Question

What are the two types of losses that can become evident in accounting for long-term contracts? What is the nature of each type of loss? How is each type accounted for?

Short answer

In long-term contract accounting, there are two types of losses that might occur:

(1) A loss suffered in the present time as a consequence of a transaction that was not profitable

(2) A loss incurred due to a deal that was not profitable.

Step-by-step solution

Meaning of Long-Term Contract

A long-term contract is one in which you agree to work for someone else for a lengthy period. Because the parties will never need to update or renegotiate the contract as the future unfolds, a long-term contract is also considered complete.

Long-term contracts, such as construction projects, are multi-year contracts. The earnings process for these contracts spans numerous accounting periods. The final result may not be delivered for years after the project began.

Explanation for two types of losses, their nature and accounting type

There are two sorts of losses that might appear in long-term contract accounting:

(1) a current period loss in a contract that is anticipated to yield a profit when completed

(2) A loss incurred due to a deal that was not lucrative.

In the current quarter, the first type of loss is an adjustment to gross profit achieved on the contract in earlier periods. When the estimated total contract costs rise significantly during construction, the increase does not wipe out all contract profit. The predicted cost increase necessitates a percentage-of-completion approach current period adjustment of previously recorded gross profit, resulting in recording a current period loss. The completed-contract method does not require any changes because gross profit is only recorded once the contract is concluded.

After the present term, cost predictions may indicate that the entire contract will be a loss. The entire loss must be documented in the current period using both the percentage of completion and the completed-contract method.