What is a Contract Asset? (Definition, Example, Calculation, and Classification)

Definition of a Contract Asset

Contract Asset can be defined as an entity’s right to consideration in exchange for goods and services that the entity transfers to a customer, particularly in the case when the right is conditioned on something other than the passage of time.

Therefore, this implies that contract asset is created in instances when the party meets certain performance obligations. As a result of this fulfillment, a contract asset is created when this, and a couple of other conditions are met.

Contract Assets are also referred to as unbilled receivables or progress payments that require to be billed.

A contract asset is defined as an entity’s right to put in consideration in exchange for goods and services that the entity has managed to transfer to a customer when the right is particularly conditioned on the remaining parts of the service contract being fulfilled.

Therefore, this implies that contract assets, by definition, are sums of money that customers can receive if certain conditions are met.

Contract Asset – Recognition

As mentioned earlier, contract asset is recognized when a performance obligation is met. However, the payment for that particular performance obligation is not solely contingent on the passage of time.

The other conditions attached to realizing the recognized contract asset mostly relate to the entity’s fulfillment of several other performance obligations specified in the contract.

Difference between Contract Assets and Trade Receivables

Contract Assets are often intermixed with Trade Receivables. However, this is an incorrect approach. Trade Receivables present a fully completed performance obligation, which entitles the fulfilling party to receive the payment unconditionally. On the other hand, as far as Contract Assets are concerned, they involve an element of contingency.

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This implies that payment will only be subdued in the case where other parts of the contract are also fulfilled.

In other words, the payment for contract assets is conditional on the subsequent completion of other performance obligation tasks mentioned in the contract.

Another underlying difference between Contract Assets and Trade Receivables is that Contract Assets come with credit risk and performance risk. On the contrary, Trade Receivables only incur credit risk.

Calculation of Contract Assets

Contract Assets normally occur in processes that involve longevity pertaining to contract fulfillment and obligation.

In this regard, it is important for accountants to understand the actual amount that needs to be recorded for contract assets in the financial statements.

In particular, in the case of construction contracts, there are several different completion stages that are involved. In this aspect, alongside performance obligations presented, it is important to calculate contract assets accurately and accurately, depending on the completion stage of a given project.

In order to calculate the contract asset value to be presented in the financial statements, the following calculations are required:

ParticularAmount
Costs incurred to datexxx
Profit incurred to datexxx
Less: Amounts invoiced to datexxx
Contract Assetxxx

In the calculation presented above, it can be seen that there are several different aspects that are included when it comes to establishing contract assets.

It is required to have a clear-cut understanding of the total costs incurred to date and the profit generated as a result of this particular cost. Only then can the contract asset cost be reliably estimated.

Alternatively, contract assets can also be created by looking at the service contract and then determining the extent of work already completed depending on the performance contract.

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Either of these approaches can be used, as long as they derive reasonable estimates.  

Accounting Treatment and Journal Entries for Contract Assets

During the normal course of the business, when a sale is made, the following transaction is required:

ParticularDebitCredit
Bank (or Accounts Receivable)xxx 
 Bank Loan (Long-Term Liability)xxx

Alternatively, when contract assets are created, the treatment is slightly different on a number of grounds. This is a contingent revenue, and therefore, it cannot be directly recorded as Accounts Receivable.

Contract Assets are created when there is a partial performance obligation involved. When there are partial performance obligations involved, the following journal entries are required:

ParticularDebitCredit
Contract Assetsxxx 
 Revenuexxx

Example of Contract Asset

The concept of contract asset is illustrated in the following example:

Hello, Inc. is a telecommunication company that sells smartphones and voice plans (or a cellular sim). The basic cost of the smartphone is $150, and it is non-refundable.

The voice plan spans over a period of 24 months, and during this duration, the basic line rent amounts to $10 per month. Therefore, the total transaction price amounts to ($150 + 24*$50) $1,350.

From the organization’s perspective, it can be seen that both, smartphone and the voice plan are considered separate performance obligations.

In this regard, $150 is allocated separately for the smartphone, whereas the remaining amount (i.e. $1,200) is allocated to the voice plan. When the contract is signed and the smartphone has been provided to the customer, the following journal entries are recorded:

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ParticularDebitCredit
Trade Receivable$150 
Contract Asset$1,200 
    Revenue $1,350

It can be seen that $150 (the price of the smartphone) is supposed to be paid unconditionally, and therefore, it is recorded as such in the financial statements.

However, the voice plan is contingent on the company providing the given service, and therefore, it will be recorded as a contract asset, and not trade receivable.

After the first month, when the bill for the voice plan is issued, the following journal entries will be required:

ParticularDebitCredit
Trade Receivable$50 
Contract Asset$50

Subsequently, when this settlement is made, the following transactions are carried out:

ParticularDebitCredit
Bank $50 
  Trade Receivable  $50

Another example of Contract Asset, and how it works is as below:

Prime Machines agreed on selling two separate machines to Gummy Inc. for a price of $5,000. These machines were individually priced at $2,000 and $3,000 respectively.

Depending on the mutual agreement on both the parties, Prime Machines agreed to deliver the first machine in April, whereas the second machine was supposed to be delivered in May. The payment was supposed to be made only after both the machines were delivered.

From the perspective of Prime Machines, it can be seen that there are two separate performance obligations that need to be fulfilled, one of them is delivery of the first machine, whereas the second one is the delivery of the second machine.

In order to record both these deliveries, the following transactions will be made in the month of April, and May, respectively.

ParticularDebitCredit
Contract Asset$2,000 
 Revenue$2,000
ParticularDebitCredit
Accounts Receivable$5,000 
  Contract Asset  $2,000
  Revenue  $3,000

Accrued and Unbilled Revenue and Contract Asset

Accrued and Unbilled Revenue is not the same as Contract Asset. This is because unbilled revenue might come into play in the case where there is relative uncertainty about the amount that needs to be billed.

For unbilled (or accrued revenue) to be classified as a contract asset, the payment must have a condition of a contingency attached. Merely lack of details does not provide ground for any asset to be declared as a contract asset.