Hi.
Else, here.
And today, we're going to look at long term construction
projects with expected losses.
We're going to do the calculation and the entries.
And sometimes, I'm also going to do the presentation
on the financial statements.
So let's get started with a question.
We're going to be working with ABC Construction.
They're a contractor, and they're building
a building for a client.
It's going to be their head office.
The project is scheduled to last for three years, 2015,
'16, and '17.
Contract price-- also called the selling price--
is going to be $80.
I'm not working with big numbers here.
We don't have to work with big numbers.
So we're just going to work with very small numbers.
And you can translate it into big numbers at any time.
So ABC Construction is estimating that the building
will cost them $74.
They had to know this or estimate this before they
quoted the client the $80.
So keep in mind that this is an estimate
that they believe it will cost them over the three year
contract.
I've got a table here that shows all the costs incurred to date,
the estimated additional cost, total billing to date,
and total cash collected to date for 2015, '16, and '17.
I want to be clear that this information is actual numbers.
So for instance, for 2015, we only know this information
at the end of 2015.
When the contract starts, there is only two pieces
of information we know--
the estimated costs, and what we're quoting to our client.
We know nothing else.
So the information for 2015 is only
available at the end of 2015.
It's very important for students to recognize it.
Now, this information is available for download
immediately under the video, so please
download it and attempt it yourself
before you watch this video.
Because the only way you can learn
is if you actually do the work yourself.
So let's get started.
We're going to take the information
from the end of 2015, and we're going to work with it.
Now, the method I'm going to use is a chart method.
Not everybody uses the chart method,
but no matter what method your textbook happens to use,
this chart method will work with it.
Let's put down 2015, 2016, and 2017.
I'm doing all three years, because every time
I calculate something, I need the prior year's calculations.
So my chart is going to cover everything.
I'm not going to fill in 2016 until I complete 2015,
and we're standing in the end of 2016.
But I still want to set up the chart for all three years.
Let's start with the contract price.
The contract price is $80.
I'm putting this under 2017 because by the end of 2017,
I must have collected the $80 for my client.
Let's start doing the calculations for 2015.
First, we need the costs to date.
In 2015, the costs to date are $42.
I got that from the chart.
I now need the estimated cost to complete this project.
According to the chart, we estimate at the end of 2015,
that it's going to cost us $33 to complete this project.
By adding these two amounts together,
it tells me what is the total estimated cost
to complete this project, $75.
Using this information, I can now
calculate how much has been completed to date.
What is the percentage complete?
The percentage complete would be calculated as $42 divided
by the 75, that's 56%.
What can we do with this information?
We can now use this information and the information
we have for the contract price, and we
can calculate how much revenue we should claim this year.
So taking the $80 and multiplying it times the 56%,
we would know the revenue to date--
$44.80.
Although we don't need the next line right now,
we're going to need it in 2016.
So I'm going to put it in.
We have to deduct the prior year's revenue,
because we're basing these calculations on total cost
to date, which includes prior years.
So in order to eliminate that, we've
got to deduct the prior year's revenue.
In this case, the prior year's revenue is zero.
So my revenue for the current year is still equal to $44.80.
We need to compare the current year's revenue
to the current year's costs.
Now, current year's costs this year are $42.
With this, we can calculate the gross profit.
The gross profit for this year is $2.80.
Something that's important to note right now,
we know that we're going to make a profit on this contract.
How do I know that?
I can compare the $75 total cost to the $80
for the whole contract price.
And I note that right now, we're making $5.
It's important to recognize that you
have to check to see if the contract is making money.
And right now, we're going to be making money.
We've done the calculations for the end of 2015.
Let's move on to doing the entries.
As construction costs are incurred on the project,
we would make continual entries to an account called
construction in progress.
So for 2015, our first entry would be one two construction
in progress.
I'm going to use a short form from now on, CIP.
How much have we incurred?
$42.
What's the other side?
As we're incurring these costs, we're
either going to pay for them, or they're going to be on account.
In addition, we might have raw materials in a raw material
inventory account that we have to move in to construction
and progress.
So our credit entry is to various accounts--
$42.
Now, note that we are doing a summary
entry at the end of 2015.
We would never actually do a summary entry.
These entries would be continuous
throughout the whole year from the moment
that the construction project started until the end of 2015.
Notice that nothing is expensed to the income statement.
The expensing to the income statement
of the cost of the project is deferred
until the calculation for revenue and gross profit
is complete at the end of 2015.
Let's just look at construction in progress for one moment.
What is this account?
This is a work in process account.
This is an inventory account.
Why?
Because as we're working through this project,
we are accumulating costs that we're not going to incur.
The client is going to incur these costs.
So it has future economic benefit for us.
Let's just look at the T accounts for one moment.
As we incur costs, we're going to add them in.
At the end of the period, the total amount of these costs
are what is sitting in construction in progress.
Notice that the entries would go in individually.
This is an inventory account.
It is the same as a work in process account.
Let's go back to the entries.
Now, let's assume the next thing we
do is we're going to bill the client.
This is considered progress billings.
The client has agreed to this in the contract
when we first signed the contract
at the beginning of 2015.
The client agreed to be billed regularly.
The fact is, a construction company cannot foot the bill
for all the construction material that they have
to purchase, the employees that they have to hire,
the construction workers, an architect,
permissions you have to get from the government,
all of these things cannot be funded by the construction
company.
So the client is going to make regular payments
to the construction company in order
to support the building of the building.
The company ABC Construction gets to bill the client.
What would be the entry when we bill the client?
Accounts receivable.
In this case, we billed them $38.
Now, normally, the credit would be sales or sales revenue.
But this is deferred until the calculation for the revenue
and gross profit.
That means we cannot use a revenue account.
Instead, we credit an account called billings on construction
in progress, or CIP--
$38.
What is billings on construction in progress?
This is a contraasset account which is grouped with CIP.
Let's take a break from the entries
and see how this would be reported on the balance sheet,
also called the statement of financial position.
On the balance sheet, we would start off with current assets.
Next, we would list cash.
We haven't received any cash yet,
so I'm just going to leave that empty.
I know a company would generally have a balance in their cash
position, but I only want to focus
on the entries for this contract.
Accounts receivable is next, and we
know we have a balance in accounts receivable-- $38
for 2015.
What comes next?
Inventories.
In this case, we've got two inventory accounts--
construction in progress.
Again, I'm going to use the short form, CIP--
$42.
But I'm going to deduct the billings--
$38.
What is the net amount called?
Revenues in excess of billings.
What is the total of these amounts?
42.
Why do we have an asset equal to $42?
You've got to think that the company completed $42 of work.
They've billed the client for 38 of that,
so they still have $4 that has future economic benefit.
Why?
Because in the future, they can go to the client
and ask for that $4.
It's work that they are doing for the client.
In addition, we've got $38 as accounts receivable.
That's the amount that right now, we have a legal right
to collect from our customers.
So a total of $42 has future economic benefit,
because we're actually going to go to the client,
and we're going to ask for these funds.
In total, we're charging the client $42.
And our total costs are going to be zero,
because the client is funding this building project, not us.
So therefore, the total amount is an asset
because it has future economic benefit.
In the future, we're going to either collect it in cash right
now-- because we can claim it now--
or we're going to collect it at some point before the end
or at the end of the project.
Back to the entries.
After we bill the client, we're going
to collect some cash from the client.
How much are we going to collect?
According to this question, we collect $35.
That's a debit to cash, and a credit to accounts receivable--
$35.
Now, note that accounts receivable has decreased to $3.
Let's look at the entries.
Accounts receivable started off with 38, but we collected 35.
Therefore, we only have the right
to collect 3 in the future.
Let's look at what this would look like now
presented on the financial statements.
Cash is now sitting at 35,000.
Accounts receivable is at 3.
CIP, still at 42, billings on CIP 38,
and we still have revenues in excess of billings $4.
So the total is still sitting at $42, exactly the same
as it was previously.
All we've done is we've converted from an accounts
receivable to a cash.
Let's get back to the entries.
At the end of every period--
in this case, a year--
we have to recognize that the gross profit is earned
on this contract, and we have to place
that on the income statement.
This is a period end adjustment that we have to make.
What is the entry?
First, we have to recognize the construction expenses, that's
going to be a debit to expense account.
There are various accounts that we can use.
We can do a debit to construction expenses,
a debit to cost of goods sold, or a debit to cost of sales.
It totally depends on what your company is using,
or-- if you're doing a textbook question-- what
your textbook is using.
All of them are exactly the same.
I'm going to do a debit to cost of goods sold.
How much?
Go back to your calculations, take a look.
We can see right here, the current year's cost.
That's what we want.
In addition, we want the current year's revenue.
So cost of goods sold is $42.
We've got to also recognize the revenue.
Credit to revenue, $44.80.
Where does the difference go?
The difference is the amount of the gross profit.
And we have to put it somewhere.
This is already calculating gross profit on our income
statements, so we can't put it on our income statement--
the difference between these two--
because it would get rid of the gross profit.
It's going to be a debit.
Where do we put this debit?
We put this debit in CIP, construction in progress--
$2.80.
Why do we use CIP for the gross profit?
In order to understand that, let's go back
to the T accounts for a moment.
Let's put in the $2.80 to CIP.
What's going to be the ending balance in CIP?
It's going to be $44.80.
That's the amount of our revenue.
Let's take a quick look at the balance sheet
to see why we do this.
Now, we still have the cash at 35 and the accounts receivable
at 3, but the CIP in the inventories is now $44.80.
The billings on CIP are still $38.
What is the revenues in excess of billings?
$6.80.
What's our total?
44.80.
that 44.80 is the amount of revenue that we recognized
on the income statement.
Let's look at the income statement in order to see this.
On the income statement, we would see revenue
from long term contracts--
$44.80.
We would see construction expenses or cost of goods
sold using the short form, $42.
What is the amount of gross profit?
$2.80.
Notice, $44.80 is equal to the amount that we have under
assets on the balance sheet.
So let's consider this--
in 2015, on our balance sheet, we clearly show that we have
a legal right to $44.80.
We've already collected $35 in cash.
The client still owes us $3 on our billings.
And from the work we have done, we know that in the future,
we're going to collect an additional $6.80,
because we have completed more work than the client has paid
us for.
Therefore, the total amount as an asset
has got to be equal to the revenue.
You can also think about it differently.
In order to better understand why this happened,
think about this in relationship to a retailer,
such as Dollarama.
If Dollarama sold a calculator for $2,
they would receive cash of $2.
So cash would increase by $2.
In addition, Dollarama would claim the $2 of revenue
on the sale.
Notice that the revenue for Dollarama
is exactly equal to the amount of the change in assets.
This is exactly the same.
The amount of change in the assets--
$44.80-- is equivalent to the revenue that we have claimed
on the income statement.
In the next video, we're going to complete the calculations
for 2016.