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.

Outlines

00:00

📝 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.

05:01

🏗️ 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.

10:02

📚 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.

Keywords

💡Contract Asset

A contract asset is a financial resource that a company has the right to receive in exchange for goods or services that it has performed but has not yet invoiced the customer. It is created when the company has performed the work under a non-cancelable agreement but cannot bill the customer due to certain conditions. In the script, the concept is illustrated when the speaker incurs costs of $120,000 for building equipment but has not yet billed the customer for the additional $20,000 due to conditions set in the agreement.

💡Contract Liability

Contract liability is an obligation that arises when a company has received payment or an unconditional promise to pay for work that has yet to be performed. It is akin to unearned revenue and is a liability on the company's books until the work is completed. In the script, a contract liability of $100,000 is created when the customer pays upfront for the work that the company has yet to start.

💡Non-Cancelable Agreement

A non-cancelable agreement is a contract between two parties that cannot be terminated or canceled by either party under normal circumstances. This type of agreement is significant in the context of contract assets and liabilities because it establishes a legally enforceable promise to pay or receive funds. In the video, the non-cancelable agreement is the basis for the creation of both a contract asset and a contract liability.

💡Revenue Recognition

Revenue recognition is the process of accounting for revenue in the period during which it is earned. It is a key principle in the script that dictates when a company can recognize revenue from the work it has performed. The script explains that revenue is recognized when the work is done, even if the customer has not yet been billed, leading to the creation of a contract asset.

💡Long-term Project

A long-term project refers to a venture or undertaking that is expected to take a significant amount of time to complete, often several years. In the script, the term is used to describe the type of projects that would typically involve contract assets and liabilities, such as the construction of customized equipment.

💡Unearned Revenue

Unearned revenue is money received in advance for goods or services that have not yet been provided. It is a liability until the goods are delivered or the services are rendered. In the script, the term is used in the context of contract liability, which is similar to unearned revenue as it represents an obligation to perform work in the future.

💡Invoice

An invoice is a bill or a written request for payment that is sent to a customer for goods or services provided. In the script, the act of invoicing is crucial as it triggers the creation of a contract liability when the company has not yet performed the work but has billed the customer.

💡Milestone

A milestone is a significant point or stage in a project that represents a major achievement or accomplishment. In the script, reaching a certain milestone, such as completing 50% of the work, is a condition that must be met before the company can bill the customer for additional funds, leading to the creation of a contract asset.

💡Account Receivable

Account receivable, often simply referred to as receivables, is the money owed by customers for goods or services that have been delivered but not yet paid for. In the script, the term is used to describe the situation where the company cannot yet bill the customer for additional work performed, resulting in the creation of a contract asset.

💡IFRS 15

IFRS 15, also known as International Financial Reporting Standard 15, is the standard for revenue recognition from contracts with customers. It provides guidance on when and how revenue should be recognized. In the script, IFRS 15 is mentioned as the relevant standard for understanding the concepts of contract assets and liabilities.

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

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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