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Chapter5: Income Measurement and Profitability Analysis

Revenue Recognition Prior to Delivery

Revenue recognition when an earnings process is virtually complete is inappropriate for certain types of long-term contracts. The types of companies that make use of long-term contracts are many and varied. A recent survey of reporting practices of 500 large public companies indicates that approximately one in every five companies engages in long-term contracts.15 And they are not just construction companies. In fact, even services such as research, installation, and consulting often are contracted for on a long-term basis. Graphic 5-9 lists just a sampling of companies that use long-term contracts, many of which you might recognize.

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   The general revenue recognition criteria described in the realization principle suggest that revenue should be recognized when a long-term project is finished (that is, when the earnings process is virtually complete). This is known as the completed contract method recognition of revenue for a long-term contract when the project is complete. of revenue recognition. The problem with this method is that all revenues, expenses, and resulting income from the project are recognized in the period in which the project is completed; no revenues or expenses are reported in the income statements of earlier reporting periods in which much of the work may have been performed. Net income should provide a measure of periodic accomplishment to help predict future accomplishments. Clearly, income statements prepared using the completed contract method do not fairly report each period's accomplishments when a project spans more than one reporting period. Much of the earnings process is far removed from the point of delivery.

The completed contract method recognizes revenue at a point in time when the earnings process is complete.

p. 246

GRAPHIC 5-9
Companies Engaged in Long-Term Contracts

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   The percentage-of-completion method allocation of a share of a project's revenues and expenses to each reporting period during the contract period. of revenue recognition for long-term construction and other projects is designed to help address this problem. By this approach, we recognize revenues (and expenses) over time by allocating a share of the project's expected revenues and expenses to each period in which the earnings process occurs, that is, the contract period. Although the contract usually specifies total revenues, the project's expenses are not known until completion. Consequently, it's necessary for a company to estimate the project's future costs at the end of each reporting period in order to estimate total gross profit to be earned on the project.

 
FINANCIAL
Reporting Case

Q1, p.233

   Because the percentage-of-completion method does a better job of recognizing revenue in the periods in which revenue is earned, U.S. and International GAAP require the use of that method unless it's not possible to make reliable estimates of revenues, expenses, and progress toward completion.16 Companies prefer the percentage-of-completion method as well because it allows earlier revenue and profit recognition than does the completed contract method. For both reasons, the percentage-of-completion method is more prevalent in practice. However, much of the accounting is the same under either method, so we start by discussing the similarities between the two methods, and then the differences. You'll see that we recognize the same total amounts or revenue and profit over the life of the contract under either method. Only the timing of recognition differs.

Using the percentage-of-completion method we allocate a share of a project’s revenues and expenses to each reporting period during construction.

   Illustration 5-2 provides information to compare accounting for long-term contracts using the completed contract and percentage-of-completion methods.

ILLUSTRATION 5-2
Completed Contract and Percentage-of-Completion Methods Compared

At the beginning of 2011, the Harding Construction Company received a contract to build an office building for $5 million. The project is estimated to take three years to complete. According to the contract, Harding will bill the buyer in installments over the construction period according to a prearranged schedule. Information related to the contract is as follows:

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p. 247

   Construction costs include the labor, materials, and overhead costs directly related to the construction of the building. Notice how the total of estimated and actual construction costs changes from period to period. Cost revisions are typical in long-term contracts in which costs are estimated over long periods of time.

ACCOUNTING FOR THE COST OF CONSTRUCTION AND ACCOUNTS RECEIVABLE.   Summary journal entries for both the percentage-of-completion and completed contract methods are shown in Illustration 5-2A for construction costs, billings, and cash receipts.

ILLUSTRATION 5-2A
Journal Entries—Costs, Billings, and Cash Receipts

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   With both the completed contract and percentage-of-completion methods, all costs of construction are recorded in an asset account called construction in progress asset account equivalent to the asset work-in-progress inventory in a manufacturing company.. This account is equivalent to the asset work-in-process inventory in a manufacturing company. This is logical since the construction project is essentially an inventory item in process for the contractor.

   Notice that periodic billings are credited to billings on construction contract contra account to the asset construction in progress; subtracted from construction in progress to determine balance sheet presentation.. This account is a contra account to the construction in progress asset. At the end of each period, the balances in these two accounts are compared. If the net amount is a debit, it is reported in the balance sheet as an asset. Conversely, if the net amount is a credit, it is reported as a liability.17

Accounting for costs, billings, and cash receipts are the same for both the percentage-of-completion and completed contract methods.

   To understand why we use the billings on construction contract account, consider a key difference between accounting for a long-term contract and accounting for a typical sale in which revenue is recognized upon delivery. Recall our earlier example in which Taft Company gives up its physical asset (inventory; in this instance a supercomputer) and recognizes cost of goods sold at the same time it gets a financial asset (an account receivable) and recognizes revenue. So, first a physical asset is in the balance sheet, and then a financial asset, but the two are not in the balance sheet at the same time.

Construction in progress is the contractor’s work-in-process inventory.

   Now consider our Harding Construction example. Harding is creating a physical asset (construction in progress) in the same periods it recognizes a financial asset (first recognizing accounts receivable when the customer is billed and then recognizing cash when the receivable is collected). Having both the physical asset and the financial asset in the balance sheet at the same time constitutes double counting the same arrangement. The billings on construction contract account solves this problem. Whenever an account receivable is recognized, the other side of the journal entry increases the billings on construction contract account, which is contra to (and thus reduces) construction in progress. As a result, the financial asset (accounts receivable) increases and the physical asset (the net of construction in progress and billings) decreases, and no double counting occurs.

The billings on construction contract account prevents “double counting” assets by reducing construction in progress whenever an accounts receivable is recognized.

GROSS PROFIT RECOGNITION—GENERAL APPROACH.   Now let's consider recognition of gross profit. The top portion of Illustration 5-2B shows the journal entry to recognize revenue, cost of construction (think of this as cost of goods sold), and gross profit under the completed contract method, while the bottom portion shows the journal entries that achieve this for the percentage-of-completion method.

p. 248

ILLUSTRATION 5-2B
Journal Entries—Profit Recognition

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   It's important to understand two key aspects of Illustration 5-2B. First, the same amounts of revenue, cost, and gross profit are recognized under both the completed contract and percentage-of-completion methods. The only difference is timing. To check this, sum all of the revenue recognized for both methods over the three years:

The same total amount of profit or loss is recognized under both the completed contract and the percentage-of-completion methods, but the timing of recognition differs.

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   Second, notice that in both methods we add gross profit (the difference between revenue and cost) to the construction in progress asset. That seems odd—why add profit to what is essentially an inventory account? The key here is that, when Harding recognizes gross profit, Harding is acting like it has sold some portion of the asset to the customer, but Harding keeps the asset in Harding's own balance sheet (in the construction in progress account) until delivery to the customer. Putting recognized gross profit into the construction in progress account just updates that account to reflect the total value (cost + gross profit = sales price) of the customer's asset. However, don't forget that the billings on construction contract account is contra to the construction in progress account. Over the life of the construction project, Harding will bill the customer for the entire sales price of the asset. Therefore, at the end of the contract, the construction in progress account (containing total cost and gross profit) and the billings on construction contract account (containing all amounts billed to the customer) will have equal balances that exactly offset to create a net value of zero.

   When title officially passes to the customer, Harding will prepare a journal entry that removes the contract from its balance sheet by debiting billings on construction contract and crediting construction in progress for the entire value of the contract. As shown in Illustration 5-2C, the same journal entry is recorded to close out the billings on construction contract and construction in progress accounts under the completed contract and percentage-of-completion methods.

Construction in progress includes profits and losses on the contract that have been recognized to date.

The same journal entry is recorded to close out the billings and construction in progress accounts under the completed contract and percentage-of-completion methods.

ILLUSTRATION 5-2C
Journal Entry to Close Billings and Construction in Progress Accounts

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   Now that we've seen how gross profit is recognized for long-term contracts, let's consider how the timing of that recognition differs between the completed contract and percentage-of-completion methods.

TIMING OF GROSS PROFIT RECOGNITION UNDER THE COMPLETED CONTRACT METHOD.   The timing of gross profit recognition under the completed contract method is simple. As the name implies, all revenues and expenses related to the project are recognized when the contract is completed. As shown in Illustration 5-2B and in the T-accounts below, completion occurs in 2013 for our Harding example. Prior to then, construction in progress includes only costs, showing a balance of $1,500,000 and $2,500,000 of cost at the end of 2011 and 2012, respectively, and including $4,100,000 of cost when the project is completed in 2013. Harding includes an additional $900,000 of gross profit in construction in progress when the project is completed in 2013 because the asset is viewed as “sold” on that date. The company records revenue of $5,000,000, cost of construction (similar to cost of goods sold) of $4,100,000, and the resulting $900,000 gross profit on that date.

Under the completed contract method, profit is not recognized until the project is completed.

FINANCIAL
Reporting Case

Q2, p.233

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Under the completed contract method, construction in progress is updated to include gross profit at the end of the life of the contract.

TIMING OF GROSS PROFIT RECOGNITION UNDER THE PERCENTAGE-OF-COMPLETION METHOD.   Using the percentage-of-completion method we recognize a portion of the estimated gross profit each period based on progress to date. How should progress to date be estimated?

   One approach is to use output measures like units of production. For example, with a multi-year contract to deliver airplanes we might recognize progress according to the number of planes delivered. Another example of an output measure is recognizing portions of revenue associated with achieving particular milestones specified in a sales contract. Accounting guidance18 states a preference for output measures when they can be established, arguing that they are more directly and reliably related to assessing progress than are input measures.

Under the percentage-of-completion method, profit is recognized over the life of the project as the project is completed.

   Another approach is to use an input measure like the “cost-to-cost ratio,” by which progress to date is estimated by calculating the percentage of estimated total cost that has been incurred to date. Similar input measures might be used instead, like the number of labor hours incurred to date compared to estimated total hours. One advantage of input measures is that they capture progress on long-term contracts that may not translate easily into simple output measures. For example, a natural output measure for highway construction might be finished miles of road, but that measure could be deceptive if not all miles of road require the same effort. A highway contract for the state of Arizona would likely pay the contractor more for miles of road blasted through the mountains than for miles paved across flat dessert, and a cost-to-cost approach reflects that difference. Recent research suggests that the cost-to-cost input measure is most common in practice.19

Progress to date can be estimated as the proportion of the project’s cost incurred to date divided by total estimated costs, or by relying on an engineer’s or architect’s estimate.

p. 250

   Regardless of the specific approach used to estimate progress to date, under the percentage- of-completion method we determine the amount of gross profit recognized in each period using the following logic:

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   where total estimated gross profit = total estimated revenue − total estimated cost.

   Illustration 5-2D shows the calculation of gross profit for each of the years for our Harding Construction Company example, with progress to date estimated using the cost-to-cost ratio. Refer to the bottom part of Illustration 5-2B to see the journal entries used to recognize gross profit in each period, and the T-accounts below Illustration 5-2D to see that the gross profit recognized in each period is added to the construction in progress account.

ILLUSTRATION 5-2D
Percentage-of-Completion Method—Allocation of Gross Profit to Each Period

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Under the percentage-of-completion method, construction in progress is updated each period to include gross profit.

   Income statements are more informative if the sales revenue and cost components of gross profit are reported rather than the net figure alone. So, the income statement for each year will report the appropriate revenue and cost of construction amounts. For example, in 2011, the gross profit of $500,000 consists of revenue of $2,000,000 (40% of the $5,000,000 contract price) less the $1,500,000 cost of construction. In subsequent periods, we calculate revenue by multiplying the percentage of completion by the contract price and then subtracting revenue recognized in prior periods, similar to the way we calculate gross profit each period. The cost of construction, then, is the difference between revenue and gross profit. In most cases, cost of construction also equals the construction costs incurred during the period.20 The table in Illustration 5-2E shows the revenue and cost of construction recognized in each of the three years of our example. Of course, as you can see in this illustration, we could have initially determined the gross profit by first calculating revenue and then subtracting cost of construction.21

In the income statement, we separate the gross profit into its two components: revenue and cost of construction.

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ILLUSTRATION 5-2E
Percentage-of-Completion Method—Allocation of Revenue and Cost of Construction to Each Period

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A Comparison of the Completed Contract and Percentage-of-Completion Methods

INCOME RECOGNITION.   Illustration 5-2B shows journal entries that would determine the amount of revenue, cost, and therefore gross profit that would appear in the income statement under the percentage-of-completion and completed contract methods. Comparing the gross profit patterns produced by each method of revenue recognition demonstrates the essential difference between them:

The same total amount of profit or loss is recognized under both the completed contract and the percentage-of-completion methods, but the timing of recognition differs.

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   Although both methods yield identical gross profit of $900,000 for the entire 3-year period, the timing differs. The completed contract method defers all gross profit to 2013, when the project is completed. Obviously, the percentage-of-completion method provides a better measure of the company's economic activity and progress over the three-year period. That's why the percentage-of-completion method is preferred, and, as mentioned previously, the completed contract method should be used only when the company is unable to make dependable estimates of future costs necessary to apply the percentage-of-completion method.22

The percentage-of-completion method provides a more realistic measure of a project’s periodic profitability and almost always is used for long-term construction contracts.

p. 252

BALANCE SHEET RECOGNITION.   The balance sheet presentation for the construction-related accounts by both methods is shown in Illustration 5-2F. The balance in the construction in progress account differs between methods because of the earlier gross profit recognition that occurs under the percentage-of-completion method.

ILLUSTRATION 5-2F
Balance Sheet Presentation

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   In the balance sheet, the construction in progress (CIP) account (containing costs and profit) is offset against the billings on construction contract account, with CIP > Billings shown as an asset and Billings > CIP shown as a liability. Because a company may have some contracts that have a net asset position and others that have a net liability position, we usually will see both net assets and net liabilities shown in a balance sheet at the same time.

Billings on construction contract are subtracted from construction in progress to determine balance sheet presentation.

   Construction in progress in excess of billings essentially represents an unbilled receivable. Sometimes companies include it as a component of accounts receivable in their balance sheets, or as part of inventory. The construction company is incurring construction costs (and recognizing gross profit using the percentage-of-completion method) for which it will be paid by the buyer. If the construction company bills the buyer an amount exactly equal to these costs (and profits recognized) then the accounts receivable balance properly reflects the claims of the construction company. If, however, the amount billed is less than the costs incurred (plus profits recognized) the difference represents the remaining claim to cash—an asset.

   On the other hand, Billings in excess of construction in progress essentially indicates that the overbilled accounts receivable overstates the amount of the claim to cash earned to that date and must be reported as a liability. This is similar to the unearned revenue liability that is recorded when a customer pays for a product or service in advance. The advance is properly shown as a liability representing the obligation to provide the good or service in the future.

Disclosure of the method used to account for long-term contracts will appear in the summary of significant accounting policies.

   The first disclosure note to any set of financial statements usually is a summary of significant accounting policies. This note discloses the method the company uses to account for its long-term contracts. As an example of this, Graphic 5-10 shows the disclosure note that appeared in a recent annual report of Fluor Corporation.

p. 253

GRAPHIC 5-10
Disclosure of Revenue Recognition Policy for Construction Contracts—Fluor Corporation

Real World Financials

 

Notes: Engineering and Construction Contracts (in part)
The company recognizes engineering and construction contract revenues using the percentage-of-completion method, based primarily on contract costs incurred to date compared with total estimated contract costs.… Changes to total estimated contract costs or losses, if any, are recognized in the period in which they are determined. Revenue recognized in excess of amounts billed is classified as current assets under contract work in progress. Amounts billed to clients in excess of revenues recognized to date are classified as current liabilities under advance billings on contracts.


LONG-TERM CONTRACT LOSSES.   The Harding Construction Company example above involves a situation in which a profit was realized on the construction contract. Unfortunately, losses sometimes occur on long-term contracts. As a prelude to the following discussion, notice in Graphic 5-10 that Fluor Corporation recognizes losses “in the period in which they are determined.”

Periodic Loss Occurs for Profitable Project.   When using the percentage-of-completion method, a loss sometimes must be recognized in at least one period over the life of the project even though the project as a whole is expected to be profitable. We determine the loss in precisely the same way we determined the profit in profitable years. For example, assume the same $5 million contract for Harding Construction Company described in Illustration 5-2 but with the following cost information:

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   At the end of 2011, gross profit of $500,000 (revenue of $2,000,000 less cost of construction of $1,500,000) is recognized as previously determined.

   At the end of 2012, the company now forecasts a total profit of $400,000 ($5,000,000 − $4,600,000) on the project and, at that time, the project is estimated to be 60% complete ($2,760,000 ÷ $4,600,000). Applying this percentage to the anticipated gross profit of $400,000 results in a gross profit to date of $240,000. But remember, a gross profit of $500,000 was recognized in 2011.

   This situation is treated as a change in accounting estimate because it resulted from a change in the estimation of costs to complete at the end of 2011. Costs to complete—$4,600,000—were much higher than the 2011 year-end estimate of $3,750,000. Recall from our discussion of changes in accounting estimates in Chapter 4 that we don't go back and restate the prior year's gross profit. Instead, the 2012 income statement would report a loss of $260,000 ($500,000 − 240,000) so that the cumulative amount recognized to date totals $240,000 of gross profit. The loss consists of revenue of $1,000,000 ($5,000,000 × 60% = $3,000,000 less 2011 revenue of $2,000,000) less cost of construction of $1,260,000 (cost incurred in 2012). The following journal entry records the loss:

Recognized losses on long-term contracts reduce the construction in progress account.

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   The 2013 income statement would report a gross profit of $160,000 determined as follows:

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p. 254

   The 2013 gross profit comprises $2,000,000 in revenue ($5,000,000 less revenue of $3,000,000 recognized in 2008 and 2009) and $1,840,000 in cost of construction (cost incurred in 2013).

   Of course, when using the completed contract method, no profit or loss is recorded in 2011 or 2012. Instead, a $400,000 gross profit (revenue of $5,000,000 and cost of construction of $4,600,000) is recognized in 2013.

Loss Is Projected on the Entire Project.   When using either the percentage-of-completion or completed contract methods, a more conservative approach is indicated when an overall loss is projected on the entire contract. Again consider the Harding Construction Company example but with the following cost information:

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   At the end of 2012, revised costs indicate a loss of $100,000 for the entire project ($5,000,000 − 5,100,000). In this situation, the total anticipated loss must be recognized in 2012 for both the percentage-of-completion method and the completed contract method. As a gross profit of $500,000 was recognized in 2011 using the percentage-of-completion method, a $600,000 loss is recognized in 2012 so that the cumulative amount recognized to date totals a $100,000 loss. Once again, this situation is treated as a change in accounting estimate, with no restatement of 2011 income. If the completed contract method is used, because no gross profit is recognized in 2011, the $100,000 loss for the project is recognized in 2012 by debiting loss from long-term contracts and crediting construction in progress for $100,000.

An estimated loss on a long-term contract is fully recognized in the first period the loss is anticipated, regardless of the revenue recognition method used.

   Why recognize the estimated overall loss of $100,000 in 2012, rather than at the end of the contract? If the loss was not recognized in 2012, construction in progress would be valued at an amount greater than the company expects to realize from the contract. To avoid that problem, the construction in progress account is reduced to $2,660,000 ($2,760,000 in costs to date less $100,000 estimated total loss). This amount combined with the estimated costs to complete of $2,340,000 equals the realizable contract price of $5,000,000. Recognizing losses on long-term projects in the period the losses become known is equivalent to measuring inventory at the lower of cost or market.

   The pattern of gross profit (loss) over the contract period for the two methods is summarized in the following table. Notice that an unanticipated increase in costs of $100,000 causes a further loss of $100,000 to be recognized in 2013.

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   The table in Illustration 5-2G shows the revenue and cost of construction recognized in each of the three years using the percentage-of-completion method.

   Revenue is recognized in the usual way by multiplying a percentage of completion by the total contract price. In situations where a loss is expected on the entire project, cost of construction for the period will no longer be equal to cost incurred during the period. The easiest way to compute cost of construction is to add the amount of the recognized loss to the amount of revenue recognized. For example, in 2012 revenue recognized of $706,000 is added to the loss of $600,000 to arrive at the cost of construction of $1,306,000.23

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ILLUSTRATION 5-2G
Percentage-of-Completion Method: Allocation of Revenue and Cost of Construction to Each Period—Loss on Entire Project

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*$2,760,000 ÷ $5,100,000 = 54.12%
The difference between revenue and loss

   The journal entries to record the losses in 2012 and 2013 are as follows:

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   Using the completed contract method, no revenue or cost of construction is recognized until the contract is complete. In 2012, a loss on long-term contracts (an income statement account) of $100,000 is recognized. In 2013, the income statement will report revenue of $5,000,000 and cost of construction of $5,100,000, thus reporting the additional loss of $100,000. The journal entries to record the losses in 2012 and 2013 are as follows:

Recognized losses on long-term contracts reduce the construction in progress account.

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p. 256

   You can see from this example that use of the percentage-of-completion method in this case produces a large overstatement of income in 2011 and a large understatement in 2012 caused by a change in the estimation of future costs. These estimate revisions happen occasionally. However, recall that if management believes they are unable to make dependable forecasts of future costs, the completed contract method should be used.

INTERNATIONAL FINANCIAL REPORTING STANDARDS

 

Long-Term Construction Contracts. IAS No. 11 governs revenue recognition for long-term construction contracts.24 Like U.S. GAAP, that standard requires the use of the percentage-of-completion method when reliable estimates can be made. However, unlike U.S. GAAP, IAS No. 11 requires the use of the cost recovery method rather than the completed contract method when reliable estimates can't be made.25 Under the cost recovery method, contract costs are expensed as incurred, and an offsetting amount of contract revenue is recognized to the extent that it is probable that costs will be recoverable from the customer. No gross profit is recognized until all costs have been recovered, which is why this method is also sometimes called the “zero-profit method.” Note that under both the completed contract and cost recovery methods no gross profit is recognized until the contract is essentially completed, but revenue and construction costs will be recognized earlier under the cost recovery method than under the completed contract method. Also, under both methods an expected loss is recognized immediately.

   To see this difference between the completed contract and cost recovery methods, here is a version of Illustration 5-2B that compares revenue, cost and gross profit recognition under the two methods:

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To record gross profit.

Revenue recognition occurs earlier under the cost recovery method than under the completed contract method, but gross profit recognition occurs at the end of the contract for both methods. As a result, gross profit as a percentage of revenue differs between the two methods at various points in the life of the contract.

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 IFRS ILLUSTRATION

p. 257

CONCEPT REVIEW EXERCISE

LONG-TERM CONSTRUCTION CONTRACTS

During 2011, the Samuelson Construction Company began construction on an office building for the City of Gernon. The contract price is $8,000,000 and the building will take approximately 18 months to complete. Completion is scheduled for early in 2013. The company's fiscal year ends on December 31.

   The following is a year-by-year recap of construction costs incurred and the estimated costs to complete the project as of the end of each year. Progress billings and cash collections also are indicated.

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Required:

1.

  

Determine the amount of gross profit or loss to be recognized in each of the three years applying both the percentage-of-completion and completed contract methods.

2.

  

Prepare the necessary summary journal entries for each of the three years to account for construction costs incurred, recognized revenue and cost of construction, contract billings, and cash collections and to close the construction accounts in 2013 using the percentage-of-completion method only.

3.

  

Prepare a partial balance sheet for 2011 and 2012 to include all construction-related accounts using the percentage-of-completion method.

SOLUTION

1.

  

Determine the amount of gross profit or loss to be recognized in each of the three years applying both the percentage-of-completion and completed contract methods.

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2.

  

Prepare the necessary summary journal entries for each of the three years to account for construction costs incurred, recognized revenue and cost of construction, contract billings, and cash collections and to close the construction accounts in 2013 using the percentage-of-completion method only.

p. 258

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3.

  

Prepare a partial balance sheet for 2011 and 2012 to include all construction related accounts using the percentage-of-completion method.

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15Accounting Trends and Techniques—2009 (New York: AICPA, 2009), p. 428.

16Specifically, U.S. GAAP requires that the percentage-of-completion method be used whenever (1) reasonable estimates can be made of revenues and costs, (2) the contract specifies the parties' rights, consideration to be paid, and payment terms, and (3) both the purchaser and seller have the ability and expectation to fulfill their obligations under the contract [FASB ASC 605–35-25: Revenue Recognition–Construction–Type and Production–Type Contracts–Recognition (previously “Accounting for Performance of Construction-Type and Certain Production-Type Contracts,” Statement of Position 81-1 (New York: AICPA, 1981))]. Similar criteria are included in IAS No. 11, “Construction Contracts” (IASCF, as amended, effective January 1, 2009, paragraph 23).

17If the company is engaged in more than one long-term contract, all contracts for which construction in progress exceeds billings are grouped together and all contracts for which billings exceed construction in progress also are grouped together. This would result in the presentation of both an asset and a liability in the balance sheet.

18FASB ASC 605–35–25–71: Revenue Recognition–Construction–Type and Production-Type Contracts–Recognition–Input and Output Measures (previously “Accounting for Performance of Construction-Type and Certain Production-Type Contracts,” Statement of Position No. 81-1 (New York: AICPA, 1981)).

19R. K. Larson and K. L. Brown, 2004, “Where Are We with Long-Term Contract Accounting?” Accounting Horizons, September, pp. 207–219.

20Cost of construction does not equal the construction costs incurred during the year when a loss is projected on the entire project. This situation is illustrated later in the chapter.

21As a practical matter, if the percentage of completion figure is rounded we may calculate different amounts of revenue by (a) directly calculating revenue using the percentage of completion, and (b) indirectly calculating revenue by first calculating gross profit using the percentage of completion and then calculating revenue by adding gross profit to cost of construction. In that case, given that gross profit is defined as revenue minus cost, it is best to use approach (a) and first calculate revenue directly, solving for gross profit by subtracting cost of construction from revenue.

22For income tax purposes, the completed contract method may be used for home construction contracts and certain other real estate construction contracts. All other contracts must use the percentage-of-completion method.

23The cost of construction also can be determined as follows:

   

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*2,760,000 ÷ $5,100,000

24“Construction Contracts,” International Accounting Standard No. 11 (IASCF), as amended, effective January 1, 2009.

25Earlier in this chapter we referred to the “cost recovery method” in a different circumstance—when a company had already delivered a product to a customer but had to delay gross profit recognition until a point after delivery because of an inability to make reliable estimates of uncollectible accounts. In that case, gross profit only could be recognized after costs had been recovered (and cash collections exceeded cost of goods sold). IFRS' use of “cost recovery method” is similar, in that gross profit recognition is delayed until after cost has been recovered, but note that in this case the product is being constructed for the customer and therefore has not yet been delivered.

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