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After the contract went into effect, LabCo experienced difficulties designing and manufacturing the laser cutting machine. They were forced to redo initial designs, outsource engineering costs, and the price of steel used to construct the cutting machine unexpectedly rose.
LabCo had to re-estimate their costs to complete the project and concluded that the excess costs would exceed the total fixed fee contract price they negotiated with Halibut. To update their estimated costs, LabCo continued using the percentage of completion method. LabCo appropriately recorded a loss in the period in which they became aware.
Provisions for losses shall be made in the period in which they become evident under either the percentage-of-completion Financial accounting standards essay or the completed-contract method ASC When the cutting machine was finally complete, they delivered it to Halibut to have it tested.
During the final test, the machine failed to meet the specifications of Halibut. LabCo was forced to redesign and fix the various problems with the machine.
Accordingly, during the period of performance, billings and costs are accumulated on the balance sheet, but no profit or income is recorded before completion or substantial completion of the work ASC The two methods, percentage of completion and completed contract, are not acceptable alternatives for the same situation ASC LabCo should have realized after running into unexpected costs the first time that they should have switched to the completed contract method.
It is clear that the percentage of completion method was not the acceptable alternative because LabCo could not effectively estimate costs.
The completed contract method is the preferable method because there was a lack of dependable estimates. The situation can also be handled with a Change in Accounting Estimate approach.
When LabCo incurred significant difficulties with the design and manufacturing of the laser machine, they decided to update their estimates used in the percentage of completion method to reflect both the cost overruns incurred as well as the cost overruns expected to be incurred.
Handling it with this approach prohibits the retrospective treatment to the situation. It will affect only the period of change and future periods, if the change affects both, in which case it does. Due to LabCo dealing with continued problems with the Halibut contract, and prior estimates adjusted previously during the contract period, it forced the Chief Accountant of LabCo to allow the change in accounting principle from percentage of completion method to completed contract method.
LabCo can make this change by it being impossible to determine whether a change in principle or a change in estimate has occurred. The Change in Accounting Estimate would seem sufficient to apply to this situation, but it will not work because a change in estimate cannot be applied retrospectively.
Therefore, I have concluded that the best way to handle this issue is the Change in Accounting Estimate affected by the Change in Accounting Principle approach. I have come to this conclusion based on the facts that due to a change in accounting principle and change in accounting estimate both being involved in this situation, and retrospective application not being applicable, the entire effect of the two changes should be applied in a prospective method.
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(IASB) and the Financial Accounting Standards Board (FASB).