Source: Chapter 5, Intermediate Financial Accounting II
Tags: long-term contracts, percentage of completion, completed contract method, CIP, construction in progress, revenue over time, contract losses
Difficulty: Intermediate to Advanced | Prerequisites: Part 1 of these notes (Revenue Recognition Fundamentals); comfort with journal entries, debits and credits, and the income statement.
Long-term contracts (construction, defence, infrastructure) create a timing problem: the work spans multiple accounting periods, but the contract price is fixed at the start. How should revenue and profit be reported while the project is still underway? This section applies the over-time recognition framework from Part 1 to multi-year projects, focusing on the percentage-of-completion method, the completed-contract alternative, the journal entries that track costs and billings, and how to handle losses when a project goes over budget. This is one of the most heavily tested areas of Chapter 5.
Long-term contracts typically have one performance obligation and qualify for over-time revenue recognition. Under percentage of completion, revenue each period equals the contract price multiplied by the percentage complete to date, minus revenue already recognised. Costs flow through Construction in Progress (CIP), billings reduce CIP via a contra account, and losses must be recognised immediately once projected total costs exceed the contract price.
Construction in Progress (CIP)
A balance sheet asset account that accumulates construction costs (and, under percentage of completion, recognised gross profit) as work progresses. CIP can never go negative. Think of it as a running tally of everything the contractor has invested in the project, plus any profit recognised so far.
Billings on construction contract
A contra asset account that offsets CIP. It records the amounts billed to the customer as the project progresses. In simple terms, this is the invoicing side. It reduces the net CIP balance on the balance sheet.
Net balance (CIP minus billings)
If positive, reported as a current asset (the contractor has done more work than it has billed). If negative, reported as a current liability (the contractor has billed ahead of the work completed).
Percentage of completion
A method of recognising revenue over time based on the proportion of work completed. The percentage is calculated using a cost-based input measure: actual costs to date divided by total estimated costs. In simple terms, if you have spent 40% of the total expected costs, you recognise 40% of the total expected revenue.
Completed contract method
An alternative approach where no revenue or gross profit is recognised until the contract is finished. All costs accumulate in CIP and revenue is booked only upon completion. Think of it as the "wait until it's done" method.
Periodic loss
A loss that occurs in a single period on a project that is still projected to be profitable overall. This happens when costs in a given year exceed the revenue recognised for that year.
Overall (projected) loss
A loss projected for the entire contract, meaning total estimated costs exceed the contract price. The full anticipated loss must be recognised immediately in the period it becomes apparent, regardless of the revenue recognition method used.
Cumulative construction costs
All costs incurred from the start of the project through the current period. Calculated as: construction costs incurred this year plus construction costs incurred in all prior years.
Total estimated and actual construction costs
The sum of cumulative actual costs to date plus the estimated costs still needed to complete the project. By the final year, the estimated costs to complete drop to zero and this figure equals the total actual costs.
Three types of entries recur throughout a long-term contract. Record them as costs are incurred, billings are sent, and cash is collected.
Debit: Construction in Progress (CIP) for costs incurred during the year
Credit: Cash, Materials, Payables, etc.
CIP accumulates all costs related to the contract. It functions like a work-in-progress inventory account.
Debit: Accounts Receivable
Credit: Billings on Construction Contract
Billings on Construction Contract is a contra asset to CIP. It does not reduce CIP directly; instead, the two are netted on the balance sheet. If CIP exceeds billings, the net amount is a current asset. If billings exceed CIP, the net amount is a current liability.
Debit: Cash
Credit: Accounts Receivable
This is a straightforward collection entry and has no effect on revenue recognition.
This method recognises revenue over time based on the proportion of work completed each period. Long-term contracts often qualify because the asset has no alternative use and the seller has a right to payment for work done.
Percentage complete = Cumulative actual costs to date / Total estimated and actual construction costs
Where total estimated and actual construction costs = cumulative actual costs to date + estimated costs still needed to complete.
Revenue this period = (Contract price x Percentage complete to date) minus Revenue recognised in prior periods
The first term gives you cumulative revenue to date. Subtracting what was already booked in earlier periods gives the current-period amount.
Gross profit = Revenue recognised this period minus Construction costs incurred this period
Alternatively: Total expected gross profit x Percentage complete to date, minus Gross profit recognised in prior periods.
Debit: Construction in Progress (for the gross profit component)
Debit: Cost of Construction (for costs incurred this period)
Credit: Revenue from Long-Term Contracts (total revenue recognised this period)
The CIP balance under this method reflects cumulative costs plus cumulative gross profit, which together equal cumulative revenue recognised.
Robertson enters a $12 million fixed-price tunnel contract. Costs by year:
2016: $3m incurred, $6m estimated to complete
2017: $5m incurred, $2m estimated to complete
2018: $2.5m incurred, $0 estimated to complete
Year 2016:
Cumulative cost: $3m
Total estimated cost: $3m + $6m = $9m
Percentage complete: $3m / $9m = 33.33%
Revenue: $12m x 33.33% = $4m
Gross profit: $4m minus $3m = $1m
Year 2017:
Cumulative cost: $3m + $5m = $8m
Total estimated cost: $8m + $2m = $10m
Percentage complete: $8m / $10m = 80%
Revenue: ($12m x 80%) minus $4m already recognised = $5.6m
Gross profit: $5.6m minus $5m = $0.6m
Year 2018:
Cumulative cost: $3m + $5m + $2.5m = $10.5m
Percentage complete: 100% (no remaining costs to complete)
Revenue: ($12m x 100%) minus ($4m + $5.6m) = $2.4m
Gross profit: $2.4m minus $2.5m = negative $0.1m (a loss in the final period)
Under this approach, no revenue or gross profit appears on the income statement until the contract is finished. All construction costs accumulate in CIP during the project, and the full revenue and profit are recognised only upon completion.
This method is simpler but less informative. It is used when reliable estimates of progress cannot be made.
Debit: Construction in Progress (for the gross profit, i.e. the difference between contract revenue and total costs)
Debit: Cost of Construction (for total construction costs)
Credit: Revenue from Long-Term Contracts
As long as total construction costs remain below the contract price, nothing appears on the income statement during the construction years. The balance sheet still carries CIP and billings, but they net to an asset or liability position without any profit component.
Two types of loss can occur on a long-term contract, and the accounting treatment differs.
This happens when a single period's costs exceed that period's recognised revenue, even though the total contract is still expected to be profitable. Under percentage of completion, the loss for that period simply flows through the normal calculation: revenue minus cost of construction for that year.
This occurs when total estimated and actual construction costs exceed the contract price. The entire anticipated loss must be recognised immediately in the period the loss becomes apparent.
How to identify a projected loss: if total estimated costs (cumulative actual costs plus estimated costs to complete) exceed the contract price, you are projecting a loss.
First, calculate the cumulative loss: total estimated costs minus the contract price.
Then, determine the current-period loss: cumulative loss minus any gross profit (or plus any loss) already recognised in prior periods.
Example: if gross profit in 2016 was $500,000 and the cumulative loss by 2017 is negative $100,000, then the 2017 loss must be negative $600,000 (because $500,000 minus $600,000 = negative $100,000).
In Year 1, gross profit is $0 (no income statement recognition when the project is expected to be profitable).
If a projected overall loss emerges in Year 2, the company must immediately recognise it:
Debit: Loss on Long-Term Contracts (gross loss)
Credit: Construction in Progress
The loss equals the total estimated costs minus the contract price. The CIP balance is written down to reflect this projected loss.
The exam will typically ask for revenue recognised, construction cost recognised, or gross profit recognised. Revenue is always calculated the same way regardless of whether the project is in a profit or loss position. For gross profit, you must first check whether the project is profitable or in a loss position:
If profitable: gross profit = revenue minus cost of construction for the period.
If in a loss position: calculate the cumulative loss first (total estimated costs minus contract price), then subtract any prior gross profit to find the current-period loss.
Percentage complete:
Cumulative actual costs to date / (Cumulative actual costs to date + Estimated costs to complete)
Revenue recognised this period:
(Contract price x Percentage complete to date) minus Revenue recognised in prior periods
Gross profit this period (profitable project):
Revenue recognised this period minus Construction costs incurred this period
Gross profit this period (alternative formula):
(Total expected gross profit x Percentage complete to date) minus Gross profit recognised in prior periods
Where total expected gross profit = Contract price minus Total estimated costs
Cumulative construction costs:
Construction costs incurred this year + Construction costs incurred in all prior years
Total estimated and actual construction costs:
Cumulative actual construction costs + Estimated costs to complete at year end
Projected loss test:
If total estimated and actual construction costs > contract price, a loss is projected.
Cumulative loss amount:
Total estimated and actual construction costs minus Contract price
"CIP can go negative." It cannot. CIP is an asset account that accumulates costs and (under percentage of completion) recognised profits. If a projected loss arises, the CIP balance is written down but never below zero.
"Billings reduce CIP directly." They do not. Billings on Construction Contract is a separate contra asset account. CIP and billings are netted for balance sheet presentation, but they are maintained in separate ledger accounts.
"Under completed contract, you never recognise a loss until the project is finished." Wrong. If a projected overall loss becomes apparent in any year, it must be recognised immediately, even under the completed contract method.
"Revenue calculation changes when a project is in a loss position." Revenue is always calculated the same way (contract price x percentage complete, minus prior revenue). What changes is the gross profit calculation, which must account for cumulative losses.
⚠️ Expect a multi-year construction problem. You will need to calculate percentage complete, revenue, cost of construction, and gross profit for each year.
⚠️ Know the three journal entry types cold: recording costs (debit CIP), recording billings (debit A/R, credit billings), and recording collections (debit cash, credit A/R).
⚠️ The revenue recognition entry under percentage of completion (debit CIP and cost of construction, credit revenue) is heavily tested.
⚠️ Be prepared to identify whether a project is in a profit or loss position before calculating gross profit. The approach changes depending on the answer.
⚠️ Projected overall losses must be recognised immediately, even under the completed contract method. This is a common trick question.
⚠️ Memorise the formulas. The exam tests application more than interpretation.
True or False: Under the completed contract method, revenue is recognised each year based on costs incurred.
False. No revenue is recognised until the contract is completed.
Fill in the blank: Percentage complete = cumulative actual costs to date / ______.
Total estimated and actual construction costs (i.e. cumulative costs + estimated costs to complete)
True or False: If total estimated costs exceed the contract price, the projected loss must be recognised immediately under both percentage of completion and completed contract methods.
True.
Fill in the blank: CIP minus Billings on Construction Contract, if positive, is reported as a ______.
Current asset
True or False: Revenue calculation changes when a project enters a loss position.
False. Revenue is always calculated the same way. Only gross profit changes.
Q: A contractor has a $700,000 fixed-price contract. In Year 1, costs incurred are $100,000 and estimated costs to complete are $400,000. What is the percentage complete and revenue recognised in Year 1?
A: Percentage complete = $100,000 / ($100,000 + $400,000) = 20%. Revenue = $700,000 x 20% = $140,000.
Q: Using the same contract, in Year 2 the contractor incurs $500,000 in additional costs and estimates $200,000 to complete. What are the percentage complete and revenue for Year 2?
A: Cumulative costs = $100,000 + $500,000 = $600,000. Total estimated costs = $600,000 + $200,000 = $800,000. Percentage complete = $600,000 / $800,000 = 75%. Revenue = ($700,000 x 75%) minus $140,000 = $525,000 minus $140,000 = $385,000.
Q: What is the journal entry to recognise revenue under percentage of completion in Year 1 of the $700,000 contract (revenue $140,000, costs $100,000)?
A: Debit Cost of Construction $100,000. Debit Construction in Progress $40,000 (the gross profit). Credit Revenue from Long-Term Contracts $140,000.
Q: A project has recognised $500,000 in gross profit in Year 1. In Year 2, total estimated costs now exceed the contract price, and the cumulative projected loss is negative $100,000. What gross profit (loss) should be recognised in Year 2?
A: The Year 2 loss must be large enough to swing from the prior $500,000 profit to a cumulative loss of negative $100,000. So the Year 2 loss = negative $600,000.
Q: Under the completed contract method, when is an overall projected loss recognised?
A: Immediately, in the period the loss becomes apparent. Even though revenue and profit are normally deferred until completion, a projected overall loss cannot be deferred. It is recognised as soon as total estimated costs exceed the contract price.
This material builds directly on the five-step revenue recognition model from Part 1. Long-term contracts apply Step 2 (typically one performance obligation) and Step 5 (over-time recognition) in their most detailed form.
The CIP account connects to your understanding of inventory and work-in-progress from earlier accounting courses. The netting of CIP against billings introduces a balance sheet presentation concept that also appears in lease accounting (right-of-use assets vs lease liabilities).
Loss recognition rules here parallel the broader principle of conservatism in accounting: losses are recognised when probable, gains only when realised.
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