248 Chapter? Chapter 7 Construction Contracts Related standard: PFRS 15 Revenue from Contracts with Customers Learning Objectives 1. Apply PERS 15 to account for revenues from, and. costs oj, construction contracts. 2. Account for onerous construction contracts. 3. Account for changes in the transaction price of a construction contract. 4. Account for uncertainty in the collectability of contrac revenue. Introduction An entity applies PFRS 15 Revenue from Contracts with Customers to account for revenues from contracts with customers. PFRS 15 supersedes PAS 11 Construction Contracts. e Revenue — is “income arising in the course of an entity's ordinary activities.” (PFRS 15. Appendix A) © Contract - is “an agreement between two or more parties that creates enforceable rights and obligations.” (PFRS 15.Appendix A) Customer - is “a party that has contracted with an entity te obtain goods or services that are an output of the entity's ordinary activities in exchange for consideration.” (FR 15. Appendix A) Core principle under PFRS 15 An entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled i" exchange for those goods or services. atte ll || i] J oon oeConstruction Contracts _ fl Summary of the Revenue recognition Principles wader PERS 15: [Step 1: Identify the contract with the customer The contract is with a customer and | (among others) the collectability of the consideration is probable. Step 2: Identify the performance obligations in the contract Each promise to deliver a distinct good or service in the contract is treated as a separate performance obligation A promised good or service is distinct if: a. The customer cai benefit from the good or service either on its own or together with other resources that are readily available to the customer; and b. The promise to transfer the good ‘or service is separately identifiable from other promises in the contract. Step 3: Determine the transaction price ‘The transaction price is the amount that the entity expects to be entitled to in exchange for satisfying a performance obligation. Step 4: Allocate the transaction price to the performance obligations The transaction price is allocated to the performance obligations based on the relative stand-alone prices of the distinct goods or services. Step 5: Recognize revenue when (or as) a performance obligation is satisfied ~ For a performance obligation satisfied over time, revenue is recognized as the entity progresses towards the complete satisfaction of the performance obligation. - For a performance obligation satisfied at a point in time, revenue is recognized when the entity completely satisfies thealge performance obligation, Revenue is measured a) amount of transaction price alllog to the performance satisfied. ai | Obligatig, Definition of Construction contract Construction contract — is a contract specifically negotiated fo, the construction of an asset or a combination of assets that are lose interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use. Construction contracts include: a. Contracts for the rendering of services that are directly related to the construction of an asset, e.g, those for the services of Project managers and architects; and b. Contracts for the destruction or restoration of assets, and the restoration of the environment following the demolition of assets. Construction contracts are generally long-term. The dete at which the contract is entered into and the date the contract is completed normally fall on different financial reporting perils The primary issue in the accounting for construction contracts, therefore, is the timing of recognition of contract revenue and contract costs. Application of the Basic Principles of PFRS 15 Step 1: Identify the contract with the customer A contract with a customer is accounted for only when all of tk following criteria are met: . a. The contracting parties have approved the contract (in writin orally or implied in customary business practices) and committed to perform their Tespective obligations; alcConstruction Contracts p. The entity can identify each party’s rights regarding the goods or services to be transferred; c. The entity can identify the payment terms for the goods or services to be transferred; d, The contract has commercial substance (i.e., the risk, timing or amount of the entity’s future cash flows is expected to change ag a result of the contract); and e. The consideration in the contract is probable of collection. When assessing collectability, the entity considers only the customer's ability and intention to pay the consideration on due date. No revenue is recognized on a contract that does not meet the criteria above. Any consideration received from such contract is recognized as a liability and recognized as revenue only when either of the following has occurred: a. The entity has no remaining obligation to transfer goods or services to the customer and all, or substantially all, of the consideration has been received and is non-refundable; or b. The contract has been terminated and the consideration received is non-refundable. Combination of contracts Each contract is accounted for separately. However, two or more contracts entered into at or near the same time with the same customer (or related parties of the customer) are combined and accounted for as a single contract if: a The contracts are negotiated as a package with a single commercial objective; b. The amount of consideration to be paid in one contract depends on the price or performance of the other contract; or c. Some or all of the goods or services promised in the contracts are a single performance obligation. Negotiating multiple contracts at the same time is not sufficient evidence to demonstrate that the contracts represent a single arrangement.252 Chapter? AAS? Step 2: Identify the performance obligations in the contrac, Each promise to transfer the following is a performance obligayi,, that is accounted for separately: a. A distinct good or service (or a distinct bundle of goods 4, services); or b. A series of distinct goods or services that are substantially th, same and have the same pattern of transfer to the customer A promised good or service is distinct if: a. The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer; and b. The promise to transfer the good or service is separatey identifiable from other promises in the contract. Customer can benefit: A customer can benefit from a good or service if the good or service could be used, consumed, sold for an amount that is greater than scrap value or otherwise held in a way that generates economic benefits. The fact that the entity regularly sells a good or service separately indicates that a customer can benefit from the good ot service on its own or with other readily available resources. Separately identifiable: A promise to transfer a good or service is separately identifiable if the good or service: | i. is mot an input to a combined output specified by the | customer. | ii. does not significantly modify another good or service | promised in the contract. iii, is not highly interrelated with other goods or servic promised in the contract. For example, the customer’ — decision of not purchasing a good or service does not affect the other promised goods or services in the contract.ruction Contracts 253 Construct A promised good or service that is not distinct is combined with other promised goods or services until a bundle of goods or services that is distinct is identified. In some cases, this may result to treating all the promised goods or services in a contract as a single performance obligation. Series of distinct goods or services A series of distinct goods or services that are substantially the same and have the same pattern of transfer to the customer are accounted for as a single performance obligation if each good or service in the series represents a performance obligation that would be satisfied over time if each was accounted for separately; and the entity would use the same measure of progress toward the satisfaction of the performance obligation for each of those goods or services. Performance obligations include only activities that involve the transfer of a good or service to a customer. Performance obligations do not include administrative tasks to set up a contract. Example: Determining whether goods and services are distinct Entity A, a contractor, enters into a contract to build a resort hotel fora customer. Entity A is responsible for the overall development and identifies various goods and services to be provided, including design, engineering, site preparation, procurement, Construction, piping and wiring, installation of uninterruptible Power supply system, swimming pools and Jacuzzi, and finishing. The entity, and its competitors, regularly sells many of these 800ds and services separately to customers. Analysis: The Promised goods and services are capable of being distinct Under criterion (a). The customer can benefit from the goods and Services either on their own or together with other readily Available resources. This is evidenced. by the fact that the goods [Saae Chapter 7 and services are regularly sold to customers. In addition, th, customer could generate economic benefit from the individ goods and services by using, consuming, selling or holding them, | However, the goods and services are not distinct unde, crilerion (b) because they are not separately identifiable from each) other. This is evidenced by the fact that the entity Provides 4 significant service’ of integrating the goods and services (the | inputs) into the hotel resort (the combined output) for which the | customer has contracted. | Conclusion: Because both criteria are not met, the goods and services are not distinct. The entity accounis for all the goods and services in the contract not separately but as a single performance obligation. Satisfaction of performance obligations At contract inception, the entity shall determine whether the identified performance obligations will be satisfied either: a. Over time; or b. Ata point in time A performance obligation is satisfied over time if one of the following criteria is met: a. The customer simultaneously receives and consumes the benefits provided by the entity's performance as the entity performs. Example: If the contract with the customer is discontinued and the customer enters into a contract with another entity to fulfill the remaining performance obligation. the other entity would not need to substantially re-perform the work that the entity has completed to date. b. The entity's performance creates or enhances an asset (8 work in progress) that the customer controls as the asset is created or enhancedConstruction Contracts Rss eee ¢ The entity's performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date. Alternative use: i. An asset does not have an alternative use to the entity if the entity is restricted contractually from directing the asset for another use during or after the asset’s completion, or in the absence of a contractual restriction, the entity would incur significant costs of rework before it can direct the asset for another use, or the entity could only sell the asset at a significant loss. Enforceable right to payment for performance completed to date: ii, Anentity has an enforceable right to payment for performance completed to date if the entity is entitled to compensation for the completed performance if the contract is terminated for reasons other than the entity’s failure to perform as promised, and the compensation is sufficient to cover the costs incurred in satisfying the performance obligation plus a reasonable profit margin. A reasonable profit margin need not equal the profit margin expected if the contract was fulfilled as promised. For many construction contracts, it is likely that the performance obligation is satisfied over time. However, an entity should consider all available information to determine whether one of the criteria above is met. If the entity cannot obligation is satisfied over time, Performance obligation is satisfied at a point in time. demonstrate that a performance it is presumed that the256 Chapter 7 tere eeeceneee Example 1.1: Alternative use % Entity A énters into 1 a contract with a customer to builg , el. Entity A customizes solar panels for | ch solar panel can differ substantially on the | basis of each customer's needs. If the customer cancels the Contrag | for reasons other than Entity A’s failure to perform, Entity A g), | | | | Customized solar pan | | various customers, Ea | all keep the solar panel. However, due to its specialized naty Significant: modificatio sold to another custom Te, n is needed before the solar panel Can be er, Analysis; At contract inception, Entity A assesses whether its Performance obligation to bu ild the solar panel is a performance obligation that is satisfied over time using the criteria in (a) to (c) above, As part of that assessment, Entity A considers whether the solar panel has an alternative use to Entity A. (See criterion ‘¢’ Although Entity A is not contractually restricted from directing the solar Panel to another customer, the customer. Specific design of the solar power limits Entity A’s practical ability to readily direct it to another customer without incurring significant costs of rework. Consequently, the solar panel has 10 alternative use to Entity A. However, before Entity A can conclude that its performance obligation is satisfied over time, Entity A shall also assess if it has an enforceable right to Payment for performance completed to date. See Example 1.2 below, Example 1.2; Enforceable right to payment | (Continuation of Example 1.1) The customer is required to make a 15% adv, contract inception. Subsequent payments are | | Progress on the contract, after proportionate deductions for the) | advance payment and 10% retention. The 10% retention is due) | when the solar panel is completed and has passed the prescribed performance tests. The payments are non-refundable unless Enti | A fails to periorm ag=promised:If ane Neugiomer cancel ance payment a based on Entity 4's) j ale:struction Contracts ~ Constr _ 257 | contract, Entity A retains any payments received but has no right “| to further compensation. ; —— a _ Analysis: Entity A considers whether it has an enforceable right to payment for performance completed to date if the customer were to terminate the contract for reasons other than Entity A’s failure to perform as promised. (Gee criterion’c’) Entity A has an enforceable right to payment for performance completed to date because the payments are non-refundable and are based on Entity A’s progress on the contract. The cumulative amount of the payments is expected, at all times throughout the contract, to sufficiently cover Entity A’s costs plus a reasonable profit margin. Accordingly, in Examples 1.1 and 1.2, Entity A can conchide that its performance obligation to build the solar panel is a performance obligation that is satisfied over time. Example 1.3: Enforceable right to payment (Continuation of Example 1.1 and Variation of Example 1.2) The customer is required to make a 15% advance payment at contract inception, periodic payments equal to 40% throughout the estimated construction period, and the remaining 45% when the solar panel is completed and has passed the prescribed performance tests. The payments are non-refundable unless Entity A fails to perform as promised. If the customer cancels the contract, Entity A retains any payments received but has no right to further compensation Analysis: Entity A does not have an enforceable right to payment for performance completed to date because even though the payments are non-refundable, the cumulative amount of those payments is not expected, at all times throughout the contract, to compensate Entity A’s performance completed to date.oN as Chapter 7 For example, if the customer cancels the contract y 100% completion, Entity A would only be entitled to 55% Paymen, (15% advance + 40% periodic payments) and that would p, insufficient to cover Entity A’s costs plus a reasonable Profit margin. Accordingly, in Examples 1.1 and 1.3, Entity 4, Performance obligation to build the solar panel is a performance obligation that is satisfied at a point in time. Example 1.4: Enforceable right to payment (Continuation of Example 1.1 and Variations of Examples 1.2 & 1.3) The customer is required to make a 15% advance payment a contract inception. The balance is payable when the solar panel is | completed and has passed the prescribed performance tests. The | payment is refundable only when Entity A fails to perform as| promised. Analysis: Entity A does not have an enforceable right to payment for performance completed to date (same reason as with Ex. 1.3). Step 3: Determine the transaction price The transaction price is “the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected ot behalf of third parties (e.g., some sales taxes).” (PFRS 15.Appdx. A) In a construction contract, the transaction price normally consists of the following: | a. The contract price; and | b, Any subsequent variations in the contract price to the extent that it is probable that they will result in revenue and they af | capable of being, measured reliably, | However, the transaction price may not be equal to the | contract price if the consideration in the contract is affected by a of the following: wee eaeConstruction Contracts Variable consideration; Constraining estimates of variable consideration; The existence of a significant financing component in the contract; d. Non-cash consideration; or e. Consideration payable to a customer. oP Aconstruction contract may be either: 1. Fixed price contract - a construction contract in which the contractor agrees to a fixed contract price or a fixed rate per ‘unit of output, which in some cases is subject to cost escalation clauses. 2. Cost plus contract - a construction contract in which the contractor is reimbursed for allowable or defined costs, plus a fee. The two types of cost-plus contracts are: a. Cost-plus-variable-fee contract ~ the contractor is reimbursed for the costs plus a percentage of those costs. The contract price is the sum of the costs and the variable fee. b. Cost-plus-fixed-fee contract - the contractor is reimbursed for'the costs plus a fixed amount. The contract price is the sum of the costs and the fixed fee. Some construction contracts may contain characteristics of both a fixed price contract and a cost plus contract, such as in the case of a cost plus contract with a ceiling price. Example: ; You contracted Mr. Architect Engineer Contractor to build a house for you. Case 1: The contract states a price of POM for the house. | Analysis: The contract is a fixed price contract. The transaction price is P6M,260 er o 2: The contract states that you shall reimburse Mr. Contragj>) € total construction costs plus 15% thereof. " | Analysis: The contract is a cost-plus-a-variable-fee contract, The transaction price is equal to the reimbursable costs plus 15, thereof, Case 3: The contract states that you shall reimburse Mr. Contractor the total construction costs plus P2M. Analysis: The contract is a cost-plus-a-fixed-fee contract. The transaction price is equal to the reimbursable costs plus P2M. Cost-plus pricing is used in cases where it is difficult for the contractor to quote the contract price because either a. itis not possible to accurately estimate the scope of the project; or b. there have been no precedent similar projects that can be used as basis for price quotation. The cost-plus-variable-fee, which is common in government contracts, has the following disadvantages: a. Disadvantage to the contractor: The contractor's recovery of overhead costs depends on the cost of materials, which can be affected by significant price fluctuations. There can be a tisk that the agreed percentage may prove to be too low for the contractor to recover overhead costs and eam a profit. b. Disadvantage to contractee: There is no incentive for the contractor to be cost-efficient. Instead, the contractor ® tempted to increase the cost because the greater the cost, the greater will be the profit. Accordingly, the contractee may end up paying an outrageously overstated contract price.onstruction Contracts 5 a 261 Step 4: Allocate the transaction price t Sr tions pl io the performance The transaction price is allocated to the performance obligations based on the relative stand-alone prices of the distinct goods or services. The stand-alone selling price is the price at which a promised good or service can be sold separately to a customer If there is only one performance obligation in a contract, the transaction price is allocated only to that single performance obligation. Step 5: Recognize revenue when (or as) a performance obligation is satisfied If the performance obligation in the contract is satisfied over time, revenue is recognized over time as the entity progresses towards the complete satisfaction of the obligation. If the performance obligation in the contract is satisfied at a point in time, the entity recognizes revenue when the performance obligation is satisfied. Revenue is measured at the amount of the transaction price allocated to the satisfied performance obligation. Performance obligations satisfied over time An entity recognizes revenue from a performance obligation that is satisfied over time based on the entity’s measurement of its progress towards the complete satisfaction of the obligation in the contract. For example, if the performance obligation is 70% completed, revenue is recognized equal to 70% of the transaction price. Methods of measuring progress ; An entity shall use a single method of measuring progress consistently for each performance obligation satisfied over time and shall remeasure its progress at the end of each reporting period. Appropriate methods of measuring progress include: a. Output methods b. Input methods262 g Chapter 7 Input methods Inputs methods recognize revenue on the basis of efforts or inp), expended relative to the total expected inputs needed to fully satisfy a performance obligation. Examples of efforts or inputs include: a. Costs incurred b. Resources consumed c. Labor hours expended d. Machine hours used e. Time elapsed Cost-to-cost The most common application of the input methods is the “cost- cost” method. Cost-to-cost method refers to the estimation of stage of completion by reference to the proportion that contract costs incurred for work performed to date bear to the estimated total contract costs. In other words, the percentage of completion is determined as the ratio of total costs incurred to date over the estimated total contract costs. Formula #1: Percentage of Total costs incurred to date completion Estimated total contract costs > Total costs incurred to date represent the cumulative costs incurred from contract inception up to the current reporting date. > Estimated tolal contract costs (Estimated total costs at completion pertain to the forecasted total costs of completing the contract This can also be determined as the sum of total costs incurred date and estimated costs to complete.suction Contracts 263 Estimated costs t ele pert > Ee ted ‘0 complete pertain to the anticipated additional costs required to fully complete the contract. Formula #2: Variation A variation of the formula above is presented below: ral costs incurred to date _ = Total costs incurred to date + Estimated costs to complete Percentage of completion Illustration 1: Cost-to-cost In 20x1, ABC Construction Co. enters into contact to construct a building for a customer. The contract price of P6M will be billed to the customer periodically based on ABC’s progress on the construction. | Case 1: Estimated total contract costs | The estimated total contract costs are PAM. The actual costs incurred in 20x1 are P1.2M. ss Requirement: How much revenue is recognized in 20x1? Solution: Step 1: Identify the contract with the customer : The contract is a construction contract, i.e, a contract specifically negotiated for the construction of an asset. Step 2: Identify the performance obligations in the contract The performance obligation is to construct a building. This is satisfied over time because: a. The entity's performance creates an asset (e.g., work in progress) that the customer controls as the asset is created. b. The entity’s performance does not create an asset with an alternative.use to the entity and the entity has an enforceable right to payment for performance completed to date:264 Chapter 7 Step 3: Determine the transaction price The transaction price is the contract price of POM. Step 4: Allocate the transaction The whole of the P6M transaction price is allocated to the single performance obligation of constructing @ building. Step 5: Recognize revenue when (or as) a performance obligation is satisfied Because the performance obligation is satisfied over time, ABC shall recognize revenue over time as it progresses towards the complete construction of the building. ABC shall measure its progress by, in this case, using the ‘cost-to-cost’ method, an application of the input method. Revenue in 20x] is computed as follows: Percentage of Total costs incurred to date completion Estimated total contract costs Percentage of completion = 1.2M + 4M Percentage of completion = 30% Revenue in 20x1 = Contract price x Percentage of completion Revenue in 20x1 = 6M x 30% Revenue in 20x1 = P1,800,000 Case 2: Estimated costs to complete | The actual costs incurred in 20x1 are P1.2M. The estimated costs # | complete as of Dec. 31, 20x1 are P2.8M Requirement: How much revenue is recognized in 20x1? Solution.ruction Contracts N a Total costs incurred to date Total costs incurred to date + Estimated costs to complete percentage of == ———— completion Percentage of completion = 1.2M + (1.2M+ 2.8M) percentage of completion = 1.2M = 4M percentage of completion = 30 Revenue in-20x1 = Contract price x Percentage of completion Revenue in 20x] = 6M x 30% Revenue in 20x1 = P1,800,000 Illustration 2: Estimated costs to complete - Subsequent period information on an entity’s contract costs is as follows: 20x1 20x2 Total costs incurred to date 400,000 1,500,000 Estimated costs to complete 1,600,000 375,000. Requirement: Compute for the following: a. Percentage of completion as of Dec. 31, 20x1 b. Percentage of completion as of Dec. 31, 20x2 c. Percentage completed in 20x2. Solutions: Total costs incurred to date = Total costs incurred to date + Estimated costs to complete Percentage of completion Requirement (a): Percentage of completion as of Dec. 31, 20x1 Percentage of completion = 400,000 + (400,000 + 1,600,000) Percentage of completion = 400,000 + 2,000,000 Percentage of completion as at Dec. 31, 20x1 = 20% Requirement (b): Percentage of completion as of Dec. 31, 20x2 Percentage of completion = 1,500,000 = (1,500,000 + 375,000) Percentage of completion = 1,500,000 + 1,875,000 * Percentage of completion as at Dee: 31, 20x2 = 80%266 Chapter? Requirement (c): Percentage of progress made in 20x2 The computed percentages above are the cumulative percentage, of completion at the end of each year. Meaning, the 80, completion as at Dec. 31, 20x2 includes the 20% completed in 29.3, Therefore, the perceniage completed in 20x2 is 60% (80% minus 20%) Efforts-expended (labor hours-based) method Another application of the inputs method is the efforis-expende, (labor hours-based) method. Under this method, the percentage of completion is based on “efforts expended” in. completing the contract — normally in direct labor hours, rather than on costs. This method is most commonly used by general contractors who profits are directly related on how they manage subcontractors rather than from the value of the subcontracts themselves. The percentage of completion is computed as follows: Percentage of _ Total labor hours to date completion ~ "Estimated total contract Labor hours OR Percentage Total labor hours to date of = Total labor hrs. to date + Estimated labor hrs. to completion complete Illustration: Efforts-expended method Information on an entity's labor hours on a contract is as follows: 20x1 20x2 Total direct labor hours to date 400 1,500 Estimated direct labor hrs. to complete 1,600 375 Requirement: Compute for the percentages of completion as of Dec 31, 20x1 and 20x2. Soltttion:construction Contracts 267 Percentage Total labor hours to date of = Total labor hrs. to date + Estimated labor hrs. to completion complete 20rd Percentage of completion = 400 = (400 + 1,600) Percentage of completion = 400 = 2,000 Percentage of completion as at Dec. 31, 20x1 = 20% 20x2 Percentage of completion = 1,500 + (1,500 + 375) Percentage of completio: 500 + 1,875 Percentage of completion as at Dec. 31, 20x2 = 80% > The percentage completed in 20x2 is 60% (80% minus 20%). Contract costs Contract costs include: a. Incremental costs of obtaining a contract b. Costs to fulfill a contract Incremental costs of obtaining a contract Incremental costs of obtaining a contract - are costs incurred in obtaining a contract with a customer that the entity would not have incurred had the contract not been obtained (e.g, sales commission). ® Such costs are recognized as asset if the entity expects to recover them. Cosis that would have been incurred regardless of whether the contract was obtained are recognized as expense, unless those costs are explicitly chargeable to the customer regardless of whether the contract is obtained. >268 . Chaptery | at ae es i ae peg Tm remental costs of obtainjn, hen incurred if the expect or less. As a practical expedient, inc contract are recognized as expense W! amortization period of the asset is one year Costs to fulfill a contract wae Costs incurred in fulfilling a contract that are within the scope other standards (e.g., PAS 2 Inventories, PAS 16 PPE, or PAS Intangible Assets) are accounted for in accordance With thos standards. Costs incurred in fulfilling a contract that are outside the scope of other standards are recognized as asset if all of the following criteria are met: a. The costs are directly related to a contract or specifically | identifiable anticipated contract. b. The costs generate or enhance resources that will be used in satisfying performance obligations in the future; and cc. The costs are expected to be recovered. Examples of costs that are directly related to a contract: a. Direct materials (e.g., costs of materials used in construction). b. Direct labor (e.g, site labor costs, including site supervision). c. Other costs that are incurred only because the entity entered into the contract. Examples: i, Payments to subcontractors ii Costs of moving plant, equipment and materials to and from the contract site iii, Costs of hiring plant and equipment iv. Costs of design and technical assistance that are direct!’ related to the contract d. Costs that are explicitly chargeable to the customer under the contract (eg., estimated costs of rectification and guarante® work, including expected warranty costs, and claims ffo™ third parties). e. Allocations of costs that relate directly to the contract of? contract activities! Examples?Construction Contracts 260 i. Insurance ii, Depreciation of plant and equipment used on the contract iii, | Costs of design and technical assistance that are not directly related to a specific contract iv. Costs of contract management and supervision vy. Borrowing costs capitalized in accordance with PAS 23 Borrowing Costs vi. Other construction overheads The following costs are expensed when incurred: a. General administration costs for which reimbursement is not specified in the contract b. Costs of wasted materials, labor or other resources that were not reflected in the price of the contract c. Selling costs d. Research and development costs for which reimbursement is not specified in the contract e. Depreciation of idle plant or equipment that is mot used on a particular contract {. Costs that relate to satisfied or partially satisfied performance obligations in the contract (i.e, costs that relate to past performance) 8. Costs for which an entity cannot distinguish whether the costs relate to unsatisfied performance obligations or to satisfied or partially satisfied performance obligations Any incidental income derived from the construction that is not included in contract revenue is accounted for as reduction of contract costs, e.g., income from the sale of excess/scrap materials. Amortization and impairment Contract costs recognized as asset are amor! basis that is consistent with the transfer of the related goods or Services to the customer. tized on a systematic270 carrying amount of the asset exceeds: a Chapter 7 Oa caer a Impairment loss is recognized to the extent that the a. the remaining amount of consideration that the entity expegs to receive in exchange for the goods or services to Which the asset relates; less b. the costs that relate directly to providing those goods o, services and that have not been recognized as expenses, (PFRS 15.101) Illustration: A contractor uses the “cost-to-cost” method in determining its Progress on a contract. The estimated total contract cost is P10M. The following costs were incurred in the first year of the construction: Costs of negotiating the contract (immediately expensed) Costs of materials used in construction Costs of materials purchased but not yet used. Site labor costs Site supervision costs Depreciation of equipment used in construction Depreciation of idle equipment not used in the contract Costs of moving equipment to and from the contract site Costs of hiring equipment 100,000 | | | | | 3,000,000 500,000 1,000,000 200,000 120,000 60,00) 40,000 140,000 Requirement: Compute for the percentage of completion. Solution Costs of materials used in construction Site labor costs Site supervision costs Depreciation of equipment used in construction Costs of moving equipment to and from the contract site Costs of hiring equipment Total costs incurred to date 3,000,000 1,000,000 200,000 120,000 40,000 ume, we ae aYr Construction Contracts = & percentage of - Total costs incurred to date completion Estimated total contract costs & percentage of completion = 4, 500,000 + 10,000,000 Percentage of completion = Adjustments to the measure of progress Aweakness of the input methods is that there may not be a direct relationship between the inputs and the transfer of control of the asset to the customer. In such cases, the inputs used in measuring the entity’s progress are adjusted. ' When using the “cost-to-cost” method, an entity excludes "the following when measuring its progress on a contract: a. Costs that do not contribute to the entity's progress in i satisfying the performance obligation, e.g., costs of significant i inefficiencies, such as wasted materials, labor and other ji tesources that were not reflected in the contract price. yb. Costs incurred that are not proportionate to the entity’s K progress in satisfying the performance obligation. Examples: i i, Advance payments to subcontractors for which the t subcontracted work has not yet been started. t ii, Materials acquired but not yet used on the contract However, the entity may adjust the input method to tecognize revenue only to the extent of that cost incurred if the entity expects at contract inception that all of the following conditions would be met: | 1. The good is not distinct; 2. The customer is expected to obtain control of the good significantly before receiving services related to the good; 3. The cost of the transferred good is significant relative to the total expected costs to completely satisfy the performance obligation; and 4. The entity procures the good from a third party and is not significantly involved in designing and manufacturing the good (but the entity is acting as principal) | =e272 Chapter 7 Ilustration 1: Revenue to the extent of cost incurred On Sept. 1, 20x1, ABC Co. enters into a contract with a customer j. remodel a plant's electrical wirings and install a new generator fg, a total consideration of PI2M. The remodeling and the installation are treated as a single performance obligation satisfied overtime, | The expected contract costs are as follows: | Generator 4,000,000 Other costs 5,000,000 Expected total contract costs 9,000,000 Additional information: © ABC Co. uses the cost-to-cost method in measuring its progress, © ABC Co. incurs total costs of P6,000,000 in 20x1, including the cost of the generator. © The customer obtains control of the generator when it is delivered to the site in December 20x1. However, the generator will not be installed until March 20x2. e ABC Co. regards the cost of the generator as significant in | relation to the expected total contract costs (i. 4M > 9M = 44.44%). e Although ABC Co. acted as a principal in procuring the | generator, ABC Co, is not involved in designing o manufacturing the generator. Requirements: a. How much revenue is recognized in 20x1? b. How much profit is recognized from the contract in 20x1? Solutions. Analysis: > The costs incurred to date include the cost of an uninstallel material, i.e., generator. + Because all the conditions listed above (#’s.1.to.4) are met. th” cost of the generator is excluded from when computing |construction Contracts 73 applying the percentage of completion. Instead, the cost of the generator is recognized both as revenue and cost of goods sold. Consequently, no profit is recognized from the generator in 20x1, Percentage of = ———_Total costs incurred to date _ completion Estimated total contract costs = (6M total costs incurred - 4M cost of generator) ~ (9M expected total contract costs — 4M cost of generator) =2M+5M Percentage of completion = 40% Requirement (a): Revenue in 20x1 Total contract price 12,000,000 Less: Cost of generator (4,000,000) Total i 8,000,000 Multiply by: Percentage of completion 40% Total 3,200,000 Add back: Cost of generator 4,000,000 Revenue > 7,200,000 Requirement (b): Profit in 20x1 Expected total contract cost 9,000,000 Less: Cost of generator (4,000,000) Total 5,000,000 Multiply by: Percentage of completion 40% Total . 2,000,000 Add back: Cost of generator , 4,000,000. Cost of goods sald 6,000,000 Revenue ~ : 7,200,000 Cost of goods sold (6,000,000) Profit 1,200,000274 Chapter 7 Illustration 2: Adjustments to the input method yt » ABC Co. uses the “cost-to-cost” method in measuring its Progres. on a construction contract. The estimated total contract cost s PI0M. Actual costs incurred during the year totaled Poy, including ?2M advance payment to a subcontractor (the subcontracted work is not yet started) and 200,000 cost o; materials not yet installed. The unused materials are no} significant in relation to the expected total contract costs, Moreover, ABC Co. retains control over the unused materials because it can use them on contracts with other customers. Requirement: Compute for the percentage of completion in 20x1, Solution: Because the conditions listed above (ie, #’s 1 to 4) are not met, the P2M advance payment to the subcontractor and the P200K unused materials are simply eliminated when measuring ABC’s Progress. Percentage of _ Total costs incurred to date completion Estimated total contract costs Percentage of completion = (6M - 2M — 200K) = 10M Percentage of completion = (3.8M + 10M) = 38% Presentation When either party to a contract has performed, the contract is Presented in the statement of financial position as a conirac liability or a contract asset. An unconditional right to consideration is presented separately as a receivable, Contract liability ~ is “an entity’s obligation to transfer goods of services to a customer for which the entity has receined consideratio" (or the amount is due) from the Customer.” (PrRsis.appendix A) 4Construction Contracts 7 7 275 A contract liability is recognized at the earlier of the date: a, The entity teceives consideration before the good or service is transferred to the customer (i.e., advance payment). : b. The entity has an unconditional right to the consideration before the good or service is transferred to the customer (e.g., a non- cancellable contract requires payment in advance). ‘ Contract asset — is “an entity's right to consideration in exchange for goods or services that the entity has transferred to a customer when that right is conditioned on something other than the passage of time (e.g., the entity’s future performance).” (PFRS 15. Appendix A) A contract asset (excluding amounts recognized as a receivable) is recognized when the good or service is transferred to the customer before the consideration is received or becomes due. Receivable - is an entity’s right to consideration that is A right to consideration is unconditional if only the before payment of that consideration is ject to refund in the future. unconditional. passage of time is required due, even if the amount is sul On initial recognition, any difference between the the receivable in accordance with PFRS 9 and the measurement of ognized is presented as an corresponding amount of revenue rec expense (e.g., a5 an impairment loss). liability and Receivable ers into a contract to install a gate for fabricated in ABC’s place of business and will be assembled and installed in the customer's premises on Mar. 31, 20x1. The contract requires the customer to pay a consideration of P1,000 in advance on Jan. 31, 20x1. The customer pays the consideration on Mar. 1, 20x1. ABC installs the gate on Mar, 31, 20x1. Illustration 1: Contract On Jan. 1, 20x1, ABC Co. enti a customer. The gate will be276 Caples Requirement: Provide the journal entries under each of following sce narios: (a) the contract is cancellable and ©) the contract is non-cancellable. (Ignore contract costs) Solutions: Scenario A: Canceilable Scenario B: Non-cancellable liek ot No entry No entry © No entry because neither party has performed its obligation, Scenario A: Cancellable Jan. 31, 20x1 lan. 2 No entry Receivable... 1,000 Contract liability... ss... 1,000 A receivable is recognized under Scenario B because ABC Co, has an unconditional right to consideration (i.c., the contract is non-cancellable and it requires payment on this date). ABC Co, is entitled to the consideration whether the customer pursues or cancels the contract. A corresponding contract liability is recognized for ABC’s obligation to install the gate. Scenario B: Non-cancellable ca ® No receivable is recognized under Scenario A because ABC Co. does not have an unconditional right to consideration (ie, the contract is cancellable), _ [Scenario A: Cancellable Scenario B: Non-cancellable _| Casi 1,000 | Receivable .......:se:s:01+-1,000_| # Under Scenario A, contract liability is credited when the advanced payment is received. ” Under Scenario B, receivable is credited. The contract liability is recognized on Jan. 31, the earlier of the date th unconditional right to the consideration is obtained (Jan. 3!) and the date the advanced payment is received (Mar. 1). eee ieConstruction Contracts a Scenario A: Cancellable | cancellable Mar 31.2081 1 i = icellable _ Contract liability......1,000 | Contract liability......1,000 Revenue... 1,000 Revenue... eeeed,000 r Reverie is recognized only on Mar. 31 when the performance obligation is satisfied (i.¢., the gate is installed). Illustration 2: Contract asset On Dec. 1, 20x1, ABC Co. enters into a contract with a customer for the installation of roof tiles. The expected number of roof tiles to be installed is 1,000 units. The contract price is P100 per roof tile installed. However, the customer pays the total consideration only when all of the 1,000 roof tiles have been installed. ABC assesses its performance obligation to be satisfied over time because the customer simultaneously receives and consumes the benefits provided by ABC’s performance as ABC performs; and ABC's performance enhances an asset that the customer controls as it is enhanced. As of Dec. 31, 20x1, 800 roof tiles have been installed. The remaining 200 tiles have been installed on Jan. 7, 20x2. The customer pays the consideration on Jan. 9, 20x1. Requirement: Provide the journal entries. Ignore contract costs. Solution: Dec. 1, 201 No entry Dec. 31,] Contract asset (800 units x P100) 80,000 sa Revenue : 80,000 Jin.7, | Receivable (1,000 units x P100) 100,000 ee Contract asset 80,000 Revenue (200 units x P10) 20,000 Jen 9, | Cash 100,000 2 x tnt | Receivable 100,000278 * Notes: * Contract asset TOOf tiles are installed), is recognized on Dec. 31 (rather ‘receivable’) because ABC Cos right to consideratio conditioned upon the full installation of the 1,000 roof tiles, Revenue is recognized as ABC Co. progresses toward; complete satisfaction of the performance obligation Receivable is recognized on Jan. 7 because ABC Co. ob: Ss Ste ey mn thay is IS the (Le, as the tains an unconditional tight to consideration as all the roof tiles have been installed. £2 Rementter the following: Scenario » Consideration is received or becomes due before goods or Services are transferred to the Accounting - — | © Recognize a contract lability | customer, > Goods or services are transferred to the customer before consideration is received: a. Right to consideration is conditional. b. Right to consideration is unconditional. @ Recognize a contract asset. 7 Recognize a receivable. PERS 15 does not prohibit the use of alternative terms for “contract asset” and “contract liability” so long as sufficient information is provided to enable users of the financial statements to distinguish between “receivables” and “contract assets.” For example, the “Advances from customers” account may be used in lieu of contract liability when the consideration received in advance. However, this account cannot be used if te consideration becomes due (rather than received) before the goo ion E or services are transferred to the customer (see Ilustratiot Scenario B; Jan.31, 20x1 above). 71 | | | | | | | } | iConstruction Contracts 279 Accounting for Construction Contracts Asummary of the old and current accounting is provided belo PAS 11 (old standard) ‘An asset is recognized for “unbilled” accounts receivable when the entity recognizes revenue that is not yet billed. Once the customer is invoiced, the unbilled receivable is reclassified ag a “billed” accounts receivable. On the other hand, billings in excess of costs are recognized as liabilities PERS 15 (current standard) Contract asset is recognized when the entity performs but its right to consideration is still conditional. Once the entity's right — to consideration becomes unconditional (such as when none but the passage of time is required before payment is due), the contract asset is reclassified as receivable. More specifically, PAS 11 requires the entity to present: a. the gross amount due from customers for contract work as an asset; and b, the gross amount due to customers for contract work as a liability. Contract liability is recognized if the consideration is received or becomes due before the entity performs. The excess of (1) costs incurred and recognized profits, net of losses, over (2) progress billings represents gross amount due from customers. The excess of (2) over (1) represents gross amount due to customers. Illustration: Percentage of completion On Jan. 1, 20x1, ABC enters into a contract to construct a building for a customer. ABC identifies its performance obligation to be satisfied over time. ABC uses the input method based on costs to Measure its progress on the contract. The contract price is POM. Information on the construction is provided below: 20x1 20x2_| 20x3 ed per year | 2,760,000 | 3,540,000 | 500,000 | - per year? _ 50% | 30% 20% £_ Collections on billings per year 90% | balance d. Estimated costs to complete 4,140,000 | 700,000 2 (at each yr.-end)280 Chapter 7 ~~ © The billings per year are stated as percentages of the contract price. The contract, non-cancellable. 10% retention. “Retention” is 20x2 are net of at the end of the d payable to the contractor cepted. © The collections on billings in 20x and an amount withheld by the contractee an contract when the project is completed and acc Requirements: a. Compute for the gross pro! construction in 20x1, 20x2 and 20x3, b. Provide the journal entries. c. Determine the amounts presented in # fits, revenues and costs of respectively. he financial statements. Solutions: Requirement (a): > _Gross profits 20x1 20x2 20x3 9,000,000 _9,000,000° _ 9,000,000 2,760,000 6,300,000 6,800,000 4,140,000 __700,000 6,900,000 _7,000,000__6,800,000 2,100,000 2,000,000 2,200,000 40% 90% 100% 840,000 1,800,000 2,200,000 - (849,000) _(1,800,000) 400,006, Total contract price Ya) Costs incurred to date” Estimated costs to complete (b) Estimated total contract costs Expected gross profit Multiply by: % completion (@) + @ Gross profit earned to date Less: Gross profit in prior yrs. Gross profit for the year 840,000 __960,000 “Costs incurred to date’ is the sum of costs incurred in the current year and previous years. In 20x?, the costs incurred to date is computed as (2 76M costs in 20x] + 3.54M costs in 20x2) = 6.3M. y Revenues 20x1 20x2 20x3 Total contract price 9,000,000 9,000,000 9,000,000 Multiply by:% of completion __40%__—90%_W0 Revenue to date 3,600,000 8,100,000 9,00000 “Less: Revenue recognized in prior yrs. = (3,600,000) (8,100,000. Revenue for the year 3,600,000 4,500,000 9000" 00) (9540,000)_ 60010" Cost of construction * “Gross profit for the year — _ 1900 960,000 LE= nstruction Contracts ve a _ ; ‘ + Under the ‘cost-to-cost’ method, the ‘cost of construction’ (contract costs amortized to expense) is equal to the contract costs incurred in that period. Alternatively, this can also be ‘squeezed’ after computing the revenue and gross profit for the year. 4 Notice that billings and collections do not affect revenue, cost of construction and gross profit. Requirement (b): Journal entries > 20x1 a) _Incurrence of cost Traditional accounting PERS 15 Construction in progress 2.76M Contract costs 2.76M Cash (orother accounts) __2.76M Cash (or other accounts) __2.76M “Construction in progress” is an account used to accumulate contract costs incurred and profits (less losses) recognized to date. b)_Billing Traditional accounting PFRS 15 Accounts receivable 45M Receivable 4.5M Progress billings (9Mx 50%) _4.5M. Contract liability 45M. “Progress billings” is an account used to record amounts billed for work Performed on a contract. ©) Collection Traditional accounting PERS 15 Cash (4.5m x 90%) 4.05M Cash 4.05M Accounts receivable 4.05M | __Receivable 4.05M d) Revenue recognition Traditional accounting PFRS 15 Cost of construction. 2.76M Contract liability 3.6M Construction in progress 840K® Revenue 3.6M Revenue 3.6M Cost of construction 2.76M® Contract costs 2.76M.282 Chapter 7 a Nas ae ee, ‘equal to the gross profit As the progress is measured using the ‘cost-to-cost’ method, all Costs incurred ay, amortized. > _20x2 Traditional accounting PERS 15) Construction in progress 3.54M Contract costs 3.54M | Cash (or other secourts) 354M Cash (orcthereccourts)__3.54M Accounts receivable 2.7M Receivable oa Progress billings (Mx 30%|_2.7M Contract liability 2™M Cash 27M x 90%) 243M Cash 243M Accounts receivable 2.43M Receivable 243M | Cost of construction 354M Contract liability 45M ~| Construction in progress 960K Revenue 45M | Revenue 45M. | Cost of constru 354M Contract costs M 20x3 Traditional accounting PERS 15 | Construction in progress 5M Contract costs 5M | Cash (or other accounts) 5M Cash (or other accounts) 5M ‘Accounts receivable 18M Receivable 18M | Progress billings (9M x20%) 18M. Contract liability 18M | Cash 252M ©) Cash 252M Accounts receivable. 2.52M Receivable 252M Cost of construction 500K Contract liability 900K Construction in progress 400K Revenue 900K Revenue 900K Progress billing OM Construction in progress to eliminate the accounts 9M Cost oF construction 500K Contract costs 500k bt: {10% 01 45M billing in 201) + (10% of 27M billing in 20:2) + 8M billing in 2003 = 252MConstruction Contracts ~ = - 7 283 Requirement (c): Financial statements Traditional Accounting Construction in PERS 15 in progress _ ___ Contract costs 2.760.000 [ sit — 3,600,000 Dee —— 340.000, 3,540,000 — eee poue = | rain 8,100,000 500,000 400,000 9,000,000 liability = eats 75,500,000 tees 900,000 22731/x1 4,500,000 e121 7,200,000 12/312 1,800,000 9,000,000 © See ‘Requirement (a)' for revenues and costs of construction. © The debit balance in the contract liability account on 12/31/x2 is presented as asset. The year-end adjusting entry is as follows: Contract asset Contract liabili made to simplify the recording in 20x3. 0x2 may also be recorded as follows: PFRS 15 Contract liability (900K +36M) 3.6M Contract asset 900K Revenue Areversing entry would be: Alternatively, the revenue in 4.5M_450,000 1,620,000 (Current babies: Constnction in progress 3,600,000 is Less: Progress bilings _ 4,500,000 Gross amt due to cust 900,000 = Total 900,000 = 20x1 2x2 Ud ed + thet tog Revenue 3,600,009 4,500.00 960,000 |} Reverse 3600,000 4,500,000 21010) Cost ot construction [email protected],000) (3.540.000) (500,000) |] Cost of constan. _(2.760,000) (3,540,000) (Stax Gros prot 0,70) 360000 400,000 || Gree profit 540,000 _ 260,000 a8 OX Shortcut: Under the ‘cost-o-cost’ method, the balance of the CIP account is equa to the revenue recognized to date Output methods Output methods recognize revenue on the basis of direct measurements of the value to the customer of the goods or services transferred to date relative to the remaining goods or services promised under the contract. Examples of output methods: a. Surveys of performance completed to date b. Appraisals of results achieved, milestones reached, time elapsed and units produced or units delivered The disadvantages of output methods are that the outputs used to measure progress may not be directly observable and the information required to apply them may be costly. The ‘cost-to-cost’ method (input method) of estimatité stage of completion is the most commonly tested method in past CPA board examinations. However, in practice, many entitie® use the output methods. This is normally the-case~in.t Ue:285 construction of “high-rise” buildings", dams, bridges, and other structures wherein the incurrence of costs is not necessarily proportionate to the entity’s progress on the contract. The input method is more commonly used for non-complex structures, suich ag roads. sGeverslly, a “high-rise” building is one that is taller than the maximum height which peo wiling to walk up; it normally requires an elevator. The threshold for distinguishing, a high puilding (€.g, number of floors and vertical measurement) varies from country to country. A alg taller than a high-cse building is called a “skyscraper” Making the direct measurements under some output methods require a considerable degree of expertise. In practice, these are generally determined by experts (e.g., engineers and architects). A CPA is not expected to be proficient in making those measurements. A CPA applying an output method would rely on the expert’s direct measurements. The different methods of measuring progress result to different amounts of revenue, costs and profit. Accordingly, PFRS 15 requires the consistent application of a single method for each performance obligation satisfied over time. Illustration 1: Output method - Survey of work Information on an ongoing construction contract with a fixed contract price of P1M is shown below: Cost of construction (contract casts recognized as expense) 500,000 Percent complete (based on a survey by a professional) 80% Requirement: Compute for the gross profit for the year. Solution: Total contract price 1,000,000 Multiply by: Percentage of completion 80% Revenue to date 800,000 Less: Revenue recognized in prior YTS. 2 Revenue for the year 800,000 Cost of construction for the year (given) ____ (600,000) 300,000 Gross profit for the year iMlustration 2: Physical proportion of the contract work In 20x1, ABC Co. was subcontracted to construct the first Portion, of a 94.5-kilometer, four-lane expressway. Construction started jy 20x1 and it was expected that the expressway will be opened t, the public in three years’ time. Per House Resolution, the total contract price for the first portion of the expressway consisting of 41 kilometers is P13B. ABC uses the output method based on physical proportion of contract work in estimating the stage of completion of a project. Additional information on the project is shown below: Costs incurred Estimated costs No. of kilometers Year each year to complete completed during the year 20x1 2.3B 7.7B 10.25 20x2 5.5B 24B 22.55 Requirement: Compute for the revenue and the cost of construction recognized as expense in 20x2, respectively. Solution: 20x1 20x2 No. of kilometers completed to date 10.25 32.80 Divide by: Total kilometers to be completed 41 41 Percentage of completion to date 25% 80% > Profits: 20x1 2072 Total contract price 13B 138 _Estimated total contract cosis* (108) 2028) Expected total profit from construction 3B 2.6B Multiply by: %ofcompletion | 25% OH "Profit to date 0.738 2248 Profit for the year 0.75B 1.498 a online’ |construction Contracts : 287 * Estimated total coniract costs are equal to the costs incurred to date plus estimated costs to complete at each year-end. These are computed as follows: - 20x1: (2.3B + 7.7B) = 10B = 2032: (2.38 + 5.5B + 2.48) = 10.28 » Revenues and Costs of constructio 20x1 20x2 Total contract price s 13B 13B Multiply by: % of completion 25% 80% Contract revenue to date 3.258104 Contract revenue recognized in prior years : (3.25B) Contract revenue for the year 3.25B 7.15B Cost of construction (squeeze) (Q2.5B)___(5.66B) Profit for the year 0.75B 1.49B 4 Unlike the cost-to-cost method, under the output method, the cost of construction is not equal to the actual costs incurred in that period. Changes in the measure of progress The measure of progress is updated as circumstances change over time to reflect any changes in the outcome of the performance obligation. Changes are accounted for prospectively as changes in accounting estimate in accordance with PAS 8 Accounting Policies, Changes in Accounting Estimates and Errors. Reasonable measures of progress Revenue for a performance obligation satisfied over time is tecognized only if the progress towards the complete satisfaction of the performance obligation can be reasonably measured. If the outcome of a performance . obligation cannot be Teasonably measured, revenue is recognized only to the extent of costs incurred that are expected to be recovered. This accounting method is traditionally called the “zero- profit” method. There is zero profit because the revenue recognized is equal to the costs incurred,Illustration: Zero-profit method Information on a construction contract with a contract price of POM is provided be! pam ET els | 20x17 | 2032 20x3 a. Contract costs incurred per y' { 2,760,000 | 3,540,000 500,00)" b. Estimated costs to complete | jap measurable | not measurable, (at each yr.-end) | | Requirements: a. Compute for the 20x1, 20x2 and 20x3 revenues. b. Provide the journal entries in 20x1 assuming billings were 50%, of the contract price and collections were 90% of the billings. Solutions: | Requirement (a): 20x1 20x2 20x3 Revenue 2,760,000 3,540,000 — 2,700,000 Contract costs incurred per yr. (2,760,000) (3,540,000) (500,000) Gross profit for the year * > 2,200,000 & Notes: ® Prior to completion (ie, 20x1 and 20x2), the revenues recognized are equal to the contract costs incurred. Accordingly, no gross profits are recognized during these years. On completion (ic, 20x3), the revenue recognized. is the excess of the contract price over the revenues recognized it prior years: (9M contract price - 2.76M revenue in 20xl - 3.54M revenue in 20x2 = 2.7M). * Gross profit is recognized only in the year of completion. Requirement (b): Journal entries ~20x1 only Traditional accountin PERS 15 Construction in progress 2.76M | Contract costs 276M | __Cash (or other account 276M | Cash (orother accounts) 276+ Accounts receivable Receivable 45M Progress billings OM@sO%)PE5M=| (= /Contractliability ass latesConstruction Contracts 89 Cash (45x 90%) 4.05M Cash 4.05M Accounts receivable 4.05M Receivable 4.05M. Cost of construction —_2.76M Contract liability -2.76M Revenue 2.76M Revenue 2.76M Cost of construction 2.76M Contract costs 2.76M The 20x1 financial statements will show the following: Statement of financial position PFRS 15 Current assets: 20x41 Receivable Total , Total 450,000 Current liabilities: Current liabilities: Construction in progress 2,760,000 |} Contract liability 1,740,000 Less: Progress billings 4,500,000 Grossamt. due to cust. 1,740,000 Total Onerous contract (Expected losses) PAS 11 (old standard) PERS 15 (current standard) When it is probable that total | As soon as a contract ‘becomes, contract costs will exceed total | onerous, an entity recognizes a contract revenue, the expected loss is provision for the loss it expects to recognized immediately as expense. incur on the contract in accordance with PAS 37 Provisions, Contingent Liabilities and Contingent Assets. An onerous contract is “a contract in which the unavoidable cosis_of_meeting the obligations290 _—_Shapters eo s under the contract exceed” jo economic benefits expected to 4, received under it.” (PAS 37 Appas.a, " ity’ ate ‘The amount of loss is determined irrespective of the entity’s progress on ih. contract, Illustration 1: Onerous contract . In 20x1, ABC Co, started work on a PIM fixed price contrag, Information on the construction is shown below: 20x1 20x2 > S Costs incurred to date 200,000 825,000 Estimated costs to complete 600,000 275,000 Requirement: Compute for the loss in 20x2. Solution: The contract is analyzed as follows: : 20x1 20x2 Total contract price 1,000,000 1,000,000 Costs incurred to date 200,000 825,000 Estimated costs to complete 600,000 275,000. Estimated total contract costs 800,000 1,100,000 Expected total profit (loss) on completion 200,000 (200,000) The contract becomes onerous in 20x2 as the estimated total contract costs exceed the contract price. The loss recognized in 20x? is determined as follows: 20x17 20x2 Total contract price 1,000,000 1,000,000 Estimated total contract costs (800,000) (1,100,000) Expected total profit (loss) on completion 200,000 (100,000) Multiply by: percentage of completion 25% 0) NIA Profit (loss) to date 50,000 (100,000) Profit (loss) recognized in prior yrs. = (60,000) Profit (loss) for the year 50,000 (150,000) ( @O00K costs incurred to date + 800K estimated total contract costs) = 25%E struction Contracts = onsracio Conaeg «NIA = the progress in 20x2 is ignored so that the P100,000 loss is recognized in full. ‘The P50,000 profit recognized in 20x1 not restated. Thus, to reflect the expected total loss on the contract of P100,000, P150,000 loss is recognized in 20x2 (ie, 50K profit in 20x1 - 150K loss in 20x2 = 100K loss to date). The amounts recognized in profit or loss are computed as follows: 20x1 20x2 Total contract price 7,000,000 1,000,000 Multiply by: percentage of completion 25% 75% Revenue to date 250,000 750,000 Revenue in prior years sk (250,000) Revenue for the year 250,000 500,000 Costs of construction (200,000) (625,000) ® Gross profit (loss) for the year 50,000 (125,000) Loss on onerous contract = + (25,000) Profit (loss) for the year 50,000 _(150,000) ©) 26x2: (825K costs incurred to date ~ 1.1M estimated total contract costs) = 75% ©) 20%2: (825K costs incurred to date ~ 200K costs incurred in 20x1) 625,000 squeezed’ (150K loss for the year - 125K gross loss) = 25K loss provision > Journal entries: (Billings and Collections are ignored) 20x1 * Traditional accounting -___PFRS 15 Construction in progress 200K Contract costs 200K Cash (or other accounts) 200K Cash (or other accounts) 200K Cost ofconstruction 200K Contract asset 250K Construction in progress 50K Revenue 250K Revenue 250K Cost of construction 200K Contract costs 200K ue re _ Traditional accounting PFRS 15, | Construction in progress 625K Contract costs 625K res (or ther accounts) 625K Cash (or other accounts) 625K le of construction 625K Contract asset 500K eston a Revenue 500K aqe ees, Pe Rem sr ae 292 Chapter So, oe Sean? Pet OS eS lt ee Revenue BOOK ~ Construction in progress 150K Cost of construction 625K Contract costs 625K | Loss on onerous contract 25K} | Provision 2K > Financial statements Statement of financial position i i | ) | Gross amt. due o cut. 250000 7255000. Toe 250,000 725,000. || Total Current liabilities: Revere ‘Cost of construction, Cro low Loss on uncompleted contract Profit (los) for the yeer Illustration 2: Reversal of provision (Continuation of Illustration 1) The contract is completed in 20x3. 20x1 20x2 20x3 Costs incurred to date 200,000 825,000 1,020,000 Estimated costs to complete 600,000 275,000 - Requirement: Compute for the profit (loss) in 20x3. Solution: The contract is analyzed as follows: 20x1 20x2 20x3 “ Costs incurred to date 200,000 825,000 1,020,000 Estimated costs to complete. 600,000 275,000 . veal- Cons! rruction Contracts 293 Estimated total contract costs 300,000 1,100,000 1,020,000 “Exped pected tel profit loss) on completion 200,000 __ (100,000) _ (20.000) The actual total loss on the contract is P20,000. The profit recognized in 20x3 is determined as follows: 20x1 20x2 20x3 Total contract price 1,000,000 1,000,000 1,000,000 Estimated total contract costs (800,000) (1,100,000) _ (1,020,000) Expected total profit (loss) 200,000 (100,000) (20,000) Multiply by: % of completion 25% N/A 100% Profit (loss) to date 50,000 (100,000) (20,000) Profit (loss) in prior yrs. ¥ (50,000) 100,000 Profit (loss) for the year 50,000 __(150,000) 80,000 @ The profit and loss recognized in 20x1 and 20x2 are not restated. Instead, {o reflect the total loss on the contract of P20,000, P80,000 profit is recognized in 20x3 (.,50K profit in 20x1.- 150K loss in 20x2 + 80K profit in 203 += 20K total loss on contract). The amounts recognized in profit or loss are computed as follows: 20x1 20x2 20x3 Total contract price 1,000,000 1,000,000 1,000,000 Multiply by: % of completion 25% 75% 100% Revenue to date 250,000 750,000 1,000,000 Revenue in prior years - (250,000) (750,000) Revenue for the year 250,000 500,000 250,000. Costs of construction (200,000) (625,000) (195,000) » Gross profit (loss) for the year 50,000 (125,000) 55,000 Loss on onerous contract és (25,000) - Gain on reversal of provision 25,000 Profit (loss) for the year 50,000 (150,000) 80,000 102M costs incurred to date in 20x3 - 825K costs incurred to date in 20x2 = 195K > Journal entries: (Billings and Collections are ignored) 203 | Traditional accounting | Construction in progress 195K La Cash ther acon bhCost of construction 198K] Contract asset Construction in Progress 80K Revenue 0K | Revenue 250K | Gain on completed contract 25K i Cost of construction 195K 1 Contract costs 195K Provision 25K | Gain on reversal of provision 25, Mlustration 3; Onerous contract: Zero-profit method In 20x1, ABC Co. started work on a PIM fixed price contract, Information on the construction is shown below: 20x1 202 20x3 Costs incurred to date 200,000 825,000 1,020,000 © In 20x1, ABC Co. cannot reasonably measure the outcome of the performance obligation but expects to recover all contract costs. © In 20x2, ABC estimates the total contract Costs to be P1,100,000. * The contract is completed in 20x3 for a total cost of P1,020,000. Requirement: Compute for the profit (loss) in 20x1, 20x2 and 200, respectively. Solution: The contract is analyzed as follows: | 20x1 20x2 20:3 Contract price 1,000,000 1,000,000 1,000,000 Contract costs N/A 1,100,000 1,020,000. Expected profit (loss) N/A 200,000} (20,000), The contract becomes onerous in 20x2. The profits (losses) are determined as follows: 20x1 20x2 20x3 Revenue 200,000 625,000 175,000 _Contract costs incurred per yr. (200,000) (625,000) (195,000. Gross profit for the year : - (20,000) aletruction Contracts - Cons itracts: +05 Loss on onerous contract (100,000) Gain on reversal of provision Profit (loss) for the year (100,000) & Notes: @ The revenues recognized in 20x1 and 20x2 are equal to the contract costs incurred in those periods. # The revenue recognized in 20x3 is computed as: 1M contract price ~ 200K revenue in 20x] ~ 625K revenue in 20x2 = 175,000. © Reconciliation: 0 profit in 20x1 - 100K loss in 20x2 + 80K profit in 20x3 = -20K total loss on contract Variable consideration If the consideration includes a variable amount, the entity shall estimate the amount to which it will be entitled in exchange for transferring the promised goods or services to the customer. The amount of consideration can vary because of discounts, rebates, refunds, credits, price concessions, penalties, incentives, performance bonuses, or other similar items. It can also vary if the entity’s entitlement to the consideration is contingent on the occurrence or non-occurrence of a future event. The variability of consideration may be explicitly stated in the contract or implied by the entity's customary business practices, published policies, specific statements, or by other facts and circumstances. The amount of variable consideration is estimated using either of the following methods, depending on which method is expected to better predict the amount to which the entity will be entitled: a. Expected value range of possible amount entity has a large nu characteristics. | ; che single most likely amount in a range of b. Most likely amount ~ 1 a possible amounts. This may be appropriate when there are — the sum of probability-weighted amounts in a ts. This may be appropriate when the mber of contracts with similaraM Chapter 296 ll. only two possible outcomes (for example, an entity ithe achieves a performance bonus or does not). Constraining estimates of variable consideration The estimated amount of variable consideration is included jn the transaction price only to the extent that it is highly probable that, significant reversal in the amount of cumulative revenue Tecognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved. Example 1: Penalty A construction contract states a Price of PIM. However, a penalty of P100,000 will be charged if the construction is not completed Within two months from the agreed date of completion. * Analysis: The consideration includes a fixed amount of 900,000 and a variable amount of P100,000. Constraining estimates of variable consideration: ‘The entity determines the probability of the Penalty being charged and includes the variable consideration (and thus a transaction price of PIM) only if itis highly probable that the penalty will not be charged. Example 2: Estimating variable consideration A construction contract states a price of PIM. However, for each day that completion is delayed after the deadline, the contract price decreases by P1,000, whereas for each day that the completion is earlier than the deadline, the contract price increas? by P1,000. In addition, upon completion, a third party will inspect the asset and assign a rating based on metrics defined in the contract. If 4 | specified rating is met, the entity will receive a bonus of P20,000._J age. Construction Contre 297 Analysis: The consideration includes a fixed amount of PIM and a variable amount, which the entity needs to estimate using the methods described earlier. The entity makes separate estimates for each of the components of the variable amount. For example, the entity uses: a. the expected value method to estimate the variable consideration associated with the daily penalty or incentive because there can be a range of possible amounts (i.e, P1M plus or minus P1,000 per day); and b. the most likely amount to estimate the variable consideration associated with the incentive bonus because there can only be two possible outcomes (i.e., +P20,000 or +P0) After making the estimate, the entity considers the requirements on constraining estimates of variable consideration to determine whether all or part of the estimate should be included in the transaction price. Incentive payments. Incentive payments are additional amounts paid to the contractor if specified performance standards are met or exceeded. For example, a contract may allow for an incentive payment to the contractor for early completion of the contract. Incentive payments are inchided in the transaction price, and consequently to contract revenue when, in applying the constraining estimates of variable consideration principle, it is highly probable that a significant reversal in the amount of cumulative revenue recognized will mot occur when the Uncertainty associated with the variable consideration is Subsequently resolved. Mlustration: Incentive payment ABC Co. started work on a construction contract in 20x1. The “ontract provides for a P400,000 bonus if the building is completed ae298 el _ Chapte within 4 years. ABC Co. uses the ‘cost-to-cost’ Methog i . in measuring its progress on the contract. Information on the Projeq, is as follows: Pere hl ttc es 20x1 2032393 Costs incurred to date 1,000,000 1,960,000 4,160 p99 Estimated costs to complete 4,000,000 2,940,000 — L,04g 09) | * In 20x1 and 20x2, it is not highly probable that the | Construction will be completed within the 4-year limit, j * In 20x3, ABC Co, acquired new equipment and employed additional Personnel. This has fast-tracked construction work, ABC Co. now believes it is highly probable that the construction will be completed within the 4-year limit. Case 1: Fixed price contract | Compute for the revenues in 20x1, 20x2 and 2 0x3, respectively, assuming the contract price is P6M. Solution: 20x1 20x2 20:3 Total contract price @ 6,000,000 6,000,000 _ 6,400,000 I Costs incurred to date 1,000,000 1,960,000 4,160,000 Estimated costs to complete 4,000,000 2,940,000 1,040,000 Estimated total contract costs 5,000,000 4,900,000 5,200,000 Expected gross profit 1,000,000 1,100,000 _ 1,200,000 Multiply by: % of completion @ 20% 40% 80% Gross profit earned to date 200,000 440,000 960,000 Less: Gross profit in prior yrs, (200,000) _ (440,000) Gross profit for the year 200,000 240,000 520,000 ‘2 The bonus is included in the transaction price only in 20x3 when i that the bonus will be received: (5M contract price + 400,000 bowne 400,000). 2% of completion = Costs incurred to date « Estimated total contract costs 20x14 20x2 20x3 Total contract price 6,000,000 6,000,000 6,400,000 Multiply by: % of completion 20% 40% Ee Revenue to date 1,200,000.2,400,000.25,120.00Y onstruction Contracts soo comiratinmimets eer the yer 1,200,000 1,200,000 2,720,000 Cost of construction (qweze) (1,000,000) (960,000) (2,200,000) Gross profit for the year M00) es) Bann) Case 2: Cost-plus-variable fee Compute for the revenues in 20x1, 20x2 and 20x3, respectively, assuming the contract price is set as ‘cost plus 20%’. | Solution: 20x1 20x2 20x3 Costs incurred to date 1,000,000 1,960,000 4,160,000 Estimated costs to complete 4,000,000 2,940,000 __ 1,040,000 Estimated total contract costs 5,000,000 4,900,000 5,200,000 Multiply by: Cost + Variable fee 120% 120% 120% Total 6,000,000 5,880,000, 6,240,000 Incentive payment 400,000 Estimated total contract price 6,000,000 5,880,000 6,640,000 Multiply by: % of completion 20% 40% 80% Revenue to date 1,200,000 2,352,000 5,312,000 Less: Revenue in prior yrs = (1,200,000) _ (2,352,000) Revenue for the year 1,200,000 1,152,000 2,960,000 Cost of construction &! (1,000,000) (960,000) (2,200,000) Gross profit for the year 200,000 __192,000___760,000 equal to costs incurred per yr.: (20x1: 1M); (20x2: 1.96M - 1M = .96M); (20x3: 4.16M — 196M =2.2M) Additional concept: Under a “cost plus a certain percentage of costs,” the gross profit rate based on Cost remains relatively constant from period to period. 20x1 20x2 20x3 aE Gross, profit 200,000 192,000 440,000 ess profit rate 20% 20% 20% “TOOK gross profit including bonus ~ (400K bonus x 80% completion) = 440,000 a300 oe ee ta following reconciliation: we can make the Fe a: Using the concept above, dee ___ 4,900, 5,2 Estimated total contract costs Soe pest i 0 Multiply by: Gross profit rate = rs Total 1,000,000 980,000 1,040.97 . 4000 | Incentive payment 00 | 000, Estimated total gross profit 1,000,000 os 440,00 | Multiply by: % of completion 20% b 809, Gross profit to date 200,000 392,000 1152000 | Less: Gross profit in prior yrs. ~__ (200,000) (392.000) | 200,000, 192,000 760,000 Gross profit for the year Cost of construction 1,000,000 960,000 2,200,009 | Revenue for the year 1,200,000 1,152,000 2,960,000 | Case 3: Cost-plus-fixed fee if Compute for the revenues in 20x1, 20x2 and 20x3, respectively, | assuming the contract price is set as ‘cost plus PIM’. | Solution: 20x1 20x2 20x3 Costs incurred to date 1,000,000 1,960,000 4,160,000 Estimated costs to complete 4,000,000 2,940,000 _ 1,040,000 Estimated total contract costs 5,000,000 4,900,000 5,200,000 | Fixed fee 1,000,000 1,000,000 1,000,000 Incentive payment 400,006 Estimated total contract price 6,000,000 5,900,000 6,600,000 Multiply by: % of completion 20% 40% 80% Revenue to date 1,200,000 2,360,000 5,280,000 Less: Revenue in prior yrs = (1,200,000) _ (2,360,000) Revenue for the year 1,200,000 1,160,000 2,920,000 Cost of construction (1,000,000) (960,000) _ (2,200,000) Gross profit for the year 200,000 200,000 720,000, | Optional reconciliation: | ae Fixed fee 1,000,000 1,000,000 1,000," Incentive payment _ sont | Estimated total gross profit 1,000,000 1,000,000 7,400,008 | Ke| syuttiply by: % of completion 20% 40% 80% _ fit to date 200,000 1,120,000 (Gross pro! 400,000 _ tas Gross profitin prior yrs. __00,0n0)_{ann.eer Gross profit for the year 200,000 200,000 720,000 costo‘ construction _1.000,000__990,000_2,200600. Revenue for the year 1,200,000 1,160,000 __2,920,00 Cost escalations ‘A cost escalation is a contractual provision that stipulates an increase in the contract price in the event of an increase in certain costs. For example, an escalation clause may specify that the contract price will increase with inflation to safeguard the contractor from price changes in materials and labor. Escalation dauses are normally expressed as a percentage of an originally contracted amount. The opposite of an escalation clause is de- escalation clause. . ‘An escalation is included in (or a de-escalation is excluded from) the transaction price when, in applying the constraining estimates of variable consideration principle, it is highly probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved. Illustration: Cost escalation ABC Co. started work on a construction contract in 20x1. The contract price is PIM; however, this will increase by 5% if the cumulative inflation rate exceeds 6%. Information on the project is as follows: 5 et Pees AO a as Costs incurred to date 224,000 518,000 Estimated costs to complete 476,000 222,000 Cumulative inflation rate 4.95% 6.73% Requirement: Compute for the gross profit recognized in 20x2. Solution:302 — ee ee ee (@) Costs incurred to date 224,000 518,009 ——Estimated costs to complete _476,000_222,09) (b) Estimated total contract costs 700,000 ) Expected gross profit (loss) 300,000 310,009 —Multiply by: % of completion «+ _32% _7vy | Gross profit (loss) to date 96,000 217,009 > Gross profitin prioryears = (96,000) Gross profit (loss) for the year 96,000___ 127,00) ~ “1M initial contract price x 105% = 1,050,000 Contract modifications A contract modification is a change in the scope and/or price of : contract that is approved by the contracting parties, in writing orally or implied by customary business practices. Similar term; are “change order,” “variation” and “amendment.” If the contract modification is not approved, the entity shall continue to apply PFRS 15 to the existing contract until the modification is approved. A contract modification may exist even though the contracting parties have a dispute about the scope and/or priceo! the modification or the change in the scope has been approved but the corresponding change in price is not yet determined. In the latter case, the entity shall estimate the change to the transaction price arising from the modification. A contract modification is accounted for as a separat? contract if both of the following conditions are met: a. The scope of the contract increases because of the addition & | promised goods or services that are distinct; and b. The contract price increases by an amount that reflects stand-alone selling prices of the additional promised goods” services.truction Contracts a 303 A contract modification that is not accounted for as a separate contract is accounted for as follows: » Ifthe additional goods or services are distinct but the increase in the contract price does not reflect the stand-alone selling price, the contract modification is accounted for as if it were a termination of the existing contract and the creation of a new contract. Accordingly, the sum of (a) the consideration from the original contract that is not yet recognized as revenue and (b) the consideration from the contract modification shall be allocated to all of the remaining performance obligations. > If the additional goods or services are not distinct, they are essentially a part of a single performance obligation that is only partially satisfied. Therefore, the contract modification is accounted for as if it were a part of the existing contract. Accordingly, the effect of the contract modification on the transaction price, and on the entity’s measure of progress towards complete satisfaction of the performance obligation, is recognized as an increase or decrease in revenue at the date of the contract modification. The adjustment to revenue is made ona cumulative catch-up basis. 2 Summary of concepts: A contract modification is accounted for: a. Asa separate contract if the modification results to additional goods or services that are distinct and the modified contract price reflects the stand-alone selling prices of those additional goods or services. nt for the existing contract “as is” and The entity continues to accou! as a new and separate contract. accounts for the modification termination of the existing contract and the ¢ the additional goods or services are distinct does not reflect the stand-alone selling b. As if the modification is a creation of a new contract i} but the modified contract price prices of those additional goods or services. on-prive from the original_contract plus the %_ ‘The batan/ Chapter ‘ation from the modification is Performance obligations. allocated 10 the tema © AS if the modification is a part of the existing contract if the Addition, 00d or services are not distinct. 3 The effect of the modification is accounted for as a prospectiyy catch up adjustment to revenue. ( Variations on the contract (Change orders) A variation is an instruction by the customer for a change in the Scope of the work to be performed under the contract. Examples of variations; 1. Changes in the specifications or design 2. Changes in the scope of work 3. Changes in the duration of the contract 4. Renegotiations on the originally agreed contract price Changes in the transaction Price After contract inception, the transaction Price can change for various reasons, including the resolution of uncertain events. A subsequent change in the transaction Price, arising from other than a contract modification, shall be allocated to the performance obligations based on the relative stand-alone prices of the distinct goods at contract inception. Accordingly, subsequent changes in stand-alone selling prices are ignored. Amounts allocated to a satisfied performance obligation shall be recognized as revenue, or as a reduction of revenue, in the period in which the transaction price changes. : A subsequent change in the transaction price shall be allocated to all of the performance obligations in the contra¢ unless it is clear that it relates only to a specific part of the contract. A change in the transaction Price after a contrat modification is accounted for as follows: