Construction Contracts

Long Term Construction Contracts

➤ Is a contract specifically negotiated for the construction of an asset or a combination

of assets that are closely interrelated or interdependent in terms of their design,
technology, and function or their ultimate purpose or use.
➤ These are construction projects that extend thru more than one accounting period.
➤ Construction contracts include:
a. Contracts for the rendering of services that are directly related to the construction of an
asset.
b. Contracts for the destruction or restoration of assets and the restoration of the
environment following the demolition of assets.
➤ PFRS 15 replaces PAS 18 (Revenue), PAS 11 (Construction Contracts), and related interpretations
effective January 1, 2018.

PFRS 15- REVENUE FROM CONTRACTS WITH CUSTOMER

Step1 : Identify the contract(s) with the customer

● Parties have approved the contract
● Each party's rights and payment terms are identifiable
● Contract has commercial substance
● It is probable that the consideration will be collected
❖ When above criteria are not met, re-assess the contract going forward to
determine whether the criteria are subsequently met.
❖ What is the treatment of payments received from a customer prior to the
satisfaction of the criteria?

● No revenue is recognized on the contract that does not meet the above criteria. Any
consideration received from such contract is recognized as a liability and recognized as
revenue only when either of the following has occurred:

1. 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 non-refundable
2. The contract has been terminated and the consideration received is non-refundable

Step2 : Identify the performance obligations in the contract

 ● Performance obligations - promised good or service that is distinct or a series of distinct
goods or services that are substantially the same and have the same pattern of transfer to
the customer.

● A good or service is distinct if:

❖ The customer benefits from the good or service on its own, or together with other
readily available resources; and
❖ The good or service is separately identifiable from other goods or services in the
contract.
● 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 all three scenarios listed below, there is only one performance obligation

❖ Sale of lot only (associated infrastructure (road, drainage, etc.))

❖ Sale of house and lot
❖ Sale of condominium unit

Step3 : Determine the transaction price

➢ Transaction Price - 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 on behalf of third parties.

● In a construction contract, the transaction price normally consists of the following:

1. The contract price, and

2. Any subsequent variations in the contract price to the extent that it is probable that they will
result in revenue and they are capable of being measured reliably.

➢ However, the transaction price may not equal to the contract price if the consideration in
the contract is affected by any of the following:
a. Variable consideration
b. Constraining estimates of variable consideration
c. The existence of a significant financing component in the contract
d. Non-cash consideration
e. Consideration payable to a customer

➢ Variable Consideration
 ● An entity enters into a contract with a customer to build an asset for Php1 million. In
addition, the terms of the contract include a penalty of Php100,000 if the
construction is not completed within three months of a date specified in the
contract.

➢ Constraining Estimates of Variable Consideration

- An entity enters into a contract with a customer on 1 January 20X8 to sell Product A
for PHP100 per unit. If the customer purchases more than 1,000 units of Product A in
a calendar year, the contract specifies that the price per unit is retrospectively
reduced to PHP90 per unit. Consequently, the consideration in the contract is
variable.

- For the first quarter ended 31 March 20X8, the entity sells 75 units of Product A to the
customer. The entity estimates that the customer's purchases will not exceed the
1,000-unit threshold required for the volume discount in the calendar year.

- In May 20X8, the entity's customer acquires another company and in the second
quarter ended 30 June 20X8 the entity sells an additional 500 units of Product A to
the customer.

➢ The existence of a significant financing component in the contract

- An entity enters into a contract with a customer to sell an asset. Control of the
asset will transfer to the customer in two years. The contract includes two
alternative payment options: payment of PHP5,000 in two years when the customer
obtains control of the asset or payment of PHP4,000 when the contract is signed.
The customer elects to pay PHP4,000 when the contract is signed

➢ Non-Cash Consideration
- An entity enters into a contract with a customer to provide a weekly service for one
year. The contract is signed on 1 January 20X1 and work begins immediately. In
exchange for the service, the customer promises 100 shares of its common stock
per week of service (a total of 5,200 shares for the contract). The terms in the
contract require that the shares must be paid upon the successful completion of
each week of service.

➢ Consideration Payable to a Customer

- An entity that manufactures consumer goods enters into a one-year contract to

sell goods to a customer that is a large global chain of retail stores. The customer
 commits to buy at least CU15 million of products during the year. The contract also
requires the entity to make a non-refundable payment of CU1.5 million to the
customer at the inception of the contract. The CU1.5 million payment will
compensate the customer for the changes it needs to make to its shelving to
accommodate the entity's products.

Construction Contract may be classified into:

➢ Fixed Price Contract-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.
➢ Cost Plus Contract-the contractor is reimbursed for allowable or otherwise defined costs,
plus a fee.
a. Cost plus variable fee contract-the contractor is reimbursed for the costs plus a
percentage of those costs.
b. Cost plus fixed fee contract-the contractor is reimbursed for the costs plus a fixed
amount.

Step4 : Allocate the transaction price

➢ 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.
➢ Entity allocates a discount to all promised goods or services in the contract except if the
entity has observable evidence that the discount relates to one or more, but not all of the
performance obligations in the contract.

Step 5 : Recognize revenue when a performance obligation is satisfied.

➢ An entity shall recognize revenue when it satisfies a performance obligation by transferring

a promised good or service to a customer, which is when control is passed, either:
1. Over time - all through out
2. At a point in time. - one time payment

Satisfaction of Performance Obligations

 ➢ Over time if one of the following criteria is met:
- The customer simultaneously receives and consumes the benefits provided by the
entity's performance as an entity performs.
Ex: An entity enters into a contract to provide monthly payroll processing services
to a customer for one year.

- The entity's performance creates or enhances an asset that the customer controls
as the asset is created or enhanced.
Ex: - The entity has a present right to payment for the asset.
- The customer has legal title to the asset.
- The entity has transferred physical possession of the asset.
- The customer has the significant risks and rewards of ownership of the
asset.
- The customer has accepted the asset.

- 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.
Ex: An entity enters into a contract with a customer, a government agency, to build
a specialized satellite The entity builds satellites for various customers, such as
governments and commercial entities. The design and construction of each
satellite differ substantially, on the basis of each customer's needs and the type of
technology that is incorporated into the satellite.
- The entity has an enforceable right to payment for performance completed to date
Ex : The customer pays a deposit upon entering into the contract and the deposit
is refundable only if the entity fails to complete construction of the unit in
accordance with the contract. The remainder of the contract price is payable on
completion of the contract when the customer obtains physical possession of the
unit. If the customer defaults on the contract before completion of the unit, the
entity only has the right to retain the deposit.

➢ At a point in time-all other performance obligations are satisfied at a point in time.

- Revenue is recognized at the point in time when the customer obtains control or
the promised asset.

Measuring progress for revenue recognized over time

➢ Output Method-Recognized 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. The disadvantage of this
method is that the outputs used to measure progress may not be directly observable.
 ➢ Input Method-Recognized revenue on the basis of efforts or inputs expended relative
to the total expected inputs needed to fully satisfy a performance obligation. The
most common application of the input method is the cost to cost method.

Percentage of completion = Total costs incurred to date / Estimated total contract cost

➢ Total costs incurred to date represent the cumulative costs incurred from the
inception up to the current reporting date.

➢ Estimated total contract costs pertain to the forecasted total costs of completing the
contract. This can also be determined as the sum of total costs incurred to date and
estimated costs to complete.

➢ Estimated cost to complete pertain to the anticipated additional costs required to fully
complete the contract.

Percentage of completion =Total costs incurred to date/

Total costs incurred to date + Estimated costs to complete

Methods to account Long-term Construction Contracts

➢ Percentage of Completion Method-when the outcome of the construction contract

can be estimated reliably, that is, the estimate of costs to complete and the extent of
progress toward completion of long-term contracts are reasonably dependable.

➢ Zero Profit Method-under this method, revenue is recognized in an amount exactly

equal to costs incurred until reasonable objective estimates of the percentage of
completion are available.

Presentation to Financial Statement

➢ Contract Liability-an entity's obligation to transfer goods or services to a customer for
which the entity has received consideration from the customer.

➢ Contract Asset- 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.

➢ Receivable-an entity's right to consideration that is unconditional.