 Hello and welcome to the session in which we would look at the percentage of completion method or also known as contract accounting. Now most revenues is recognized at delivery. What does that mean? It means you walk into a store, you buy something, they deliver the product to you, you pay for it, that's what revenue is. Or a company deliver product to another company, basically inventory supplies and the revenue is recognized. Time revenues can be recognized before the final delivery. What does that mean? It means before you deliver all what you're supposed to deliver, a company can recognize, can record some of that revenue. This is where the percentage of completion method comes into place. It's when we can recognize that revenue before the final delivery. What could be some examples where you would use the percentage of completion method? Now bear in mind, there are certain conditions to be able to use the percentage of completion method, we're going to talk about them on the next slide, but think about when a company is constructing a high-rise building, hotel, landmark, it may take several years or you're building a highway or you have a contract to build airplanes. When you have such project, the company might be able to recognize revenue before delivery and there are two methods for contract accounting. One of them is percentage of completion, which is using the percentage of completion method or using the completed contract method. Well in this session, we will focus on the percentage of completion method because once you understand the percentage of completion method, the completed contract method is very easy to understand. Now you need to know the rules. When do we use the percentage of completion method? Well, there are specific rules. First is you must be able to estimate the progress toward completion. So simply put, since you have a long-term project, you have a long-term contract. Can you estimate how far you are into this project? How do you estimate? You need a measuring stick. You need some sort of a measuring stick, that's what it is, a measuring stick. A measuring stick means can you measure your progress toward completion? Well most companies use what's called the cost, cost to total cost. So they would use, they would estimate how much cost they will need to complete the project and as they incur cost, they will use the cost as a measuring stick. Therefore, you have to be able to reasonably estimate the cost of the project and so notice plus all. So yes, you have to be able to estimate cost and you have to have to meet other conditions. What are those three other conditions? One is you have to have an enforceable and a clear contract. Simply put, in the contract, rights and obligation are clearly spelled out, including consideration. What are you going to be getting? What are your rights? What are your obligations in that contract? And obviously the contract cannot be easily cancelable. In other words, once you sign this contract, it's not easy to get out of it. That's why it's called enforceable, there's a step penalty if you do so. It's not worth it. Also the buyer is expected to make payments to satisfy the obligation. So when you started long-term construction, if the buyer, if you don't expect the buyer to be able to make payments, well, that's not really revenue, therefore, you cannot use the percentage of completion method. So the buyer can satisfy the obligation, well, also the seller is expected to complete their obligation to satisfy the obligation under the contract. So both the buyer and the seller can meet their obligation. Again, you can estimate cost in those three conditions exist. You can use the percentage of completion method, which is recognizing revenue before delivery. Now when would you use the completed contract method? Well, if the project is a short-term project by its nature, it's not a contract, it's not long-term construction, you cannot use the percentage of completion. So it's less than a year, you cannot use percentage of completion. The contract failed the percentage of completion conditions, which is what? Any of these conditions, any of them, if you fail them, then you cannot use the percentage of completion method. It's as simple as that. Or sometime what's going to happen is this, the contract, you can meet all of those, but the contract has inherent risk beyond the normal reoccurring risk. For example, you could have a political risk, you might be faced with some natural disaster, you really cannot predict this, but it could happen. But what is a political risk? Think of Iran and getting into a contract in 2015 with Airbus and Boeing to buy 100 airplanes for their national airline company. Well, they signed the contract. Maybe they can estimate, Boeing and Airbus, they can estimate the cost and everything. However, Iran is subject to economic sanctions. What does that mean? It means at some point, the U.S. administration might tell U.S. companies, you can no longer do business with Iran, and that's exactly what happened. Therefore, there is an inherent political risk in this contract. So what would Boeing have to do? They will have to wait. They will have to wait. They cannot recognize their revenue as a percentage of completion. And this is what we meant by there's an inherent political risk or some sort of a risk beyond the normal business risk. So that's beyond the normal business risk. Now, what is the measuring stick? It's very important to understand how to use the measuring stick. Again, the most common one is cost to total cost. I said the most common, I didn't say the only one. Anyway, you can measure your progress. For example, if you're building a highway, you can measure your progress. If you have a 100 miles highway, you can measure your progress as you complete part of that highway. If you completed 20 of the 100 miles, you are 20 percent in. Therefore, you are able to complete, you are able to estimate your degree of completion as well as other measurement method as well. So when we're using cost to total cost, the first thing you have to do, the first thing you have to do is you have to find the percentage completed to date. That's the first step. How do you find the percentage completed to date? Well, you will take your cost incurred to date. And I keep emphasizing the word to date and you're going to see why divided by the most recent estimate of total cost. So you would look at how much cost you incurred up to this point in this project. And what is the total cost, the most recent estimate? And the reason I say the most recent estimate because your cost for the project could change. Don't worry, we will work an example. Then you will find your percentage complete. So you will first, you find how much am I in, what's my degree of percentage of completion? Step two, you will take this degree of percentage completed which you computed in step one in the first step and you multiply this by total revenue. Now you could multiply it by total revenue. You can multiply it by gross profit for the project. I'm going to use total revenue, but bear in mind your textbook or your CPA review course or whatever you are using, they could multiply it by gross profit. And you're going to see what the gross profit is in a moment. I will mention it. Then you know that you could use gross profit. So every time the word revenue appears, you could replace it with gross profit, but I will use revenue because I want to give you the complete picture. Once you take the percentage of completed, the percentage completed in step one, multiplied by total revenue, you're going to come up to your revenue to be recognized to date. How much revenue you should recognize to date up to this point? Then step three, you will take your revenue, recognize the date. And you subtract any revenue recognize in prior periods of this is year one. The prior period will be zero to come up with your current period revenue. Current period revenue means what? How much revenue you can recognize to date? So notice you have to complete step one. You have to take the information from step one to build your step two. Then from step two, you build step three from revenue to be recognized to date. Well, that's a lot of information. The best way to illustrate this is to look at a simple example first. And the reason I say simple example because first to get to learn how to complete the percentage of completion, start with a simple example. Although you may not think it's simple, but you're going to see, we're going to start with a simple example, then we'll work few other examples where it's involving losses and changing the more changing an estimate. But before we look at the example for the percentage of completion, 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 if you are studying for your CPA. That's great. You can keep it. I don't replace your accounting course. My motto is saving accounting students and CPA candidate one at a time. By providing resources, lectures, lessons, multiple choice, true, false, exercises. This is a partial list of my accounting courses. My CPA review material is aligned with your Becker, Roger, Gleam and Wiley. So it's very easy to go back and forth between my material and your CPA review course. I do give you access to 1500 previously released AI CPA questions with detailed solution in their original format. If you're a CPA candidate, you don't want to miss those. 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, Facebook, Twitter and Reddit. So let's take a look at this example to illustrate the concept. Adam Construction Company has a contract to construct a $1 million highway at an estimated cost of 750,000. Well, that looks like a really not an expensive highway, but it doesn't matter. You can ignore the reality of it. The contract is to start March 20 X1 year one and the highway to be completed December X3. So it's going to take year one, year two and year three, three years. So let's take a look at what we have at this point and start to analyze this contract. So the contract that will pay us a million dollar for the whole contract. Our cost is estimated to be 750. So the first thing is we can estimate our cost and we're going to assume this is what the government and we're going to assume we have enough resources to complete this project. So simply put, the government will always pay. We have enough resources. We can estimate the cost. We can use the percentage of completion method. And as of right now, our estimated gross profit for this project is 250,000. So make a note of this. So we estimate to make a profit from this project, quarter of a million, over a period of three years. Now, obviously we're going to have other projects running at the same time. That's not the only project, but this is one of the projects we're going to be working with. Let's start to look at the data that we are giving. This is the data for X1, year one, year two, and year three. So first I'm going to explain every piece of information on this slide because you don't want to start unless you understand what you are giving. Here's what you are giving. You are giving cost to date. For year one, you spend 250,000 on cost incurred cost. Then you are giving estimated cost to complete the project. Well, I incur 200,000. My estimated cost is 550 to complete. So notice my total cost is I expected 750,000 as of year one. In year one, I build the government, the county, the state, $175,000. The government paid 140,000. So this is what you are giving. In year two, cost to date is 500,000. And this is cost to date. What does that mean? It means if I ask you, how much cost you incurred in year two? Well, you incurred in year two 300,000. How? Well, cost to date is 500,000, but you already incurred 200,000 from the prior year. It means your cost in X2 is 300,000. Why am I mentioning this? Because in your course or on the CPA exam, you could be given cost to date or just cost. There's a difference between cost to date or just cost. Here, I'm giving you cost to date. Therefore, you have to figure out how much cost you incurred in X2. Now, in X2, here's what's going to happen. You went from 500,000 cost to date. Your estimated cost to complete the project is 300,000. Hold on a second. What happened to my cost? Now, my total cost for the project is $800,000. Wow. Yes, do you see what happened? My cost went up. Why? Could be many reasons. Could be my employee went on a strike. I had to hire employees and pay them higher rates. The material went up in cost. Something happened. My cost went up. It means now my gross profit, it's going to go down to 200,000. And we're going to see how this worked. Then I built the client, then I collected the cash. So this is the information that you are giving. So make sure you know what information you are giving first. Now, we're going to go ahead and first complete our degree of completion. Remember, the first step is you want to know, OK, I have my cost. Can I measure my degree of completion for every year? Let's start with year one. My year one, my contract price is a million. It doesn't change. Cost to date is $200,000. Estimated cost to complete the project is $550. My total cost is $750,000. That's the most recent estimated total cost. And my gross profit right now is $250,000 because my project will earn me a million. The cost is $750,000. My gross profit is $250,000. Now I need to compute my percentage of completion. This is what I'm trying to complete. Well, it's my cost to date. The formula is cost to date divided by the most estimated cost. So $200,000 divided by $750,000. In year one, I completed 26.67% of the project. Well, let's do year two and year three. In year two, my contract price doesn't change. Cost to date is $500,000. My estimated cost to complete the project is $300,000. My total cost went up to $800,000. Now my gross profit starting in year two, it's gonna go down to $200,000 for the total project. Now I need to compute my degree of completion as of year two. Well, it's cost to date $500,000 divided by the total most recent estimated cost of $800,000. Therefore, my degree of completion is 62.5%. So $500,000 divided by $800,000. Year three, my contract price doesn't change. My cost to date is $800,000. That's it, I no longer have any cost to complete. I complete the project in year three. So cost to date divided by the most recent estimated total cost, $800,000 divided by $800,000. I completed 100% of the project and my gross profit is at $200,000. Now we're gonna take a look at my balance sheet entries and I'm gonna emphasize the word balance sheet because we're gonna have balance sheet entries and income statement entries. This is the percentage of completion method. Okay, how do we record our entries on the balance sheet? Again, you're gonna be introduced to new accounts, new concepts, so please pay attention to everything I'm gonna be doing here because it's critical to your understanding the journal entries as well understanding the whole process of construction contract. Okay, so in year one, I incurred $200,000 in cost. Here's what I'm gonna do. For my cost incurred, I'm gonna debit an account called construction and process. This is specifically an asset and specifically an inventory account. So CIP, this is a new account. You're not familiar with this yet. So CIP, construction and progress, construction and process, it doesn't matter, I will be abbreviating this as CIP going forward. So for your cost, you are gonna debit an asset account called CIP and you will credit whatever you incurred, material, cash, payable, whatever you incurred. So notice, all these accounts are balance sheet account, construction and process balance sheet, material, cash, payable balance sheet. I took care of this $200,000. I build the government $175,000. Well, when I build someone, I'm gonna debit account receivable. That's pretty straightforward. Usually when I build someone, I credit sales. Guess what? Under construction and process, you cannot credit sales. You are going to credit a new account called billing on construction, $175,000. Well, what type of account billing on construction? It's a contra CIP. So it's gonna be reducing this account, contra CIP. Why do I credit billing on construction and I don't credit sales? Well, here's what's gonna happen. When I spend the $200,000, I created an asset called CIP. So this is the asset. This is the asset. Then what I did is I build the client. I created another asset called account receivable. Hold on a second. So now just by spending $200,000, I have $375,000 in assets. Well, that cannot be the case because I only spend $200,000. How can I have assets worth of $375,000? So what I have is this. I have a $200,000 as a physical asset. This is a physical asset. This is what I spend. If you look at the highway, you can see $200,000 worth of work. That's a physical asset. Then the account receivable is a financial asset. I cannot keep both. I cannot keep both on my books, the physical and the financial. So what I would do against account receivable, I will credit billing on construction and billing on construction would reduce my CIP. So this is why I use, I have to use a new account called billing on construction which is a contrast CIP. Then the government paid me $140,000. I debit cash, credit account receivable. So those are the balance sheet journal entries for year one. So what I suggest you do is to pass for a second or a minute or whatever you need to and see if you can journalize the balance sheet entries for year two. Well, and by the way, as you are doing this, keep track using T account. So what you should do now have CIP have a billing account, have an AR account and keep track of your CIP billing and track and AR you're gonna see why. So make sure you keep track of your T accounts, especially the balance sheet account. Year two, what's gonna happen is construction and process, it's gonna be 300,000. Again, why 300,000? I mentioned it earlier. Your cost to date is 500,000 of which you already incurred 200,000. Therefore, CIP is debited 300,000. I credit material, cash, payable, whatever I incurred. Account receivable, I build 340,000. Debit account receivable, credit billing. We explain why you credit billing and the government paid 300,000. I debit my cash, credit my account receivable. For year three, I incurred cost to date 800,000. It means I already incurred 800,000 to date. Previously, I recognized 500,000 of it. Therefore, what's left is 300,000. So on year three, I also incurred 300,000. Debit CIP 300, again, keep track of your CIP. Credit material, cash, payable, 300,000. Then I build the government, 485,000. Debit AR, credit billing. The government paid 560. Debit cash, credit accounts receivable. So those are the journal entries that I perform on the balance sheet. Those are called balance sheet journal entries because all the accounts that are appearing, all six accounts are balance sheet accounts. It's very important to see how this balance sheet account appear on the balance sheet because we have some new accounts. Here's what's gonna happen. For year X1, you're gonna have account receivable of 135,000, which is 175 minus 140. You're gonna have CIP 200,000. Well, actually you're gonna have a different CIP. We'll see why later, but we can make the point here. You're gonna have CIP 200,000. Again, the billing is a contrast CIP, so CIP minus the billing will give us 25,000. So simply put, we have an asset called CIP an access of billing, a new account, which is CIP minus billing of minus billing will give us 25,000, and this is under current assets. This is what it appears on the balance sheet. Year X2, please pay attention here. Your receivable will be 75,000, which is, you know, you started with 35, you bill the client 340 minus 300,000, so basically you added 40,000 to your receivable. Your receivable should be 75,000 as of year two. Now pay attention to what happened in year two. Please look at this, look at see what happened here. As of year two, as of year two, if you look at your billing, at your total billing, and you compare your total billing to your total CIP, you have billings of 515,000 and you have CIP of 500,000. So what you did as of year two, you build the government more than the work you have completed so far, and this could happen because you needed to, you wanted them to pay you so you build them more, that's normal because you wanted to buy material. So when your billing is more than your CIP, guess what's gonna happen? This asset will turn into a liability. So notice in year one, you had CIP, CIP was greater than billing, it's an asset. In year two, billing is greater than CIP, you have a current liability. So in year two, it turned into a liability of 15,000 and that's why I told you to keep track of your CIP and of your billing. But don't worry, we're gonna see the full picture at the end. So now what we're gonna do, we're gonna look at the income statement account. So you're already familiar with this, you're already familiar with the percentage of completion. Now we are going to work on the income statement account. Remember in the prior slide, we looked at the balance sheet account, now we're gonna look at the income statement journal entries. First thing we have to figure out is how much revenue and cost to recognize on the income statement. Okay, here's what's gonna happen. For year X one, we're gonna take our total revenue times the degree of completion, which is 26.67%. We can recognize revenue of the one million, we can recognize 266,667 that's rounded. The cost we incurred in year one is 200,000 minus 200,000. We have a gross profit of 66,667, this is to date. Everything here I'm computing is to date, revenue to date, cost to date and gross profit to date. Then you're gonna deduct any revenue cost or profit recognize in previous years. Well, this is year one, we have nothing in prior years. Therefore, we recognize in year one, 266,667 in revenue, 200,000 in cost and gross profit of 66,667. Now we're gonna record the journal entries. These are the income statement entries and we're gonna see a closing entry at the end. These are the income statement entries. So here's what we do. For the revenue, we will credit 267,667, construction revenue, basically a revenue account that goes on the income statement. For the 200,000, we are going to debit construction expense, we spend 200,000 in expenses. And the difference between those is a profit, construction and process or CIP, 66,667. So there are two things that goes into your CIP account. Now you're gonna add to your CIP, your cost plus your profit, okay? So in your CIP for year one, it's gonna be 200,000 from the prior slide and 66,667 from this slide. So the cost and the profit is put into CIP, okay? Now, can you record the revenue for year two? I'll give you a minute to see if you can do that. And I hope you did that correctly. In year two, my total revenue is a million. I multiply it by the degree of completion of 62.5%. My total revenue is 625,000. That says my revenue to date. This column is to date. My cost to date is 500,000. My gross profit to date is 125,000. This is everything is to date. I'm gonna take to date, what I computed to date, then I'm going to subtract anything that I recognize in the prior year. What did I recognize in the prior year? I recognize this much. So what I'm gonna do, I'm gonna take 625, minus the revenue recognize in the prior year, 266,667. So my revenue to this year, 358,333. I'm gonna take my cost to date, deduct any cost recognize in the prior year. My cost this year is 300,000. Now, 358,333, minus 300,000 will give me a profit of 58,333,000. I'm ready to journalize my entry. My revenue is 358,333, which is coming from my revenue from this column. The cost is 300,000. And I put my profit, 58,333 in my CIP and my CIP account. Again, what I illustrated earlier, I showed you that billing was greater than CIP. Now, CIP reversed, but the point remain that if your CIP, if your billing is greater than your CIP, you have a liability. And that's why I did it earlier to show you that it's a liability. If at any point in time, your billing is greater than your CIP. Okay, so I did this on purpose earlier so you can see the point. You can see the point. But here too, you also put the profit, then it will reverse. Year three, the total revenue is a million. You have completed 100% of the project. Your revenue to date is a million. Your cost to date is 800,000. Your gross profit so far should be 200,000. We're gonna take all previously recognized revenue, which is previously recognized revenue is 625,000, year one and year two. We're gonna take all the previously recognized cost half a million. We're gonna take revenue to date minus any previously recorded, which gonna give us 375. Cost to date minus previously recorded of half a million. It's gonna give us cost 300,000. Revenue minus cost will give us profit of 75,000 for year three. For year three, we credit revenue 375, debit construction expense 300,000 and add the profit to our CIP account of 75,000. So all in all, now we recorded all the balance sheet account. Here's what's gonna happen. If you did what I asked you to do then you kept track of your CIP. You should have in CIP right now. Let me just put it in another place here. You should have in CIP. If you kept track of everything, you should have in CIP a million dollar. And if you kept track, as I told you of your billing account, you should have in your billing account a credit total of a million as well. Once the project is done, remember, CIP and billing is a contrast CIP. Guess what? The net effect is zero. So once the project is done, you would remove the project. You will debit billing for a million and you will credit CIP for a million to basically zeroed out both account. Even if you keep them, your net effect is zero. But the point I'm trying to show you is you build a client for the full amount for a million. Your CIP is a million, then you cancel them and you finish the project. You finish the project. So I wanna make sure you understand the step because if you can see the step then you understand the concept. So there's a lot, there's a lot. And this is a simple example. What could happen under the percentage of completion method is you could have where the project is originally profitable then it become not profitable or it could be profitable in some years and unprofitable in the others, okay? Now we kept this simple example. We kept simple. We did not change anything. We did not incur a loss. But bear in mind, you have to be able to work with examples where you could incur a loss in a particular year or you could incur a loss for the whole project. And we will work examples that deals with this. Even we can change this example a little bit to deal with it. But what should you do now? Go to farhatlectures.com, work MCQs and look at other resources that's gonna start to help you understand this concept. We're gonna look at the completed contract method, how it works. We're gonna look at the losses if you incur a loss in a particular year or if you incur loss for the whole project. There's a lot of practice questions about this topic on my website. Go ahead, subscribe, invest in yourself. Good luck, study hard and of course, stay safe.