Using Revenue Recognition to Manage Cash Flow
We recently were asked to assist a foreign construction company with their Canadian corporate income tax returns. They were in the midst of their first Canadian project and had worked with their local accountant in determining their net income. For accounting purposes, they determined their net income using the percentage of completion method. This is the typical method used in the construction industry.
Under the percentage of completion method revenue from construction projects is recognized based on their stage of completion. Physical completion is typically monitored by third party quantity surveyors or other qualified consultants. For accounting purposes, stage of completion is usually determined by costs incurred to date over the estimated total cost of each contract. Under the percentage of completion method, profit margins depend on the accuracy of a variety of cost estimates, and other milestones being met on target. Such estimates depend upon various judgments often being difficult to accurately determine until the project is underway. Given the complexity of the estimation process, it is possible that actual completion costs may vary from estimates. Provisions for estimated losses on uncompleted contracts are made as soon as a loss becomes determinable.
In the case of our foreign contractor, their Canadian project had a total fixed contract price and was expected to be completed within 24 months. The short duration of the contract provided an opportunity to use the completed contract method of determining income for income tax purposes. The contractor was not restricted from using this method simply because the financial reporting method differed. Adopting the completed contract method for income tax purposes allowed the contractor to defer the Canadian income tax on the project to the following year.
The Canada Revenue Agency (CRA) allows the use of the completed contract method for contracts that are reasonably expected to be completed within two years. This method requires that all revenue of the project, including any holdbacks, is taken into income in the year in which the work is physically completed. The completion of the contract would normally be supported by the date of the final engineer’s or architect’s certificate. If a certificate is not required, the date of completion should be determined based on the facts and documented accordingly to support that date in case of review by the CRA.
When using the completed contract method any additions to the project should be considered separate contracts. As a result, they cannot be used to delay the completion of the original contract.
All direct expenses of a short-term contract must be deferred for income tax purposes when using the completed contract method. Overhead and indirect expenses do not need to be deferred unless the contractor defers them on a consistent basis. When cost overruns on the project result in a loss, any loss can only be deducted at the time of completion. This tax treatment differs from accounting treatment that requires an immediate write down. No loss provisions can be claimed in a prior year.
A contractor currently using the percentage of completion method for short-term contracts may change to the completed contract method as long as the contractor has never used the completed contract method before. A contractor can always go back to the percentage of completion method, but would then be required to always use that method. When making a method change, care must be taken to ensure a proper reporting of income during the transition.