CHAPTER 5 Revenue Recognition and Profitability Analysis 259 Illustration 5–24B Journal Entries—Revenue Recognition 2016 2017 2018 Recognizing Revenue upon Completion Construction in progress (CIP) ............. 900,000 Cost of construction ............................. 4,100,000 Revenue from long-term contracts ... 5,000,000 To record gross profit. Recognizing Revenue Over Time According to Percentage of Completion Construction in progress (CIP) ............. 500,000 125,000 275,000 Cost of construction ............................. 1,500,000 1,000,000 1,600,000 Revenue from long-term contracts ... 2,000,000 1,125,000 1,875,000 To record gross profit. It’s important to understand two key aspects of Illustration 5–24B . First, the same amounts of revenue (the $5 million contract price), cost, and gross profit are recognized whether it’s over the term of the contract or only upon completion . The only difference is timing. To check this, we can add together all of the revenue recognized for both methods over the three years: Revenue Recognition: Over Time Upon Completion Revenue recognized: 2016 $2,000,000 -0- 2017 1,125,000 -0- 2018 1,875,000 $5,000,000 Total revenue $5,000,000 $5,000,000 The same total amount of revenue is recognized whether it’s over the term of the contract or only upon completion, but the timing of recognition differs. Second, notice that, regardless of the timing of revenue recognition, we add gross profit (the difference between revenue and cost) to the CIP asset. That seems odd—why add profit to what is essentially an inventory account? The key here is that, when Harding recognizes gross profit, Harding is acting like it has sold some portion of the asset to the customer, but Harding keeps the asset in Harding’s own balance sheet (in the CIP account) until delivery to the customer. Putting recognized gross profit into the CIP account just updates that account to reflect the total value (cost 1 gross profit 5 sales price) of the customer’s asset. But don’t forget that the billings account is contra to the CIP account. Over the life of the construction project, Harding will bill the customer for the entire sales price of the asset. Therefore, at the end of the contract, the CIP account (containing total cost and gross profit) and the billings account (containing all amounts billed to the customer) will have equal balances that exactly offset to create a net value of zero. Now let’s discuss the timing of revenue recognition in more detail. REVENUE RECOGNITION UPON THE COMPLETION OF THE CONTRACT. If a contract doesn’t qualify for revenue recognition over time, revenue is recognized at the point in time that control transfers from the seller to the customer, which typically occurs when the contract has been completed. At that time, the seller views itself as selling the asset and recognizes revenues and expenses associated with the sale. As shown in Illustration 5–24B and in the T-accounts on the next page, completion occurs in 2018 for our Harding example. Prior to then, CIP includes only costs, showing a cumulative balance of $1,500,000 and $2,500,000 at the end of 2016 and 2017, r espectively, and totaling $4,100,000 ($1,500,000 1 1,000,000 1 1,600,000) when the project is completed in 2018. Upon completion, Harding recognizes revenue of $5,000,000 and cost of construction (similar to cost of goods sold) of $4,100,000, because the asset is viewed as “sold” on that date. Harding includes the resulting $900,000 gross profit in CIP, increasing its balance to the $5,000,000 total cost 1 gross profit for the project. CIP includes profits and losses on the contract that have been recognized to date. If a contract doesn’t qualify for revenue recognition over time, revenue is recognized when the project is completed.
Spiceland_Inter_Accounting8e_Ch05
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