Executive Summary
Two primary methods exist for the recognition of profit or loss related to long- term construction contracts. These methods are the percentage-of-completion method and the completed-contract method. The examples below will outline the effects of the
differences between the two methods, explaining the theories and journal entries therein.
Example: Long-Term Contract with an Overall Loss
• On July 1, 2014, Torvill Construction Company Inc. contracted to build an office building for Gumbel Corp, for a total contract price of $1,900,000.
On July 1, 2016, Torvill estimated that it would take between 2 and 3 years to complete the building. On December 31, 2016, the building was deemed substantially completed. Following are accumulated contract costs incurred, estimated costs to complete the contract, and accumulated
billings to Gumbel for 2014, 2015, and 2016.
Table 4-1: Long-Term Contract: Beginning Balances
o Using the percentage-of-completion method, prepare schedules to compute the profit or loss to be recognized as a result of this contract for the years ended December 2014, 2015, and 2016.
(Ignore income taxes.)
o Using the completed-contract method, prepare schedules to compute the profit or loss to be recognized as a result of this contract for the years ended December 2014, 2015, and 2016.
(Ignore income taxes.)
At
12/31/14 At 12/31/15 At 12/31/16 Contract costs incurred to date $300,000 $1,200,000 $2,100,000 Estimated costs to complete the contract 1,200,000 800,000 0
Billings to Gumbel 300,000 1,100,000 1,850,000
Solution: Percentage-of-Completion Method
From the above information, the contract price of this transaction is $1,900,0000.
Using the percentage-of-completion method, revenues, costs, and gross profit will be recognized as Torvill makes progress toward completion of their long-term contract. The ratio of estimated costs to date and estimated total costs provides the percentage of total recognized gross profit. Then, gross profit recognized in prior years is deducted from the total amount of gross profit recognized to find the current year amount. This concept is demonstrated below.
Table 4-2: Percentage-of-Completion: Gross Profit Recognition Schedule
2014 2015 2016
Estimated costs to date $300,000 $1,200,000 $2,100,000
Estimated costs to complete 1,200,000 800,000 0
Estimated total costs $1,500,000 $2,000,000 $2,100,000
Estimated gross profit $400,000 -$100,000 -$200,000
Percent complete 20% 60%* 100%
Recognized gross profit (total) $80,000 -$100,000 -$200,000 Recognized gross profit (prior years) 0 80,000 -100,000 Recognized gross profit (current year) $80,000 -$180,000 -$100,000
Notice the interim loss in the year 2015. In the previous year, only 20% of gross profit was recognized, but since there was a net loss in 2015, Torvill was required to recognize the entire loss in the current year. To recognize this loss and eliminate the profit from the prior year, the gross profit recognized in 2014 was deducted from the loss in 2015 to arrive at a cumulative loss of $180,000.
To journalize transactions for the percentage-‐of-‐completion method, Torvill must make an entry to record the cost of construction, to record progress billings, to record collection of receivables, and to recognize revenue and gross profit. The table below demonstrates each entry. (Note: Because the problem provides no
information regarding the collection of receivables, the entry uses “xx” to demonstrate the journal entry.)
Table 4-3: Percentage-of-Completion Method: 2014 Journal Entries
Account Debit Credit
Construction in progress 300,000
Materials, Cash Payables, Etc 300,000
Accounts Receivable 300,000
Billings on Construction in Progress 300,000
Cash xx
Accounts Receivable xx
Construction in Progress 80,000
Construction Expense 300,000
Revenue from Long-Term Contracts 380,000 Torvill will record similar entries for 2015 and 2016. At the end of 2016,
however, Torvill will make an additional entry to record the completion of the contract, debiting billings on construction in progress and crediting construction in progress for the contract price.
Table 4-4: Percentage-of-Completion Method: 2015 Journal Entries
Account Debit Credit
Construction in progress 900,000
Materials, Cash Payables, Etc 900,000
Accounts Receivable 800,000
Billings on Construction in Progress 800,000
Cash xx
Accounts Receivable xx
Construction Expense 940,000
Construction in Progress 180,000
Revenue from Long-Term Contracts 760,000
Notice the entry to recognize revenue and gross profit in 2015. Because there is an interim loss in this year, the Construction Expense account is used as a plug for the credits to Construction in Progress and Revenue from Long Term Contracts. The Construction in Progress account is credit for the $180,000 loss, and the Construction Expense account includes the loss recognized in the current period that has not yet been recognized.
Table 4-5: Percentage-of-Completion Method: 2016 Journal Entries
Account Debit Credit
Construction in Progress 900,000
Materials, Cash Payables, Etc 900,000
Accounts Receivable 750,000
Billings on Construction in Progress 750,000
Cash xx
Accounts Receivable xx
Construction Expense 860,000
Construction in Progress 100,000
Revenue from Long-Term Contracts 760,000
Billings on Construction in Progress 1,900,000
Construction in Progress 1,900,000
Notice the additional journal entry to record the completion of the contract in 2016. To record completion of the contract, Torvill debits Billings on Construction in Progress and credits Construction in Progress for the total contract price.
Solution: Completed-Contract Method
Using the completed-contract method, Torvill will record the same entries to record cost of construction, to record progress billings, and to record collections at the end of each period. However, because the completed-contract method does not recognize profit until the end of the contract period, there will be no entries to recognize revenue and gross profit until the end of 2016.
Also, Torvill will recognize the interim loss from 2015 immediately after it is incurred. The related journal entry is as follows:
Table 4-6: Completed-Contract Method: 2015 Journal Entries
Account Debit Credit
Loss on Long Term Contract 100,000
Construction in Progress 100,000
At the end of 2016 when the contract is completed, Torvill will make the following entry to recognize gross profit (loss).
Table 4-7: Completed-Contract Method: 2016 Journal Entries
Account Debit Credit
Loss on Long Term Contract 100,000
Construction in Progress 100,000