Chapter 5, Problem 5.19E

Long-term contract; revenue recognition over time; loss projected on entire project

• LO5–9

On February 1, 2018, Arrow Construction Company entered into a three-year construction contract to build a bridge for a price of $8,000,000. During 2018, costs of $2,000,000 were incurred with estimated costs of $4,000,000 yet to be incurred. Billings of $2,500,000 were sent, and cash collected was $2,250,000.

In 2019, costs incurred were $2,500,000 with remaining costs estimated to be $3,600,000. 2019 billings were $2,750,000, and $2,475,000 cash was collected. The project was completed in 2020 after additional costs of $3,800,000 were incurred. The company’s fiscal year-end is December 31. Arrow recognizes revenue over time according to percentage of completion.

Required:

1. 1. Calculate the amount of revenue and gross profit or loss to be recognized in each of the three years.
2. 2. Prepare journal entries for 2018 and 2019 to record the transactions described (credit “various accounts” for construction costs incurred).
3. 3. Prepare a partial balance sheet to show the presentation of the project as of December 31, 2018 and 2019.

To determine

Contract

Contract is a written document that creates legal enforcement for buying and selling the property. It is committed by the parties to performing their obligation and enforcing their rights.

Revenue recognized point of long term contract

A long-term contract qualifies for revenue recognition over time. The seller can recognize the revenue as per percentage of the completion of the project, which is recognized by revenue mines cost of completion until date.

A contract does not meet the performance obligation norm. The seller cannot recognize the revenue till the project complete.

The revenue recognition principle

The revenue recognition principle refers to the revenue that should be recognized in the time period, when the performance obligation (sales or services) of the company is completed.  

To calculate: The amount of revenue and gross profit or loss to be recognized in the year 2018, 2019, and 2020.

Explanation of Solution

Recognized revenue

In the year 2018:

Here,

Contract price is $8,000,000,

Actual cost to date is $2,000,000,

Total estimated cost is $6,000,000.

Now, calculate the revenue recognition:

$\begin{array}{c}\text{Revenue recognition =Contract price}\times \left(\frac{\text{Actual cost to date}}{\text{Total estimated cost}}\right)\\ =\$8,000,000\times \frac{\$2,000,000}{\$6,000,000}\\ =\$8,000,000\times 33.33\%\\ =\$2,666,667\end{array}$

Hence, the calculated revenue recognition is $2,666,667.

In the year 2019:

Here,

Contract price is $8,000,000,

Actual cost to date is $4,500,000,

Total estimated cost is $8,100,000,

Revenue recognition in 2018 is $2,666,667.

Now, calculate the revenue recognition:

$\begin{array}{c}\text{Revenue recognition =}\left(\begin{array}{l}\left(\begin{array}{l}\text{Contract price}\\ \times \left(\frac{\text{Actual cost to date}}{\text{Total estimated cost}}\right)\end{array}\right)\\ -\text{Revenue recognition in 2}0\text{18}\end{array}\right)\\ \text{=}\left(\left(\$8,000,000\times \frac{\$4,500,000}{\$8,100,000}\right)-\$2,666,667\right)\\ =\left(\left(\$8,000,000\times 55.5556\%\right)-\$2,666,667\right)\\ =\$4,444,448-\$2,666,667\end{array}$

$=\$1,777,778$

Hence, the calculated revenue recognition is $1,777,778.

In the year 2020:

Here,

Contract price is $8,000,000,

Revenue recognition in 2018 is $2,666,667,

Revenue recognition in 2019 is $1,777,778.

Now, calculate the revenue recognition:

$\begin{array}{c}\text{Revenue recognition =Contractprice}-\left(\begin{array}{l}\text{Revenue recognition in 2}0\text{16}\\ \text{+ Revenue recognition in 2}0\text{17}\end{array}\right)\\ =\$8,000,000-\left(\$\text{2},\text{666},\text{667}+\$\text{1},\text{777},\text{778}\right)\\ =\$8,000,000-\$4,444,445\\ =\$3,555,555\end{array}$

Hence, the calculated revenue recognition is $3,555,555.

Recognized gross profit

In the year 2018:

Here,

Revenue recognition in 2018 is $2,666,667

Actual cost to date is $2,000,000.

Now, calculate the gross profit recognition:

$\begin{array}{c}\text{Gross profit recognition =}\left(\begin{array}{l}\text{Revenue recognition in 2}0\text{16}\\ -\text{ Actual cost to date}\end{array}\right)\\ \text{=}\$\text{2},\text{666},\text{667}-\$2,000,000\\ =\$666,667\end{array}$

Hence, the calculated gross profit recognition is $666,667.

In the year 2019:

Here,

Revenue recognition in 2019 is ($100,000)

Gross profit recognition in 2018 is $666,667.

Now, calculate the gross profit recognition:

$\begin{array}{c}\text{Gross profit recognition =}\left(\begin{array}{l}\text{Revenue recognition in 2}0\text{17}\\ -\text{ Gross profit recognition in 2}0\text{16}\end{array}\right)\\ \text{=}\left(\$100,000\right)-\$666,667\\ =\left(\$766,667\right)\end{array}$

Hence, the calculated gross loss recognition is ($766,667).

In the year 2020:

Here,

Revenue recognition in 2020 is ($300,000)

Revenue recognition in 2019 is ($100,000).

Now, calculate the gross profit recognition:

$\begin{array}{c}\text{Gross profit recognition =}\left(\begin{array}{l}\text{Revenue recognition in 2}0\text{18}\\ -\text{ Revenue recognition in 2}0\text{17}\end{array}\right)\\ \text{=}\left(\$\text{3}00,000\right)-\left(\$\text{1}00,000\right)\\ =\left(\$200,000\right)\end{array}$

Hence, the calculated gross loss recognition is ($200,000).

Working note:

Calculate the value of gross profit (in millions)

Particulars	2018		2019		2020
Contract price		$8		$8		$8
Actual costs to date	$2		$4.5		$8.3
Estimated costs to complete	$4		$3.6		$0
Total estimated cost		$6		$8.1		$8.3
Estimated gross profit		$2		($0.1)		($0.3)

Table (1)

(1)

To determine

To record: The journal entry for the year 2018 and 2019.

Explanation of Solution

In the year 2018:

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Construction in progress		$2,000,000
	Various accounts			$2,000,000
	(To record construction cost)

Table (2)

• Construction in progress is an asset. There is an increase in asset value. Therefore, it is debited.
• Various accounts are revenue. There is an increase in liability value. Therefore, it is credited.

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Account receivable		$2,500,000
	Billings on construction contract			$2,500,000
	(To record progress billings)

Table (3)

• Account receivable is an asset. There is an increase in asset value. Therefore, it is debited.
• Billings on construction contract is revenue. There is a decrease in liability value. Therefore, it is debited.

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Cash		$2,250,000
	Account receivable			$2,250,000
	(To record cash collection)

Table (4)

• Cash is an asset. There is an increase in asset value. Therefore, it is debited.
• Account receivable is an asset. There is a decrease in asset value. Therefore, it is credited.

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Construction in progress		$666,667
	Cost of construction		$2,000,000
	Revenue from long-term contracts			$2,666,667
	(To record gross profit)

Table (5)

• Construction in progress is an asset. There is an increase in asset value. Therefore, it is debited.
• Cost of construction is an expense. There is a decrease in liability value. Therefore, it is debited.
• Revenue from long-term contracts is revenue. There is an increase in liability value. Therefore, it is credited.

In the year 2019:

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Construction in progress		$2,500,000
	Various accounts			$2,500,000
	(To record construction cost)

Table (6)

• Construction in progress is an asset. There is an increase in asset value. Therefore, it is debited.
• Various accounts are revenue. There is an increase in liability value. Therefore, it is credited.

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Account receivable		$2,750,000
	Billings on construction contract			$2,750,000
	(To record progress billings)

Table (7)

• Account receivable is an asset. There is an increase in asset value. Therefore, it is debited.
• Billings on construction contract is revenue. There is a decrease in liability value. Therefore, it is debited.

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Cash		$2,475,000
	Account receivable			$2,475,000
	(To record cash collection)

Table (8)

• Cash is an asset. There is an increase in asset value. Therefore, it is debited.
• Account receivable is an asset. There is a decrease in asset value. Therefore, it is credited.

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Cost of construction (2)		$2,544,445
	Revenue from long-term contracts			$1,777,778
	Construction in progress			$766,667
	(To record expected loss)

Table (9)

• Cost of construction is an expense. There is a decrease in liability value. Therefore, it is debited.
• Revenue from long-term contracts is revenue. There is an increase in liability value. Therefore, it is credited.
• Construction in progress is an asset. There is a decrease in asset value. Therefore, it is credited.

Working note:

Calculate the cost of construction

Given,

Revenue recognition in 2019 is $1,777,778

Loss recognition in 2019 is $766,667.

Now, calculate the gross profit recognition:

$\begin{array}{c}\text{Gross profit recognition =}\left(\begin{array}{l}\text{Revenue recognition in 2}0\text{17}\\ \text{+ Loss recognition in 2}0\text{17}\end{array}\right)\\ =\$1,777,778+\$766,667\\ =\$2,544,445\end{array}$

(2)

To determine

To prepare: A partial balance sheet to show the presentation of the project as of December 31, 2018 and 2019.

Explanation of Solution

In the year ended 2018:

Balance sheet At December 31,2018
Current assets	Amount
Account receivable	$250,000
Cost and profit in excess of billings (3)	$166,667

Table (10)

Working note:

Calculate the costs and profit in excess of billings:

Given,

Profit is $2,666,667 $\left(\$2,000,000+\$666,667\right)$

Billing profit is $2,500,000.

Now, calculate the costs and profit in excess of billings:

$\begin{array}{c}\text{Costs and profit in excess of billings =}\left(\begin{array}{l}\text{Profit }\\ -\text{ Billing profit}\end{array}\right)\\ =\$2,666,667-\$2,500,000\\ =\$166,667\end{array}$

(3)

In the year ended 2019:

Balance sheet At December 31,2019
Current assets	Amount
Account receivable	$525,000
Current liability	Amount
Cost and profit in excess of billings (4)	$850,000

Table (11)

Working note:

Calculate the costs and profit in excess of billings:

Given,

Profit is $5,250,000

Billing profit is $4,400,000.

Now, calculate the costs and profit in excess of billings:

$\begin{array}{c}\text{Costs and profit in excess of billings =}\left(\begin{array}{l}\text{Profit }\\ -\text{ Billing profit}\end{array}\right)\\ =\$5,250,000-\$4,400,000\\ =\$850,000\end{array}$

(4)