Construction Industry Audit Technique Guide (ATG) - Chapter 6

Publication Date - May 2009

NOTE: This document is not an official pronouncement of the law or the position of the Service and can not be used, cited, or relied upon as such. This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.

Table of Contents
Chapter 5 / Chapter 7

Chapter 6: Financial Accounting Versus Tax Accounting

• Introduction
• Financial Accounting
• Balance Sheet Reporting
• Sample Financial Statements using Percentage of Completion Method:
  • Balance Sheet
  • Statement of Income and Retained Earnings
  • Schedule 1 on Earnings from Contracts
  • Schedule 2 on Contracts Completed
  • Schedule 3 on Contracts in Progress

Introduction

The accounting methods available within in the construction industry are unique to this industry. Understanding both the financial accounting and tax accounting requirements is important, so the proper book-to-tax adjustments are made.

Financial Accounting

The primary sources for generally accepted accounting principles (GAAP) for accounting for construction contracts are Accounting Research Bulletin (ARB) No. 45, Long-Term, Construction-Type Contracts and Statement of Position (SOP) 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. Under (GAAP) there are two methods of recognizing revenues on construction contracts.

ARB 45, which was issued in 1955, describes the two generally accepted methods of accounting for long-term construction type contracts; the percentage of completion method and the completed contract method. Because of the complexities and uncertainties in accounting for contracts, SOP 81-1 was issued in 1981 to provide additional guidance on the application of generally accepted accounting principles (GAAP).

Under SOP 81-1, the two methods are not alternatives from which a contractor is free to choose. SOP 81-1 establishes a strong preference for the percentage of completion method on the presumption that contractors have the ability to make estimates that are sufficiently dependable.

Therefore, the financial statements (whether audited, reviewed, or complied) that are prepared for bonding, banking, or other reporting purposes are almost exclusively prepared using the percentage of completion accounting method. However, in some circumstances, where the estimation of the final outcome may be impractical except to assure no loss will be incurred, the percentage of completion method will use a zero profit method (i.e. equal amount of revenue and cost are recognized until the results can be more precisely estimated).

The completed contract method may be used for financial purposes in circumstances in which the financial position would not vary materially from the percentage of completion method (i.e. this would primarily occur with shot-term contracts). Additionally, the completed contract method may be used in circumstances in which the contractor cannot make reasonable estimates.

However, as discussed in the chapter on Small Contractors and Large Contractors, many more accounting method choices are available to the contractor for tax purposes, depending on the length of the contract, the type of construction involved, and the average annual gross receipts of the taxpayer.

International Accounting Standards

Similar to SOP 81-1, which is a United States standard, International Accounting Standard (IAS) 11 provides guidance for the accounting of the revenues and costs of construction contracts. Under IAS 11, the percentage of completion method should be used when the outcome of a construction contract can be reasonably estimated. In circumstances in which the outcome cannot be reasonably estimated, no profit should be recognized. Contract revenue should only be recognized to the extent of contract costs are incurred.

When accounting for contracts using the percentage of completion method (PCM), costs determine the revenue and not the contract’s earned or billed income, recognition. Determining completion by costs (Total Costs Incurred divided by Total Estimated Costs) is a computation not made through the day-to-day book recording procedures. For instance, there is not a general ledger account for total estimated contract costs.

To account for the difference between percentage of completion method and billings, two balance sheet accounts are created:

1. Costs and Estimated Earnings in Excess of Billings (Asset)
2. Billings in Excess of Costs and Estimated Earnings (Liability)

This situation illustrates the concept of journal entries for a construction contract using the percentage of completion method. The contractor entered into a long-term construction contract during the 2001 taxable year. The total estimated contract price is $3,000,000, the total estimated contract costs are $2,000,000 and the contract is to be completed in 2002. The total costs incurred on this contract during 2001 are $1,000,000. The contractor billed the customer $1,200,000 during 2001.

During the tax year journal entries to record the transactions of this contract would be recorded as shown below. (Note: the two entries below are a summary of the numerous transactions that would have been recorded as the costs and billings were incurred.

At year-end, the contractor would determine the income to be included under the percentage of completion method as follows:

The necessary to bring the books and financial statements in accordance with the percentage of completion method would be as follows:

At year-end the costs and estimated earnings in excess of billings account has a debit balance of $300,000 and thus is represent as an asset on the balance sheet.

Basically, these two balance sheet accounts represent the difference between the accrual method and the percentage-of-completion method for reporting income on a long-term contract. Under either method, the costs related to the long-term contract are deducted as incurred. Therefore, generally no difference exists between the two

methods for costs.

A basic reporting principle prevents assets and liabilities from being netted or offset against each other. Thus both accounts (Costs and Earnings in Excess of Billings and Earnings and Costs in Excess of billings) should be present on the balance sheet. The following procedures are performed at year-end:

1. For each contract in progress at year-end, the total cost incurred to date plus the estimated earnings (on percentage of completion method) is reduced by the total amount of bills rendered to arrive at a net balance. The net balance, for each contract, will be a debit if the total costs and estimated earnings exceed the billings and a credit if the billings exceed the costs and estimated earnings.
2. All contracts that have a debit balance are added together with the total shown as an asset on the balance sheet.
3. All contracts that have a credit balance are added together with the total shown as a liability on the balance sheet.

See the Contracts In Process Schedule at the end of the chapter for an illustration of the procedures above.

Schedule M-1 and M-3 adjustments result from both timing differences and permanent differences between financial and tax accounting. The following items are intended to point out some of the differences in financial and tax accounting that is unique to the construction industry. These differences should be reconciled through Schedule M-1 and M-3 adjustments.

As discussed above, Statement of Position 81-1 (SOP 81-1) virtually requires construction companies to report income on the percentage of completion method. Generally, the bonding company or a lending bank will require the taxpayer to submit audited (possibly reviewed) financial statements, which will be reported on the percentage of completion method. For tax accounting, the contractor may use a different method, such as completed contract method, percentage of completion method, or capitalized cost method.

SOP 81-1 paragraph 12 provides a listing of contracts that are covered by this statement. Included in that listing are engineers, architects, and construction management taxpayers. Therefore, for financial purposes these contracts would be accounted for under the percentage of completion method. However, for tax purposes, they generally cannot use a long-term contract method (e.g., completed contract or percentage of completion). Revenue Ruling 70-67, Revenue Ruling 80-18, Revenue Ruling 82-134, Revenue Ruling 84-32.

SOP 81-1 paragraph 44 provides a number of methods to measure the extent of progress towards completion. They include the cost-to-cost method, variations of the cost-to-cost method, efforts expended method, the units-of-delivery method, and the units-of-work-performed method. For tax purposes, IRC § 460 generally requires the cost-to-cost method. However, the taxpayer may also elect the percentage of completion, 10% method in which none of the contract revenue or costs is included in taxable income until the contract is 10% complete. The contractor may also elect the simplified cost-to-cost method to determine contract completion.

SOP 81-1 paragraph 85 requires the contractor to report the total loss on a contract as soon as it is evident that a loss will occur. “When the current estimates of total contract revenue and contract cost indicate a loss, a provision for the entire loss on the contract should be made. Provisions for losses should be made in the period in which they become evident under either the percentage-of-completion method or the completed-contract method.” However, for tax purposes, the loss is not recognized until the job is completed, if on the completed contract method, and as incurred, if on the percentage of completion method.

Sample Financial Statements using Percentage of Completion Method

The exhibits below illustrate the financial statements when reporting construction contracts on the percentage of completion method. They also include items to consider when reviewing these statements.

• Exhibit 6A - Balance Sheet
• Exhibit 6B - Statement of Income and Retained Earnings
• Exhibit 6C - Schedule 1 – Earnings from Contracts
• Exhibit 6D - Schedule 2 – Contracts Completed
• Exhibit 6E - Schedule 3 – Contracts in Progress

Notes

¹ This account should reconcile to the Schedule 3 – Contracts in Progress

Notes

¹ This amount is from Schedule 2 - Contracts Completed. It represents the amounts of revenue earned and costs incurred during the 2002 tax year.

² This amount is from Schedule 3 – Contracts in Progress. It represents the amounts of revenue earned and costs incurred during the 2002 tax year.

Notes

¹ Contract Totals for Revenues Earned, Cost of Revenues and Gross Profit (Loss) would be used for the tax return if on the Completed Contract Method.

² Before January 1, 2002

³ Year Ended December 31, 2002

Notes

¹ Amounts are from inception of the contract to December 31, 2002.

Notes

² Amounts are from before January 1, 2002.

³ Amounts are at December 31, 2002 (Balance Sheet Accounts).

⁴ Amounts are for the Year Ended December 31, 2002.

Audit Considerations:

1. Job # 120 has a total estimated loss of (10,000) – the full loss is being reported for financial purposes. However, the job is only 51.13% complete. Thus, there should be a Schedule M-1 adjustment from book to tax.
2. Where is Job # 132? – Not located on this schedule or the completed contract schedule.
3. Job # 133 has an unusually low gross profit compared to other jobs. Why?