Income Measurement
(Part 2)
I N T ERMEDIATE ACCOU N T I NG I
CHA PT ER 5
(This presentation is under construction.)
1
LONG-TERM CONTRACTS
When the product/service delivery occurs over a long
period of time (longer than one fiscal period).
There are two methods of accounting for revenue and
expense recognition under long–term contracts:
Completed Contract Method
Percentage-of-completion Method
2
ACCOUNTING FOR COSTS OF CONSTRUCTION
AND ACCOUNTS RECEIVABLE
All costs of construction are recorded in an asset (inventory)
account called Construction in Progress.
Period billings are credited to a contra-asset account called
Billings on Construction Contract.
3
COMPLETED CONTRACT METHOD
No revenues or expenses are recognized until the project is
complete.
The completed contract method does
not properly portray a company's
performance over the construction
period and should only be used in
unusual situations when forecasts of
costs to complete the project are
highly uncertain..
4
COMPLETED CONTRACT METHOD
Example
At the beginning of 2013, 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:
2013
2014
2015
Construction costs incurred
during the year
$1,500,000 $1,000,000 $1,600,000
Billings made during the year $1,200,000 $2,000,000 $1,800,000
Cash collections during year
1,000,000 1,400,000 2,600,000
Totals
$4,100,000
$5,000,000
5
COMPLETED CONTRACT METHOD
Journal Entries – Costs, Billings & Collections (2013)
Construction in Progress
1,500,000
Various Accounts
1,500,000
To record construction costs
Accounts Receivable
1,200,000
Billings on Construction Contract
1,200,000
To record progress billings
Cash
1,000,000
Accounts Receivable
1,000,000
To record cash collections
Repeat these entries for 2014 and 2015 using the appropriate
data for each year.
6
COMPLETED CONTRACT METHOD
Journal Entries – Completed Contract (2015)
Construction in Progress (gross profit)
Cost of Construction (total cost)
900,000
4,100,000
Revenue from Long-term Contracts
5,000,000
To record gross profit
Billings on Construction Contract
Construction in Progress
5,000,000
5,000,000
To record transfer of finished asset
7
PERCENTAGE OF COMPLETION METHOD
Allocates a fair share of a project's revenues and expenses to
each reporting period during construction.
The allocation of project profit is accomplished by estimating progress to date.
Progress to date (the percentage of completion) can be estimated as the proportion of
The percentage
of completion
the project's cost incurred
to date divided
by totalmethod
estimated costs, by project
by GAAP
unless it in estimate.
not
milestones, or by relying is
onrequired
an engineer's
or architect's
possible
to make
estimates
of
To determine periodic gross
profit,
the reliable
percentage
of completion
is multiplied by
andearned
progress
estimated gross profit torevenues,
determineexpenses,
gross profit
to date, and then the current
toward completion.
period's gross profit is determined
by subtracting from this amount the gross profit
recognized in previous periods.
Periodic revenues are determined by multiplying the percentage of completion by the
total contract price and then subtracting revenue recognized in prior periods. In most
cases, the cost of construction equals the construction costs incurred during the
period.
8
PERCENTAGE OF COMPLETION METHOD
Estimated Gross Profit
Contract Price – (Actual Costs to Date +
Est Costs to Complete)
Percent Complete
Actual Costs Incurred/
(Total Actual Costs +
Estimated Costs to Date)
Gross Profit Recognized
This Period
(Total Est Gross Profit X Percentage
Completed to Date) – Gross Profit
Recognized in Prior Periods
9
COMPLETED CONTRACT METHOD
Example
At the beginning of 2013, 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:
2013
2014
2015
Construction costs incurred
during the year
Construction costs incurred in
prior years
Cumulative construction costs
Estimated costs to complete at
end of year
Total estimated and actual
construction costs
Billings made during the year
Cash collections during year
$1,500,000
$1,000,000 $1,600,000
-0-
1,500,000
2,500,000
1,500,000
2,500,000
4,100,000
2,250,000
1,500,000
-0-
$3,750,000
$4,000,000 $4,100,000
$1,200,000
1,000,000
$2,000,000 $1,800,000
1,400,000 2,600,000
10
PERCENTAGE OF COMPLETION METHOD
Journal Entries – Costs, Billings & Collections (2013)
Construction in Progress
1,500,000
Various Accounts
1,500,000
To record actual construction costs incurred
Accounts Receivable
1,200,000
Billings on Construction Contract
1,200,000
To record progress billings
Cash
1,000,000
Accounts Receivable
1,000,000
To record cash collections
Repeat these entries for 2014 and 2015 using the appropriate
data for each year.
11
PERCENTAGE OF COMPLETION METHOD
Journal Entries – Gross Profit (2013)
Construction in Progress (gross profit)
click for gross profit
calculation
500,000
Cost of Construction (actual costs)
1,500,000
Revenue from Long-term Contracts (costs + profit)
2,000,000
To record gross profit
1) Estimated Gross Profit:
Contract Price – (Actual Costs to Date + Est Costs to Complete)
$5,000,000 – (1,500,000 + 2,250,000) =
2) Percent Complete
$1,250,000
Actual Costs Incurred / (Actual Costs + Est Costs to Complete)
$1,500,000 / (1,500,000 + 2,250,000) =
40%
3) Gross Profit Recognized: (Est Gross Profit X Percent Complete) – Gross Profit Recog in Prior Periods
$1,250,000 X 40% =
$500,000
12
PERCENTAGE OF COMPLETION METHOD
Journal Entries – Gross Profit (2014)
Construction in Progress (gross profit)
Cost of Construction (actual costs)
click for gross profit
calculation
125,000
1,000,000
Revenue from Long-term Contracts (costs + profit)
1,125,000
To record gross profit
1) Estimated Gross Profit:
Contract Price – (Actual Costs to Date + Est Costs to Complete)
$5,000,000 – (2,500,000 + 1,500,000) =
2) Percent Complete
$1,000,000
Actual Costs Incurred / (Actual Costs + Est Costs to Complete)
$2,500,000 / (2,500,000 + 1,500,000) =
62.5%
3) Gross Profit Recognized: (Est Gross Profit X Percent Complete) – Gross Profit Recog in Prior Periods
$1,000,000 X 62.5% = $625,000 - $500,000 = $125,000
13
PERCENTAGE OF COMPLETION METHOD
Journal Entries – 2015
Construction in Progress (gross profit)
Cost of Construction (actual costs)
click for gross profit
calculation
275,000
1,600,000
Revenue from Long-term Contracts (costs + profit)
1,875,000
To record gross profit
Billings on Construction Contract (account balance)
5,000,000
Construction in Progress (account balance)
1) Estimated Gross Profit:
Contract Price – (Actual Costs to Date + Est Costs to Complete)
$5,000,000 – (4,100,000 + 0) =
2) Percent Complete
5,000,000
$900,000
Actual Costs Incurred / (Actual Costs + Est Costs to Complete)
$4,100,000 / (4,100,000 + 0) =
100%
3) Gross Profit Recognized: (Est Gross Profit X Percent Complete) – Gross Profit Recog in Prior Periods
$900,000 X 100% = $900,000 - $625,000
$275,000
14
PERCENTAGE OF COMPLETION METHOD
Income Statement Presentation - 2013
Revenue from Long-term Contracts
$2,000,000
Cost of Construction
1,500,000
Gross Profit
$500,000
Note that the gross profit
reported on the income
statement is the same as
that recorded in the
journal for each reporting
period.
15
PERCENTAGE OF COMPLETION METHOD
Balance Sheet Presentation - 2013
Revenue from Long-term Contracts
$2,000,000
Cost of Construction
1,500,000
Gross Profit
$500,000
Note that the gross profit
reported on the income
statement is the same as
that recorded in the
journal for each reporting
period.
16
PERCENTAGE OF COMPLETION METHOD
Balance Sheet Presentation - 2013
Construction in progress is compared to billings on construction
contract.
• A debit balance indicates costs (plus profits for the
percentage-of-completion method) in excess of billings and
is reported as an asset.
• A credit balance indicates billings in excess of costs (plus
profits for the percentage-of-completion method) and is
reported as a liability.
17
GROSS PROFIT FOR COMPLETED CONTRACT
AND PERCENTAGE-OF-COMPLETION METHODS
Note that the same total amount of gross profit is
recognized under the two methods; the only
difference is timing.
$
$
18
Income Measurement
(Part 2)
I N T ERMEDIATE ACCOU N T I NG I – CHA PT ER 5
E N D OF P R ESENTATION
(This presentation is under construction.)
19