Over time recognition method

The accounts are used the same way as in point-in-time recognition, with one key difference: the CIP account accumulates both the actual costs incurred to date and the gross profit recognized to date, not just the costs.

Step 1: Calculate the percentage of completion

The percentage of completion is calculated every end of the year to track the progress of the project.

Exams most often use the input method, also called the cost-to-cost method.

$$\text{Percentage of completion}=\frac{\text{Actual costs incurred to date}}{\text{Actual costs incurred to date}+\text{Estimated costs to complete}}$$

The denominator is also called total estimated contract costs. In the exams, candidates should be careful in determining the type of costs provided by the problem because it can provide directly the total estimated costs or a breakdown of it.

The examples moving forward pertain to the input method.

Step 2: Calculate the total gross profit from the contract

The total gross profit from the contract should also be calculated every year-end.

This is the estimated total profit that the company is expecting to obtain at the conclusion of the contract. The inputs used in the computation are similar to a normal gross profit computation as follows:

This portion is important because, just like in point in time recognition method, estimated losses on a contract are also recognized immediately in full despite the percentage of completion while gross profits are recognized on a piecemeal basis using the percentage of completion computed from the previous step.

Step 3: Calculate the revenue and gross profit to be recognized to date

For over time recognition of revenues, the following items are needed for the journal entries:

The revenues to be recognized in the current period is calculated as follows:

The gross profit to be recognized follow the same logic as above except that the main input is the gross profit computed from the previous step:

The costs to be recognized in a profitable period are simply the actual costs incurred in the current period - no special computation is needed. In a loss period, though, construction expense is no longer just the actual costs incurred: it equals the current-period revenue recognized plus the current-period loss, since the full loss must be recognized immediately (see the callout above).

In a profitable period, revenue minus actual costs incurred for the period equals the gross profit computed above; that consistency is the basis for the year-end journal entries in step 4.2 below.

Step 4: Record the relevant year-end journal entries

The accounts to be used for this method are the same as the point in time recognition method but the journal entries are different because of the recognition of the gross profit in each year-end.

Step 4.1: Contract costs are accumulated in the CIP account similar to the previous method.

Debit construction in progress (CIP) and credit cash and/or accounts payable for the actual costs incurred during the period - the same entry used in the point-in-time method. Because CIP is a balance sheet account, these costs accumulate there and become an input to the total estimated contract costs formula from step 1.

Step 4.2: Contract revenues are recorded along with the gross profit.

This journal entry is specific to the over time recognition method. In this journal entry, we use the inputs determined in the preceding steps.

The sections of the journal entry are:

• The debit in construction expense should be the same amount as the debit in CIP in the previous journal entry to record the actual construction costs - this holds in a profitable period. In a loss period, construction expense instead equals the current-period revenue recognized plus the current-period loss (see step 3).
• The debit in CIP account is the gross profit computed in Step 3. In a loss period, this line is a credit instead of a debit, since CIP is reduced by the loss rather than increased by a profit.
• The credit in construction revenues should be the same as the “revenue to be recognized in the current period” computed in Step 3

After the above journal entry, the CIP account in the balance sheet accumulates two items:

1. actual costs incurred to date; and
2. gross profit recognized to date.

This total makes it the same as the total revenues recognized to date. It is important to know this fact in relation to the nature of the Progress Billing account which will be discussed in the next journal entry.

The example below walks through steps 1-3 and this step 4.2 entry for two profitable years, then a third year in which revised estimates turn the contract into a loss.

Example: applying the percentage-of-completion method

Ace Builders signs a contract to construct a warehouse for a contract price of $1,000,000. Total estimated contract costs are $600,000, so the total estimated gross profit on the contract is $400,000.

Year 1: Actual costs incurred to date are $180,000, and estimated costs to complete are $420,000.

• Percentage of completion: $\frac{\$180,000}{\$180,000+\$420,000}=30\%$
• Revenue to recognize in Year 1: $30\%\times \$1,000,000=\$300,000$
• Gross profit to recognize in Year 1: $30\%\times \$400,000=\$120,000$
• Costs incurred in Year 1: $180,000
• Year 1 journal entry (Step 4.2): debit construction expense $180,000, debit CIP $120,000, credit construction revenues $300,000

Year 2: By year-end, actual costs incurred to date total $420,000 (an additional $240,000 spent during the year), and estimated costs to complete have dropped to $180,000.

• Percentage of completion: $\frac{\$420,000}{\$420,000+\$180,000}=70\%$
• Revenue recognized to date: $70\%\times \$1,000,000=\$700,000$; less the $300,000 recognized in Year 1 leaves $400,000 to recognize in Year 2
• Gross profit recognized to date: $70\%\times \$400,000=\$280,000$; less the $120,000 recognized in Year 1 leaves $160,000 to recognize in Year 2
• Year 2 journal entry (Step 4.2): debit construction expense $240,000, debit CIP $160,000, credit construction revenues $400,000

Year 3: Unexpected delays push total estimated contract costs up to $1,050,000, turning the contract into a $50,000 loss ($1,000,000 contract price − $1,050,000 total estimated costs). The project is completed by year-end, so actual costs incurred to date reach the full $1,050,000 and revenue recognized to date reaches the full $1,000,000.

• Revenue to recognize in Year 3: $1,000,000 total − $700,000 recognized in Years 1 and 2 = $300,000
• Current-period loss: the $50,000 total expected loss plus the $280,000 of gross profit already recognized = $330,000 (this reverses the prior profit and brings cumulative income down to the full $50,000 loss)
• Year 3 journal entry (Step 4.2): debit construction expense $630,000 (the $300,000 revenue recognized plus the $330,000 loss), credit CIP $330,000 (the loss - CIP is credited, not debited, in a loss period), credit construction revenues $300,000

Answer: Cumulative gross profit (loss) after Year 3 is $120,000 + $160,000 − $330,000 = −$50,000, matching the $50,000 total loss now expected on the contract.

Step 4.3: Progress billings are recorded the same way as the point in time recognition method.

Debit accounts receivable and credit progress billings for the amount billed to the customer - the same entry as in the point-in-time method. Progress billings is a contra-asset account that offsets CIP, not a liability in its own right; only the net balance of the two accounts appears on the balance sheet, as a contract asset or a contract liability.

The progress billings account is a contra-asset account (to CIP) with a normal credit balance representing the portion of the contract price that has already been billed to the client. This is separate from the revenues recognized using the percentage of completion because the billings may be calculated using a different approach.

As mentioned previously, the revenues recognized on the contract are actually accumulated in the Construction in progress (CIP) account in the balance sheet with a normal balance in the debit side.

Step 4.4: Collections of accounts are recorded against the accounts receivable previously set-up, just like in a point in time recognition method.

Debit cash and credit accounts receivable for the amount collected - the same entry as in the point-in-time method. The progress billings account is not affected by collections.

Step 4.5: The conclusion of the contract is recorded by closing the CIP and progress billings accounts with each other.

Unlike the point in time recognition method where the CIP is closed to construction expenses and the progress billings are closed to construction revenues, the journal entry upon the conclusion of the contract for an over time recognition of revenue is to simply close the CIP against the progress billings account. This is possible because at the end of the contract, the total revenues recognized to date (i.e., CIP) should be equal to the progress billings since we will bill the contract price in full.

Step 5: Understand the financial statement presentation

The pro forma presentation for the income statement and balance sheet is presented below. Notice that the main difference of this method when compared to the point in time recognition method is the presence of income statement items in Years 1 and 2, despite the contract not yet concluded.