Does your business operate by taking on long-term contracts? If so, among the many other business challenges you face, you must also decide how to recognize and report the income and expenses related to these contracts. What are your options? And how can you decide between them?
To help you get started, here is a brief guide to the most common means of accounting for long-term contracts.
1. Completed Contract Method
Constructive receipt of income in a business sense means that the income has been received without added strings attached and without risk of forfeiture. But any payment for a long-term contract generally is not free and clear until the contract is completely done to the customer's satisfaction. So, you may choose to recognize revenue and expenses when that contract is completed.
This method is best for contracts that aren't easily broken up into distinct steps. The ability to put off revenue recognition for months or even years can also offer a useful tax benefit. However, it may cause your accounting books to spike at times — such as if multiple contracts are completed at the same time.
2. Percentage Complete Method
A more accurate method for long-term contracts might be the percentage completed method. In this scenario, you would report income and expenses in stages during the project. When the contract is 25%, 50%, or 75% complete, for instance, you would report an equal percentage of both income received and expenses incurred.
The percentage complete method does require that the company be able to quantify and identify these milestones — either by estimation or by dividing the project into distinct phases. If you can't break up such stages, you may not be able to accurately reflect the percentage complete.
3. Cash Method
The cash method of accounting is generally the easiest way to keep your books. When it comes to long-term contracts, you would simply record revenue as you receive it and expenses as they are paid — regardless of how much of the contract remains.
However, this method could also be inaccurate as well. If you have to purchase the bulk of supplies early in the contract, your expenses may far outweigh the revenue for some time. And if liens or disputes leave some doubt about forfeiture of part of the contract, that income might not be as "constructively received" as it seems.
Which method is right for your long-term contracts? The best way to determine this is to work with an experienced accountant in your area. They can help you evaluate your projects, the tax implications, and the choices you have for revenue recognition. Get started by consulting with an accounting service today.
Share27 November 2019
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