 Hello and welcome to the session in which we will discuss the taxation of long-term contracts. The first thing we need to understand is what is considered a long-term contract? Well, it's a contract that's entered into but not completed within the same tax year. So if we are discussing a calendar tax year, this is year one, this is year two. Calendar means January till December. We entered into the contract here, but we did not complete until we got to year two. So it's entered into one year and it's spanned to year two. And this contract involved building contract, installing contract or manufacturing contract. Now we have to be a little bit aware of manufacturing contract. Manufacturing contract are long-term contract only if the contract is to manufacture a unique item. The item has a unique use and not normally carried in the finished goods inventory. So if you're producing your inventory, well, that's not if you're producing inventory, that's not a long-term contract. Also, items that normally require more than 12 calendar months are complete. So you are building something, you are manufacturing something and it's taken longer than 12 months. I'll give the example of an airplane. If you have to build an airplane, it's going to take longer than 12 months. The contract to manufacture that airplane will take longer than 12 months. So that's how it works. Now bear in mind, service contract, auditing, accounting, legal services, consultation don't qualify as a long-term contract. So sometimes they might give you a multiple choice question just to kind of to determine whether you know what's a long-term contract or not. Easy, peasy answer. Before we proceed any further, I have a public announcement about my company farhatlectures.com. Farhat accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead, start your free trial today, no obligation, no credit card required. Let's take a look at this example. Adam, a calendar year taxpayer, entered into two contracts during the year, 20x2. The first contract, construct a building, foundation, building, foundation, Adam to begin work in November 20x2, the works to be completed in May 20x3. Is this a long-term contract? Well, it's less than 12 months. Although it's less than 12 months, it spans a long two period, two tax period. It's a long-term contract and it's not a manufacturing contract. Second contract, legal services to be performed over three years. Is this a long-term contract? Well, it's longer than 12 months. It's services. Services are not considered long-term contract. Now, how to account for long-term contracts? We have two methods. We have the percentage of completion method, which is the general method used unless an exception exists. So simply put, how do we account for long-term contract? Percentage of completion, unless an exception exists. What is a percentage of completion? And this is why I always recommend that if you're studying for your CPA exam to take the financial accounting and reporting part first. Why? Because you would learn about percentage of completion method. So it will be helpful. Simply put, you would recognize revenue slash profit as you complete the work. Well, if an exception exists, you can use the completed contract method. So we have two methods, percentage of completion and CC, completed contract. If an exception exists. What is a completed contract method? No revenue is recognized until the contract is completed and accepted. Well, simply put, the customer accepted the contract or started to use the product, then it's completed. So in your opinion, just to ask you right now, which method you think the taxpayer prefers? Well, I would say the taxpayer should prefer the completed contract because you are deferring paying taxes until the project is done. The IRS would always prefer that use the percentage of completion because they wonder cut as you are completing this project. Let's take a look at the completed contract method because that's the exception. Everything is percentage of completion unless an exception exists. You would use the completed contract. When does that exception exist? If you are doing home construction contract. Contract in which at least 80% of the costs are dwelling unit and building with four or fewer units. So it's simply put, you are not building hotels or large apartments, home construction and certain other real estate construction project. As long as they are completed within two year period beginning of the commencement date of the contract and you are a small business. Now what is a small business? Well, your average gross receipt is less than 27 million for the previous three taxable year. And I believe this is for the year 2022. This is subject to inflation. So simply put, if you're a small business, you can use the completed contract method as long as you meet other criteria. Now sometime what could happen is you could have a dispute under the completed contract method. Simply put, you completed the contract and the customer is not happy. A dispute could be because there's a disagreement about the work, the quality of the work. They are asking you to change the price, whatever the reason is. If a disputed amount is substantial, is large enough and you cannot determine the gain or the loss because there's a dispute and you really don't know what's going to happen once dispute is settled. You wait until the dispute is settled. If the dispute, if the disputed amount, if the disagreement amount is less than the profit, recognize. So you know there's a dispute and you assume even if the plaintive, if the person that's disputed me will win the case, I would still have a profit because I know the additional cost would still keep me with a profit. Well, the profit in the year of completion will be recorded less estimated additional cost because remember you might have to incur additional cost because of the dispute. So you would recognize some profit and some revenue. If the disputed cost is greater than the profit. So now you know it's a disputed cost and you think it's going to wipe out all of your profit. You made a mistake and that's what's going to happen. You recognize the loss when the dispute is resolved. Now it's important here to recognize that notice you would wait until the dispute is resolved under taxation under financial accounting under gap. As soon as you think there's a loss, you recognize the loss immediately. So notice the difference in treatment under tax you wait. Why? Because they don't want you to take the loss until later. The government don't wait you don't want you to get that tax deduction until way later. Let's take a look at an example to illustrate this concept. In 20x2 Adam a calendar year taxpayer using the completed contract method for long term construction contract and long term long term contract are sometimes called long term construction or long term manufacturing but long term contract to construct the foundation for a building for Ryan under a long term contract. So we already established it's a long term contract. We already established we are using the completed contract. The original contract price was 300,000 with an estimated cost of 260. Simply put Adam is thinking I am going to be making a profit once all said and done of 40,000 on this project. When Ryan inspected the foundation well he noticed few crack in the foundation now Adam finished the work. Ryan refused to pay until Adam fixes the cracks or reduce the price. So Ryan says look I'm not going to pay you you have two options fix the cracks or you have to reduce the price. So assuming that fixing the crack will cost Adam an additional 25,000. Well my profit was 140 now I think I'm going to have to reduce it by 25 because my cost went up I'm still profitable of 15,000. Adam would report 375 of revenues why 370 I'm sorry would report 275 of revenues which is 300,000 minus 25 minus 260 which is the cost and what we're left with Adam is assured 15,000. So in year x2 we would report revenue of 275 minus the expenses of 260 and we would report profit of 15. Now in 20x3 when Adam did the work fix the crack he was able to do so at a cost of 22. Now Adam would report 25 in revenues that he did not report in 20x0 because really the work wasn't completed and would report 22,000 of expenses and 3,000 of the profit will be recorded in 20x3. Now let's assume the same fact but except that it will cost Adam 50,000 to fix the foundation. Well think about it if it's going to cost 50,000 for Adam to fix the foundation all the profit has been wiped out and we have a loss of 10,000. Under those circumstances Adam will wait until the dispute is resolved simply put until the work is done then Adam will take a loss of 10,000 assuming they meet all other criteria. Now let's talk a little bit more about the percentage of completion method how to recognize revenue under this method the percentage of completion well now bear in mind that we're going to be doing this for two years but in some cases we could have this percentage of completion for multiple years especially if you are studying for the financial accounting and reporting exam so but for taxation you don't have to go this far if you're interested go to my intermediate accounting course so this is how you will complete you will do this you will take the contract cost incurred during the period how much cost you incurred during this period and you will divide this by the estimated cost to complete the project so you spend a hundred dollar and the estimated cost is a thousand well you completed equal to 10 percent that's the percentage then you will take this percentage and you multiply it by the contract price so if the price is five thousand well you have revenues of five hundred dollars how much was completed taken the contract contract cost incurred during the period minus the estimated cost to complete the best way to illustrate this is to look at an example Adam entered into a contract that was to take two years to complete with an estimated cost of eight hundred thousand the contract price was one point two million so if all goes well one point two million minus eight hundred thousand Adam should enjoy a profit of four thousand cost of the contract for twenty x zero total six hundred thousand so in year one or in year zero the first year Adam incurred six hundred thousand what was the gross profit reported for year twenty x zero well cost incurred six hundred thousand divided by total cost that's seventy five percent so in year one Adam completed seventy five percent of the project therefore Adam can recognize seventy five percent of one point two million therefore Adam can recognize nine hundred thousand in revenues nine hundred thousand in revenues minus eight hundred thousand dollar in cost will give Adam a gross profit of one hundred thousand for year twenty x zero to be taxable that's fine after the contract was completed at the end of year twenty x one at a total cost of nine hundred thousand so in year two what happened is somehow we were short of labor the the price of the material went up it does not matter our cost went from eight hundred thousand to nine hundred thousand what is the gross profit reported using the percentage of completion now we are done we'll take one point two million which is the total a contract price minus nine hundred thousand now the total profit is three hundred thousand then we have to deduct from this profit the profit that we recognize in year twenty x zero the three hundred thousand is the total gross profit for the whole project now it used to be four hundred thousand but now it's three hundred thousand but we have to we already recognize one hundred thousand therefore in year twenty x one which is year two we only recognize two hundred thousand dollar in profit what should you do to to learn this go to far hat lectures look at additional resources multiple choice true false additional exercises if you are if you'd like to learn more about the percentage of completion method versus the complete of contract from a financial accounting perspective it will help you substantially go to my intermediate accounting one subscription give you access to all good luck study hard invest in yourself invest in your career accounting is worth it the cpa is worth it the enrolled agent exam is worth it and stay safe