Contract Method of Accounting: Understanding the Basics

Businesses that offer services or products often work with contracts that specify terms and conditions of the transaction. The contract method of accounting is a particular way of recognizing revenue and expenses associated with contracts. In this article, we will discuss the basics of the contract method of accounting, including its advantages and disadvantages, and how it differs from other accounting methods.

Definition of the Contract Method of Accounting

The contract method of accounting is a revenue recognition method used when a company in its business model, uses contracts as a means of operation or delivery to customers. In this method, companies determine revenue based on the contract`s completion percentage, whereas costs are allocated to a contract based on the progress of the work.

The contract method of accounting is different from other accounting methods, such as the cash and accrual basis of accounting. Under the cash method, companies recognize revenue and expenses when they receive or pay cash, respectively. The accrual basis recognizes revenue when it is earned, regardless of when cash is received, and expenses when they are incurred.

Advantages and Disadvantages of the Contract Method of Accounting

The contract method of accounting has several advantages. Firstly, it allows companies to recognize revenue and expenses as they actually occur, which provides a more accurate reflection of the company`s financial status. Secondly, this method helps in reconciling the cash flows of the company. Thirdly, it helps in tracking the progress of the work on a contract and recognizing the corresponding revenue according to the cost of completion.

However, the contract method also has its disadvantages. The primary disadvantage is that it requires a lot of bookkeeping and record-keeping, which can be time-consuming and costly. Additionally, if a contract is terminated before completion, it can be difficult to calculate the revenue and expenses for the work performed.

How the Contract Method of Accounting Differs from Other Accounting Methods

The contract method of accounting differs from other accounting methods in several ways. Firstly, it recognizes revenue and expenses based on the completion percentage of a contract rather than the timing of cash flows. Secondly, it requires the company to maintain records on the progress of the work on a contract. Finally, it allows companies to recognize revenue based on what they have earned, rather than when they receive cash.

Conclusion

The contract method of accounting is a useful tool for companies that work with contracts. While it requires a lot of record-keeping and can be time-consuming, it provides accurate financial information and allows businesses to track the progress of the work on a contract. Understanding the basics of the contract method of accounting is essential, particularly if you are a business owner who works with contracts.