 Hello and welcome to the session in which we would look at long-term contract or long-term construction contract where the company actually incur losses. The prerequisite for this session is understanding the percentage of completion method and the completed contract method. So it's critical. If you don't understand how the percentage of completion method work, if you don't understand how the completed method work, please stop. Although I'm going to be showing you the percentage of completion briefly in an example, but you really want to have a good understanding of those two methods before we discuss losses when it comes to long-term contract. There are two types of losses that we have to learn about and deal with. One loss is loss in the current period on a profitable contract and we deal with the situation when we are dealing with a percentage of completion method. What does that mean? It means we have a long-term construction project and let's assume it's a four-year project, year one, year two, year three, and year four. In year one, we had a profit. In year two, we had a profit. In year three, we had a loss. In year four, we had a profit. All in all, we have a profit. So in one year, which is year three, we have a loss in that current year, but the whole project is profitable. So overall, the construction project is profitable. The long-term project is profitable. Then sometimes we have to deal with the loss on unprofitable contract. And whatever we learn here, we have to do the same entries, whether we are using the percentage of completion or the completed contract method. Let's assume this project again, year one, year two, year three. But let's assume in year three, we had a large loss. Large loss that it doesn't matter what happened in year four, whether we have a plus or a minus in year four, the whole project is unprofitable, incurring a loss. So this is a loss on unprofitable contract and the entries would apply on both, percentage of completion and the completed contract method. Now the way I'm going to be introducing those losses, first I'm going to work with a regular contract, basically, there is no regular, a profitable contract. Just a quick review of what we did in the prior session in case you are not familiar with this. Then we move on and we'll start to work with losses. So let's take a look at this contract. Year one, the contract price is $700,000. So we signed a project for $700,000. Year one, we incurred $150,000 in cost and the estimated cost to complete is $450,000. We built the customer $140,000 and we received from the customer $120,000. And we have the data for year X2 and X3. Now the first thing you want to compute is your degree of percentage completion because we're using the percentage of completion method. Here's what we do. Cost incurred to date is $150,000. Estimated cost to complete is $450,000. So the total cost for the project is $600,000. Well, we're going to take cost to date, which is $150,000 divided by $600,000. And we're going to find that the degree of percentage for year one is 25%. Okay, that's fine. We're going to take 25%, multiply it by $700,000, the contract price. And for year one, we have revenue to date, $175,000 minus prior revenue recognized, which is at year one. We have no prior revenue recognized. Therefore, we're going to come up with revenue this year, $175,000. Revenue this year, $175,000 minus cost of this year, $150,000. That's going to be our gross profit for year one. Let's compute year two and year three. Year two, cost incurred to date is $450,000. Estimated cost to complete the project, $181,000. What happened is this? Our cost went up from $600,000 for the total project to $631,000. What does that mean? It means in year one, when we signed the project, when we signed the contract, we had revenue of $700,000. Total cost expected to be $100,000. So we expected, this is the $600,000. We expected to make $100,000 in gross profit. When we got to year two, the profit does not change. Total cost changed to $631,000. Well, that's bad news, but nevertheless, we are still profitable. The contract is still profitable. Then what we do is we take cost incurred to date divided by the total estimated cost. In year two, we are 70% completed. We're going to take 71% times $700,000. It's going to give us $499,208 revenue recognizable to date. We're going to subtract from that revenue recognized in prior year, which is $175,000. Revenue recognized this year, $324,208. Cost incurred this year, $300,000. Gross profit for year two is $24,208. Well, that's fine. Although we incur more cost than we needed, but at least we are still profitable for this year, as well as for the whole project. Year three, cost incurred to date, $631,000. Estimated cost to complete the project is done zero. $631,000 divided by $631,000 is 100%. The contract price is $700,000. $700,000 times 100%. This revenue recognized to date minus revenue recognized in prior year, which is $499,208, which is $175,000 in year one, $324,208 in year two. Then revenue recognized this year, $200,792,000 minus cost of $181,000 gives us a gross profit of $19,792. So if we add up all our gross profit, it should add up to $69,000. If we add up all our cost, it should add up to $631,000 and our revenue is obviously $700,000. Now let's take a look at the balance sheet entries and get that out of the way. Now I'm going to go over the balance sheet entries very briefly because I consider this a review and we can't spend too much time, we have to move on. So starting in the future scenarios, what I'm going to be doing, I'm going to be, I'm not going to go over the balance sheet entries anymore because once you understand them, that's it. We can't keep wasting time for every scenario. I'm going to focus on the income statement entries. Nevertheless, let's start with the balance sheet entries. Again, the reason I go through review because you can go to the prior session where I discuss it in details. For the $150,000 that we incur in year one, we debit construction and process CIP, which is an inventory account. Then we credit material, cash, payable, whatever we spent. We billed the customer $140,000. We debit account receivable and we credit billing on construction, which is a contra CIP. It reduces CIP and I explain why this is we credit billing. Then we receive $120,000 cash, we debit cash, credit receivable. And the entries for year two and year three are the same. So this is the balance sheet entries. The income statement entries are different. So let's take a look at the income statement entries. For the income statement entries for year one, and here you have to pay a little bit more of attention because we're going to be changing those figures in future scenarios. For year one, this is year one, we have revenues of $175,000, credit revenue, cost of $150,000, debit construction cost. Then gross profit is the difference. You book the gross profit in CIP. And we'll do the same thing for year two and year three, the revenue, the cost, and the gross profit and the same thing for year three. And at the end, we close CIP and construction and process. They should equal to $700,000. Now we're going to start to look at scenarios where we're going to start to incur the losses that we wanted to discuss for this session. But before we do so, I would like to remind you whether you are an accounting student or a CPA candidate to take a look at my website, farhatlectures.com, I don't replace your CPA review course. I'm a supplemental material. I can help you understand your material better by providing you with resources, multiple choice, lectures, true, false. And this is a partial list of all my accounting courses. And my CPA review material are aligned with your Becker, Roger, Gleam, Wiley, Miles, or your CPA review course. I give you access to 1500. Previously released AI CPA questions with detailed solution. If you have not connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation, like this recording, share it with other connect with me on Instagram, Twitter, and Reddit. So we're going to be working with the same data, except we're going to making some changes in year two. So for year one, as we just nothing happened for you, nothing changed in year one. In year one, we have 25% completed. I show you how to compute this and we have 25,000 in profit. In year two, our cost incurred now is 340,000 and cost to complete the project 182. So in year two, what we find out is this, 790,000 is the cost incurred to date, which is 150 plus 340. So what change is the cost that we incur in year two? So our cost for the project is 671. Well, that's bad, but we are still at a profit, because 700,000 is how much we expect to receive for this project. The cost is 671. Now we completed of the project, 73%, which is 490 divided by 671. We're going to recognize 71% of the revenue to date. So revenue to date is 511,177 minus the previous year revenue of 175. Revenue in the current year is 336,177, and our cost incurred this year is 340. Notice our cost this year is 340. Well, we have more cost than revenues. So for year two, we have a loss, 3,823. So in year one, we had a gain. In year two, we have a loss, but so far, overall, the project is still profitable, because our total cost is expected to be 671, and our contract is 700,000. Let's look at year three. Year three, 671,000, nothing left to complete the project. 100% of the project is completed. 700,000 minus 511,177 previously recognized will give us current year of revenue 1888,823 minus 181 in current cost will give us a profit of 7,831. So simply put, this is our net profit for the whole project. Let's take a look at the journal entries. I'm only going to cover the income statement entries for year one, same as the prior scenario, credit revenue, debit construction cost, and debit the profit 25,000. In year two, credit revenue, debit cost, and now what we have to do, we have to debit credit, reduce CIP by 3,823. So the loss reduces your CIP. Then in year three, you credit the revenue, debit the construction expense, and debit the gross profit. So all in all, all in all, we are still at a profit. Why? Because the project, it will bring us 700,000 minus 671, so the whole project still profitable. I'm assuming this is around 29,000. Yes, it should be 29,000. And if you net these out, they should net out all gross profit of 29,000. So we had a plus year, minus year, plus year over all the project is profitable. Let's up in the scenario. Here in year one is the same. In year two, the cost that we incur is 420,000. So let's take a look at how we do this for year two. So year one, we should know how to do year one. In year two, cost incurred to date is 570, 150 plus 420. Estimated cost to complete the project is 181. Estimated total cost for this project is 751. Here we have a project that we can get only $700,000 for it. Our cost is 751. So we have a loss of, let me put the loss in red of 51,000. Now we know that starting in year one, this project is cost went out of control, labor, material. For some reason, we had to pay more. Well, let's see what would happen under those circumstances. So the degree of completion is of year two, 570 divided by 751 is 76%. 76%. And the contract price is 700,000. Revenue recognizable is 700,000 times 76%. It's 531,292 is revenue to date minus revenue of the prior year of 175. So this year, we are going to be recognizing revenue of 356,292. Now, please listen to me carefully. Listen to me carefully. Once we know the project is profitable. What does that mean? I'm sorry. Once we know the opposite. Once we know the project is unprofitable, guess what? We have to record all the losses in that year to be conservative. We have to record all the losses. How much are the losses in total? 51,000. So what we have to do in year two, we have to book an entry where it give us the losses, all the losses, book all the losses in year two and get done with it. Once we know that's the case. So to book 51,000 and losses, we have to have a large enough cost to give us a total loss for the project of 51,000. Well, what does that mean? It means we have to have enough losses to wipe out the 25,000 of year one to wipe it out, wipe out the profit and give us a total loss of 51,000. What does that mean? It means you have to book a loss of 76,000. So this is your loss. Why 76,000? I need a number large enough to eliminate the 25,000 and keep me with a loss of 51. Well, 51 plus what I need to eliminate 25 will give me a total loss of 76. Therefore, I would say I need a gross loss, not gross profit, a gross profit, a negative gross profit of 76, which is a loss. What does that mean? It means my expenses, this becomes a plug. So I have to have enough cost to give me, because the profit is 356,292, that's giving based on the 76%, my cost becomes a plug. So if I have a revenue of 356, so if I have a revenue of 356,292, and I need a loss of 76,000, why 76,000? Because I need to remove the 25,000 from the prior year and I need to have a 51,000 total project loss. Therefore, I need 76,000 in losses. Well, if that's the case, I have to work backward. So my expenses or my cost for this project for year two has to be 292. Once again, it's a plug. So now I know it's a plug 432,292. Many students ask me, where did you come up with this figure? It's a plug. You have to work backward. Year three, 751,000 cost incurred to date 100% of the project is done. That means revenue recognized to date 700,000 minus revenue from prior period 531,292 gives you your revenue this year. Here's what's going to happen. That's it. The project is no longer profitable. The project is no longer incurring a loss. What does that mean? It means in year three, your revenue equal to your loss. Therefore, you have no profit, no loss. In year three, you have zero profit, zero loss. Whatever your revenue is, your cost will equal to that revenue. So you wipe out any revenue and any loss and notice what happened over a three-year period. We have a loss of 51,000, and this is exactly what we need to record. Now let's take a look at the journal entries that's going to show us these entries. Year one should be pretty straightforward. We did it three times credit revenue, debit cost, and debit CIP. In year two, credit revenue, debit the cost, the number that we plug, and credit CIP. So this credit CIP, so if we have a CIP, remember we booked the profit in CIP. If we started with 25, then we credited 76, we end up with a net loss of 51, which is this is what we need to do. In year three easy, your revenue equal to your expenses. It means you have no profit and no loss. And obviously in year three, you close the project itself. What should you do now? What should you do now is go to my website, farhatlectures.com and work MCQs and look at additional resources that's going to help you reinforce the concepts that we learned. Invest in yourself, invest in your courses. This topic is important. Your CPA exam is worth it. Your accounting courses are worth it. It's going to pay you dividend down the road. Study hard and stay safe.