Hi.
[INAUDIBLE] here.
And today, we're going to continue
with long-term construction projects
with expected losses, both the calculation
entries and the financial statement presentation.
Here's the question.
In 2016, we're going to use the same chart
process that we used for 2015.
We'll be using the information for the end of 2016
that was given in the question.
So be sure you've downloaded the question from my Dropbox.
The link is below.
All right, let's get started.
First, remember that we would only
do the chart at the end of the year
after we've made the other three entries.
Let's do all those entries first,
because they are made continually
throughout the year.
Yes, I know for purposes of this question,
we're actually doing some re-entries.
But normally, the company would make these entries
as they occur throughout 2016.
First, let's record the costs incurred on the project.
You'll notice that this information
is the costs incurred to date.
But that's the total cost for 2015 and 2016 together, $63.
We have to calculate the costs incurred only in 2016.
We do this by subtracting the information from 2015 and 2016.
If we're looking for only the costs incurred in 2016,
it would be $63 minus $42, which would be equal to $21.
Those are the costs incurred for only 2016.
Let's make the entry.
You'll notice I've already got all the accounts listed down.
That's because the accounts are similar to 2015.
So we've got a debit to construction
in progress for $21.
We also have a credit to materials, cash, accounts
payable, all the additional accounts that we
would use throughout the year as we are incurring cost, $21.
Now we have to record it in the T account.
You'll notice in the T accounts, I've
placed the opening balances from the prior year.
CIP already has an existing balance of $44.80 from 2015.
Accounts receivable has a balance of $3.
And billings on CIP, I forgot to put
the opening balance in there.
That would be a credit of $38.
And again, that comes from 2015.
Let's do the entry, then, for 2016.
We said CIP increased.
Debited, $21.
The other side was the miscellaneous accounts,
which we're not tracking for purposes of this question.
So let's go back to the entries.
What did we bill the client?
Again, we have to calculate that for this year only.
In 2016, we have billed a total of $58.
That includes both 2016 and 2015.
Therefore, in order to calculate the amount that we billed only
in 2016, we deduct $38 from last year from the $58 total.
In 2016, we billed them $20.
Let's do the entry.
When we billed the client, we would
debit accounts receivable $20.
We would credit billings on CIP $20.
Let's update the T accounts.
Accounts receivable, $20.
Billings on CIP, $20.
Now we have to record the cash that the client has actually
paid.
Again, we see the total cash collected to date.
So the $54 includes the $35 from last year.
We've got to deduct the $35 from the $54 in order
to get the amount of cash that we collected in this year, $19.
Let's do the entry.
Cash collections.
Debit cash, $19.
Credit accounts receivable, $19.
Let's update the T accounts.
Accounts receivable goes down, $19.
Again we're not tracking the cash account
because there's too many entries that
are going in and out of it.
So we're just going to update the accounts receivable.
Now that we've recorded all these entries that
have occurred during 2016, we're standing at the end of 2016.
Remember, we wouldn't have the information about 2016
until the end of the year.
We can now complete our chart for 2016.
For the purposes of the chart, we actually
need the costs to date.
So we're going to be using the information
from our original question in order to update this chart.
Cost to date, $63.
Remember, that's the total for 2015 and 2016.
Estimated cost to complete are simply the costs
that we expect in 2017.
And in this case, it's $21.
Estimated total cost to complete is the addition
of these two numbers.
Therefore, the total estimated costs are $84.
The next step in the process is always the same.
Compare the total estimated cost to the selling price
of the contract.
Total costs are $84, and the selling price is $80.
That means that, on this construction contract,
we'll have a loss of $4.
What are we going to do about that?
This is an example of a construction project
that has an overall loss, meaning that overall,
for this construction contract, we expect to lose money.
Let's talk about what happens because of this.
In construction, there are two types of contracts.
One is a normal construction contract
that results in a profit at the end of that period.
For those types of contracts, we always
use the same method in order to calculate the revenue.
We use percentage of completion.
A good example of percentage of completion would be 2015.
That's because in 2015, we actually
had an overall profit on the contract of $5.
We calculated that as $80 minus the $75.
Percentage of completion method recognizes revenues, expenses,
and gross profits equal to the amount
of the progress made to date.
That's why we use the percentage.
However, when we find out that a construction project is
expected to have an overall loss,
like now in 2016 with a loss of $4,
then the cost recovery method must be used.
Key here is the word "expected."
We have to use the cost recovery method
because the realization of profit
at the end of the contract is now unpredictable.
The cost recovery method is also used
when there is significant uncertainty
about the ability of the client to pay their scheduled payment.
Say, in this case, if our customer for the building
were not paying on time and they appeared
to be in financial difficulty.
What exactly is the cost recovery method?
Under this method, you recognize the costs from the period,
and also recognize revenue equal to those costs.
Let's give an example.
If we had costs $30, we would recognize revenue up
to the $30.
The end result, a gross profit of $0.
This method is also called the zero-profit method
in some textbooks, because the costs equal the revenue.
So the gross profit is always $0.
That defers all the gross profit until the completion date
of the contract.
In addition, losses expected on an overall contract
must be recognized immediately.
Why?
Remember that reporting financial information
is all about providing useful information to decision makers.
If the current building project with our client
is expected to have an overall loss,
then this is information that the stakeholders
in ABC Construction would want to know now.
Immediately, rather than later.
The reason we recognize 100% of the losses
now is because the value of this information
to our stakeholders regarding their future decisions
about ABC Construction.
Note, there is an issue with the cost recovery method.
This revenue recognition method is
highly biased in that revenue is recognized as late as possible.
It does a very poor job of reflecting actual performance
and expected cash flows over the contract period.
Its use is justified only in the face
of significant uncertainties.
Right now, we're expecting to lose money.
That's uncertain.
It's a significant uncertainty, so we have
to use a cost recovery method.
OK, let's go back to our example and see how this
will impact our calculations.
First, we calculate the percentage complete.
We do that by taking the $63 and dividing it
by the total estimated cost, $84.
The result, 75%.
That means, according to the costs, year-to-date costs,
we are estimating that 75% of this project is complete.
We now use the 75% and multiply it by $80, the selling price,
so that we can figure out what our year-to-date revenue is.
$80 times 75%, our year to date revenue, $60.
In order to calculate the revenue for this current year,
we have to deduct the prior year's revenue, $44.80.
The revenue for the current year is, therefore, $15.20
What's our current year's costs?
Let's flip back to the question so we can see this.
Current year's cost, $21.
Gross profit for the year, a loss of $5.80.
Now, we just finished the chart, and we can see that our loss is
$5.80.
However, the overall contract is a loss position,
so we have to recognize 100% of that loss immediately.
Is $5.80 the total loss on this contract?
And we know it's not.
The total loss on this contract is $4.
So how are we going to correct this?
We compare the current cumulative position
to the required loss and make an adjustment.
Let's figure this out.
I'm going to do this as a step-by-step process.
Step 1, calculate the cumulative gross profit on the contract.
Cumulative means all prior years.
So we've got 2015, we had a profit of $2.80.
In 2016, we had a loss of $5.80.
Therefore, our cumulative gross profit is a $3 loss.
Step 2, compare that cumulative gross profit
to the required gross profit for the whole contract.
$80 minus $84 equals $4 loss.
Now calculate the adjustment necessary in order
to recognize 100% of that loss.
Negative $1.
We need an additional loss of $1 in order
to ensure that we have the correct cumulative loss of $4.
This means we need to increase our cumulative loss of $3
to the $4 to get a total loss equal to what we expect,
a loss of $4.
There are two ways that textbooks generally
handle this.
Method 1 is, you'll be asked to increase the current year's
costs.
Note that our loss, when we used our actual costs of $21,
is too low.
In order to increase the loss by $1,
we could increase our current period's cost by $1.
That would make our cumulative loss equal to $4.
Let's take a look at that.
If we increase our current year's costs,
we would get a bigger loss.
Revenue is going to remain at $15.20.
But we're going to adjust the current year's costs, $21,
plus the $1 additional cost we need, $22.
Now, recalculate the gross profit.
Or in this case, the gross loss.
Let's recalculate our cumulative loss
to make sure we have the proper $4 loss position.
Let's update Step 1.
2015 would remain the same, $2.80 But 2016 would now go
to $6.80 loss.
Our cumulative loss would no longer be $3.
Instead, it's sitting at $4.
Excellent.
By increasing the current year's costs,
we've wiped out the profit from 2015
and recognized 100% of the loss on the contract.
We know this method works.
What adjusting entry would we make at the end of the year?
We do a debit to cost of goods sold
for our updated costs, $22.
We would do a credit to revenue for the appropriate amount,
$15.20.
What about the difference?
We would credit CIP for $6.80.
Let's look at our T accounts to see what this would do.
There would be a credit to CIP of $6.80.
The total in CIP, $59.
Total in accounts receivable, $4.
Total of billings on CIP, $58.
Let's look at the balance sheet, also
called the statement of financial position,
and the income statement at the end of the period.
All right, so let's look at the impact
on the financial statements.
We're going to start with the current asset.
Cash cumulative would have been $35,000 for 2015
and $19,000 for 2016, $54.
Accounts receivable, $4.
Per inventories CIP, $59.
Billings in progress, $58.
Revenues in excess of billings, $1.
Total on the balance sheet for assets, $59.
Now, let's compare that $59 to the actual revenues
to date, which are $60 according to our chart.
We are $1 too low.
Why?
Because we adjusted CIP by $6.80 loss, instead of a $5.80 loss.
That's why there's a difference between the cumulative revenue
and the total amount of assets on the balance sheet.
Let's look at the income statement.
Revenues from long-term contracts, $15.20.
Cost of goods sold, the adjusted $22.
Gross profit, a loss of $6.80.
Let's look at both statements together.
Remember how in 2015, we were able to see
that the total amount on the income statement
was equal to the revenues from the long-term contract?
Again, it doesn't look like it's the same anymore.
But if we looked at only 2016 with no adjustment,
we would see very quickly that there's still a connection.
Let's just look at 2016 by itself.
I'm going to use a different color.
Now, if we looked at this all by itself,
our cash would be $19 for 2016.
Our accounts receivable for this year only is $1.
Our CIP, if we had not made the adjustment for $6.80 of losses,
but only $5.80 of losses.
Our billings, $20.
Our revenues in excess of billings, a negative of $5.80.
Total for the whole year?
Notice the tie-in.
You can immediately see, if we had done the entries only
for 2016, we would have had a total tie into revenue.
Keep in mind this $59.
That $59, compared to the cumulative revenue of $60,
is only $1 off.
Again, that $1 is because we put an additional $1 of loss
into CIP in order to adjust the cumulative contract.
You can see how this method would impact CIP,
and also cost of goods sold, and would
result in the necessary change to recognize
the cumulative loss.
What is the second method?
In the second method, we record an adjustment
to a totally separate account.
Let's go back to a clean copy of our chart.
Using this method, there is no change
to the current year's costs.
Instead, we add to the bottom of a chart an addition.
The adjustment is for the $1 that we need,
additional loss this year, in order
to ensure the cumulative loss is equal to $4.
This will create an adjusted gross profit, $6.80.
The entry at the end of the period is also different.
Our previous entries are still the same.
But at the end of the year, we would now do two entries.
A debit to cost of goods sold would
be for the correct amount of the costs, $21.
The credit to revenue would be for the appropriate amount,
$15.20.
The credit to CIP would be for the current year's losses only,
$5.80.
Notice that the loss is credited to CIP.
Then we would do an additional entry.
We would debit expected loss on construction contract, $1.
And we would credit CIP for this additional dollar.
Notice the credit to the CIP is equal to the same amount
as the credit to CIP previously, a total of $6.80.
However, cost of goods sold remains
at its appropriate amount, the amount that was actually
incurred this period, $21.
The additional $1 adjustment goes into a different expense
account.
This expense account would be noted underneath cost of goods
sold in the income statement.
Let's enter these into our T accounts.
First, we'd have the $5.80 loss.
That goes into CIP.
Then we would have an additional $1.
The end result, $59.
This is the same as Method 1.
But the entries are different.
And how it looks on our income statement is different also.
Notice that the balance sheet would still be the same.
Cash would be $54.
Accounts receivable, $4 CIP, $59.
Less billings on CIP, $58.
Revenues in excess of billings, $1.
The total for assets, $59.
It's the income statement that would look different.
A revenue from the long term contract, $15.20.
Cost of goods sold, $21.
Expected loss on construction contract, $1.
Total costs, $22.
Gross profit or loss, $6.80.
So, which method is better?
Method 1 or Method 2?
That decision is left to the accountant in ABC Construction,
and his or her professional judgment.
Both methods are totally acceptable.
In the next video, we will be looking at 2017.