
