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.

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

Could you help me arrive at the correct answer?

Thanks,

Laura


Instructor Response:

Hi Laura,

The percentage of completion method for accounting for long term contracts can be counter-intuitive.

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