258 SECTION 1 The Role of Accounting as an Information System Illustration 5–24A Journal Entries—Costs, Billings, and Cash Collections The second journal entry occurs when Harding bills its customer according to whatever schedule the contract permits. Notice that periodic billings are credited to billings on construction contract . This account is a contra account to the CIP 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 a contract asset. Conversely, if the net amount is a credit, it is reported as a contract liability. 24 To understand why we use the billings on construction contract account (or “billings” for short), consider a key difference between accounting for a long-term contract and accounting for a more normal sale of inventory to a customer. In the normal case, the seller debits an account receivable and credits revenue, and also debits cost of goods sold and credits inventory. Thus, the seller gives up its physical asset (inventory) and recognizes cost of goods sold at the same time it gets a financial asset (an account receivable) and recognizes revenue. First the physical asset is in the balance sheet, and then the financial asset, but the two are not in the balance sheet at the same time. Now consider our Harding Construction example. Harding is creating a physical asset (CIP) 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 account solves this problem. Whenever an account receivable is recognized, the other side of the journal entry increases the billings account, which is contra to (and thus reduces) CIP. As a result, the financial asset (accounts receivable) increases and the physical asset (the net amount of CIP and billings) decreases, and no double counting occurs. Remember, we recognize accounts receivable when the seller has an unconditional right to receive payment, which is the case if only the passage of time is required before the payment is due, and we recognize a contract asset when the seller’s right to receive payment depends on something other than the passage of time. Consistent with those definitions, Harding will report an account receivable for amounts it has billed the client and not yet been paid, and will report a contract asset (CIP – Billings) for the remaining amount of work completed, for which it eventually will be paid once it is able to bill the client. REVENUE RECOGNITION—GENERAL APPROACH. Now let’s consider revenue recognition. The top portion of Illustration 5–24B shows the single journal entry to recognize revenue, cost of construction (think of this as cost of goods sold), and gross profit when recognizing revenue upon completion of the contract, while the bottom portion shows the journal entries that achieve this when recognizing revenue over the term of the contract. At this point focus on the structure of the journal entries (what is debited and credited). We’ll discuss how to calculate the specific amounts later in the chapter. Accounting for costs, billings, and cash receipts does not depend on the timing of revenue recognition. 24 If the company is engaged in more than one long-term contract, all contracts for which construction in progress exceeds billings are reported in the balance sheet as contract assets, and all contracts for which billings exceed construction in progress are reported as contract liabilities. The billings on construction contract account prevents “double counting” assets by reducing CIP whenever an account receivable is recognized. 2016 2017 2018 Construction in progress (CIP) .......... 1,500,000 1,000,000 1,600,000 Cash, materials, etc. ...................... 1,500,000 1,000,000 1,600,000 To record construction costs. Accounts receivable 1,200,000 2,000,000 1,800,000 Billings on construction contract ... 1,200,000 2,000,000 1,800,000 To record progress billings. Cash ................................................... 1,000,000 1,400,000 2,600,000 Accounts receivable ...................... 1,000,000 1,400,000 2,600,000 To record cash collections.
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