The following are the primary accounting methods for long-term contracts, explained briefly, for smaller and larger contractors.
Ave. Gross Receipts < $10 million (or < $25 million starting in 2018)
Completed Contract Method
- No revenue is reported or costs deducted until the contract is complete:
- Generally considered complete when 95% of expected costs have been incurred
- Aggressive billing and collections do not impact income
- Biggest tax deferral opportunity
The disadvantages of this method occur when several contracts finish in the same year, causing a spike in income and a spike in the tax rate. Contractors also cannot deduct losses on a contract until the job is complete.
Note that home contracts are exempt from Section 460 and that the completed contract method is generally used by home builders.
- Revenue reported when collected
- Costs deducted when paid
- Large deferral opportunities by managing billings and acceleration of payment of costs
The disadvantages of the cash accounting method with long-term contracts is that contractors must spend cash to claim deductions and delay receipts to defer income, which is counter to smart business planning. Aggressive billing may result in acceleration of income. Also, a declining economy could mean large tax bills in down years due to the inevitable reversal of income deferrals.
- Revenue reported when billed
- Costs deducted when incurred
The disadvantages to the accrual accounting method are that aggressive billing generally results in acceleration of revenue, accrued losses on contracts are not deductible until the job is complete and tax planning techniques may be counter to business planning.
Percentage of Completion Method
- Ongoing recognition of revenue and income, computed by the stage of project completion when compared to total costs to complete the project
- Based on estimated future costs
The disadvantages to the percentage of completion accounting method are that accrued losses on contracts are not deductible and income can be accelerated due to things like uninstalled materials charged to jobs, overbillings by subcontractors or underestimated total costs to complete a job. The accuracy of the method is dependent upon the accuracy of estimates. Inaccurate estimates could result in inaccurate reporting of tax.
A Note About Alternative Minimum Tax (AMT)
The 2018 tax law increased the AMT exemptions for individuals, however AMT continues to apply. Percentage of completion is required for AMT purposes. Thus the difference in income between percentage of completion and the income under the taxpayer’s method of accounting for long-term contracts is an adjustment for AMT purposes. If the contractor is organized as a partnership, S-corporation, or sole proprietorship, the owners should evaluate the effect of AMT when selecting their accounting method.
Home builders, as an exception, are permitted to use the completed contract method for AMT.
Ave. Gross Receipts > $10 million (or > $25 million starting in 2018)
Larger contractors are required to use the Percentage of Completion method under Code Section 460.
To offset the potential for accelerated income, companies may elect a 10% method, which defers recognition of revenue or costs until a job is at least 10% complete. This method is also allowable under AMT. It may be useful in instances when a contract commences toward the end of a tax year.
Larger companies are also required to use a look-back approach once a job is complete. Income in prior years is recalculated using actual costs, which may result in a change in gross profit for the prior year. Tax is recalculated and compared to tax actually paid for the year. Interest is calculated on the resulting over or under payment.
Code Section 460 also requires companies to allocate certain overhead costs to contracts. This may provide a deferral opportunity if the contractor is diligent in estimating overhead costs that may be allocated to the contract in future years.
To select the most advantageous accounting method or to determine if your company should change its accounting method in 2018, controllers and CFOs may need the guidance of a CPA knowledgeable in accounting for long-term contract rules. It helps to get a second opinion to support the right accounting method for your contracts that is both tax law compliant and offers the best potential for tax planning or deferral.
Continue Reading: Plan Ahead in 2018 for Accounting for New Long-Term Contracts
Scott Allen, CPA, joined Cornwell Jackson as a Tax Partner in 2016, bringing his expertise in the Construction and Oil and Gas industries and 25 years of experience in the accounting field. As the Partner in Charge of the Tax practice at Cornwell Jackson, Scott provides proactive tax planning and tax compliance to all Cornwell Jackson tax clients. Contact him at Scott.Allen@cornwelljackson.com or 972-202-8032.