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.
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: $350,000Using the percentage of completion method, how much gross profit will Weiss Enterprises report in Year 3?
- $0
- $50,000
- $300,000
- $400,000
- 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.
- How much of the contract was completed in the current year, and
- 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