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The Tax Cuts and Jobs Act (TCJA) has expanded the requirements for revenue reporting methods for long-term contracts. Under the expansion, some companies that were previously required to use the percentage of completion method (PCM) now qualify for an exception. This change will influence some companies’ financial statements.
Many businesses routinely enter into long-term contracts. These businesses include creative agencies, real estate developers, home builders, and engineering firms. Typically, when using accrual-basis accounting, long-term contracts are reported under either the completed contract method or the percentage of completion method (PCM). The completed contract method records revenues and expenses when contracts are completed. The PCM ties revenue recognition as job costs are incurred.
PCM is usually preferred by the U.S. Generally Accepted Accounting Principles (GAAP), so long as estimates are “sufficiently dependable.” PCM functions by comparing the actual costs incurred to the expected total costs to estimate the percentage complete. This number can also be calculated using an annual completion factor. PCM also accounts for job cost allocation policies, change orders, and change in estimates.
PCM allows you to report income earlier, as well as affecting the overall balance sheet. Underbilling of customers based on the percentage of costs incurred leads you to report an asset for costs in excess of billings. If you overbill based on the costs incurred, you will report a liability for billings in excess of costs.
Syncing tax records and financial statements
The TCJA modified Section 451 of the Internal Revenue Code beginning in 2018. These TCJA changes require a business to recognize revenue for tax purposes no later than when it is recognized for financial reporting purposes. Sec. 451(b) states that taxpayers using the accrual method of accounting must meet the “all events test” no later than the taxable year that the item is accounted for as revenue for the taxpayers “applicable financial statement.”
These changes in 451 mean that if your business uses the PCM for financial reporting, you will usually need to use the same method for tax methods.
Taxable income from long-term contracts, for long-term tax purposes, is generally determined under the PCM. Though, there is an exception for smaller companies entering into contracts to construct or improve real property.
The TCJA requires that for tax years beginning in 2017 or later, construction firms having average annual gross receipts of $25 million or less will not be required to use PCM for contracts that are expected to be fulfilled within two years, this is in contrast to the previous $10 million limit.
Choosing the best method
When using reliable estimates, the PCM method provides more current insight into financial performance on long-term contracts than the completed contract method. However, the PCM method is significantly more complex. We can help to determine the best method for your company based on your operations and size. Contact us at 818-334-8623 or click here, and we will contact you.