Accounting: The Language of Business - Vol. 2 (Intermediate: Part 128)

Accounting is more than just the act of keeping a list of debits and credits. It is the language of business and, by extension, of all things financial. Our senses collect information from our surroundings that our brains then interpret; accountants translate the complexities of finance into information that the public can understand (Investopedia.com).

Revenue Recognition (Part O)

by

Charles Lamson

Recall from Part 127 that there are two accounting methods for revenue recognition for long-term contracts: the percentage-of-completion method and the completed-contract method. Total revenue and costs for a long-term contract are the same under both methods. The difference between the two approaches is the timing of revenue and gross profit recognition on the contract. The percentage-of-completion method recognizes gross profit over the production period whereas the completed-contract method recognizes gross profit only at the end of the contract.

Firms can estimate the degree of completion by using input measures (for example, miles of highway and the number of cell towers installed), or engineering estimates.

Input Measures. A common method used in practice, the cost-to-cost approach estimates the cumulative percentage of completion by dividing the total cost incurred to date by total estimated costs as follows: 

Cumulative Percentage Complete = Total Costs Incurred to Date / Estimated Total Cost of the Project     (8.1)

The estimated total cost of the project equals the total actual costs incurred to date plus the estimated costs to complete the project. The estimated total cost of the project is likely to change throughout the contract. This does not create a problem because the ratio is computed each period using the current costs to date and estimated total cost.

Output Measures.    In addition to the cost-to-cost approach, which is an input measure of the degree of completion, firms also use output measures in practice. Output measure examples include miles of highway completed or square footage completed of a building. Example 8.22 illustrates the use of an output measure to estimate the percent completed.

Percentage-of-Completion Method Accounting Procedures.    As a company constructs an asset, it accumulates resources used in construction such as raw materials in an inventory account called construction in progress (CIP). Long-term construction contracts usually allow a company, also called a contractor, to bill the customer periodically over the contract term. When a company bills the customer, it increases accounts receivable with a debit. The credit is to an account called billings on construction in progress. Billings on construction in progress is a contra account to the construction-in-progress account and reduces the net carrying value of the asset in billings on CIP (accounts receivable). Using the contra account avoids double counting the total asset value.

As discussed, revenue is based on the progress to date (that is, the percentage of the project that has been completed). Unique to accounting for long-term construction contracts, revenue from long-term contracts is credited, the construction costs account is debited, and the debit to the CIP account is the difference between the revenue and the construction cost (the gross profit). At the end of the project, the company removes the CIP account from the books with a credit and removes the billings on construction and progress account with a debit.

At each balance sheet date, the company reports the balance of accounts receivable and the net amount of the CIP and billings on CIP. If the CIP amount is higher than the billings account, the net amount is an asset called costs and recognized profits in excess of billings. If, however, the amount in the billings account is higher than in the CIP account, then the net amount is a liability called billings in excess of costs and recognized profits.

The measurement of the net asset or net liability position of each contract has implications for financial statement users:

• If the company reports on net asset position, the contract has unbilled receivables. That is, the contractor has an asset, giving the firm the right to bill the buyer for work performed.

• If the company reports a significant amount of unbilled receivables, the buyer may have little capital at risk and can easily abandon the project.

• If the company reports a significant net liability position, this implies that the contractor has received cash in advance and has the obligation to perform on the contract. However, if the contractor expends cash received for alternative uses, there may be insufficient resources to complete the project.

To summarize, the percentage-of-completion method involves the following accounting procedures:

1. Accumulate resources used in construction such as raw materials by increasing an asset (inventory), construction in progress (CIP). 

2. When the contractor sends bills to the customer, increase accounts receivable with a debit and increase billings on CIP with a credit.

3. When the contractor receives cash from the customer, increase cash with a debit and decrease accounts receivable with a credit.

4. Recognize the revenue and the associated costs each year, basing the amount of revenue in a given year on the progress to date (that is, the percentage of the project that has been completed). Credit revenue from long-term contracts, debit the construction costs, and debit the difference between the revenue and the cost of the construction (the gross profit) to the CIP account.

5. At each balance sheet date, report the net amount of the CIP and billings on CIP on the balance sheet. As asset, costs and recognized profits in excess of billings, is reported if the CIP is higher than the billings on CIP. a liability, billings in excess of costs and recognized profits, is reported if the billings on construction in progress amount is higher than the CIP. At the end of the project, remove the CIP account from the books with a credit and remove the billings on construction in progress account with a debit.

As discussed, the company estimates revenue on the contract based on progress toward completion. Example 8.22 illustrates the percentage of completion method showing all journal entries. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 404-407*

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