L05 6 Swallow Company is a large real estate construction c

. L0.5, 6 Swallow Company is a large real estate construction company that has made a Subchapter S election. The company reports its income using the percentage of completion method. In 2018, the company completed a contract at a total cost of $4.8 million. The contract price was $7.2 million. At the end of 2017, the year the contract was begun, Swallow estimated that the total cost of the contract would be $5.4 million. Total accumulated cost on the contract at the end of 2017 was $1.8 million. The relevant tax rte is 35%, and the relevant Federal interest rate is 5%. Assume that all income tax returns were filed and taxes were paid on March 15 following the end of the calendar tax year. a. Compute the gross profit on the contract for 2017 and 2018. b. Compute the lookback interest due or receivable with the 2018 tax return. Before bidding on a contract, Swallow generally makes three estimates of total contract costs: (D optimistic, (2) pessimistic, and 3) most likely (based on a blending of optimistic and pessimistic assumptions). The company has asked you to write a letter explaining which of these estimates should be used for per centage of completion purposes. In writing your letter, you should consider the fact that Swallow is incorporated and has made an S corporation election Therefore, the income and deductions flow through to the shareholders who are all individuals in the 35% marginal tax bracket. The relevant Federal interest rte is 8%. Swallow\'s mailing address is 400 Front Avenue, Ashland, OR 97520. c.

Solution

PART-1)

% of work completed in 2017 (=(1,800,000 / 5,400,000)

33.33%

Total estimated gross profit (=7,200,000 – 5,400,000)

1,800,000

Gross profit to date (1,800,000 * 33.33%)

599,940

% of work completed in 2018 (=(4,800,000 / 7,200,000)

66.67%

Current year gross profit [=(66.67% * 1,800,000) - 599,940)]

600,120

Gross profit to date (2,400,000 * 66.67%)

1,600,080

PART-2)

Per return

Year-2017

Year-2018

Cumulative cost incurred

$1,800,000.00

$4,800,000.00

Cost of contract

$5,400,000.00

$1,800,000.00

Contract price total

$7,200,000.00

$7,200,000.00

Percentage of completion

33.33%

66.67%

Gross income

$2,399,940.00

$4,800,240.00

Minus: Costs

-$5,400,000.00

-$1,800,000.00

Income from the contract

-$3,000,060.00

$2,800,120.00

Plus: Other income Federal interest rate @ 35%

$0.00

$140,006.00

$0.00

$280,012.00

Income tax @35%

$0.00

$98,004.20

Lock back interest due or received

$0.00

$182,007.80

PART-3)

Letter to management on the estimation choice to use:

Mailing address,

400/ 97520 Front Avenue,

Ashland.

To: swallow company

            In the consideration of several cost estimates, we have reached to a conclusion to adopt optimistic estimate technique in comparison to pessimistic and a combined of optimistic and pessimistic. Optimistic considers the period with lesser costs and additionally considers the end period revenue recognition. During 2017, less amount cost of $1,800,000 in comparison to $5,400,000.

    Optimistic uses the end period contract actual revenue and costs. Tax in 2017 was nearly $ 997,192.73, and interest amount of $140,006. Pessimistic uses the first-period contract outcomes. During 2016, there had no taxation and interest at the beginning of the contract. In regard to technical diversity, the Swallow Company may use the combination of these two methods.

% of work completed in 2017 (=(1,800,000 / 5,400,000)	33.33%
Total estimated gross profit (=7,200,000 – 5,400,000)	1,800,000
Gross profit to date (1,800,000 * 33.33%)	599,940
% of work completed in 2018 (=(4,800,000 / 7,200,000)	66.67%
Current year gross profit [=(66.67% * 1,800,000) - 599,940)]	600,120
Gross profit to date (2,400,000 * 66.67%)	1,600,080