Long Term Construction Contracts

09/08/2021 0 By indiafreenotes

Construction workers tend to work based on contractors they make with the owners of property. Traditionally these contractors could choose from a variety of accounting procedures to account for the revenue they received from such contracts.

Long-term contracts are contracts for the building, installation, construction, or manufacturing in which the contract is completed in a later tax year than when it was started. However, a manufacturing contract only qualifies if it is for the manufacture of a unique item for a particular customer or is an item that ordinarily takes more than 1 year to manufacture.

Long term contracts frequently provide that the seller (builder) may bill the purchaser at intervals, as it reaches various points in the project. Examples of long-term contracts are construction-type contracts, development of military and commercial aircraft, weapons-delivery systems, and space exploration hardware. When the project consists of separable units, such as a group of buildings or miles of roadway, contract provisions may provide for delivery in installments. In that case, the seller would bill the buyer and transfer title at stated stages of completion, such as the completion of each building unit or every 10 miles of road. The accounting records should record sales when installments are “delivered.”

A company satisfies a performance obligation and recognizes revenue over time if at least one of the following three criteria is met:

  • The customer simultaneously receives and consumes the benefits of the seller’s performance as the seller performs.
  • The company’s performance creates or enhances an asset (for example, work in process) that the customer controls as the asset is created or enhanced.
  • The company’s performance does not create an asset with an alternative use. For example, the asset cannot be used by another customer.

In addition to this alternative use element, at least one of the following criteria must be met:

(a) Another company would not need to substantially re-perform the work the company has completed to date if that other company were to fulfill the remaining obligation to the customer.

(b) The company has a right to payment for its performance completed to date, and it expects to fulfill the contract as promised.

Long-Term Methods of Accounting

There are 2 primary methods of accounting to determine when revenue is recognized for long-term contracts:

  • Completed contract method (CCM)
  • Percentage of completion method (PCM)

Completed Contract Method

Using the completed contract method, the taxpayer does not recognize revenue until the contract is completed and accepted by the customer. Except for home construction contracts, CCM can only be used by small contractors for contracts with an estimated life that does not exceed 2 years. There should be no terms in the contract with the only purpose of deferring tax.

The CCM is required for home construction contracts that are for the construction of residential buildings with 4 or fewer dwelling units, where at least 80% of the estimated cost is for the dwelling units and related land improvements, even if the contract is for longer than 2 years or the contractor is a large contractor. Other types of construction contracts qualify for the completed contract method if they satisfy the general CCM requirements.

Percentage of Completion Method

Except for home construction contracts, large contractors must use the percentage of completion method for long-term contracts. PCM must also be used to determine liability under the alternative minimum tax (AMT) system. Under the PCM, the amount of progress on the project is determined by the total costs actually incurred as compared to the total estimated cost. Hence, revenue in any given year is determined by the actual contract costs incurred for that year divided by the total estimated cost multiplied by the total contract price:

Reportable Income = Contract Price × Annual Contract Cost/Estimated Total Cost