Contract Assets and Contract Liabilities
Summary
TLDRThis 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
- π 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.
- π 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.
- πΌ 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.
- π The company invoices Adam for $100,000, leading to a debit to receivables and a credit to the newly created contract liability account.
- πΈ 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.
- π 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.
- π οΈ 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.
- π 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.
- π 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.
- ποΈ 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.
- π 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.
Outlines
π Introduction to Contract Asset and Liability
This paragraph introduces the concept of contract assets and liabilities, typically associated with long-term projects or construction contracts. The speaker uses an example of a non-cancelable agreement to build customized equipment for Adam Company, which involves receiving an advance payment of $100,000 upon signing. The key point here is the creation of a contract liability, which is an obligation to perform work in exchange for the payment received or promised. The speaker emphasizes the importance of invoicing and the accounting entries involved when receiving the advance payment, resulting in a debit to receivables and a credit to contract liability.
ποΈ Contract Liability and Asset Creation Process
The second paragraph delves deeper into the accounting treatment of contract liabilities and assets. It explains how, after incurring costs of $120,000 for the project, the company has a contract liability of $100,000 and an additional $20,000 of work performed that cannot yet be billed to the client due to certain conditions. The speaker illustrates the accounting entries for the work done and the costs incurred, which include debiting the contract liability and crediting revenue for the amount already paid by the client. The paragraph also introduces the concept of a contract asset, which arises when work has been done but billing is not yet possible due to contractual conditions, resulting in a debit to the contract asset and credit to revenue for the unbilled amount.
π Conclusion on Contract Assets and Liabilities
In the final paragraph, the speaker wraps up the discussion on contract assets and liabilities, summarizing the process of their creation and eventual conversion into account receivables and revenue. The paragraph also serves as a call to action for the audience to visit the speaker's educational platform, Forehead Lectures, for additional resources on revenue recognition, IFRS 15, and U.S. standards. The speaker encourages the audience to study hard and stay safe, highlighting the importance of understanding these accounting concepts for professional development.
Mindmap
Keywords
π‘Contract Asset
π‘Contract Liability
π‘Non-Cancelable Agreement
π‘Revenue Recognition
π‘Long-term Project
π‘Unearned Revenue
π‘Invoice
π‘Milestone
π‘Account Receivable
π‘IFRS 15
Highlights
Introduction to the concept of contract asset and contract liability in the context of long-term projects and contracts.
Explanation of contract liability as an obligation to perform work, akin to unearned revenue, resulting from a non-cancelable agreement.
Illustration of the creation of contract liability through invoicing without performing work yet, emphasizing the legal enforceability of the agreement.
Process of accounting for contract liability with an example of receiving payment before work is done.
The role of receivables and liabilities in the context of contract liabilities and their impact on financial statements.
Definition and explanation of contract asset as a result of performing work and incurring costs beyond the received payment.
Scenario of incurring costs beyond the advance payment and the resulting creation of a contract asset.
The conditions that prevent billing the customer for additional work done, leading to the existence of a contract asset.
Accounting treatment for contract assets, including the debiting and crediting process when work is done but billing is not yet possible.
Transition of contract asset to account receivable and revenue once the conditions for billing are met.
The impact of contract assets and liabilities on cash flow and revenue recognition in financial accounting.
Public announcement about Forehead Lectures as a supplemental educational tool for CPA exam preparation.
Description of Forehead Lectures' resources, including lectures, multiple choice questions, and exercises for accounting courses.
The importance of understanding revenue recognition, contract asset, and contract liability in accordance with IFRS 15 and U.S. standards.
Encouragement for students to utilize additional resources, such as MCQs and exercises, to deepen their understanding of accounting concepts.
Closing remarks with well wishes for study success and health in the context of ongoing educational pursuits.
Transcripts
hello and welcome to this session in
which we will discuss the concept of
contract asset and contract liability
now from the word contract usually what
we are dealing with is Construction
contract or long-term project that
doesn't have to be construction but some
sort of a project that's going to take
several years and that's why the word
contract is there because usually when
you have a long-term project you will
sign a contract between two parties and
as a result we could have a contract
asset or a contract liability now the
best way to illustrate this concept of
contract asset and contract liability is
to walk you through an example
illustrating how these accounts come
into place how these accounts such as
contract asset contract liabilities are
created so let's assume I entered into a
non-cancelable agreement and that's
important non-cancelable to build the
customized equipment for half a million
and the customer is Adam company so
that's the deal the agreement stipulate
that I will receive 20 after signing the
agreement so after I signed the
agreement
Adam will have to pay me one hundred
thousand dollars so what's gonna happen
is this I'm gonna have to invoice Adam
because otherwise the One's Gonna Pay
you unless you invoice them so I have to
invoice them I have to create an invoice
and send it to Adam for one hundred
thousand now I all although I invoiced
for 100
000 I did not do any work yet
here we have the creation of a contract
liability I did not do the work yet but
I invoice them but now I have the
obligation to do the work so think of
contract liability you can think of it
as unearned revenue and you're going to
see at the end of the day it looks and
acts like unearned Revenue but when I
signed this contract and I send the
invoice well what's going to happen is
this I'm gonna be expecting Adam company
to send me one hundred thousand
therefore I will debit receivable 100
000 and I will credit a liability of one
hundred thousand so
I what I did I said I have a liability
now of one hundred thousand I expect
Adam to send me a check of one hundred
thousand now a week 10 days later or the
following day whatever that time is I
received a check I received that money
from Adam company
what would I do then I will debit the
cash 100 000 and I will remove the
receivable so notice what happens at the
end of the day when all said and done
all what I have left on my books for now
is the cash for 100 000 sitting in the
bank account and I have a contract
liability so I want you to kind of make
a t account about contract liability and
put in there one hundred thousand I
don't have to tell you it's a liability
it says right there contract liability
but that contract liability is for work
needs to be performed so what is a
contract liability so let's kind of
Define it a little bit a little bit more
it's the obligation now we have the
obligation to do what to do work for
Adam company which is build the
equipment to transfer goods or services
to perform work and we already received
the fund or we have an unconditional
promise to get the money before start
the work before starting the work so
this is what a contract liability is we
have an obligation we either receive the
fund or we have unconditional promise
and that's why I emphasize the word
non-cancelable agreement
to tell you there is a promise and that
promise is in condition in conditional
we expect to receive the money the
agreement assigned and it's legally
enforceable so this is how a contract
liability is created now the next thing
we're going to look at is what's going
to happen to the contract liability and
how do we create a contract asset as
part of this example before we proceed
any further I have a public announcement
about my company forhat lectures.com
forehead accounting lectures is a
supplemental educational tool that's
going to help you with your CPA exam
preparation as well as your accounting
courses my CPA material is aligned with
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courses are aligned with your accounting
courses broken down by chapter and
topics my resources consist of lectures
multiple choice questions true false
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now let's take a look at how a contract
asset is created now remember I signed
the agreement and I'm I started the work
and here's what I did I'm gonna incur
costs I incurred costs I hired people I
hired contractors I bought material I
bought supplies because I need to build
that piece of equipment and overall for
the first quarter I incurred 120
000 in cost remember the client already
paid me one hundred thousand that's fine
I am grateful for Adam but I had to
incur more cost well I cannot build the
client yet for the additional twenty
thousand they paid me one hundred
thousand because I needed to work I
needed to start the work but I incurred
more cost I am not if I need material if
I need supplies I'm not gonna wait I'm
gonna have to incur that cost because I
know I'm gonna get this money later but
now since I I incurred more than what I
received
I cannot build the client yet now why
can't I build a client for that
additional 20 000. it could be many
reasons it could be part of the
agreement I have to wait until the
project is done that's a condition
or it could be I can only build them on
a yearly basis no I just I just finished
the first quarter I have to wait until a
year from the signing of the agreement
or it could be I need to reach a certain
Milestone like for example 50 done of
the work before I can build them for the
additional funds whatever it is there is
a condition and I cannot build the
client that additional twenty thousand
now bear in mind I have to debit a total
of 120 total of assets because this is
how much I incurred
so let's kind of keep on going
remember
I already did 120 000 worth of work and
we're gonna assume this is all kind of
Revenue the 120 000 that's all revenue
it could be more than 120 but let's
assume it's 120. now the first thing I'm
going to do since I perform the work I'm
going to debit my contract liability
remove my liability for a hundred
thousand and record 100 000 in Revenue
remember the contract liability that was
created on the prior
slide I told you to create a contract
liability of a hundred thousand contract
liability now I removed it I did the
work I did this one hundred thousand
worth of work for the cash that the
customer
paid me I'm gonna go a step further and
tell you what's going to happen to the
cash remember they gave me one hundred
thousand dollar in cash with that cash I
bought materials supplies and what I did
for that I debited the asset I debited
an asset account for 100 000 and I
credited the cash because I'm assuming
I'm building some sort of an inventory
for Adam therefore I debit the asset so
that's why whether it's Material
supplies payroll it's all debiting some
sort of an asset so this is how I use
the mod how I use the money
now I still have
twenty thousand dollar because remember
I build them for an additional twenty
thousand dollar because I did I did the
work I incurred the cost now the cost
could be cash could be payable it
doesn't really matter what do I do with
this additional twenty thousand dollar
that I cannot build the client yet so
this is where contract asset comes into
place I'm going I'm gonna have to debit
contract asset which is unbilled account
receivable if I can build them if I can
build them it's easy if I can build them
I will debit account receivable the
account receivable that we know and I
credit sales revenue or just Revenue
let's keep it consistent Revenue but I
cannot debit account receivable because
I cannot if I invoice them they're gonna
be angry they're gonna be mad they're
gonna be like well this is not the deal
well you can Bill me you know once fifty
percent is done but I need on my books I
need to to know how much do I still have
of unbuild account receivable I know I'm
going to receive the money because
there's a condition that's the only
thing that's stopping me from billing
them therefore I'm gonna have to debit
an account called contract asset twenty
thousand and I will credit Revenue
because I did the work so notice 100 000
of Revenue uh 20 000 of Revenue I have
revenue of 120 now the revenue could be
higher I just said I incurred 120 of
course and I may assume its Revenue the
revenue could be higher but the point is
we don't have to worry about the amount
of Revenue specifically for now but I
credit Revenue
so notice how the contract asset is
created now once I can build them so
let's take let's take this step further
so you understand where this is gonna go
once I can build a client
one let's assume I called the client
said look I I incurred an additional
twenty thousand dollar and would you
mind if I bill you for that and if the
customer said yeah sure why not go ahead
and Bill me for that if I can build them
I'm gonna debit account receivable 20
000 and I will remove the CR the
contract asset of twenty thousand so
this asset is removed because now I can
build them then once I receive the cash
from them for that twenty thousand I
debit cash twenty thousand and I will
credit receivable 20 000 and voila
account receivable is gone contract is
gone all what I have left is Cash of 20
000 revenue of twenty thousand this is
just take taking it to the next step
just to show you what's gonna happen to
all of this information all of these
accounts so what is a contract asset
well simply put we have the right we how
do we have the right we have some sort
of a non-cancerable agreement to receive
funds in exchange for goods and services
we have that right
and we already performed the work but
for some reason for some condition we
cannot build the client at this time
that's fine if we cannot build the
client at this time because there's a
condition guess what on our books we're
going to have a contract asset and we're
going to record the revenue but we
cannot build a client it's not an
account receivable now
bear in mind if the condition to build
the client has to do with the passage of
time in other words the condition is
that as time goes by I can bill you and
as time goes by I can bill you then it
will be receivable so just bear that in
mind in case you get a multiple choice
question about this but this is
basically in a nutshell contract asset
and contract liability I might work
another example but this in this
illustration I wanted to explain it how
does it all come into how how is it like
how is it created or born how a contract
liability is Bored for what reason how a
contract asset is born and how does it
go away what should you do now go to
forehead lectures look at additional
resources mcqs through faults that's
going to help you understand the revenue
recognition contract asset contract
liability
IFRS 15 so on and so forth or the U.S
standards for Revenue recognition good
luck everyone study hard and of course
stay safe
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