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Construction Industry Audit Technique Guide (ATG) - Chapter 6

Publication Date - May 2009

NOTE: This document is not an official pronouncement of the law or the position of the Service and can not be used, cited, or relied upon as such. This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.


Table of Contents
Chapter 5 / Chapter 7


Chapter 6: Financial Accounting Versus Tax Accounting

Introduction

The accounting methods available within in the construction industry are unique to this industry. Understanding both the financial accounting and tax accounting requirements is important, so the proper book-to-tax adjustments are made.

Financial Accounting

The primary sources for generally accepted accounting principles (GAAP) for accounting for construction contracts are Accounting Research Bulletin (ARB) No. 45, Long-Term, Construction-Type Contracts and Statement of Position (SOP) 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. Under (GAAP) there are two methods of recognizing revenues on construction contracts.

ARB 45, which was issued in 1955, describes the two generally accepted methods of accounting for long-term construction type contracts; the percentage of completion method and the completed contract method. Because of the complexities and uncertainties in accounting for contracts, SOP 81-1 was issued in 1981 to provide additional guidance on the application of generally accepted accounting principles (GAAP).

Under SOP 81-1, the two methods are not alternatives from which a contractor is free to choose. SOP 81-1 establishes a strong preference for the percentage of completion method on the presumption that contractors have the ability to make estimates that are sufficiently dependable.

Therefore, the financial statements (whether audited, reviewed, or complied) that are prepared for bonding, banking, or other reporting purposes are almost exclusively prepared using the percentage of completion accounting method. However, in some circumstances, where the estimation of the final outcome may be impractical except to assure no loss will be incurred, the percentage of completion method will use a zero profit method (i.e. equal amount of revenue and cost are recognized until the results can be more precisely estimated).

The completed contract method may be used for financial purposes in circumstances in which the financial position would not vary materially from the percentage of completion method (i.e. this would primarily occur with shot-term contracts). Additionally, the completed contract method may be used in circumstances in which the contractor cannot make reasonable estimates.

However, as discussed in the chapter on Small Contractors and Large Contractors, many more accounting method choices are available to the contractor for tax purposes, depending on the length of the contract, the type of construction involved, and the average annual gross receipts of the taxpayer.

International Accounting Standards

Similar to SOP 81-1, which is a United States standard, International Accounting Standard (IAS) 11 provides guidance for the accounting of the revenues and costs of construction contracts. Under IAS 11, the percentage of completion method should be used when the outcome of a construction contract can be reasonably estimated. In circumstances in which the outcome cannot be reasonably estimated, no profit should be recognized. Contract revenue should only be recognized to the extent of contract costs are incurred.

Balance Sheet Accounts

When accounting for contracts using the percentage of completion method (PCM), costs determine the revenue and not the contract’s earned or billed income, recognition. Determining completion by costs (Total Costs Incurred divided by Total Estimated Costs) is a computation not made through the day-to-day book recording procedures. For instance, there is not a general ledger account for total estimated contract costs.

To account for the difference between percentage of completion method and billings, two balance sheet accounts are created:

  1. Costs and Estimated Earnings in Excess of Billings (Asset)
  2. Billings in Excess of Costs and Estimated Earnings (Liability)

Example:

This situation illustrates the concept of journal entries for a construction contract using the percentage of completion method. The contractor entered into a long-term construction contract during the 2001 taxable year. The total estimated contract price is $3,000,000, the total estimated contract costs are $2,000,000 and the contract is to be completed in 2002. The total costs incurred on this contract during 2001 are $1,000,000. The contractor billed the customer $1,200,000 during 2001.

During the tax year journal entries to record the transactions of this contract would be recorded as shown below. (Note: the two entries below are a summary of the numerous transactions that would have been recorded as the costs and billings were incurred.

Journal Entries Using Percentage of Completion Method
Journal Entries Debit Credit
Costs Incurred

$1,000,000

 
Accounts Payable  

$1,000,000

Accounts Receivable

$1,200,000

 
Costs and Estimated Earnings in Excess of Billings  

$1,200,000

At year-end, the contractor would determine the income to be included under the percentage of completion method as follows:

Year-End Percentage of Completion Method
Total Costs Incurred ($1,000,000)
Divided By
Total Estimated Costs ($2,000,000)
Times Estimated Contract Price ($3,000,000) Equals PCM Income ($1,500,000)

The necessary to bring the books and financial statements in accordance with the percentage of completion method would be as follows:

Adjusting Journal Entry for Percentage of Completion Method
Journal Entries Debit Credit
Costs and Estimated Earnings in Excess of Billings

$1,500,000

 
Income  

$1,500,000

At year-end the costs and estimated earnings in excess of billings account has a debit balance of $300,000 and thus is represent as an asset on the balance sheet.

Basically, these two balance sheet accounts represent the difference between the accrual method and the percentage-of-completion method for reporting income on a long-term contract. Under either method, the costs related to the long-term contract are deducted as incurred. Therefore, generally no difference exists between the two

methods for costs.

Accrual vs. Percentage of Completion Methods
Accrual vs. Percentage of Completion Methods Amount

Income Billings per Accrual Method

$1,200,000

Income per Percentage of Completion Method

$1,500,000

Costs and Earnings in Excess of Billings

$300,000

Balance Sheet Reporting

A basic reporting principle prevents assets and liabilities from being netted or offset against each other. Thus both accounts (Costs and Earnings in Excess of Billings and Earnings and Costs in Excess of billings) should be present on the balance sheet. The following procedures are performed at year-end:

  1. For each contract in progress at year-end, the total cost incurred to date plus the estimated earnings (on percentage of completion method) is reduced by the total amount of bills rendered to arrive at a net balance. The net balance, for each contract, will be a debit if the total costs and estimated earnings exceed the billings and a credit if the billings exceed the costs and estimated earnings.
  2. All contracts that have a debit balance are added together with the total shown as an asset on the balance sheet.
  3. All contracts that have a credit balance are added together with the total shown as a liability on the balance sheet.

See the Contracts In Process Schedule at the end of the chapter for an illustration of the procedures above.

Book and Tax Differences

Schedule M-1 and M-3 adjustments result from both timing differences and permanent differences between financial and tax accounting. The following items are intended to point out some of the differences in financial and tax accounting that is unique to the construction industry. These differences should be reconciled through Schedule M-1 and M-3 adjustments.

Revenue Recognition

As discussed above, Statement of Position 81-1 (SOP 81-1) virtually requires construction companies to report income on the percentage of completion method. Generally, the bonding company or a lending bank will require the taxpayer to submit audited (possibly reviewed) financial statements, which will be reported on the percentage of completion method. For tax accounting, the contractor may use a different method, such as completed contract method, percentage of completion method, or capitalized cost method.

Contract Related Services

SOP 81-1 paragraph 12 provides a listing of contracts that are covered by this statement. Included in that listing are engineers, architects, and construction management taxpayers. Therefore, for financial purposes these contracts would be accounted for under the percentage of completion method. However, for tax purposes, they generally cannot use a long-term contract method (e.g., completed contract or percentage of completion). Revenue Ruling 70-67, Revenue Ruling 80-18, Revenue Ruling 82-134, Revenue Ruling 84-32.

Determining Completion for Percentage of Completion Method

SOP 81-1 paragraph 44 provides a number of methods to measure the extent of progress towards completion. They include the cost-to-cost method, variations of the cost-to-cost method, efforts expended method, the units-of-delivery method, and the units-of-work-performed method. For tax purposes, IRC § 460 generally requires the cost-to-cost method. However, the taxpayer may also elect the percentage of completion, 10% method in which none of the contract revenue or costs is included in taxable income until the contract is 10% complete. The contractor may also elect the simplified cost-to-cost method to determine contract completion.

Loss Recognition

SOP 81-1 paragraph 85 requires the contractor to report the total loss on a contract as soon as it is evident that a loss will occur. “When the current estimates of total contract revenue and contract cost indicate a loss, a provision for the entire loss on the contract should be made. Provisions for losses should be made in the period in which they become evident under either the percentage-of-completion method or the completed-contract method.” However, for tax purposes, the loss is not recognized until the job is completed, if on the completed contract method, and as incurred, if on the percentage of completion method.

Sample Financial Statements using Percentage of Completion Method

The exhibits below illustrate the financial statements when reporting construction contracts on the percentage of completion method. They also include items to consider when reviewing these statements.

  • Exhibit 6A - Balance Sheet
  • Exhibit 6B - Statement of Income and Retained Earnings
  • Exhibit 6C - Schedule 1 – Earnings from Contracts
  • Exhibit 6D - Schedule 2 – Contracts Completed
  • Exhibit 6E - Schedule 3 – Contracts in Progress
Exhibit 6A XYZ Corporation Balance Sheet December 31, 2002
Assets: Current Assets: Cash

$9,000

 

Contract Receivables

$335,000

 

Costs & Estimated Earnings in Excess of Billings 1

$28,711

 

Total Current Assets

$372,711

$372,711

Property & Equipment:

 

 

Furniture, Fixtures, & Equipment

$6,000

 
Accumulated Depreciation

($1,500)

 

Total Property and Equipment

$4,500

$4,500

Other Assets: Deposits

$750

 

Total Other Assets

$750

$750

Total Assets

 

$377,961

Liabilities and Stockholder's Equity: Liabilities: Accounts Payable

$121,000

 

Accrued Liabilities

$17,000

 

Deferred Income Taxes

$36,000

 

Billings in Excess of Costs and Estimated Earnings1

$5,666

 

Total Liabilities

$179,666

$179,666

Stockholder’s Equity: Common Stock

$1,000

 
Retained Earnings

$197,295

 
Total Stockholder’s Equity

$198,295

$198,295

Total Liabilities and Stockholder’s Equity

 

$377,961

Notes

1 This account should reconcile to the Schedule 3 – Contracts in Progress

Exhibit 6B XYZ Corporation Statement of Income and Retained Earnings December 31, 2002
Contract Revenue Earned 1

$1,439,159

Less Costs of Revenue Earned 1

($1,174,000)

Gross Profit

$265,159

Less General and Administrative Expenses

($199,000)

Income before Income Taxes

$66,159

Less Income Taxes:  
Current Income Taxes

($12,000)

Deferred Income Taxes

($4,000)

Net Income 2

$50,159

Add Beginning Retained Earnings

$147,136

Ending Retained Earnings

$197,295

Exhibit 6C XYZ Corporation Schedule 1 – Earnings from Contracts Year Ended December 31, 2002
Description Revenues Earned Cost of Revenues Gross Profit (Loss)
Contracts Completed during the Year1

$502,000

$361,000

$141,000

Plus Contracts in Progress at Year-End2

$937,159

$813,000

$124,159

Earnings from Contracts

$1,439,159

$1,174,000

$265,159

Notes

1 This amount is from Schedule 2 - Contracts Completed. It represents the amounts of revenue earned and costs incurred during the 2002 tax year.

2 This amount is from Schedule 3 – Contracts in Progress. It represents the amounts of revenue earned and costs incurred during the 2002 tax year.

Exhibit 6D XYZ Corporation Schedule 2 – Contracts Completed Year Ended December 31, 2002
Project Number Construction Project Revenues Earned 1 Cost Of Revenues 1 Gross Profit (Loss) 1 Revenues Earned 2 Cost Of Revenues 2 Gross Profit (Loss) 2 Revenues Earned 3 Cost Of Revenues 3 Gross Profit (Loss) 3
121 John’s Store $312,000 $248,000 $64,000 $193,000 $172,000 $21,000 $119,000 $76,000 $43,000
122 Ron’s Club $267,000 $197,000 $70,000 $178,000 $144,000 $34,000 $89,000 $53,000 $36,000
127 Parking Lot $403,000 $312,000 $91,000 $250,000 $199,000 $51,000 $153,000 $113,000 $40,000
128 Hospital $35,000 $38,000 ($3,000) 0 0 0 $35,000 $38,000 ($3,000)
130 Office Building $106,000 $81,000 $25,000 0 0 0 $106,000 $81,000 $25,000
Totals $1,123,000 $876,000 $247,000 $621,000 $515,000 $106,000 $502,000 $361,000 $141,000

Notes

1 Contract Totals for Revenues Earned, Cost of Revenues and Gross Profit (Loss) would be used for the tax return if on the Completed Contract Method.

2 Before January 1, 2002

3 Year Ended December 31, 2002

Exhibit 6E XYZ Corporation Schedule 3 – Contracts in Process Year Ended December 31, 2002
# Revenues Estimated Gross Profit (Loss) Revenues Earned 1 Cost of Revenues 1 Gross Profit (Loss) 1 Billed to Date 1 Estimated Cost to Complete 1
119 1,275,000 210,000 1,228,310 1,026,000 202,310 1,225,000 39,000
120 211,000 (10,000) 107,887 113,000 (5,113) 106,000 108,000
123 53,000 15,000 43,237 31,000 12,237 46,000 7,000
124 258,000 50,000 129,000 104,000 25,000 117,000 104,000
125 218,000 40,000 79,607 65,000 14,607 74,000 113,000
126 85,000 13,000 47,222 40,000 7,222 43,000 32,000
129 220,000 42,000 181,685 147,000 34,685 180,000 31,000
131 160,000 38,000 28,852 22,000 6,852 30,000 100,000
133 152,000 1,000 37,245 37,000 245 39,000 114,000
  2,632,000 399,000 1,883,045 1,585,000 298,045 1,860,000 648,000

Notes

1 Amounts are from inception of the contract to December 31, 2002.

Exhibit 6E XYZ Corporation Schedule 3 – Contracts in Process Year Ended December 31, 2002 (continued)
# Revenues Estimated Gross Profit (Loss) Revenues Earned 2 Cost of Revenues 2 Gross Profit (Loss) 2 Cost and Estimated Earnings in Excess of Billings 3 Billings in Excess of Costs and Estimated Earnings 3 Revenues Earned 4 Cost of Revenues 4 Gross Profit (Loss) 4 Percentage Complete 4
119 1,275,000 210,000 1,049,000 880,000 169,000 3,310 0 179,310 146,000 33,310 96.34%
120 211,000 (10,000) 0 0 0 1,887 0 211,000 221,000 (10,000) 51.13%
123 53,000 15,000 0 0 0 0 2,763 43,237 31,000 12,237 81.58%
124 258,000 50,000 0 0 0 12,000 0 129,000 104,000 25,000 50.00%
125 218,000 40,000 0 0 0 5,607 0 79,607 65,000 14,607 36.52%
126 85,000 13,000 0 0 0 4,222 0 47,222 40,000 7,222 55.56%
129 220,000 42,000 0 0 0 1,685 0 181,685 147,000 34,685 82.58%
131 160,000 38,000 0 0 0 0 1,148 28,852 22,000 6,852 18.03%
133 152,000 1,000 0 0 0 0 1,755 37,245 37,000 245 24.50%
  2,632,000 399,000 1,049,000 880,000 169,000 28,711 5,666 937,159 813,000 124,159  

Notes

2 Amounts are from before January 1, 2002.

3 Amounts are at December 31, 2002 (Balance Sheet Accounts).

4 Amounts are for the Year Ended December 31, 2002.

Audit Considerations:

  1. Job # 120 has a total estimated loss of (10,000) – the full loss is being reported for financial purposes. However, the job is only 51.13% complete. Thus, there should be a Schedule M-1 adjustment from book to tax.
  2. Where is Job # 132? – Not located on this schedule or the completed contract schedule.
  3. Job # 133 has an unusually low gross profit compared to other jobs. Why?

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