Revenue Recognition

Question 1

Barr Corp. started a three-year construction project in Year 1. The following data relate to this project:

Contract price $4,200,000
Costs incurred in Year 1 1,750,000
Estimated costs to complete 1,750,000
Progress billings 900,000
Collections on progress billings 800,000
Progress on the contract is measured based on costs incurred and revenue is recognized as the performance obligation is satisfied. What amount of gross profit should be reported for this project in Barr's Year 1 income statement?

A. $100,000 [7%]
B. $300,000 [2%]
C. $350,000 [85%]
D. $450,000 [4%]

Answer 1

Recognizing revenue over the course of long-term construction contracts is logical when the work that generates the revenue is performed over the term of the contract. Because revenue is recognized as the performance obligation is satisfied (ie, over time), there must be some means of measuring progress toward completion.

In this scenario, an input method called the cost-to-cost approach is used. Under this method, the costs incurred to date are compared with the total estimated costs of completing the performance obligation; the resulting ratio is the percentage complete. The percentage complete can be used to calculate the current revenue and profit if the contract is profitable.

Year 1 gross profit is $350,000, calculated as follows:
Contract Price- Total estimated costs=total contract profit
Costs incurred to date/Total estimated costs=Percent contract completed
Total contract profit x Percent contract complete= Total profit to date
Total profit to date - Profit previously recognized = current profit recognized

Question 2

The following data pertains to a company’s long-term contracts, which commenced during Year 2:

Project 1 Project 2
Contract price $420,000 $300,000
Costs incurred during Year 2 240,000 280,000
Estimated costs to complete 120,000 40,000
Billed to customers during Year 2 150,000 270,000
Received from customers during Year 2 90,000 250,000
If the company recognizes revenues and costs from contracts at a point in time, what amount of gross profit (loss) would the company report in its Year 2 income statement?

A. $(20,000) (44%)
B. $0 (35%)
C. $340,000 (15%)
D. $420,000 (4%)

Answer 2

Revenue from long-term contracts can be recognized using two different approaches. Recognition at a point in time involves recognizing revenue when the customer fully controls the performance obligation (usually when the contract is complete). Long-term contracts are measured only at a point in time when they do not qualify to be measured over time. When an entity engages in multiple long-term contracts, the profit or loss from each will be added or netted together for financial statement purposes.

The company will report a loss from the contracts of $20,000, calculated as follows:

Project 1 Expected profit (loss) on contract $420,000 − $360,000 = $60,000
Project 2 Expected profit (loss) on contract
$300,000 − $320,000 = ($20,000)

Profit (loss) recognized $0 ($20,000)
Because Project 1’s contract is not complete (costs of $120,000 are required to finish the project), the performance obligation has not been satisfied, and none of the contract’s profit is recognized in Year 2. However, no matter the approach used to recognize revenue, losses from long-term contracts are always fully recognized in the earliest period in which they are expected and can be estimated. Because Project 2 is expected to result in a loss, the entire loss will be recognized (Choice B).