Contract Assets and Contract Liabilities

Summary

This session delves into the concepts of 'contract asset' and 'contract liability', using an example of a non-cancelable agreement to build customized equipment. It explains how contract liabilities arise from unearned revenue when services are yet to be rendered, and contract assets are formed when work is done but billing is pending due to certain conditions. The speaker also promotes their educational tool, Forehead Lectures, for CPA exam preparation, before concluding with the implications of these accounting terms under IFRS 15 and U.S. revenue recognition standards.

Takeaways

• 📝 The script discusses the concepts of 'contract asset' and 'contract liability', typically associated with long-term projects like construction that involve contracts between two parties.
• 🔍 An example is provided to illustrate these concepts, starting with a non-cancelable agreement to build customized equipment for a company called Adam, with an upfront payment stipulated in the contract.
• 💼 Upon signing the agreement, the company creates a 'contract liability' of $100,000, representing unearned revenue and the obligation to perform the work specified in the contract.
• 📑 The company invoices Adam for $100,000, leading to a debit to receivables and a credit to the newly created contract liability account.
• 💸 After receiving the payment from Adam, the company debits cash and credits receivables, leaving a balance of cash in the bank and the contract liability on the books.
• 🔑 The script defines 'contract liability' as an obligation to transfer goods or services, having received funds or having an unconditional promise to receive payment before starting the work.
• 🛠️ The company incurs costs of $120,000 to start the work, which is more than the $100,000 received, leading to the creation of a 'contract asset' for the unbilled amount of work done.
• 📈 The contract asset is debited for the additional $20,000 of work done beyond what has been billed, while revenue is credited for the total work performed.
• 📝 A 'contract asset' is created when there is a right to receive funds in exchange for goods and services performed, but billing is not yet possible due to certain conditions.
• 🗓️ The conditions for billing might be related to reaching a project milestone or the passage of time, which, once met, allow the company to bill the customer and convert the contract asset into an account receivable.
• 📚 The script encourages viewers to visit 'foreheadlectures.com' for additional resources to understand revenue recognition, contract assets, contract liabilities, and related accounting standards like IFRS 15.

Q & A

What is the main focus of the session in the provided transcript?

The session focuses on explaining the concepts of 'contract asset' and 'contract liability', particularly in the context of long-term projects or construction contracts.

Why is the term 'contract' used in the context of discussing assets and liabilities?

The term 'contract' is used because these financial terms typically arise in situations where a long-term project is involved, and a contract is signed between two parties to outline the obligations and rights related to the project.

What is an example of a situation that would create a contract liability?

A contract liability is created when a non-cancelable agreement is signed, and an invoice is sent to a customer for work that has not yet been performed, creating an obligation to deliver the service or product.

How is a contract liability initially recorded in the books?

A contract liability is initially recorded by debiting receivables for the amount invoiced and crediting a liability account for the same amount, representing the obligation to perform the work.

What is the relationship between contract liability and unearned revenue?

A contract liability is similar to unearned revenue in that it represents money received or promised for work that has not yet been performed or services that have not yet been delivered.

What does the speaker mean by 'non-cancelable agreement' in the context of contract liability?

A 'non-cancelable agreement' refers to a contract that cannot be terminated by either party, ensuring that there is a legally enforceable promise to pay for the work or services to be provided.

How is a contract asset different from a contract liability?

A contract asset is created when work has been performed or costs have been incurred, but billing has not yet occurred due to certain conditions specified in the contract, whereas a contract liability is an obligation to perform work for which payment has been received or is unconditionally promised.

What is an example of a condition that might prevent billing a customer for additional work performed?

A condition could be a contractual stipulation that billing can only occur upon reaching a certain milestone, such as completing 50% of the work, or waiting until the project is fully completed.

How is a contract asset recorded in the books when work has been performed but billing is not yet possible?

A contract asset is recorded by debiting the contract asset account and crediting revenue for the value of the work performed, acknowledging the right to receive payment for the work done.

What happens to the contract asset when the condition for billing is met?

When the condition for billing is met, the contract asset is reduced by debiting receivables and crediting the contract asset, reflecting the ability to bill the customer for the additional work performed.

What is Forhat Lectures and how does it relate to the session content?

Forhat Lectures is a supplemental educational tool mentioned by the speaker for CPA exam preparation and accounting courses. It is aligned with CPA review courses and accounting materials, offering lectures, multiple-choice questions, and exercises to help understand topics like contract assets, liabilities, and revenue recognition.