FRANCHISE ACCOUNTING

WHAT IS FRANCHISING   it is where a leading , known business entered into agreement  in which for fee ONE PARTY ( FRANCHISOR)  gives the other party ( FRANCHISEE)  the rights to perform certain functions  or sell certain products or services of the franchisor.

A SUBSTANTIAL PERFORMANCE  OF THE FRANCHISOR IS THE KEY TO RECOGNITION OF THE INITIAL FRANCHISE FEE.   SUBSTANTIAL PERFORMANCE OF THE FRANSHISOR DENOTES CONSUMMATION OFTHE TRANSACTIONS  WHEN:

       1.   THERE IS NO REMAINING OBLIGATION BY AGREEMENT , TRADE OR PRACTICE  TO REFUND THE INITIAL FEE.   OR TO EXCUSE NON PAYMENT OF UNPAID NOTES
2.  SUBSTANTIALLY ALL THE INITIAL SERVICES OF THE FRANCHISOR HAVE BEEN PERFORMED
3. ALL OTHER CONDITIONS WHICH AFFECT CONSUMMATION  HAVE BEEN MET.

EXAMPLE :

INITIAL FEE IS 250,000.00 ,   INITIAL DOWN IS 50,000, BALANCE OF 40,000 YEARLY PAY AT 12% INTEREST.

METHOD  1 (   THE SUBSTANTIAL FUTURE  SERVICES ARE YET TO BE PROVIDED TO THE FRANCHISEE, THAT MEANS PERFORMANCE OF FRANCHISOR HAS YET TO OCCUR.

CASH                                  50,000
NOTES RECEIVABLE      200,000
     UNEARNED INITIAL FEE                250,000

TAKE NOTE IT IS CREDITED TO A  SUSPENSE ACCOUNT, OR  DEFERRED ACCOUNT OR A LIABILITY ACCOUNT. BECAUSE THE PERFORMANCE HAS NOT YET SUBSTANTIALLY MET.

METHOD 2    THE PROBABILITY OF REFUNDING IS  REMOTE  AND THE AMOUNT OF FUTURE SERVICES OF FRANCHISOR IS MINIMAL, THAT MEANS PERFORMANCE HAS ALMOST TAKEN PLACE.

CASH                         50,000
NOTES REC              200,000
          REVENUE EARNED     250,000
TAKE NOTE IT IS CREDITED TO AN DEFINITE INCOME ACCOUNT BECAUSE THE POSSIBILITY OF THE AGREEMENT TO TAKE PLACE.


METHOD  3

 THE DOWN PAYMENT IS NOT REFUNDABLE ,  BUT  A SIGNIFICANT SERVICES BY THE FRANCHISOR IS YET TO BE PERFORMED

CASH
NOTES
         UNEARNED                  200,000
         REVENUE EARNED       50,000
 SINCE  THE DOWN IS NOT REFUNDABLE , IS CREDITED DIRECT TO INCOME ACCOUNT.

METHOD 4

THE DOWN IS NOT REFUNDABLE ., THE COLLECTION OF NOTES IS UNCERTAIN , SO NOTES IS NOT RECORDED

CASH     50,000
       EARNED REVENUE

METHOD 5

THE DOWN IS EITHER  REFUNDABLE .  OR SUBSTANTIAL  SERVICES MUST BE PERFORMED BEFORE THE FEE CAN BE CONSIDERED EARNED.

CASH
     UNEARNED FEE


IN THE FRANCHISE AGREEMENT , THERE ARE A LOT OF CONDITIONS:

1.  THERE IS AN INITIAL FRANCHISE FEE NORMALLY FOR A NUMBER OF YEARS WITH A LOT OF CONDITIONS SUCH AS:
       a.   AMOUNT OF DOWN PAYMENT AT A CERTAIN TIME  LIKE UPON SIGNING OF THE AGREEMENT
b.  a certain amount again on a certain date  say  start of operation ,  or a certain conditions that has to be met.
c.   the balance covered by a notes with interest  for a certain period  and the date of the start of amortization


2.  THERE IS ALSO SOME COST OR EXPENSES BY THE FRANCHISOR  ASSOCIATED TO THE INITIAL FEE  SUCH AS TRANSFER OF FIXED ASSETS,  TRAINING AND DEVELOPMENT COST  .  ALL OF WHICH IS TIED UP WITH A DATE OF PERFORMANCE.

3.  THERE IS ALSO  A CONTINUING FEE BASED ON WHATEVER IS THE AGREEMENT, SAY A PERCENTAGE OF SALES,   FOR A CERTAIN NUMBER OF PERIODS, THEN THAT FEE IS CHANGED FOR  ANOTHER AMOUNT ONWARD.
4.   THERE IS ALSO A CONTINUING COST TO BE INCURRED BY FRANCHISOR .  THE FAIR MARKET VALUE OF THIS CONTINUING COST IS ALSO DETERMINED.


ILLUSTRATIVE PROBLEM

A CONTRACT HAS BEEN SIGNED ON MAY 1, 2011, WITH THE FF; PROVISIONS

 1.  AN INITIAL IRREVOCABLE FEE OF 500,000  TO BE PAID AS FF:
                100,000 UPON SIGNING  mAY 1, 2011
                  50,000  WHEN OPERATION STARTS. IN OCTOBER 2011
                 350,000 PAYABLE 7 YEARS  OR 50,000 BEG.  MAY 1 2011 AT 12% INTEREST.

2.   DIRECT COST ASSOCIATED WITH THE INITIAL FEE   THIS IS NOT A CONTINUING COST,  THIS IS RELATIVE TO THE INITIAL FEE.

                a           80,000 COST OF EQUIPMENT  DELIVERY ON MAY1  2011, THE FAIR MARKET IS 120,000.
             b.  initial services of 140,000 ,  50,000 prior to signing,   90,000 to be incurred in oct 1 2011.

3.  CONTINUING FEE of 10% of gross  sales  , which is estimated to be 90,000 per month , for  3 years , then 150,000  a month thereafter.

4.  CONTINUING COST  starting the commencemnent of operation,   to be incurred by franchisor 10,000 a month., these cost have a fair market value of 11,000.


JOURNAL ENTRIES:

MAY 1  

1.         CASH                                    100,000
            NOTES REC.                        350,000
                     REVENUE                                          120,000
                   UNEARNED REVENUE                      330,000

THE REVENUE OF 120,000 IS ARRIVED AT BECAUSE THE EQUIPMENT WAS PERFORMED BY THE FRANCHISOR ON TIME,  OF COURSE THE 330,000 IS ASSUMED TO BE UNEARNED DEPENDING ON THE DATE OF  THE PERFORMANCE OF  ANY AGREEMENT.

2.  COST OF EQUIPMENT                  80,000
       MACHINERY AND EQUIPMENT             80,000

OF COURSE IF THERE IS ACCUMULATED DEPN , IT IS DEBITED

3.   FRANCHISE EXPENSE                  60,000
           ACCTS. PAYABLE                                60,000
       this is relative to initial fee and not regular continuing fee

OCT 1

 1.  CASH                             50,000
              REVENUE FROM INITIAL FEE     50,000
       THIS IS AS PER AGREEMENT TO BE RECEIVED OCT.

2.    UNEARNED INITIAL FRANCHISE FEE        258,000
                REVENUE FROM INITIAL FRANCHISE FEE           258,000

       explanation : since all the agreement by oct  has already been met, a need to recognized the actual revenue must be computed.
 supposed to be  the 330,000 is credited to revenue on entry no. 2 in OCT.  but  the 72,000 has not incurred yet by the franchisor because it will be incurred monthly, hence cannot credit to revenue in total now.   THAT IS WHY   330,000 LESS  72,000 IS  258,000.00   this 72,000 will be amortized for 36 months.

       THE INITIAL FEE IS                                                                                         500,000
        1.   TO DEDUCT THE FAIR MARKET VALUE OF THE EQUIPMENT       (120,000)
        2.      TO DEDUCT THE POSSIBLE DEFICIENCY BETWEEN THE
    CONTINUING FEE AGAINSt THE CONTINUING COST as ff:.

THE CONTINUING FEE IS ONLY( 90,000 X 10%                             9,000         
THE CONTINUING COST IS HAS A FAIR MARKET VALUE OF 11,000
             DEFICIENCY  A MONTH                                                       2,000
          FOR 3 YEARS AS PER CONTRACT                                       36 MOS
TOTAL                                                                              ....................................  (   72,000
--------------------------------------------------------------------------------------------------
ADJUSTED INITIAL FEE                                                                                        308,000
--------------------------------------------------------------------------------------------------
 LESS :  THE PAYMENT IN OCT  and already credited to revenue                           ( 50,000)
NET ..........  TO BE CREDITED TO  REVENUE FROM INITIAL FEE                   258,000


3.  FRANCHISE EXP                                80,000
             ACCTS. PAYABLE

4.  CASH                                        9,000
     UNEARNED INITIAL               2,000
                 REVENUE  CONTINUING FEE      11,000
 THE 2,000 IS DEBITED TO UNEARNED  FOR THE NEXT 36 MONTHS TO CLOSE THE UNEARNED INITIAL REVENUE

5.   franchise exp                            10,000
          accts/ pay                                        10,000

NOVEMBER

 CASH                                               9,000
 UNEARNED INITIAL REVENUE   2,000
          REVENUE EARNED CONTINUING    11,000

FRANCHISE EXP                          10,000
 PAYABLE                                                10,000


DECEMBER

CASH                                               9,000
 UNEARNED                                   2,000
       REVENUE                                         11,000

FRANCHISE EXP              10,000
 PAYABLE                                       10,000

INTEREST RECEIVABLE             28,000
    INTEREST INCOME                              28,000
TO ACCRUE INTEREST INCOME

JAN   2012

INTEREST INCOME              28,000
     INT. REC                                              28,000
REVERSE THE ACCRUED.

CASH                                    9,000
UNEARNED                         2,000
        REVENUE                                11,000

franchise exp          10,000
   accts. pyable                      10,000

this will be the repetitive entry onward , except the amortization f the  2,000.00  and of course the additional entry on the collection of notes receivable 

THE ENTRY IN FEB, ONWARD

Next Generation DSRs - Analytic power !

To handle real Analytics (see my recent post Reporting is NOT Analytics) you need real Analytic power. BI tools are based on the language they use to interrogate the database (typically SQL) and with no library of analytic tools - it's not nearly enough.

We use SQL (Structured Query Language) to query relational databases like SQLServer, Oracle, MySQL and Access. SQL is a great tool for handling large quantities of data, joining tables, filtering results and aggregating data. However, SQL's math library is only sufficient for accounting (sum, product, division, count) and while I do know it can do a few more things, it's not enough to be useful for Analytics. Even getting it to calculate a simple correlation-coefficient is a big challenge. Want to build a simple regression model? That's just not going to happen in base SQL, we need something designed for the task.

R, SAS, SPSS, Statistica, and a good number of others, are the real deal and the difference between any of them and what you can do in SQL (or Excel) is vast! With these tools it's no longer a question of "can you build a regression model?" now it's "which particular flavor of regression do you need?". What! There's more than one? Oh yeah!

I'm not getting into which analytic tool is the best. I use R, and that's what I'll talk to, but I have good friends, analytic-powerhouses who insist on using SAS or SPSS. These tools have different strengths and weaknesses and within the analytic community a lot of time, blog posts and misinformation go into arguing the relative merits of one vs. another. My take is that for most business-analytic purposes any of them will get the job done. The one you choose should be driven most heavily by your ability to get the analytic tool working against your data.

The problem is that these analytic tools do not generally reside in the same space as your database or BI tool, so you spend a lot of time interfacing data between systems. It's slow, sometimes very slow, and requires replication in your resources.

In recent years many database and BI tools have started offering integration with statistical tools (Oracle, SAP Hana, Tableau, Spotfire, MicroStrategy). The ideal here is in-database analytics where we run the complex stats in-tandem, indeed in the same memory space as the database. That is very attractive but I would look very carefully at the depth of integration offered before getting too excited. In some cases, I think, vendors have done just enough to tick the box without making it truly useful. As examples:

• One vendor limits the transfer of data between database and R to simple table structures. Now, imagine running a regression model. What goes into the regression is very likely a simple table - check! What comes out is anything but: it's a complex object combining multiple tables of different dimensionality and named values (like r-sq). We need this data to determine the validity of the model and make future predictions. Force me to return just one table structure and I must throw most of the information and capability away. Before anyone asks, no, this is not unique to regression models.
• Another vendor has integrated R into the reporting layer. This is relatively functional as long as the data you want to work with can be generated in a report. If you need very large amounts of input data you may well exceed reporting limits. If you want to build a separate model for each product in your database, you may have to run the report separately for each one.
• Standard R was not originally designed for parallel execution (though you can get around this with a little coding help). Current processors (CPUs) even on low-level laptops are multi-cored. Servers routinely run more cores per CPU, more CPUs per server and we want to scale-out across multiple servers. A BI offering that only offers single core R execution is wasting your resources and time.

Bottom line, to do real Analytics, you need real Analytic tools. But even the best tools must be able to get at the data to be useful. Choose carefully,

Next Generation DSRs - Reporting is NOT analytics

I've written a number of posts now on the next generation of Demand Signal Repositories. DSRs are the specialized database and reporting tools primarily used by CPGs for retail Point of Sale data.

So far, I've looked at the challenges (and big opportunities) around handling the large quantities of data involved: better database technologies, scale-out platforms, true multi-retailer environments, effective data blending and dramatic simplification of data structures.

Taken as a whole this get's the necessary data into one place where it is relatively simple to overlay it with the BI or analytic tools of your choice and still get good performance. This is the starting point.

Now, we can get to the fun stuff, Analytics. Let's start by addressing a widespread misunderstanding

Reporting is NOT analytics

I've blogged on this before, actually one of my very first blog posts, but it bears repeating and extending from the original

Reporting is about "what happened"; Analytics is concerned with "why?", "what if?"and "what's best?".

You need reports. Hopefully they are well constructed, with appropriate metrics, good visualization and exception highlighting. Perhaps they are also interactive so you can drill-down, pivot and filter. These are useful tools for exploratory "what happened" work, but, almost exclusively, reports leave it up to the reader to construct the "why".

Great reporting can pull together facts that you think are related for visual inspection (e.g. weekly temperature and ice-cream sales by region). Perhaps you can see a pattern, sort of, but reports will not quantify or test the validity of the pattern that's up to you, the reader, to guess at.

Even great reports can't help you much with more complex relationships. In reality, ice-cream sales are also dependent on rainfall, pricing, promotions, competitor activity etc. Who knew? Well we all did of course, but there is no reasonable way to visualize this in a standard report. Want to predict sales next week given weather, price and promo data for all products in all regions? Your going to need some good analytics.

You need Analytics too. In some cases, basic, high-school, math is all you need. In most, it doesn't even get you close to the 80% solution beloved of business managers. "Winging it" in Excel, Access, PowerPivot etc. can give you very bad answers that are seriously dangerous to your success and/or employment.

Want to understand and predict the impact to sales of promotions, pricing or weather events? You need Analytics for that.

Wan't to know where you can safely reduce inventory in your supply chain while increasing service level? You need Analytics.

Wan't to alert when sales of your product are abnormally low? Analytics!

Want to know how rationalizing products across retailers would impact your supply chain? Yep, Analytics.

Want to know which shopper demographics are most predictive of sales velocity? I think you get it...

If your business question is something other than "what happened" you need Analytics.

Can We Save Good Business from Being Destroyed by Purchasing Departments?

Purchasing Departments are destroying the World of Good Business… And we can Save the Day

Imagine an epic battle. Conjure up a vision of cloven hooved archfiends dashing the lifeblood of our economy. Think about an ever escalating conflict with carnage scattered back to the 1970s. Visualize a place where one side knowingly operating under false assumptions and poorly conceived ideas skews the direction of whole industries.

Am I suffering from a persecution complex? Have I lost my mind? I don’t think so. What’s more I am about to present some scholarly evidence to support my claim.

The claim: Commonly used purchasing practices cause companies to make bad buying decisions.

There are tons of articles pointing to price being about number 5 or 6 on most customer’s list of priorities. Purchasing agents will wave this stuff around like Old Glory, but I have never bought into the story. In spite of all the propaganda to the contrary, experienced salespeople testify; when procurement guys make buying decisions, price is on the top of their list.

I believe there are two interacting issues driving this phenomenon. First, procurement types have a difficult time understanding the value derived from our products, services and solution offerings. Even though many will tout their technical backgrounds or business acumen, very few have the rare combination of technical and financial data to make long term business decisions. Even if they do have a smattering of the background, they often lose touch with the realities of their company’s daily operations. This is more prevalent today because most organizations operate under very lean staffing conditions.

Secondly, purchasing groups are commonly measured on their ability to produce year over year savings. Think about this. A few years ago I spoke to the director of purchasing of a Fortune 1000 sized company. During our conversation, I asked how he measured the performance of his department. His earnest answer shocked me. Recalling the words as closely as possible, he said, “Each team member is measured against their ability to drive costs down by 7% per year.” Since he was buying a complex commodity tied to the price of oil, I asked for elaboration. “Unit price decreases for everything we purchase are the cornerstone of our work,” was the reply. Later on he went on to tell me about how his teams buying decisions often cost money downstream in the production and quality departments. Once again I quote, “…but if the product matches the spec, that’s somebody else’s issue.”

So far my argument has been purely anecdotal and subject to dispute. But let me provide a bit of hard data to convince you the story is correct.

Recently, Design World Magazine ran a piece with data on the use of high efficiency electric motors.  Here are a couple of points to ponder:
• Electric Motors consume over half of the world’s electricity
• Industry uses over 42% of the total electricity
• The purchase price of the average electric motor is 2% of its lifetime cost
• Lifetime electricity usage represents 96% of its lifetime cost
• Repair and maintenance accounts for the other 2%

Research reveals the difference in efficiency between a standard and premium (high efficiency) electric motor ranges from 2-6% depending on horsepower, application and other factors. The typical payback to the user is less than two years. Further, this is not brand new, untested technology. We’re talking about 10 year old stuff. It should be well adapted by now.

As I already alluded, one would imagine the world would be beating a path to the high efficiency motors. This is not the case. Currently high efficiency motors represent only 28% of the motors purchased. My friend Alex Chausovsky, the principle analyst for Motor Driven Systems and Industrial Automation at IHS, says this:

“Individuals making capital expenditure decisions when building new industrial facilities rarely, if ever, consider the long-term costs associated with projects. As a result, these decision makers consistently place initial purchase price concerns ahead of total cost of ownership considerations.”

I have a slight disagreement with Alex; I don’t believe capital expenditures are the only place where decision makers place purchase price ahead of ownership considerations (or plain old business considerations).

When the purchasing person lacks a full understanding of the financial (and/or technical) ramifications of the buy, unit price drives the decision. In most instances, purchasing has their hands on the steering wheel.

Let me go back to the title of this piece: Purchasing Departments are singlehandedly destroying the World of Good Business.
For manufacturing businesses, the difference between the right buying decision and a low price purchase is huge. The right buying decision often carries a higher price tag. But it also has the promise of delivering long-ranging sustainable benefit. Things like fewer defects, higher factory utilization, more products out the door and lower maintenance costs come to mind. And, typically this kind of improvement comes via a cooperative sales effort. This is where knowledge-based distributors come into play.

Here is the rub, knowledge-based distributors sometimes sell the same products as their brown box shipping, order taking counterparts. The lackeys in the purchasing department capitalize on this point. They allow you to invest engineering time, application expertise and troubleshooting efforts early in the life cycle and then “shop” your solution. If they have even an ounce of fairness in their bones (not saying they do…but just in case), they will give you the opportunity to match the price of the supplier without technical expertise. We won’t go into this issue. Instead, we’ll just acknowledge that it happens. And when it happens often enough, most knowledge-based distributors will throttle back on their service levels; damaging the customer’s ability to be successful.

In either case, the purchasing department’s parent organization loses. And that hurts business.

How can we save the day?
Here’s the part about lowly sales guys (Who fight for truth, justice, mom’s apple pie and an incredibly meager commission checks) save the day.

Make it difficult to negotiate price. Purchasing teams learn and practice nickel and dime negotiation tactics. They would have you believe all suppliers are the same. They will refer to your work as “good service” but we know much of it goes well beyond “service” and pushes into

valuable expertise served up on demand. Establish a pricing process which allows you to maximize the gross margin when the customer’s price sensitivity is low. For example, Strategic Pricing Associates (SPA) provides their clients with a pricing cube which considers product type, customer type, size and industry to optimize the gross margin opportunity. And, distributors using SPA report margin improvements in the two point range.

Use a value-metric sales plan. Solving problems is not enough. We need to take the extra step of understanding how our solution impacts the customer. Expand your thinking from “we cut down on maintenance time” to “our solution reduced maintenance costs by $300 per month.” Always tie your actions to the extra dollars produced for the customer.

Report the results of your work as high in the organization as possible. In a world where purchasing departments are judged on their “unit price reduction,” the work you did to help their company make tens of thousands by reducing rejects on the production line means nothing. Sales guys need to establish connections with customer management at the very top. And, don’t confuse the VP of Materials, or whatever the head purchasing guy is using today, as the right spot.

Understand, not all customers are created equally. Some customers can never pay for the expert advice, timely assistance and product expertise you provide via gross margin alone; they’re just not big enough. Others will allow their purchasing department to run amok savaging suppliers for every shiny dime possible. Learn to throttle your free service and think about charging for some of your work. If you have not yet read my book, The Distributor’s Fee-based Services Manifesto invest in a copy. Here’s the link.  


A final word on this saving the day thing…
Saving the day is also about saving yourself. If you happen to be a conscientious hard working distributor sales guy, there will be times where it seems like you’re fighting an uphill battle. Every purchasing pro you chat with will claim to work on a real partnership arrangement. Some may actually walk the walk. If so, great. Just remember, all of the advice is still valid. I implore you… always build a customer reporting structure that gives you an end run around purchasing.

LONG TERM CONSTRUCTION ACCOUNTING

BECAUSE  OF THE LONG PERIOD OF TIME TO FINISH A CERTAIN PROJECT  BEING UNDERTAKEN BY CONSTRUCTION COMPANIES, IT BECOMES DIFFICULT TO DETERMINE HOW MUCH INCOME SHOULD BE RECOGNIZE IN THE FINANCIAL STATEMENT CONSIDERING THAT THE COMPLETION OF THE PROJECT WILL NOT BE FINISHED IN THE ORDINARY ACCOUNTING PERIOD,  HENCE  AN ACCOUNTING FOR SUCH SITUATION WAS DEVELOP.

THAT ARE TWO METHODS THAT WAS DEVELOP TO ANSWER FOR THIS ISSUE.

 A.  PERCENTAGE OF COMPLETION METHOD
B.   COMPLETED CONTRACT METHOD.

UNDER THE PERCENTAGE OF COMPLETION METHOD,  THE PERCENTAGE OF THE ACTUAL AMOUNT SPENT  AT THE END OF THE INTERIM PERIOD IS OBTAINED AGAINST THE TOTAL   ESTIMATED COST THAT IS STILL  NEEDED TO COMPLETE THE PROJECT  AT THE END OF THE INTERIM PERIOD.

WHAT ARE THE ACCOUNTS USED IN CONSTRUCTION ACCOUNTING

1. CONSTRUCTION IN PROGRESS -
   
              A.   DEBITED FOR THE COST OF CONSTRUCTION
              B    DEBITED FOR THE NET REVENUE
 
               A.   CREDITED TO NEGATIVE NET REVENUE( EXCEPT WHEN A TOTAL LOSS WILL BE INCURRED.
               B.    CREDITED AT THE END OF THE CONTRACT FOR THE CONTRACT PRICE  BY DEBIT TO ADVANCE BILLING.

THAT MEANS  THERE ARE TWO TYPES OF TRANSACTION THAT ENTERS TO THIS ACCOUNT,   THE  COST  AND THE PROFIT , WHICH TOTALS THE CONTRACT PRICE.

AT THE END OF THE CONTRACT THE BALANCE OF THIS ACCOUNT  SHALL BE CLOSED TO THE ADVANCE BILLING ACCOUNT WHICH ACCUMULATES THE REGULAR BILLING OF THE CONTRACT PRICE  WHICH IS DEBITED TO  ACCOUNTS RECEIVABLE AND CREDITED TO ADVANCE BILLING. NATURALLY , THE ADVANCE BILLING WILL DEFINITELY HAVE A BALANCE REPRESENTING THE CONTRACT PRICE.

2.  ADVANCE BILLING ACCOUNT

                CREDITED EVERY TIME A BILLING STATEMENT IS MADE  AND WOULD END UP WITH THE TOTAL CONTRACT PRICE   AND DEBITED AT THE END OF THE CONTRACT FOR THE CONTRACT PRICE. WITH THE CREDIT TO CONSTRUCTION IN PROGRESS

3.  CONSTRUCTION EXPENSE OR COST

       DEBITED TO THE  AMOUNT  ARRIVED AT BY MULTIPLYING THE  COMPLETION PERCENTAGE OF THE PROJECT AS AGAINST THE  PARTIAL AND ESTIMATED COST TO FINISH THE PROJECT.    RATIO  X   TOTAL ESTIMATED COST OF THE PROJECT

4.   CONSTRUCTION REVENUE   = CREDITED TO THE AMOUNT ARRIVED AT BY MULTIPLYING THE COMPLETION RATIO AS AGAINST THE  TOTAL PROJECT PRICE

            :
SAMPLE:

   TOTAL  COST ALREADY INCURRED  TODATE                      300   23.1%
   ADD: ESTIMATED COST  STILL TO BE INCURRED UNTIL
THE PROJECT IS FINISHED                                                         1,000

TOTAL  PARTIAL ACTUAL COST AND ESTIMATED COST
TO FINISH THE PROJECT                                                            1,300   100%

THE PERCENTAGE OF COMPLETION IS  23.1%

THIS PERCENTAGE 23.1%  WILL NOW BE APPLIED TO THE TOTAL CONTRACT PRICE  OF THE PROJECT TO GET THE GROSS  REVENUE.( JUST LIKE GROSS SALES )

THE SAME PERCENTAGE SHALL BE APPLIED TO THE  ACCUMULATED ACTUAL COST PLUS THE ESTIMATED COST STILL NEEDED TO COMPLETE THE PROJECT TO BE ABLE TO GET THE EQUIVALENT COST  INCURRED  AS OF THAT DATE ( JUST LIKE COST OF SALES)

EXAMPLE:

   ASSUMING CONTRACT PRICE IS                     5,000
     MULTIPLY BY     23.1%                                      1,155   AS GROSS REVENUE
LESS:  ESTIMATED COST TO FINISH   1,300
MULTIPLY BY 23.1%                               23.1%        300.30 AS COST OF FINISHED PORTION.

 EQUALS THE REVENUE FOR THIS PERIOD        854.70

CONTRACT PRICE  WHOLE CONTRACT                    5,000
LESS: ESTIMATED COST  WHOLE CONTRACT          1,300
  EXPECTED  REVENUE                                                  3,700
SINCE 23.!% IS FINISHED   X  3700.00 =  854.70

IN EFFECT THIS 854.70 IS  23.!% OF  THE  NET REVENUE, JUST LIKE THE GROSS PROFIT IN CASE OF NON CONSTRUCTION BUSINESS.

THEN THE ORDINARY TRANSACTION WILL BE THE SAME SUCH AS:

1.  THE PURCHASE OR USE OF  MATERIALS , LABOR , OVERHEAD ETC. THE RECORDING SYSTEM  WOULD DEPEND ON THE ACCOUNTING SYSTEM THAT THE COMPANY WOULD LIKE TO ADOPT,  SAYING THEY WANT TO REFLECT THE COST OF MATERIALS, LABOR , OVERHEAD AND OTHER COST.

    CONSTRUCTION IN PROGRESS     300
           CASH OR PAYABLE                            300

2.  THE BILLING

        ACCTS. RECEIVABLE                     20
           ADVANCE BILLING                            20

3, COLLECTION
        CASH                                              20
           ACCTS. REC                                      20

4. THE RECOGNITION OF THE   REVENUE
         CONSTRUCTION IN PROGRESS             1,155

             CONSTRUCTION REVENUE                   1,155
                      
5. TO RECORD THE COST OF CONSTRUCTION

           CONSTRUCTION COST                             300.30
                     CONSTRUCTION IN PROGRESS                  300.30

AT THE END OF YEAR OF CONTRACT , THE TOTAL BALANCE OF THE CONSTRUCTION IN PROGRESS ACCOUNT WOULD BE  THE TOTAL COST , PLUS THE NET REVENUE  ( MARK UP X  COMPLETION RATIO  100%.( what isbeing debited to construction in process acct is the whole cost of building that project  and the profit or mark up ..

 THIS CONSTRUCTION IN PROGRESS ACCOUNT WILL BE CLOSED TO  ADVANCE BILLING ACCOUNT.SINCE  THIS IS AN OFFSET TO ACCTS. RECEIVABLE WHICH THE TOTAL CONTRACT PRICE WILL PASSED THRU THIS ACCTS. REC. ACCT.
THE CONSTRUCTION REVENUE ACCOUNT WOULD BE THE MARK UP ITSELF.


IN EFFECT   THE NET BALANCE OF THE CONSTRUCTION IN PROGRESS IN THE ENTRY IN NO. 4, 5  REPRESENTS THE REVENUE FOR THE PERIOD  HANGED IN THE ASSET ACCOUNT  CONSTRUCTION IN PROGRESS AS A TEMPORARY ACCOUNT UNTIL IT WILL BE CLOSED AT THE END OF THE CONTRACT. 


        
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TO ILLUSTRATE  ;

A CONSTRUCTION CO. IS CONTRACTED TO CONSTRUCT A  BUILDING ESTIMATED TO COST 800,000  AT A PRICE OF 1,000,000 TO FINISHED IN 3 YEARS
                                                                                  2011                       2012             2013      total
CUMULATIVE COST  INCURRED                   136,500                   386,100          413,900  800,000
ESTIMATED COST TO FINISHED TO PROJECT 513,500             328,900
   TOTAL PARTIAL AND ESTIMATED COST       650,000              715,000


PARTIAL BILLING                                                  104,000               455,000            351,000
COLLECTION                                                           65,000                 429,000           416.000

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JOURNAL ENTRY

CONST. IN PROGRESS                                         136,500               249,600             413,900
  CASH / ACCTS PYABLE ETC                                  136,500            249,600              413,900
cost of labor , materials etc,

ACCTS REC.                                                        104,000           455,000                     441,000
     ADVANCE BILL                                                104,000              455,000                 441,000

CASH                                                                65,000                  429,000                     416,000
  ACCTS. RECE                                                  65,000                           429,000                    416,000

CONST IN PROGRESS                            210,000                       330,000                     460,000
   CONST REVENUE                                         210,000                  330,000                    460,000
to record  revenue at 21%of contract price.                               revenue at 54%           revenue at 100%

CONSTRUCTION COST                             136,500                 249,600                        413,900        
   CONST IN PROGRESS                                  136,500                 249,600                            413,900
record cost to produce rev. 21% of cost

ADJUSTING ENTRY:

ADVANCE BILLING                                                                                                1,000,000
  CONSTRUCTION IN PROGRESS                                                                                 1,000,000

THE 249,600 IN THE SECOND YEAR IS THE ACTUAL EXPENSES FOR THAT YEAR , SO THAT ADDING 136,500 PLUS 249,600 IS THE ACCUMULATED ACTUAL EXP. UP TO YEAR 2012 IS 386,100
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HOW THE CONSTRUCTION REVENUE ARRIVE AT:

 2011 COMPLETION RATIO ON THE BASIS OF EXPENSES INCURRED
    ACTUAL EXPENSES                                136,500
   DIVIDE  total cost                                        650,000
           EXPENSE RATIO                                   21%
 GROSS REVENUE =  CONTRACT PRICE 1.0m X 21%  210,000
FOR THE COST         650,000 X  21%                            (  136,500)
NET REVENUE                                                                     73,500
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 2012  EXPENSE RATIO
CUMULATIVE EXPENSES/COST                 386,100
DIVIDE TOTAL EXPENSE ESTIMATE          715,000
 COMPLETION RATIO                                       54%                         
                                                                                                             cum this yr  cum. lyr.     this yer
 GROSS REVENUE FOR THE CONT.PRICE     1,000,000  X 54%   540,000  -210,000 =  330,000
GROSS COST                                                       715,000  X 54%      386,100 - 136,500 =  249,600
      NET REVENUE                                                                              153,900  -   73,500  = 80,400   

TAKE NOTE THAT YOU CANNOT COMPUTE THE NET REVENUE FOR SUCCEEDING YEAR UNLESS YOU COMPUTE THE CUMULATIVE NET REVENUE AS OF THE PRESENT YEAR , SAY THE 153,900 THEN DEDUCT THE REVENUE LAST YEAR , 73,500 TO GET 80,400
+++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++

2013  THE LAST YEAR OF CONTRACT

FINAL  CUMULATIVE  EXPENSES           800,000
COMPLETION RATIO                                  100%
                                                                                                         cum. thisyer     cum lyr        this yr
GROSS REVENUE  FOR THE CONT. PRICE  1,000,000 X 100%    1,000,000 - 540,000     460,000
GROSS COST                                                       800,000 X 100%       800,000  -386,100     413,900
 net revenue                                                             200,000                     200,000  -153,900       46,100


                                                                                                                                                              
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DONT BE CONFUSED  ON THE JOURNAL ENTRY ON REVENUE,  WHAT WAS ADOPTED IS JUST LIKE AN ORDINARY RECORDING OF GROSS SALES AND THE RECORDING OF COST OF SALES,  HERE , THE COMPLETION RATIO IS FIRST APPLIED TO THE CONTRACT PRICE  BUT ARE REDUCED BY THE COMPLETION RATIO APPLIED TO THE  ESTIMATED COST OR EXPENSES AS OF THAT YEAR , THE NET EFFECT IS ALSO NET REVENUE (  CONTRUCTION REVENUE LESS CONSTRUCTION COST )
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IF YOU WE ARE GOING TO PUT THESE ENTRIES INTO    T   ACCOUNTS :


       ACCTS RECEIVBLE              CONTR. IN PROCESS          CONTRUCTION REVENUE
dr                          cr                       dr                        cr                    dr                          cr




    ADVANCE BILLING              CONTRUCTION EXPENSE         CONTRUCTION COST
dr                   cr                               dr                           cr                      dr                       cr




THE FOLLOWING WILL BE THE BALANCES END OF 2013

                                           PROFIT  AND LOSS
                                                             2011                       2012                              2013
CONTRUCTION REVENUE         210,000                   330,000                        460,000         
CONSTRUCTION COST              136,500                   249,600                        413,900
  NET REVENUE                              73,500                     80,400                          46,100


                                          BALANCE SHEET

ASSETS
CASH                                             65,000                    494,000                     910,000
ACCTS. REC.                                39,000                      65,000                       90,000
CONS.PROGRESS      210,000                                          -
LESS: ADV. BILL         104,000)  106,000
TOTAL                                          210,000                   559,000                 1,000,000

LIABILITIES

ACCTS. PAYABLE                     136,500                      386,100                   800,000
ADVANCE BILLING                                        559,000
less: const. in progress                                         540,000 19,000 
NET INCOME                               73,500                        80,400                    46,100
RETAINED EARNINGS                                                   73,500                   153,900

TOTAL                                        314,000                     559,000               1,000,000

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THE ADVANCE BILLING AS A RULE MUST BE OFFSET OR CONTRA ACCOUNTS TO CONSTRUCTION IN PROGRESS,  IF  CONSTRUCTION IN PROGRESS ACCOUNT IS BIGGER THAT MEANS THE EXPENSES IS IN EXCESS OF THE BILLING  ( put to asset side )

if the advance bill is more than the construction in progress , it means, the billing is excess of the cost.  reflect to liabilities side .


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POSSIBLE LOSS ON LONG TERM CONSTRUCTION

there is a possibility that while the construction is going on, it is estimated that it will incur a loss.

there are two types of loss.

1.   the estimated future cost may indicate a loss on the current period, but there will be a profit on the total contract.
2.  the estimated cost may indicate that  totally a loss will be incurred.

EXAMPLE  of  a contract that the result will be a net loss as whole, that means it may have profit on some years but in total for the whole contract it will be a net loss.

the following data is given:
                                                            YEAR 1               YEAR 2                  YEAR   3    TOTAL

 CONTRACT PRICE                                                                                                       910,000
COST TODATE                                  136,500                  386,100              990,000       990,000
ESTIMATED COST TO COMPLETE513,500                  603,900                                           
TOTAL PARTIAL AND ESTIMATE    650,000                  990,000                                 990,000

PERCENT OF COMPLETION               21%                      39%                     100%

journal entries  yr. 1:

CONTRUCTION IN PROGRESS      136,500                  249,600             603,900
           ACCTS. PAYABLE

CONTRUCTION PROGRESS          191,100                  354,900
          CONST. REVENUE                   191,100

CONSTRUCTION COST                  136,500                386,100
              CONST. IN PROGRESS         191,100                     386100

THERE IS A PROFIT OF 54,600 IN YEAR 1, BUT IN YEAR TWO , THERE IS A LOSS OF 85,800.

TAKE NOTE THAT BY THE END OF YEAR 2 , IT IS ESTIMATED THE  YEAR 3 WILL ALSO BE  A LOSS JUST LIKE THE 2ND YEAR.

IF A LOSS IS EXPECTED FOR THE WHOLE CONTRACT , THE ENTIRE LOSS OF THE WHOLE CONTRACT  SHOULD ALREADY BE RECOGNIZED IN THE YEAR WHERE IT IS DISCOVERED. THAT MEANS  THE CUMULATIVE PROFIT AS THAT DATE MUST BE THE AMOUNT OF THE TOTAL LOSS

THE REGULAR ENTRY DEBITING CONSTRUCTION COST  OR EXPENSE FOR YEAR 2 IS STILL NEEDED  AND THE CREDIT TO  CONSTRUCTION REVENUE ,  AND A CREDIT TO CONST. IN PROGRESS  FOR THE GROSS LOSS..

IF THIS THE CASE THE COMPUTATION OF NET REVENUE  IN yr. 3 Need TO BE IGNORED.. EVEN THE SUPPOSED CREDIT TO CONSTRUCTION IN PROGRESS ACCOUNT  IN RECOGNIZING THE NET LOSS IN YEAR 2 NEED  TO BE REVERSED  BECAUSE IF THE WHOLE CONTRACT WILL BE A LOSS THERE IS NO USE to have A BALANCE FOR THE CONSTRUCTION IN PROGRESS ACCOUNT  REPRESENTING A LOSS ( note that construction in progress includes the net revenue ), that is why even the profit of year 1  , debited to construction in process has to be reversed , in year 2.  SO WHAT IS LEFT ON THE BALANCE OF CONSTRUCTION IN PROGRESS ACCOUNT IS THE CUMULATIVE COST OR EXPENSE IN CONSTRUCTING THE PROJECT.

NOW SINCE THE LOSS IN YEAR 3 HAS TO BE RECOGNIZED IN YEAR TWO AN ENTRY DEBITING CONST. COST OR EXPENSE AND CREDITING  RESERVE FOR LOSS  IS NEEDED SO THAT THE CUMULATIVE PROFIT FOR YEAR WILL APPEAR TO BE THE WHOLE TOTAL LOSS OF THE PROJECT. 

 IN SHORT THE ABOVE STATEMENT  IN SUMMARY APPEARS LIKE THIS

                     CONST. COST     249,600
                             CONSTRUCTION REVENUE        163,800
                            CONST. IN PROGRESS                      85,800    LOSS
                   to record the const. cost this year and the revenue at 39% and record the loss

                  CONS. IN PROGRESS       85,800
                              RESERVE FOR LOSS YEAR 2       85,800
                    to reclassify the above entry so tha the const. in progress be closed to reserve for loss

                
                 RESERVE FOR LOSS YEAR 1     54,600
                                CONST. IN PROGRESS            54,600  
                             to reverse the balance of const. in progress last year and charged to reserve for loss

                CONSTRUCTION COST                      48,800
                               RESERVE FOR CONTRACT LOSS              48,800
               to  anticipate the loss in year 3 by crediting it to reserve for loss

  IN EFFECT THIS IS THE COMPOUND ENTRY:
of the above entries:

                 CONST COST EXP                 298,400
                        CONST. REVENUE                            163,800
                         RESERVES FOR CONTRACT LOSS 80,000
                         CONST. IN PROGRESS                     54,600
                                            
                                  

SUMMARING THESE ENTRIES ,  THE CONST. IN PROGRESS WOULD NOW  HAVE A BALANCE REPRESENTING  THE  TOTAL COST OF THE PROJECT AS OF YEAR TWO OF 386,100 AND DOES NOT ANYMORE INCLUDE THE PROFIT IN YEAR 1 54,600  AND NET LOSS OF YEAR 2 OF 85,800.00,  THEREFORE 54,600  IN CONST. IN PROCESS  LAST YEAR   IS DEBITED TO RESERVE FOR LOSS, AND THE 85,800  CREDIT TO CONST. IN PROGRESS YEAR 2 IS DEBITED AND CREDITED TO  RESERVE FOR LOSS.

THE NET LOSS IN YEAR 3,  OF 48,800  WILL BE RECORDED THIS YEAR 2 AND CHARGD TO RESERVE FOR CONTRACT LOSS.

IF THE RULE IS, IF THE WHOLE CONTRACT WILL BA LOSS,  THEYEAR WHERE THE LOSS IS KNOWN SHOULD RECOGNIZED THE TOTAL LOSS of the whole contract  THAT MEANS THE LOSS IN THE SUCCEEDING YEARS SHOULD ALSO BE CHARGED TO THE YEAR WHERE THE TOTAL LOSS WAS KNOWN. IN THIS CASE IN YEAR 2

IF THIS IS CASE THE RETAINED EARNINGS AS OF THE YEAR WHERE THE LOSS IS ANTICIPATED MUST TURNED OUT TOBE EQUAL TO  THE TOTAL LOSS OF THE CONTRACT. EVEN THE CONTRACT  HAS NOT YET ENDED.

IN THE YEAR 3 , THE  FOLLOWING ENTRIES

CONSTRUCTION  IN PROGRESS               603,900
     ACCTS. PAYABLE                                             603,900
purchase and pay all expenses for the project year 3

RESERVE FOR CONTRACT LOSS             80,000
ADVANCE BILLING                                   910,000
        CONSTRUCTION IN PROGRESS                 990,000
to close advance billing  andclose  the construction in progress and the reserve for contract loss.

IF YOU TAKE THE BALANCE SHEET BALANCE  AS OF YEAR 3

    ACCTS. RECEIVABLE                        910,000   THE CONTRACT PRICE assume no collection.

ACCTS PAYABLE                                    990,000   the cost assume no payment
CUMULATIVE PROFIT /LOSS              (  80,000)
TOTAL                                                      910,000              

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PROBLEM :

 THE FOLLOWING DATA
                                                             YR.   1                    YEAR  2               YEAR   3
CONTRACT PRICE                                                                                                        875,000
CONSTRUCTION COST THISYR.     125,000                232,500                 455,000  812,500
ESTIMATED COST TO COMPLETE   500,000                455,000

BILLING TO BUYER                          100,000              437,500                    337,500    875,000

COLLECT                                           62,500                 412,500                     400,000    875,00                               

TAKE NOTE THE CONSTRUCTION COST  IS NOT TO DATE  , IT IS FOR THE CURRENT YEAR.  IN COMPUTING FOR THE COMPLETION RATIO , IT MUST BE BASED ON CUMULATIVE COST  SPENT.

THERE IS A LOSS IN  THE 2ND YEAR , BUT THE TOTAL CONTRACT  IS A PROFIT.

COMPUTE FOR THE ESTIMATED INCOME OR LOSS FOR EACH YEAR. AND THE INCOME REALIZED EACH YEAR.

MAKE JOURNAL ENTRIES.
MAKE BALANCE SHEET/ PROFIT AND LOSS.