Contract Accounting Journal Entries, Principles

I. Methods of Revenue Recognition for Long-Term Contracts

Long-term contracts pose a unique revenue recognition problem. The seller/contractor performs
its obligation over a long period of time. Cash collection generally is not an issue because
projects generally are financed by third parties. Should the contractor recognize revenue as work
progresses, or wait until the entire project is complete? Because of the long-term nature of
construction contracts, the answer to this question has a significant impact on the contractor's
income during the contract period. Two methods are used for revenue recognition in this context:
A. Completed contract method -- No profit is recognized until the contract is complete.
This method is required if estimates of the degree of completion at interim points cannot be
made.
B. Percentage of completion -- Recognize profit in proportion to the degree of completion.
This method is required if estimates of the degree of completion at interim points can be
made and reasonable estimates of total project cost (and therefore profitability) can be
made, and when the buyer and seller can be expected to perform under the contract.
II. Basic Illustration
The following example provides an illustration of both methods. A later lesson considers the
effect of losses on contracts.
A. A contractor begins construction of a building for a client. The contract price is $10,000.
Data for two years follows. The estimated remaining cost is updated at the end of each year.
The project is incomplete at the end of year 2 because costs remain for completion after
year 2. Each year for each contract, four different types of journal entries are recorded.
Year 1
Year 2
Cost incurred in Year
$2,000
$4,000
Estimated remaining cost to complete at end of year
6,000
1,500
Progress billings in year
1,000
3,500
Collections on billings in year
800
3,000
III. Year 1
A. The first three summary journal entries for Year 1 are the same for both methods:
Construction in progress (inventory)
2,000
Materials, cash etc.
Accounts receivable
1,000
Billings
Cash
800
Accounts receivable

2,000
1,000
800

B. Construction in progress is an inventory account and a current asset. Although the contract
may run for several years, the operating cycle of a construction firm is the length of its
contracts. Thus, the inventory account is classified as a current asset. Construction in
progress is debited only when costs are incorporated into the project. Purchases of materials
for the project are recorded in the materials account.
C. Billings is contra to construction in progress. In the balance sheet, if the balance in
construction in progress exceeds cumulative billings to date, the net difference is a current
asset: Excess of construction in progress over billings on contracts. If cumulative billings
exceed the construction in progress balance, the difference is disclosed in the current
liability section. By subtracting billings from construction in progress, the seller is
transferring its equity in the project from the physical asset to the financial asset (to
accounts receivable and then ultimately to cash).
D. The completed contract method recognizes no profit in Year 1 (or even in Year 2). The

percentage of completion recognizes profit each year. Completed contract records no further
entries for the first two years.
E. The fourth entry (below) is recorded for percentage of completion only, and is an adjusting
entry. This entry records the profit on the project for the year based on the percentage of
completion, which is 25% at the end of Year 1. 25% = ($2,000/($2,000 + $6,000)). The
expected total cost of the project is $8,000 at the end of Year 1 and $2,000 of cost has been
incurred.
F. Adjusting entry for percentage of completion only:
Construction in progress
Construction expenses
Construction revenue

500
2,000
2,500

G. $2,500 revenue = 25%($10,000). The project is 25% complete allowing 25% of the total
revenue to be recognized. The $2,000 of construction expense is the cost incurred in the
period. The $500 profit can be directly computed as the percentage of completion times the
total estimated profit: .25($10,000 - $8,000) = $500. The $500 profit is recorded in the
inventory account because it represents the increase in the value of the inventory. When
$500 of profit is recognized, the net assets of the seller must also increase.
H. Caution -- The total estimated cost of the project at the end of any year equals cost
incurred to date + estimated remaining costs to complete at year-end. This amount
generally must be computed by the candidate. This amount is the denominator of the
percentage of completion and also is used to compute profit to date. For example, the
$8,000 figure would not be provided for the candidate. This amount changes each year of
the project.
I. The balance sheet and income effects for both methods at the end of Year 1:
Completed contract
Percentage of completion
Income statement
Recognized gross profit
$0
$ 500*
*The $2,500 revenue less $2,000 expense also can be reported.
Balance sheet (current assets)
Accounts receivable
200
Construction in progress
$2,000
Less billings
(1,000)
Excess of construction in
progress over billings
1,000

200
$2,500
(1,000)
1,500

If no losses are expected, the balance in construction in progress at any balance sheet date
is:
Completed contract:
Percentage of completion:

total cost to date

total cost to date
+ total recognized gross profit to date

The construction in progress and billings accounts are separate accounts. Billings is
subtracted from construction in progress only for reporting in the balance sheet.
IV. Year 2

A. The first three journal entries are the same as the first year's except for the amounts. Both
methods record these entries. These entries are not shown; the amounts are: $4,000,
$3,500, and $3,000.
B. The fourth entry (for percentage of completion below) shows how the profit for the second
year is computed as the total profit to date less the profit recognized in earlier years. Thus
in the fourth year of a project, the profit recognized is total profit through the fourth year
less the profit for the first three years. After the first year, there is no direct way to compute
profit for the year because total profit through the end of each year uses the estimated
remaining cost amount, which varies each year.
C. The percentage of completion at the end of Year 2 = cost to date/total estimated cost =
($2,000 + $4,000)/($2,000 + $4,000 + $1,500) = $6,000/$7,500 = 80%.
D. Note that the estimated remaining cost to complete ($1,500) is the only difference between
the numerator and denominator.
Profit recognized in Year 2
= total estimated profit through Year 2
- profit recognized in previous periods
= .80($10,000 - $7,500) - $500
= $1,500
Adjusting entry for percentage of completion only:
Construction in progress
Construction expenses
Construction revenue

1,500
4,000
5,500

$5,500 = .80($10,000) - $2,500 revenue in Year 1

V. End of Contract - Year 3
A. Assume that total cost incurred by the contractor for the project was $7,500 with completion
occurring in Year 3. Under percentage of completion, the final adjusting entry (fourth entry
in year) would record profit for that year and update the construction in progress account.
That entry is:
Construction in progress
500
Construction expenses
$7,500 - $6,000
1,500
Construction revenue
$10,000 - $8,000
2,000
B. The entries to complete the contract and close the accounts are:
Completed Contract:
Percentage of Completion:
Billings
10,000
Billings
Construction expenses
7,500
Construction in progress
Construction in progress
7,500
Construction revenue
10,000

10,000
10,000

C. Only in the final year of the contract is profit recognized under the completed contract
method. At completion, $2,500 of profit is recognized (revenue less expenses). Under the
percentage of completion method, the construction in progress account balance is total cost
plus total profit, or $7,500 + $2,500 = total contract price of $10,000. The billings account
reflects the full contract price under both methods.