Percentage of Completion Method

Course: Income Tax Planning
Lesson 10: Recognition of Expenses, Losses, and Deductions

Student Question:

Question 5 (below) did not make sense to me. I started out by breaking down by year – 400,000/2,100,000*3,000,000 and so forth, but did not arrive at the correct answer. So then I tried adding up 3 year – 400+650+700/2100000*3,000,000. That wasn’t correct either.

Could you help me arrive at the correct answer?

Thanks.

Laura

Weiss Enterprises signs a $3 million contract in June Year 1 to construct a new office building. The project is scheduled to be completed in March of Year 4 at a cost to Weiss of $2,100,000. Actual costs resulted as follows:

• Year 1: $400,000
• Year 2: $650,000
• Year 3: $700,000
• Year 4: $350,000

Using the percentage of completion method, how much gross profit will Weiss Enterprises report in Year 3?

1. $0
2. $50,000
3. $300,000
4. $400,000
5. Weiss Enterprise cannot use the percentage of completion method

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Instructor Response:

Hi Laura,

The percentage of completion method for accounting for long term contracts can be counterintuitive.

We need to know two things to recognize profits in any one year:

1. How much of the contract was completed in the current year, and
2. The total estimated gross profit for the contract.

We determine % complete by determining % of total costs expended in the current year.

• We know that estimated total costs for the entire contract equals $2.1MM and we know that $700M in costs were incurred in Year 3.
• Dividing the latter by the former tells us that the contract was 33% completed in Year 3.

We know that the estimated gross profit for the entire contract is $900,000 ($3MM – 2.1MM).

• We multiply 33% by $900,000 to arrive at $300,000 in recognized gross profit.

Let me know how fully this answers your question.

Have a great weekend.

Bruce