 Hello and welcome to the session in which we would look at a CPA simulation that deals with percentage of completion method and the completed contract method. Yes, this topic is still tested on the CPA exam. So, in this session, I will show you how to approach these problems. There's a lot of journal entries. You want to make sure you are comfortable solving these problems with before walking into the exam day. Before I start, I would like to remind you to check out my website, farhatlectures.com, where I have additional supplemental material about your CPA exam. I don't replace your Wiley, Glyme, Roger, Sgt. Becker or whatever course you are taking. I am just an addition. I can add resources. I can add 10 to 15 points to your CPA exam. I explain the material in depth in contrast to the CPA prep companies because that's not their job. Their job is to review the material. They assume you already learned it in college. In addition to my CPA material, I have accounting courses that if you're taking an accounting course, you want to check out my website for additional resources. Make sure to connect with me on LinkedIn, subscribe to my YouTube, share it with others and connect with me on Instagram and Facebook. Let's go ahead and start to dissect this problem and see how we would approach this problem on the CPA exam day. Adam Corporation uses the percentage of completion method to account for work performed under long-term construction contract. Adam began work under the contract, this contract number, which provided a contract price of $3,645,000. Simply put, this is your total revenue. On the CPA exam, don't expect total revenue to change. It could change, but I doubt it. What you would expect to change throughout the life of the contract is the cost. Now, in this problem, in this CPA simulation, I will not change the cost because once you change the cost, this is where it gets a little bit more complicated and sometimes you may, so what could make this problem complicated? Let me explain it to you. Usually, they don't change total revenue. What they would change in the problem is the cost. For example, the cost was initially $2 million. Then they may raise the cost to $2.2 million throughout the contract. This one potential complication they could give you and the other two potential complication that they could give you in a percentage of completion and make it really, really more challenging to you is once they increase the cost, you might incur a loss. Now, this loss could be a loss in one year, which is kind of a loss in one year, then you're going to have gains again in future years or a loss for contract and you're going to have to deal with those two different scenarios. Now, in this problem, I don't go into this depth because that's not the purpose of the problem. The purpose of this problem is to make sure you are familiar with the basic concept. If you want to learn about the losses, go to my website, forhatlectures.com, where I have additional exercises and explanation for these type of scenarios. So in this scenario, it should be pretty straightforward. You want to make sure you're comfortable with the basics before you go into in-depth explanation. So this is what we have, the data that we have for 2020 and 2021. Cost incurred during the year. So be very careful how cost is giving because cost could be giving as incurred during the year or it could be cost incurred to date. Those are two different things. Cost incurred to date, it means it's a cumulative cost that includes cost from prior years. In this problem, they're giving you each cost separately, 2020 and 2021 separately. So be careful if the information is giving cost to date or cost incurred during the year because it makes a difference because your cost, it's going to be your measuring stick. It's going to tell you how much revenue to recognize based on the cost incurred. So be careful. Then you are giving estimated cost to complete. How much left? 1.5 million and zero for 2021. Why? Because the project will be completed billing. How much did you build and how much did you collect it during the year? So this is the information that's usually giving in those type of problems. The first question reads, what portion of total contract price would be recognized as revenue in 2020 and 2021? I would say recognizing the revenue, in other words, knowing what revenue to recognize, what percentage of revenue is the key to solving these problems. So if you don't know how to recognize the revenue, then that's it. You can't do anything because if you don't know how to recognize the revenue, you're not going to know how to recognize the profit. If you don't know how to recognize the profit, you're going to have problem with your journal entry for the income statement. Now you could still be able to complete some balance sheet entries. Well, let's talk about this. So how do you compute how much revenue do you need to recognize? Well, it's all based on cost. So you have to know what is my cost incurred to date divided by total cost. So what is the cost that I incurred up to this point? Well, up to this point for 2020, I incurred 563,000. So it's 563,000. This is my cost incurred to date. And I'm going to divide this by my total. Let me put it this way, my most recent estimated total cost. Well, in 2020, my total cost is, for this project, is 563 plus 1.5 million. So let's compute the total cost to see how much another total cost. Well, let's compute the total cost. It doesn't matter yet. Actually, you know what? Let's complete the total cost because there's going to be a slight change. It's not going to make any difference to the basics. But let's go ahead and do it. So 563, 563,000 plus 1.5 million. So your total cost is 2,063,000. 2,063,000. This is your total cost. Now we're going to take 563,000 divided by 2 million and 63,000. So 563 divided by 2 million and 63,000. That's going to give us, my calculator is not working properly, that's going to give us a percentage of 27.29, 27.29%. Simply put, of this project, so simply put, if this is 100%, if this is 100% when you complete the project, you completed around, let's say this is 27.29%. This is what you completed. So what does that mean? It means you can recognize of the revenue 27.9. So the revenue is 3,645,000. You multiply it by 27.29% and that's your revenue for year 2020, which is 994,773. So now you answer the first question, how much revenue you would recognize in 2020. Also, it's not only you recognize this, you know that you completed 20s and that represent 27.29 of the project so far. How did you measure this? It's based on cost incurred today divided by the total estimated cost. Now for year 2021, because this is a two-year project, year 2021 because it's the following year, it's easy to complete this. So basically your total cost, your total revenue is this much, 3,645,000. In year one, you recognize 994,733. So what's left for year two or 2021 is 2,650,267. You could always do this for the last year of the project. If it's the last year of the project, you can take the total revenue for the project minus all the prior years because that's the last year. So the last year, what happened here is you completed what's left, which is the other percentage, which is whatever that percentage is 100% minus 27.29. You can only do this the last year. Now if you have three years then we'll have to do, let's assume you have 2021 and 22, then you'll have to complete what percentage in 2021 based on the formula that I showed you. Again, on my website, I do have this computation where you have multiple years. Now we know 2021, therefore we answered the first question. Now they want us to prepare a set of journal entries for 2020 under the percentage of completion method and under the completed contract method. Now the way I explain the percentage of completion method, you have two sets of entries. One set is for the balance sheet and one set is for the income statement. First, we're going to compute the balance sheet entries. Okay, so here's what you need to know. You incurred 563,000 of cost. How are you going to record this cost? Well, think about it. If you are a manufacturing company, if you are a manufacturing company and you are building a machinery or let's assume you are building inventory for that matter to sell. So you are building an asset and this is what you are doing now. Your long-term construction is you are building something that you are going to deliver. You are going to sell for this price. The price is already known. So what do you do when you incur cost? Well, cost is inventoried. It means it's an asset. Therefore, we debit construction and process, which is an inventory account and asset for how much? For the cost incurred, 563,000. What do we credit? Well, we credit what we incurred, whether it's cash, material, we bought it on account payable. So we credit the whatever we incurred. Also, so notice both of these accounts are balance sheet account. So this is how you record the cost incurred during the year. Now, you build the client billing during the year 580,000. So what do we do when we bill the client? Think about it. When I bill the client, I debit account receivable. I'm telling the client, please pay me for services that I did. So I will debit account receivable 580,000. Now, what do I credit after I debit account receivable? And you might be thinking right now, and rightly so, well, if I bill the client, I have to debit sales or I have to debit revenue. And in long term construction contract, you don't do that because I already told you the revenue will be 994, 994. But the revenue is 994, but you are billing them 580. So you don't credit sales or revenue. What you credit is you credit an account called billing on construction in progress. Let me explain to you why that's the case. Why that's the case. Why do you build this account? Look, you incurred, you spent 563,000, you are building an asset. And let's assume this is the asset. And for the money that you spent, you recognize this as an asset. So this is a, let's think of it, this is the building. Okay. This is, you know, this is the building. All right. I'm not really good at drawing, but think of this asset is the building itself. So you have the physical building in front of you. You are in control of it. You are recording this physical asset on the books. Now, when you bill the client, when you bill the client, you have another asset 580. Hold on a second. Now you have two assets for the same thing. You have an asset for the building, which is 563. An asset also called account receivable when you bill the client. Well, you cannot. So to remove one of the assets, which is the construction and process, what you need to do, you need to credit an account called billing on construction and process 580. So what type of account is that then? Well, guess what? This account is a contra to construction and process. And notice what you did. You bill the client. So CIP, let me show you, 563. And I'm going to put here billing on CIP is 580. Look, let's examine this. You bill the client more than the cost that you incurred. And that's possible because you need to buy material for future period. So notice what happened here. I just want to show you what happened here is, so now you have basically, basically you have an obligation. What is your obligation? Your obligation is to do more work because you bill the client 580 and you incurred only 563. So let's find the difference 580 minus 563. That's going to give us a negative 17. You have a liability of negative 17. So listen to me carefully. When billing is greater than CIP, which is in this situation, the difference is a contra liability. Now what happened if CIP is greater than billing? Let's assume you have CIP of 563 and you bill the client only 560. Then you have three positive. Billing is more than CIP is a current asset. So this is a current liability. The three is a current asset and you could be asked about this on the exam. So make sure you know the difference. Again, this is what I go over on my website explaining the details of this. I just want to show you this. So what you did now is rather than having two assets for this, you know, two account assets for the same item, now what's left is account receivable because this building, now it's a negative, you have an obligation to keep on building. So also both of these accounts are balance sheet account. This is an asset and this is a contra asset. Billing is a contra asset. You collected 525. That should be easy. You debit cash, 525. You credit account receivable, 525. So notice all those three entries, those what I call the balance sheet entries. So you have balance sheet entries and you will complete those balance sheet entries. Now at the end of the year for 2020, you will need to complete your income statement entries because you are going to recognize 994,733 of revenue. You are because that's what we started with because I told you that's the key. Therefore, and you incurred expense and you incurred and you build and you incurred expense of 563. So you're going to debit the construction expense 563. So notice the 563 is used in two different places. It's used here as an asset construction and progress 563. But remember this 563 was already eliminated from billing. Then you're going to debit construction expense for the same amount 563. You're going to credit revenue 994,733 from right here because you can recognize revenue. Now the difference between revenue and expense is profit. What are you going to do with the profit? Well, the profit is called construction in process. What you do is the profit is the difference between revenues. So notice what happened on the income statement. You're going to show revenues of 944,733 plus 563 which is construction expense. The difference is 431,733 and this is your profit or your gross profit for this year. What do you do with this gross profit? You're going to book this gross profit. You're going to take this gross profit and book it under construction and process. You're going to go back and debit construction and process. So what goes into the CIP account? So this is the CIP account. What goes into the CIP account? The cost plus the profit. The cost plus the profit. Now what's going to happen to the CIP account eventually? Your cost and your profit, your cost and your profit, think about it, your cost and your profit is your revenue. Your cost and your profit is the revenue. What happened at the end of the project, you're going to have the revenue as a debit here, the total revenue as a debit here. But also at the same time, you're going to be billing the client. You're going to be billing the client. What's going to happen? You're going to build the client for your cost and for your profit and you're going to have a billing equal to CIP. So at the end of the project, the CIP and the billing equal to each other and you close those two accounts against each other. Again, if you want a more detailed example, go to my website, but this is what you do. So this is what we do. So this statement here, this journal entry, I call it the income statement journal entry. So you have to record certain entries on the balance sheet and you should memorize these, not memorize them. You need to understand them, but if you are giving a problem like this on the CPA exam, you want to make sure you at least do the balance sheet entries correct. The income statement will be incorrect if you're, if this computation here, if your revenue is wrong, if your revenue is wrong, your income statement is wrong. At least get the points for the balance sheet accounts, because just basically straightforward entries, make sure you memorize them and know them. So this is how we prepare the journal entries for the percentage of completion. Now, they're asking you also to prepare the entries for the completed contract method. Well, easy. The completed contract method will have the same balance sheet entries. We'll have the same balance sheet entry. So the completed contract method will have the same, the same balance sheet entries. Then what happened under the completed contract method, you don't have for year 2020, you don't have the income statement entry, you don't have this entry. Why not? Because under the completed contract method, the idea of it is you don't recognize any revenue until the project is completed, until the project is completed. And when is the project completed? The project is completed in year 2021. Well, so in 2020, we don't have to worry about these entries. So what's going to happen in year 2021? In year 2021, you're going to have the total revenue, which is 3,645,000 as revenue. You're going to have the total expense. And notice your expense did, your total cost for the project did increase. Because remember, we thought we're going to incur the year 2, 1.5 million. We incur 1,765. Again, for these type of examples, go to my website. But the point is your cost did increase. So what you do, the difference between, so you're going to have, these will be your construction expense in year 2, construction expense, those two together. And this will be your revenue for year 2, 3,645. And the difference between them will be your gross profit or CIP, which will be close to billing. So again, this problem I would say, especially that we did only year one, pretty straightforward. You want to make sure at least your, look, if you're not comfortable with what I just showed you in this problem, it's like, this is as basic as it gets for percentage of completion. Okay. So what should you do? Again, I'm going to invite you to go to my website, farhatlectures.com for additional resources for your CPA exam. I do have this topic in depth covered. Once again, if you have, you might be saying, why would I go there? I do have my own accounting, I have my own CPA course. Yes, you do. I'm okay with that. You should have that. I don't replace that. I help you explain the material better, because on Wiley, Backer, Roger, they go real quick over these concepts. I don't. I teach you this material as this is the first time you are looking into it. And don't shortchange yourself for my subscription. Your CPA exam is a lifetime investment. You are investing now for the next 30 to 40 years of your lifetime. Study hard, stay safe. And that's the most important thing these days.