Question

(Long-Term Contract—Percentage-of-Completion) Widjaja Company is accounting for a long-term construction contract using the percentage-of-completion method. It is a 4-year contract that is currently in its second year. The latest estimates of total contract costs indicate that the contract will be completed at a profit to Widjaja Company.

Instructions

(a) What theoretical justification is there for Widjaja Company’s use of the percentage-of-completion method?

(b) How would progress billings be accounted for? Include in your discussion the classification of progress billings in Widjaja Company financial statements.

(c) How would the income recognized in the second year of the 4-year contract be determined using the cost-to-cost method of determining percentage of completion?

(d) What would be the effect on earnings per share in the second year of the 4-year contract of using the percentage-of-completion method instead of the completed-contract method? Discuss.

Short answer

1. Percentage-of-completion method is appropriate because it will be suitable for meeting the criteria of recognizing revenue over time.
2. Progress billing will be reported by increasing the accounts receivables and billing on the contract account.
3. Business entity has to follow three steps for calculating recognized income using the cost-to-cost method.
4. The earnings per share will increase when the percentage-of-completion method is used.

Step-by-step solution

Definition of Contract

The contract can be defined as the agreement between the parties to complete obligations on their end. Such agreement between the parties is enforceable by law; therefore, they are charged with a penalty for non-completion.

Theoretical justification

The business entity must use the percentage-of-completion method for recognizing the contract’s revenue because this is the only method that will meet the criteria of recognizing revenue over the period.

Accounting for progress billing

Progress billing will be accounted for in the following manner:

1. Increasing the accounts receivable account.
2. Increasing the billing on the contract account.

Suppose the construction in the process account reports a higher amount than the billing on construction in the process. In that case,the difference between these two accounts will be reflected in the current asset section of the balance sheet.

If billing on the construction in the process is higher than the construction in process account, then their difference will be generally reported as current liabilities.

Step 4:Using the cost-to-cost method

The income will be recognized using the cost-to-cost method as follow:

1. Firstly, the business entity will calculate the estimated income by using the contract price and estimated cost of the contract.
2. Secondly, the estimated cost incurred will be divided by the contract's total cost to determine the completion percentage.
3. In the third step, the business entity will determine the income recognized for the second year by deducting the income recognized in the first year from the income recognized up to date

Effect on earnings per share

The business entity will report higher earnings per share when the percentage-of-completion method is used instead of the complete contract method because it will recognize income in the second year when the percentage-of-completion method is used. It will not recognize any income when the complete contract method is used.