 Hello and welcome to this session in which we will discuss the concept of contract asset and contract liability. Now from the word contract usually what we are dealing with is construction contract or long-term project. It doesn't have to be construction but some sort of a project that's going to take several years and that's why the word contract is there because usually when you have a long-term project you will sign a contract between two parties and as a result we could have a contract asset or a contract liability. Now the best way to illustrate this concept of contract asset and contract liability is to walk you through an example illustrating how these accounts come into place, how these accounts such as contract asset contract liabilities are created. So let's assume I entered into a non-cancelable agreement and that's important non-cancelable to build the customized equipment for half a million and the customer is Adam company. So that's the deal. The agreement stipulate that I will receive 20% after signing the agreement. So after I sign the agreement Adam will have to pay me $100,000. So what's going to happen is this I'm going to have to invoice Adam because otherwise the one's going to pay you unless you invoice them. So I have to invoice them. I have to create an invoice and send it to Adam for $100,000. Now although I invoice for $100,000 I did not do any work yet. Here we have the creation of a contract liability. I did not do the work yet but I invoice them but now I have the obligation to do the work. So think of contract liability. You can think of it as an earned revenue and you're going to see at the end of the day it looks and acts like an earned revenue but when I sign this contract and I send the invoice well what's going to happen is this I'm going to be expecting Adam company to send me $100,000. Therefore I will debit receivable $100,000 and I will credit a liability of $100,000. So what I did I said I have a liability now of $100,000. I expect Adam to send me a check of $100,000. Now a week 10 days later or the following day whatever that time is I receive the check. I receive that money from Adam company. What would I do then? I will debit the cash $100,000 and I will remove the receivable. So notice what happens. At the end of the day when all said and done all what I have left on my books for now is the cash for $100,000 sitting in the bank account and I have a contract liability so I want you to kind of make a T account about contract liability and put in there $100,000. I don't have to tell you it's a liability. It says right there contract liability but that contract liability is for work needs to be performed. So what is a contract liability? So let's kind of define it a little bit more. It's the obligation. Now we have the obligation to do what? To do work for Adam company which is build the equipment to transfer goods or services to perform work and we already receive the fund or we have an unconditional promise to get the money before start the work, before starting the work. So this is what a contract liability is. We have an obligation. We either receive the fund or we have unconditional promise and that's why I emphasize the word non-cancelable agreement to tell you there is a promise and that promise is unconditional. We expect to receive the money, the agreement is signed and it's legally enforceable. So this is how a contract liability is created. Now the next thing we're going to look at is what's going to happen to the contract liability and how do we create a contract asset as part of this example. Before we proceed any further I have a public announcement about my company farhatlectures.com. Farhat accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions as well as exercises. Go ahead start your free trial today no obligation no credit card required. Now let's take a look at how a contract asset is created. Now remember I signed the agreement and I started the work and here's what I did. I'm going to incur costs, I incurred costs, I hired people, I hired contractors, I bought material, I bought supplies because I need to build that piece of equipment and overall for the first quarter I incurred $120,000 in cost. Remember the client already paid me 100,000 that's fine I am grateful for Adam but I had to incur more cost well I cannot build the client yet for the additional 20,000 they paid me 100,000 because I needed to work I needed to start the work but I incurred more cost I am not if I need material if I need supplies I'm not gonna wait I'm gonna have to incur that cost because I know I'm gonna get this money later but now says I incurred more than what I received I cannot build the client yet now why can't I build the client for that additional 20,000 it could be many reasons it could be part of the agreement I have to wait until the project is done that's a condition or it could be I can only build them on a yearly basis no I just I just finished the first quarter I have to wait until a year from the signing of the agreement or it could be I need to reach a certain milestone like for example 50% done of the work before I can build them for the additional funds whatever it is there is a condition and I cannot build the client that additional 20,000 now bear in mind I have to debit a total of 120 total of assets because this is how much I incurred so let's kind of keep on going remember I already did 120,000 worth of work and we're gonna assume this is all kind of revenue the 120,000 it's all revenue it could be more than 120 but let's assume it's 120 now the first thing I'm gonna do since I perform the work I'm going to debit my contract liability remove my liability for 100,000 and record 100,000 in revenue remember the contract liability that was created on the prior slide I told you to create a contract liability of 100,000 contract liability now I removed it I did the work I did this 100,000 worth of work for the cash that the customer paid me I'm gonna go a step further and tell you what's gonna happen to the cash remember they gave me 100,000 dollar in cash with that cash I bought material supplies and what I did for that I debited the asset I debited an asset account for 100,000 and I credited the cash because I'm assuming I'm building some sort of an inventory for Adam therefore I debit the asset so that's why whether it's material supplies payroll it's all debiting some sort of an asset so this is how I use the money how I use the money now I still have $20,000 because remember I build them for an additional $20,000 because I did I did the work I incurred the cost now the cost could be cash could be payable it doesn't really matter what do I do with this additional $20,000 that I cannot build the client yet so this is where contract asset comes into place I'm gonna have to debit contract asset which is unbilled account receivable if I can build them if I can build them it's easy if I can build them I will debit the account receivable the account receivable that we know and I credit sales revenue or just revenue let's keep it consistent revenue but I cannot debit account receivable because I cannot if I invoice them they're gonna be angry they're gonna be mad they're gonna be like well this is not the deal well you can bill me you know once 50% is done but I need on my books I need to to know how much do I still have of unbilled account receivable I know I'm going to receive the money because there's a condition that's the only thing that's stopping me from billing them therefore I'm gonna have to debit an account called contract asset $20,000 and I will credit revenue because I did the work so notice $100,000 of revenue $20,000 of revenue I have revenue of 120 now the revenue could be higher I just said I incurred 120 of course and I may assume it's revenue the revenue could be higher but the point is we don't have to worry about the amount of revenue specifically for now but I credit revenue so notice how the contract asset is created now once I can build them so let's take let's take this step further so you understand where this is gonna go once I can build the client let's assume I call the client said look I incurred additional $20,000 I would you mind if I bill you for that and if the customer said yeah sure why not go ahead and bill me for that if I can build them I'm gonna debit account receivable $20,000 and I will remove the contract asset of $20,000 so this asset is removed because now I can build them then once I receive the cash from them for that $20,000 I debit cash $20,000 and I will credit receivable $20,000 and voila account receivable is gone contract is gone all what I have left is cash of $20,000 revenue of $20,000 this is just taking it to the next step just to show you what's gonna happen to all of this information all of these accounts so what is a contract asset well simply put we have the right we how do we have the right we have some sort of a non-cancelable agreement to receive funds in exchange for goods and services we have that right and we already performed the work but for some reason for some condition we cannot build the client at this time that's fine if we cannot build the client at this time because there's a condition guess what on our books we're gonna have a contract asset and we're gonna record the revenue but we cannot build the client it's not an account receivable now bear in mind if the condition to build the client has to do with the passage of time in other words the condition is that as time goes by I can bill you and as time goes by I can bill you then it will be receivable so just bear that in mind in case you get a multiple choice question about this but this is basically in a nutshell contract asset and contract liability I might work another example but this in this illustration I wanted to explain it how does it all come into how the how is it like how is it created or born how a contract liability is born for what reason how a contract asset is born and how does it go away what should you do now go to far hat lectures look at additional resources mcq's through false that's going to help you understand the revenue recognition contract asset contract liability IFRS 15 so on and so forth or the US standards for revenue recognition good luck everyone study hard and of course stay safe