CHAPTER 5 Revenue Recognition and Profitability Analysis 265 contract or only upon the completion of the contract. Again, consider the Harding Construction Company example but with the following cost information: 2016 2017 2018 Construction costs incurred during the year $1,500,000 $ 1,260,000 $2,440,000 Construction costs incurred in prior years –0– 1,500,000 2,760,000 Cumulative construction costs 1,500,000 2,760,000 5,200,000 Estimated costs to complete at end of year 2,250,000 2,340,000 –0– Total estimated and actual construction costs $3,750,000 $5,100,000 $5,200,000 At the end of 2017, revised costs indicate an estimated loss of $100,000 for the entire project (contract revenue of $5,000,000 less estimated construction costs of $5,100,000). In this situation, the total anticipated loss must be recognized in 2017 regardless of whether revenue is recognized over the term of the contract or only upon the completion of the contract. If revenue is being recognized over the term of the contract, a gross profit of $500,000 was recognized in 2016, so a $600,000 loss is recognized in 2017 to make the cumulative amount recognized to date total a $100,000 loss. Once again, this situation is treated as a change in accounting estimate, with no restatement of 2016 income. On the other hand, if revenue is being recognized only upon the completion of the contract, no gross profit is recognized in 2016, and the $100,000 loss for the project is recognized in 2017. This is accomplished by debiting a loss from long-term contracts and crediting CIP for $100,000. Why recognize the estimated overall loss of $100,000 in 2017, rather than at the end of the contract? If the loss is not recognized in 2017, CIP would be valued at an amount greater than the company expects to realize from the contract. To avoid that problem, the loss reduces the CIP account to $2,660,000 ($2,760,000 in costs to date less $100,000 estimated total loss). This amount combined with the estimated costs to complete of $2,340,000 equals the contract price of $5,000,000. Recognizing losses on long-term contracts in the period the losses become known is equivalent to measuring inventory at the lower of cost or market, a concept we will study in Chapter 9. The pattern of gross profit (loss) over the contract term is summarized in the following table. Notice that in 2018 an additional unanticipated increase in costs of $100,000 causes a further loss of $100,000 to be recognized. An estimated loss on a long-term contract is fully recognized in the first period the loss is anticipated, regardless of the whether revenue is recognized over time or upon completion. Revenue Recognition: Over Time Upon Completion Gross profit (loss) recognized: 2016 $500,000 –0– 2017 (600,000) $(100,000) 2018 (100,000) (100,000) Total project loss $(200,000) $(200,000) The table in Illustration 5–24G shows the revenue and cost of construction recognized in each of the three years, assuming the contract qualifies for recognizing revenue over time. Revenue is recognized in the usual way by multiplying a percentage of completion by the total contract price. In situations where a loss is expected on the entire project, cost of construction for the period will no longer be equal to cost incurred during the period. The easiest way to compute the cost of construction is to add the amount of the loss recognized to the amount of revenue recognized. For example, in 2017 revenue recognized of $706,000 is added to the loss of $600,000 to arrive at the cost of construction of $1,306,000. 29 29 The cost of construction also can be determined as follows: Loss to date (100% recognized) $ 100,000 Add: Remaining total project cost, not including the loss ($5,100,000 2 100,000) $5,000,000 Multiplied by the percentage of completion 3 .5412* 2,706,000 Total 2,806,000 Less: Cost of construction recognized in 2016 (1,500,000) Cost of construction recognized in 2017 $1,306,000 * $2,760,000 4 5,100,000
Spiceland_Inter_Accounting8e_Ch05
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