[TBBG]

Please help! I thought with % of completion method, if you have a loss in one year, it wipes all all previous and current gains? Here is the question and the answer which seems suspect:

At the end of Year 1, Cody Co. reported a profit on a partially completed construction contract by applying the percentage of completion method. By the end of Year 2, the total estimated profit on the contract at completion in Year 3 had been drastically reduced from the amount estimated at the end of Year 1. Consequently, in Year 2, a loss equal to one-half of the previous year profit was recognized. Cody used the completed contract method for income tax purposes and had no other contracts. The Year 2 balance sheet should include a deferred tax:

A. asset and liability.

correct B.liability.

C. asset.

D. none of the answer choices are correct.

In theory, I understand that it should be a deferred tax liability because for income tax purposes, no gain is realized until the contract is complete (so income is booked for the “% of completion” method but not for “completed contract” method and you will have more taxable income in the future…. But I thought if you have a loss in any year under “% of completion” method, it wipes out all previous and current gains?? So shouldn’t the answer be D?? (Because year 2 also doesn’t have any income under % of completion method)

Thanks in advance!

Audit 86
BEC 75
FAR 82
REG 93

[Bnots]

You're thinking of the situation in which the total contract is a net loser. In that case, GAAP requires that we recognize the entire loss on the contract immediately, and that requires backing out any profit previously recognized under the percentage-of-completion method.

For example:

Year 1
Expected total revenue: $1,000
Expected total costs: $800
Expected profit (loss): $200
Costs to date: $240
Costs this year: $240
Percent complete: 30%
Revenue recognized to date: $300
Gross profit recognized this year: $300 – $240 = $60
Gross profit recognized to date: $60

Year 2
Expected total revenue: $1,000
Expected total costs: $1,200
Expected profit (loss): ($200)

Here, because the entire contract is expected to be a net loser, the entire $200 loss has to be recognized. Therefore, we have to back out the $60 in gross profit recognized in Year 1.

In this particular problem, however, the contract is still profitable, but much less than we originally expected it to be:

Year 2
Expected total revenue: $1,000
Expected total costs: $950
Expected profit (loss): $50
Costs to date: $570
Costs this year: $330
Percent complete: 60%
Revenue recognized to date: $600
Gross profit recognized this year: $300 – $330 = ($30)
Gross profit recognized to date: $30

We recognized $60 already in Year 1 when after Year 2 we should only have recognized a total of $30, so we have a $30 “correction” to make.

ETA: I believe the IRS doesn't allow you to deduct losses until the project is completed under their completed contract method, so — I think — you would actually be booking a deferred tax asset if you book an overall loss on the contract.

[TBBG]

@bnots, Thanks so much!! I get it now!

Audit 86
BEC 75
FAR 82
REG 93

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