Bookkeeping – Completed Contract Accounting (Lesson 75)

Lesson 75

A second and easier method of accounting with project accounting (construction) is the completed contract method.  This method does not utilize an engineering or detailed production schedule (chart) like the percentage of completion method.  It works well with any duration for project timelines.  In a similar fashion as the percentage of completion, completed contract utilizes the work in process account (WIP) but to a greater degree.  There are a couple of drawbacks to this advanced skill and this lesson will explain them to the reader.

This lesson explains the fundamentals of the completed contract method; how the WIP account is used and reconciled during interim accounting periods; provide some insights and drawbacks to this method; and finally finish with a comprehensive example.  When done, the accountant should have a grasp of how this accounting method is used and why it is an effective overall project accounting method.

Fundamentals of the Completed Contract Method of Accounting

The primary goal of project accounting is to match actual costs against the corresponding revenue earned on the project.  Because projects take extended periods of time to complete, there is a high risk of mismatch of costs and revenue.  This mismatch creates misleading financial statement results and often management misinterpretation.  To alleviate this inequity, accountants use either percentage of completion or completed contract method of accounting to record information to the books of record.

The percentage of completion method is generally an accounting period to accounting period actual results reporting method.  The completed contract exercises the work in process account to accumulate all costs until the project is complete.  Once completed, the project’s costs and its contract value are transferred at the same time to the income statement.  This method works best with the following conditions:

A) Projects are relatively short in duration, ideally less than 90 days; OR
B) Projects are less complex and use a few phases of the company’s phase breakout; OR
C) Project values as a percentage of total annual revenue is less than 8%.

If a project is less than 3% of an interim reporting period, I encourage directly expensing the costs to the income statement and recording revenue as allowed in the contract once the project is complete.

The key to successfully implementing the completed contract method is to exercise the work in process account.

Proper Application of the Work in Process Account

As explained in Lesson 74 the work in process (progress) account is a current asset similar to inventory in manufacturing or retail.  This account acts as a holding cell for costs associated with a project.  Its cumulative dollar value reflects all active projects at their various stages of progress.  So the WIP account is not exclusive to a single project.  Set the WIP account up as a control account in the chart of accounts.

The wonderful advantage of the WIP account is that costs can accumulate in this account and not affect the income statement results, think of this account as inventory for a contract.  Each line item is a part of the whole package sold to a customer.  The parts may include:

* Materials
* Labor
* Labor Taxes and Benefits
* Supplies
* Equipment Rental
* Custom Tools for the Respective Project
* Engineering/Outside Consulting
* Subcontractors
* Debris Removal/Site Costs
* Project Licenses & Permits
* Capitalization Costs

Those costs that can be directly assignable to a project are accumulated here.  When the purchase is made, the journal entry simply requires the WIP account as the assigned debit ledger account.  Don’t forget to assign the phase code, job ID number and a department (if applicable).  I encourage accountants to pull a register weekly from this account and verify that each entry has all elements assigned.  This step acts as a pre-step to the reconciling of this account.

One of the reports I pull is a project summation report of costs for this account.  I frequently compare the ledger’s total balance against the summation of all projects.  Look at the following illustration.

WIP Ledger Balance                      308,297
WIP Project Summary Balance Report by Project (Time Period)
Project ID                                     Balance
20160317                                     $142,743

20160411                                         29,207
20160518                                         76,117
20160525                                         60,230
.                                                    $308,297

Often the two don’t match.  When this happens, open the register and simply scan the entries looking for an entry without a project assigned.  Basically the project summary report will have a lower value than the total which means an entry was not assigned a project.  If the project summary balance is greater than the ledger balance than some form of a credit (return) in the ledger was not assigned to a project.

One last note, the ledger balance is always a lifetime to date balance.  The project summary report is usually only the open (ongoing) projects.  Sometimes an expense comes in for a closed project.   Therefore this value is not included in the summary report but is in the ledger balance.  Simply reassign this entry to cost of sales instead of the WIP account.  Remember, once a project is closed there is no need to accumulate costs related to that project.

As projects are completed, the entire project’s balance is removed from WIP and assigned to cost of sales.  This step is explained in detail in  ‘Transferring Work in Process to Costs of Construction’ in the construction industry section of this website.

The mechanics of this transfer is simple.   An accountant is taking a debit balance on the balance sheet from current assets and transferring them to cost of sales.  This is exactly what happens in a retail transaction.   Sales are credited, cash is debited, cost of sales is debited for the item sold and inventory is credited.   Here is  the completed contract entry in summation:

Sales Journal
Date        Transaction ID  Ledger         Control ID          Dept          Description               DR           CR

06/30/16  5291                   Sales              Smith 160304    Remodels  Contract Price                            $31,700
.                5291                  Cash                                                           CK # 3207 Recvd     $31,700
.                5291                  Cost of Sales  Smith 160304    Remodels  Costs on Smith K       23,417
.                5291                  WIP                Smith 160304            –         Costs on Smith K                         23,417
.                                                                                                                                               $55,117      $55,117

K = Contract

In this case the Smith project’s cost is removed from WIP and transferred to cost of sales.  In reality, it is much more complicated than this as the actual costs are grouped by labor, materials, subcontractors, permits and other as reported in the income statement section.  As explained in transferring work in process to costs of construction article, the entire Smith project costs are exported in detail to a spreadsheet.   Each line is coded with a letter code for one of the cost of sales accounts and then sorted.  Each sorted section is summed for the entry as follows:

Sales Journal
Date         Trans ID   Ledger     Control ID      Dept                Description                   DR          CR

06/30/16   5291          Sales        Smith160304    Remodels        K Price/Bath                                $31,700
.                5291          Cash                                                          CK # 3207 Rcvd         $31,700
.                5291          Materl’s    Smith160304    Remodels        See Smith SS                  9,773
.                5291          Labor        Smith160304    Remodels       See Smith SS                  6,402
.                5291          Subs          Smith160304    Remodels       See Smith SS                  6,000
.                5291          Permits     Smith160304    Remodels        See Smith SS                     155
.                5291          Equipmnt  Smith160304    Remodels       See Smith SS                     384
.                5291          Other         Smith160304    Remodels       See Smith SS                     703
.                5291          WIP           Smith160304                           See Smith SS                                 23,417
.                                                                                                                                         $55,117    $55,117

‘See Smith SS’ refers to the spreadsheet created to sort the data from WIP to create this entry.

The entry to WIP is the sum total; the breakout is with the respective cost of sales.  Notice no phase codes?  This is because phase reports are pulled from the WIP account only are used to compare actual costs of a phase against the estimated amount.

Also, notice the department is coded in this entry; departmental accounting is an income statement report so the department has to be identified.  If not, the value will show up in an ‘Other‘ department column.

Now that you have a more comprehensive understanding of how WIP works it is time to explain some insights for the completed contract method. 

Advantages and Drawbacks of the Completed Contract Method

The major and most important advantage of the completed contract method is its simplicity.  Costs are accumulated and transferred at the same time the sale is recorded.  Just like the percentage of completion method, contract billings are merely progress billings on a contract at agreed upon points in time.  Most small business contracts require a deposit and progress payments at certain intervals.  The most common I’ve seen is 25% down and 25% more at the 1/3, 2/3rds point of production and upon completion.  Here is a simple schedule:

Invoice Amount       Progress     Customer’s Balance
25%                              -0-          Paid Ahead 25%

25%                           33.33%     Paid Ahead 16.67%
25%                           66.67%     Paid Ahead 8%
25%                         100.00%     Even

The entry is always to contract billings in excess so that upon completion this account’s dollar value matches the contract value.  Once all costs are posted,  simply debit contract billings in excess (current liability account) and credit sales.  Don’t forget to include a department code on the sales line.   Now you are ready to transfer costs to costs of construction as described above.

Just like the WIP, set contract billings in excess up as a control account requiring all entries to have a control ID number (name).  The entire project value is transferred from the balance sheet to the income statement at the same time along with costs which is simpler than the incremental steps with percentage of completion method.  However, there are some drawbacks with this method.

First off, this method can create some misleading income statement reports.  Since the entire contract value and costs are transferred at the same time, the direct profit is often interpreted as having been earned during that report’s interim accounting period.  This is why it is important to keep this method to projects less than 90 days in duration.   This way the annual impact of a single project is minimal if reported in the following year.  Many of your advanced accountants will use the percentage of completion method on all contracts open at year-end so that the annual reports reflect the true financial performance.  This is explained in more detail with the tax timing differences lesson.

A second drawback is also a function of the first.  The indirect costs such as project management, transportation, insurance and communications are accumulated as a percentage of sales to assist in calculating mark-up on costs.   This method distorts that formula, so it is a good idea to take this into consideration when evaluating the mark-up formula.

A third drawback is determining value in contracts.  Often a simple contract billings in excess to WIP relationship gives some idea of existing direct profit on all existing contracts.  Take a look at this simple relationship schedule:

Contract Billings in Excess Balance     409,210   Credit Balance
Work in Process                                    342,715    Debit Balance
Expected Profit                                       66,495    Credits > Debits (Sales > Costs)

This is true if ALL costs in WIP accounted for the value of contract billings in excess.  Since many small businesses bill ahead of the actual costs, most likely contract billings exceed actual job completion.  Thus the company may have a potential issue with additional costs to be recorded.  So don’t use this as a basis with decision-making.

Finally, there is a misunderstanding related to the tax consequences of the completed contract method.  Some owners think that if you don’t record the contract as completed, then the associated profit can’t be taxed.  This is absolutely hog-wash.  The completed contract method in tax accounting allows for contractors to defer tax reporting if the contract has no accumulation of profit until paid upon completion.  This is a type of reporting with really large dollar value contracts whereby the contractor is paid costs up until the very end and is paid his profit in the final installment.  In effect, this is non-existent in small business because this is an uncommon practice with small contracts (less than $10 Million).  Most small businesses are paid ahead in contracts including profit.  Therefore this value must be reported for tax purposes.

Actually this is my final note to advantages and drawbacks of the completed contract method.  Many accountants believe you must use one method (completed contract or percentage of completion) or the other for all projects.  This is  ‘FALSE’.   A company may use both methods but it must follow its own rules.  The primary rule is the project’s projected duration.  I encourage projects of less than 90 days to use the completed contract method; more than 90 days, use percentage of completion.

Another rule may work well with the above and stipulate any project greater than a certain set value must use percentage of completion method.   In my experience, any project in excess of 8% of the expected annual sales should follow the percentage of completion no matter the expected duration.

Comprehensive Example

Snug Harbor Marine does maintenance work on fishing vessels.  A typical project involves pulling the boat out of the water, power washing the hull,  removing corroded zinc bars, sand blasting the hull, repainting, installing new zincs and other types of engine/electronic repairs.

Captain Paul of the Hedi Brenna (an 80′ lobster boat) negotiates a $120,000 maintenance and overhaul contract with Snug Harbor Marine.   The contract stipulates hull cleaning, repainting, lobster holding tank repairs with new steel grates and to have the shaft and propeller replaced with a new system including bushings and a packing clamp.   The job will take six weeks start to finish.  Captain Paul agrees to pay in $20,000 increments on Thursdays of each week.

The accountant decides to use the completed contract method to record this project. The following is a week by week summation of activity.

Week One
During week one the project manager engineers the boat cradle to match the hull design of the Hedi Brenna.  The cradle is lowered down a track into the water and the Hedi Brenna is guided into place, blocked in and pulled out of the water.  The marina’s crew power washes the hull and removes the propeller and shaft.  Bushings are removed and the new shaft dimensions are measured.  In the meantime labor begins on the sand blasting and painting phase.  On Thursday afternoon, Captain Paul delivers a $20,000 check.  On Friday the accountant finishes recording all entries to WIP assigned to this project.  There were a total of 119 entries for $17,321, all paid immediately.  Here is the project’s balances for the respective accounts:

Snug Harbor Marine – Hedi Brenna Account Status Report
Cash                              $2,679 ($20,000 – $17,321 of costs)

Work in Process            17,321
Sub-Total                                   $20,000
Contract Billings in Excess       $20,000

Week Two
Work continues on the Hedi Brenna with the biggest expense for the week of the purchase 64 feet of a round steel shaft with higher tensile strength than the original shaft.  The shaft bar is delivered.   Sand blasting continues and the lobster tank is dismantled.  Captain Paul makes another payment on Thursday.  Total costs are $22,709 during the week spread over 176 line items.  Let’s look at the balance of the accounts now:

Snug Harbor Marine – Hedi Brenna Account Status Report
Cash                                             ($30) (beginning balance of $2,679 plus $20,000 less $22,709)

WIP                                           40,030  (295 line items to date)
Sub-Total                                              $40,000
Contract Billings in Excess                  $40,000

Week Three
The shaft is now mounted on a lathe for turning to proper size and cut to the correct engineered length and propeller dimensions.  A new propeller is delivered.  Captain Paul agrees to have the old propeller repaired for $6,000 and stored as his property at the marina for $1,000 and available for sale for $11,000.  Captain Paul pays separately for the propeller repair and storage.   The repair and storage are booked directly to the income statement along with associated costs.  Captain Paul pays $20,000 on Thursday.  Total costs during week three are $14,119 with 154 line items.  The new propeller is on account for $4,850 and has not been paid.  Here is  the updated account balance report:

Snug Harbor Marine – Hedi Brenna Account Status Report
Cash                                    $10,701  (-$30 + $20,000 payment less (14,119 – 4,850 on acct))

WIP                                       54,149  (449 line items to date)
Sub-Total                                           $64,850
Accounts Payable                 $4,850

Contract Billings in Ex         60,000
Sub-Total                                           $64,850

Week Four
The lobster tank is sand blasted and primed for painting, hull tests reveal metal fatigue in a section near the engine room requiring replacement.  Snug Harbor provides a change order to Captain Paul for $23,000 and one additional week.  Captain Paul agrees to pay the entire change order amount with the regular Thursday payment.  Costs during this week is mostly labor for $14,808 over 139 line items.  Snug Harbor Marine pays the bill for the propeller.    Here is the updated account balances.

Snug Harbor Marine – Hedi Brenna Account Status Report
Cash                                       $34,043 ($10,701 + $43,000 – $14,808 – $4,850)

WIP                                          68,957 (588 line items)
Sub-Total                                           $103,000
Contract Billings in Excess               $103,000 (4 payments @ $20,000 + $23,000)

Week Five
The hull repair is complete and the new bushings and clamp are installed.   Shaft alignment begins.  Costs are mostly labor and amounts to $11,301 over 131 line items.   Captain Paul makes his fifth installment on Thursday.

Snug Harbor Marine – Hedi Brenna Account Status Report
Cash                                           $42,742

WIP                                              80,258
Sub-Total                                                $123,000
Contract Billings in Exce                       $123,000

Week Six
Both the hull and lobster tank are finished including new steel grates and air spreader lines.  All minor repairs are complete, the water line is painted, the propeller mounting is in progress.  Some equipment charges are included (crane, air compressor etc.).  Total costs equals $8,797 with 109 line items.  Captain Paul makes his sixth and final payment.  Here is the updated account balance report.

Snug Harbor Marine – Hedi Brenna Account Status Report
Cash                                 $53,945
WIP                                    89,055
Sub-Total                                       $143,000
Contract Billings in Excess           $143,000

Week Seven
The propeller was mounted, vessel was Coast Guard inspected and launched into the river for sea trials.  The chief engineer and two yard employees spent half a day out on the ocean testing the shaft, bushings etc.   All systems passed.  Captain Paul signed the paperwork and the project is now finished.  Prior to transfer to the income statement an additional 58 line entries, mostly labor for a total of $6,402 was added to WIP.

The account balances are as follows:

Snug Harbor Marine – Hedi Brenna Account Status Report
Cash                                            $47,543

WIP                                               95,457  (886 Line Items)
Sub-Total                                                   $143,000
Contract Billings in Excess                       $143,000

The accountant is confident no other costs are outstanding, so it is time to transfer the project to the income statement.  Step one is to download the WIP costs into a spreadsheet and sort the data into labor, materials, equipment, sub-contractors, engineering and other costs.  Once sorted, each group is summed and the information is now ready to transfer.  Here is the journal entry:

Sales Journal
Date            ID     Ledger          Dept               Job ID      Description                          DR              CR

ZZ/ZZ/ZZ  7608   Sales            Boat Repairs    HB-01      Completed Contract                            $100,000
.                  7608   Sales            Boat Repairs    HB-01      Change Order                                          23,000
.                  7608   Labor           Boat Repairs    HB-01      Paint/Hull Mechanics          $49,773
.                  7608   Engineer      Boat Repairs    HB-01      Cradle/Shaft Design                4,210
.                  7608   Material       Boat Repairs    HB-01      Prop/Shaft/Steel/Paint           19,909
.                  7608   Sub-Cntr      Boat Repairs    HB-01      Survey/Prop Leveling/Alig     9,432
.                  7608   Equipmnt     Boat Repairs    HB-01      Crane/Compr/Weld/Sand Bla 8,602
.                  7608   Other            Boat Repairs    HB-01      Permit/CG Fee/Supplies         3,531
.                  7608   WIP                                       HB-01      Transfer of all costs                                95,457
.                  7608   Contract Billings    –             HB-01      Transfer of all revenue        143,000       
.                                                                                                                                      $238,457    $238,457

This project’s income statement is as follows:

Sales                                                      $143,000
Costs of Restoration:
.     – Labor                            $49,773
.     – Materials                        19,909
.     – Subcontracting                 9,432
.     – Engineering                      4,210
.     – Equipment                        8,602
.     – Other                                 3,531
Sub-Total Costs of Rest                            95,457
Direct Profit                                            $47,543

Once transferred,  the new balance sheet for this project looks like this:

Snug Harbor Marine – Hedi Brenna Account Status Report
Cash                               $47,543
Current Earnings           $47,543

The account status report reflects one asset account and one equity account line of information.  Now for some insights to all this:

1)   The balance sheet is an effective report with completed contract method if interpreted correctly.

Unlike the percentage of completion method, the completed contract method utilizes the balance sheet accounts during interim financial periods.  In the above case the contract billings in excess account will match the associated assets.  The combination of assets include cash, accounts receivable and work in process.  The balance sheet does not necessarily have to balance.  Suppose in the above example Captain Paul didn’t pay a dime until the end of the contract?   The contract billings in excess would have a zero balance.  The only asset is work in process.   In effect, it is an unfunded project.   The contract is what assures payment.  At the end of the project, there are two different ways to handle this transaction.  First option is to create an invoice crediting contract billings and then create a journal entry transferring the credit to sales and transferring the costs from WIP (debit value).   A debit is made to receivables or cash depending on the moment of payment from Captain Paul.  The other option is directly credit sales with the invoice debiting cash or receivables thus bypassing contract billings in excess.  The journal entry simply transfers the WIP value.  Either way the net effect is the same.

2) Often the project balance sheet has multiple accounts involved.

Naturally work in process is the focal point on the asset side and contract billings in excess is the primary account on the liabilities side. Current earnings does not come into play until the project is complete and posted to the income statement.  Other accounts involved include cash as illustrated above,  accounts payable for unpaid bills and some internal accounts (explained in a future lesson).  Overall the transactions should never affect fixed and other assets nor long-term liabilities.

Phase costing is restricted to work in process.

As each cost is recorded to the books a phase is customarily assigned.  When pulling the phase costing report for the project the WIP account is the search database to retrieve the costs for the respective phases.  Remember, phase costing is used as a comparison to the original estimate.

From the job above there were 886 cost entries related to the Hedi Brenna.  So phase costing sorts these 886 entries into function groups (phases) like:

* Engineering
* Fabrication
* Steel Work/Welding
* Cleaning and Maintenance
* Painting
* Repair

As an example, suppose painting had 157 line items totaling $14,308.  The estimate for this phase expected $11,942 with so much to labor, materials, tools and supplies.  The 157 items could then be exported to a spreadsheet and sorted by the above cost of restoration accounts, summed and compared to the estimate.  Then the discrepancies can be analyzed for future improvements.

Summary

An easier and faster accounting method used in project (job) costing is the completed contract method.   It collects all interim information on the balance sheet via work in process and contract billings in excess.  It is designed for short-term projects typically less than 90 days in duration.   Once done all costs and the contract’s value are transferred to the income statement.

The key to this method is the work in process account.  The current asset account collects all costs (labor, materials, subcontracting, permits, equipment and other) associated with that project.  The WIP account is a control account so all costs are coded to a project and if applicable, phases.  As a regular weekly duty, the accountant should reconcile the WIP ledger balance to all open jobs.

The big advantage of the completed contract method is its simplicity; but it isn’t without its share of drawbacks.  First it can create some misleading income statement results as the entire revenue, costs and project profit are transferred at the same time.  So it is best if management uses a discerning eye for really short period interim financial reports.  Secondly, since the balance sheet acts as a collection tool, the differences between WIP and contract billings is not necessarily the direct profit for the project.  Finally, there are no tax savings associated with the use of the completed contract method.

Both the completed contract and percentage of completion method can be used by the business at the same time. There is no rule restricting one over the other.   Act on Knowledge.

If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org.  I would love to hear from you.  If interested in my services as an accountant/consultant; click on My Services in the footer of this article.

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About David J Hoare 427 Articles
I spent 12 Years as a Certified Public Accountant, Over 20 Years of Practice in Accounting and Consulting, Controller in Management of Closely Held Operations, Masters of Science in Accounting, Prepared over 1,000 Business Tax Returns and Hundreds of Individual Returns