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Illustration of an expected loss on a project



Unfortunately, not all projects make money. You've got delays, the project owner is throwing a fit, the site conditions are unruly, etc. etc. etc. Labor costs start to pile up and progress is at a standstill. What started off as a profitable project is now a project with an estimated loss. AKA, by the time the project is complete, you'll have more costs than billings.


The rule for recognizing revenue is different when you expect a loss. You don't recognize a portion of the loss as you would recognize a portion of the gross profit on a profitable job. You recognize the entire loss! Yes, if you anticipate a loss on a project, you have to recognize the total amount of the loss in the year you discover that it's going to lose money.


Example time!


Contract Price: $100,000

Total Estimated Cost: $60,000

Total Gross Profit: $40,000


Contract Price: $100,000

Total Estimated Cost: $140,000

Total Gross Loss: $(40,000)


WIP by Year:


In year 1, we're expecting profit, so we multiply our percent complete by the total estimated gross profit (51.7% x 40,000), $20,667 (rounded).


Now in year 2, things take a turn for the worse and all the sudden we're expecting a loss, a $(40,000) loss. Remember how we multiplied the percent complete by the total estimated profit last year? Well forget about it this year. Per Generally Accepted Accounting Principles (GAAP), you must recognize the entire loss upfront, not just a percentage. Meaning you recognize a loss for $(40,000) in Year 2, which undoes all the profit you recognized in Year 1. Why? According to my understanding, it’s the more conservative approach. We’ve technically incurred the loss in Year 2 because we’ve recognized that the project is going to lose money. Like other costs/expenses and liabilities, you recognize the entire amount when incurred, right? You don’t get to say “Eh, I’d rather recognize a portion of the cost this year and the rest in the following year”.


As you can see in our example, total gross loss in Year 2 is $(60,667). But that’s more than our estimated loss! Yes! Because we have to undo Year 1’s profit recognized. $(60,667) + $20,667 is $(40,000), our total expected loss! According to GAAP you should accrue the expected loss on the balance sheet, but I often show this happening on the WIP report as shown below. The large overbilling of $52,000 acts as the accrual. You increase a liability and decrease revenue. Essentially the affect as an accrual for the loss.


Since we’ve recognized the entire loss in Year 2, in Year 3 revenues and costs offset each other and we recognize zero gross profit. So in total, from inception to date we’ve recognized a total loss of $(40,000).  


Hope that made sense!


Thanks!

Ara


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