Long-term construction contracts[1]
1.
The completed-contract method
a.
The completed-contract method is used to account
for a long-term project when the percentage-of-completion method is inappropriate.
1)
It defers
all contract costs (in an inventory account) until the project is completed
and matches the costs of completion with revenue.
2)
Revenue and gross profit are recognized only
upon completion
2.
The percentage-of-completion method
a.
The percentage-of-completion method is presumed
to be preferable. It is used to recognize revenue on long-term contracts when the
1)
Extent of progress toward completion, contract
revenue, and contract costs are reasonable estimable;
2)
Enforceable rights regarding goods or services
to be provided, the consideration to be exchanged, and the terms of settlement
are clearly specified; and
3)
Obligations of the parties are expected to be
fulfilled
b.
The amount
of gross profit recognized in a period is calculated as follows:
1)
Calculate the estimated total gross profit on
the project
Example
A contractor is constructing an office complex for a
real estate developer. The agreed-upon contract price was $75 million. As of
the close of Year 4 of the project, the contractor had incurred $44 million of
costs. By its best estimates as of that date, costs remaining to finish the
project were $19 million.
Contract price $75,000k
Minus: costs incurred to date (44,000k)
Minus: estimated costs to complete (19,000k)
Estimated total gross profit $ 12,000k
2)
Calculate the percentage of the project
completed as of the reporting date, determined by the ratio of costs incurred
thus far to estimated total costs
Example
Total estimated costs for the project as of the end of
year 4 are calculated as follows:
Costs incurred to date $ 44,000k
Estimated costs to complete 19,000k
Total estimated costs $ 63,000k
The project is therefore 69.8% complete (44,000k /
63,000k)
3)
Subtract the gross profit recognized so far.
Example
The contract will recognize $2,151,000 in gross profit for year 4,
calculated as follows:
Estimated total gross profit $12,000k
Times: percentage complete * 69.8%
Gross profit earned to date 8,376k
Minus: gross profit recognized in prior periods (6,225k)
Gross profit for current period 2,151k
c.
When estimated revenue and costs are revised, a
change in accounting estimate is recognized. Recognition of the change is in
1)
The period of change if only that period is
affected or
2)
The period of change and future periods if both
are affected
d.
As soon as an estimated loss on any project
becomes apparent, it is recognized in full, under both the completed-contract
and percentage-of-completion methods.
3.
Comparative journal entries
Example
A contractor agrees to build a bridge that will take 3
years to complete. The contract price is $2 million and expected total costs
are 1.2 million.
Year1 Year2 Year3
Costs incurred during each year 300k 600k 550k
Costs expected in future 900k 600k 0
By the end of year 1, 25% (300,000 / 1200,000) of
expected costs has been incurred. Using percentage-of-completion, the
contractor will recognize 25% of the revenue or gross profit that will be
earned on the project. The total gross profit is expected to be $800,000 (2,000,000-1,200,000),
so 200,000 (800,000 * 25%) of gross profit should be recognized in year 1
%-of-completion completed-contract
Year 1: construction in progress $300k $300k
Cash or accounts payable 300k 300k
Construction
in progress $200k ----
Construction gross profit 200k ----
At the end of year 2, total costs incurred are $900k (300K+600k).
Given that 600k is expected to be incurred in the future, the total expected
cost is $1500k (900k+600k), and the estimate of gross profit is $500k ($2000k
contract price - $1500k costs). If the project is 60% complete ($900k + $1500k),
$300k of cumulative gross profit should be recognized for years 1 and 2 ($500k
*60%) under percentage-of-completion. Because $200k was recognized in year 1,
$100k should be recognized in year 2.
%-of-completion completed-contract
Year 2: construction in progress $600k $600k
Cash or accounts payable 600k 600k
Construction
in progress $100k ----
Construction gross profit 100k ----
At the end of the third year, total costs are $1,450k.
Thus, the total gross profit is known to be $550k. Because a total of $300k was
recognized in year 1 and 2, $250k should be recognized in year 3, using
percentage-of-completion.
%-of-completion completed-contract
Year 3: construction in progress $550k $300k
Cash or accounts payable 550k 300k
Cash $2000k $2000k
Construction gross profit $250k $550k
Construction in progress $1750k $1450k
4.
Progress billings
a.
Ordinarily, progress billings are made and payments
are received during the term of the contract. The entries are
The customer is billed:
Accounts Receivable
$XXXX
Progress billings $XXXX
The customer pays:
Cash $XXXX
Accounts receivable $XXXX
1)
Neither billing nor the receipt of cash affects
gross profit. Moreover, billing, receipt of payment, and incurrence of cost
have the same effects under both accounting methods.
b.
The difference between construction in progress (costs
and recognized gross profit) and progress billings to date is reported as a
current asset if construction in progress exceeds total billings and as a
current liability if billings exceed construction in progress.
Closing entry:
Progress billings $XXXX
Construction in progress $XXXX
c.
A variation on the foregoing entries is to
credit periodic revenue for the gross amount. This practice requires a debit to
a nominal account (a cost of revenue earned account similar to cost of goods
sold) that equals the costs incurred in the current period. For example, in
year 1, the second entry would be
Construction in progress (gross profit) $200k
Construction expenses (a nominal account) 300k
Gross revenue
$500k
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