Lesson Objectives:- Types of loss situations
- When to record journal entries for loss
- Which accounts are used to report loss
Let's finish out the concept of revenue recognition by reviewing losses with the completed contract method. Again, as we reviewed in the last lesson, this method is used for private companies under GAAP standards when there is uncertainty around the costs and collectability of the contract.
When we see losses in gross profit when using this method, it differs from the percentage of completion and other revenue recognition methods because revenue and expenses are not reported until the contract is actually completed.
Next, let's review the two types of losses that a company can encounter: loss in a period and loss on the entire contract. We will start with loss in a period.
Since the completed contract is very conservative, if there is a loss showing in the gross profit figure for a certain period, it is not reported, assuming that the contract is still profitable at the time of completion.
I won't go through the whole cost template again, but an example of a loss in a period would be if there were a loss of $200,000 in 2013 but the gross profit figures for 2014 and 2015 were positive. In this case, the contract would still be in a profitable position so we would not need to record a journal entry for the loss when using the completed contract method.
If there is loss in a period but not on the contract, we have nothing to record. Although if the company is seeing a loss on the contract, they will need to be transparent about the loss.
When there is a overall loss on the contract, this means there is a negative gross profit figure showing at the end of the contract. Essentially, the costs exceed the price of the contract. The company would need to record the difference between the price of the contract and the total estimated cost in order to show the overall loss on the completed contract.
For example, if there is a $500,000 loss on the contract, the company will need to use a journal entry to record the loss. The debit of $500,000 would be recorded on the loss on contract account and the credit of $500,000 would be recorded on the construction in process account.
The concept of reporting loss using the completed contract method is pretty straightforward; we only need to record journal entries if the entire contract is in a losing position. If there is a loss in a certain period, we are not required to report it because the revenues and expenses are only recorded when the contract is completed. When the contract is still profitable at completion, the loss in the period will not be reported.
In the next lesson, we will start reviewing the concept of depreciation.