AFAR-05 (Revenue - Construction Accounting) PDF

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ReSA - THE REVIEW SCHOOL OF ACCOUNTANCYCPA Review Batch 41  May 2021 CPA Licensure Examination  Week No. 5ADVANCED FINANCIAL ACCOUNTING & REPORTING A. Dayag  G. Caiga  M. NginaAFAR-05: PFRS 15 – Revenue from Contracts withCustomers: Construction AccountingWhat is a Construction Contract?...

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ReSA - THE REVIEW SCHOOL OF ACCOUNTANCY CPA Review Batch 41  May 2021 CPA Licensure Examination  Week No. 5

ADVANCED FINANCIAL ACCOUNTING & REPORTING

A. Dayag  G. Caiga  M. Ngina

AFAR-05: PFRS 15 – Revenue from Contracts with Customers: Construction Accounting What is a Construction Contract? A construction contract 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 or function or their ultimate purpose or use. Two Types of Construction Contract or Contract Price: 1. Fixed Price Contract – is 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 – is a construction contract in which the contractor is reimbursed for allowable or otherwise defined costs, plus a percentage of these costs or a fixed fee. Long-term contracts frequently provide that seller (builder) may bill the customer at intervals. The most common examples are as follows:     

Development of military and commercial aircraft High-rise buildings Skyways, roads, and bridges Weapons-delivery systems Space exploration hardware

Revenue recognition depends on the performance obligation(s): 1. Percentage of Completion / Over Time 2. Cost Recovery Method or Zero-Profit Approach / Point in Time Percentage of Completion / Over Time Revenue should be recognized OVER TIME if it can reasonably estimate its progress toward satisfaction of the performance obligations. Revenue can be recognized over time if at least one of the following criteria is met: 1. The customer consumes the benefit of the seller’s work as it is performed, or 2. The customer controls the asset as it is created or enhanced i.e., when the company’s performance creates or enhances an asset, (e.g., work in process or when a contractor builds an extension into a customer’s existing school building), or 3. The seller is creating an asset that has no alternative use to the seller, and the seller can receive payment for its progress to date even if the customer cancels the contract as when a company manufactures customized product. Company recognizes revenues and gross profits each period based upon the progress of the construction—referred to as the percentage-of-completion method. Most popular input measure used to determine the progress toward completion is the cost-to-cost method. Cost Recovery Method or Zero-Profit Approach / Point in Time If criteria (1 or 2 or 3 above) is not met, revenue should be recognized at a point in time (the company recognizes revenues and gross profit when the contract is completed) referred to as the cost-recovery (zero-profit) method/POINT in TIME. This method recognizes revenue only to the extent of costs incurred that are expected to be recoverable. Only after all costs are incurred when gross profit will be recognized. The performance obligation is satisfied when control of the goods or services is transferred from the seller to the customer. Usually transfer of control is obvious, and coincides with delivery. Other indicators of transfer of control: the customer has 1. 2. 3. 4. 5.

An obligation to pay the seller. Legal title to the asset. Physical possession of the asset. Assumed the risks and rewards of ownership. Accepted the asset.

The indicators (No. 1 to 5 as mentioned above) indicates that control has been transferred from the seller to the customer (the customer is more likely to control a good or service if the customer has those indicators). Sellers should evaluate these indicators individually and in combination to decide whether control has been transferred and revenue can be recognized.

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ReSA – THE REVIEW S CHOOL OF ACCOUNTANCY Week No. 5: CONSTRUCTION ACCOUNTING

AFAR-05

Method of Recognizing Revenue in Construction Accounting: A. Percentage-of-completion method (Over Time) – when the outcome of the construction contract can be estimated reliably, contract revenue and costs associated with the contract should be recognized as revenue and expenses, respectively, by reference to the stage of completion of the contract activity at the balance sheet date since there is a reasonable estimate of its progress toward satisfaction of the performance obligation. Measuring Stage of Completion. The stage of completion of a contract may be determined in a variety of ways. The enterprise uses the method that measures reliably the work performed. Depending on the nature if the contract, the methods may include: 1.

Input Measures/Cost Basis. Input measures are made in relation to the costs or efforts devoted to a contract. Input methods recognize revenue on the basis of the efforts or inputs to satisfy the performance obligation relative to the total expected inputs. Examples of input methods include labor-hours worked; costs incurred; time elapsed; resources consumed. Revenue can be recognized on a straight-line basis if inputs are used evenly throughout the performance period. a. Cost-to-cost method (Proportion of contract costs incurred). Perhaps the most popular of the input measures is the cost-to-cost method. Under this method, the degree of completion is determined by comparing costs already incurred with the most recent estimates of total expected costs to complete the project. The percentage that costs incurred bear to total expected costs is applied to the contract price to determine the revenue to be recognized to date as well as to the expected net income on the project in arriving at earnings to date. Some of the costs incurred, particularly in the early stages of the contract, should be disregarded in applying this method because they do not relate directly to effort expended on the contract. These include such items as subcontract costs for work that has yet to be performed and standard fabricated materials that have not yet been installed. One of the most difficult problems in using this method is estimating the costs yet to be incurred. Engineers are often consulted to help provide estimates as to a project’s percentage of completion. How difficult the estimation process may be, it is required in reporting income, regardless of how the percentage of completion is computed. b.

Efforts-expended methods. The efforts-expended methods are based on some measure of work performed. They include labor hours, labor pesos, machine hours, or material quantities. In each case, the degree of completion is measured in a way similar to the use in the cost-to-cost approach: the ratio of the efforts expended to date to the estimated total efforts to be expended on the entire contract. For example, if the measure of work performed is labor hours, the ratio of hours worked to date to the total estimated hours would produce the percentage for use in measuring income earned.

2. Output Measures/Sales Basis. Output measures are made in terms of results achieved. Examples of output methods include; surveys of work performed or performance completed to date (the value of ―work certified‖ to date may be a measure used to identify the degree of completion and therefore revenue to be recognized in profit or loss); units produced or delivered; tons produced; storey’s of a building completed; appraisals of results achieved; kilometers of a highway completed; contract milestones reached or achieved; time elapsed and values added. For example, if the contract calls for units of output, such as kilometers of roadway, a measure of completion would be a ratio of the miles completed to the total kilometers in the contract. Output methods should only be used when the output selected represents performance towards complete satisfaction of the performance obligation. The disadvantage of output methods is that the outputs used may not be available or directly observable. When this is the case, an input method may be necessary. Architects and engineers are sometimes asked to evaluate jobs and estimate the percentage of a job completed (surveys of work performed). These estimates are, in reality, output measures and usually are based on the physical progress made on the contract. This may be appropriate for the construction of buildings. Output measures are of two types: a. Proportional Cost Approach – the costs incurred computed under this method may not equal to the actual costs incurred. b. Actual Cost Approach – the costs incurred computed under this method should be equal to the costs actually incurred. The Proportional Cost and Actual Cost Approach are equally acceptable. It should be noted that progress payments and advances from customers often do not reflect the work performed.

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ReSA – THE REVIEW S CHOOL OF ACCOUNTANCY Week No. 5: CONSTRUCTION ACCOUNTING

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B. Cost Recovery Method/Zero-Profit Approach (Point in Time). Cost recovery method of construction accounting (zero-profit approach) is used when the contract’s outcome cannot be reliably estimated. The treatment below should be followed: 1. Recognize revenue only to the extent of contract costs incurred which are expected to be recoverable; and 2. Recognize contract costs as an expense in the period they are incurred. Only after all costs are incurred is gross profit recognized. In other words, the cost recovery method gives rise to zero profit. A zero-profit approach involves recognizing revenues equal to the amount of costs incurred during the period so that no net profit is recognized. But as soon as the ultimate outcome of a contract can be estimated, the percentageof-completion is applied. This no profit/no loss approach reflect the situation near the beginning of a contract, i.e., the outcome cannot be reliably estimated, but it is likely to recover the costs. Contract costs that cannot be recovered should be recognized as an expense immediately. The following are situations where this might occur:  The contract is not fully enforceable, i.e. its validity is seriously questioned;  The completion of the contract is subject to the outcome of pending litigation or legislation;  The contract relates to properties which will probably be expropriated or condemned;  The customer is unable to meet its obligations under the contract; and  The contractor cannot complete the contract or in any other way meets his/her obligations under the contract. When these uncertainties cease to exist , the contract revenue and costs should be recognized as normal by reference to the stage of completion. PFRS (IFRS) 15 states that the following cost must be capitalized: 1. The incremental costs of obtaining a contract 2. The cost of fulfilling a contract if they do not fall within the scope of another standard [such as PAS (IAS) 2 – Inventories] and the entity expects them to be recovered. Companies divide cost to fulfill a contract or fulfillment costs (contract acquisition costs) into two categories:  Those that give rise to an asset.  Those that are expensed as incurred. The capitalized costs will be amortized as revenue is recognized. This means that they will be expensed to cost of construction/sales as the contract progresses. Construction costs should comprise of: 1. Costs that relate directly to the specific contract; 2. Costs that are attributable to contract activity in general and can be allocated to the contract, such as insurance, cost of design and technical assistance not directly related to a specific contract and construction overheads; and 3. Such other costs which are specifically chargeable to the customer under the terms of the contract , which may include general administration costs and development costs. Costs that relate directly to a specific contract include the following: 1. Site labor costs, including site supervision; 2. Costs of materials used in construction; 3. Depreciation of plant and equipment used on the contract; 4. Cost of moving plant, equipment and materials to and from the contract site; 5. Cost of hiring plant and equipment; 6. Cost of design and technical assistance that are directly related to the contract; 7. Estimated costs of rectification and guarantee work, including expected warranty costs; and 8. Claims from third parties. General contract activity costs should be allocated systematically and rationally, and all costs with similar characteristics should be treated consistently. The allocation should be based on the normal level of construction activity. Borrowing cost may be attributed in this way. Costs that may be attributable to contract activity in general and can be allocated to specific contracts include: 1. Insurance; 2. Costs of design and technical assistance that are not directly related to a specific contract; 3. Construction overheads Some costs cannot be attributed to contract activity and so the following should be excluded from construction costs: 1. General administration costs (unless reimbursement is specified in the contract); 2. Research & Development (unless reimbursement is specified in the contract);

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ReSA – THE REVIEW S CHOOL OF ACCOUNTANCY Week No. 5: CONSTRUCTION ACCOUNTING

AFAR-05

3. Depreciation of idle plant and equipment not used on any particular contract; 4. Cost of wasted materials, labor or other resources; and 5. Costs that related to satisfied performance obligations Special Issues on Recognition of Contract Costs  Costs are recognized in the same proportion that applies to the recognition of revenue, except for the following.  Abnormal costs (e.g. to rectify an error in the production or service process) are expensed as incurred; and  Input costs that are not proportionate to the construction process.  If an incurred cost is not proportionate to the progress in the satisfaction of the performance obligation that cost shall be excluded when measuring the progress of the contract. A cost incurred that is not proportionate to the progress towards completion is excluded from the measurement of progress.  In this situation revenue will be recognized to the extent of the actual cost incurred in respect of that component  Companies recognize an asset for the incremental costs (or incremental costs of obtaining a contract) if these costs are incurred to obtain a contract with a customer. In other words, incremental costs are those that a company would not incur if the contract had not been obtained, such as: a. Sales commissions; b. Direct labor, direct materials, and allocation of costs that relate directly to the contract (e.g., costs of contract management and supervision, insurance, and depreciation of tools and equipment); and; c. Costs that generate or enhance resources of the company that will be used in satisfying performance obligations in the future. Such costs include intangible design or engineering costs that will continue to give rise to benefits in the future. Other costs that are expensed as incurred include general and administrative expenses (unless those costs are explicitly chargeable to the customer under the contract) as well as costs of waste, labor, or other resources to fulfill the contract that were not reflected in the price of the contract. In summary, companies only capitalize costs that are direct, incremental, and recoverable (assuming that the contract period is more than one year). Recognition of Expected or Anticipated Losses When it is probable that total contract costs will exceed total contract revenue, the expected (anticipated) loss should be recognized as an expense (or loss) immediately . The amount of such loss is determined irrespective of: 1. Whether or not the work has commenced on the contract; 2. The stage of completion of contract activity; or 3. The amount of profits expected to arise on other contracts which are not treated as a single construction contract. Long-term Contract Losses Two types of losses can become evident under the long-term contracts: 1. Loss in Current Period on a Profitable Contract; and 2. Loss on an Unprofitable Contract. Under PFRS 15, the loss in Current Period on a Profitable Contract and Loss on an Unprofitable Contract are similarly accounted for. Profitable Contract – Loss in Current Period. This situation happens when, during the construction, there is a significant increase in the estimated total contract costs but the increase does not eliminate all profits on the contract.

Financial Statement Presentation Percentage-of-Completion/Over Time During the life of the contract, the difference between the Construction-In-Progress and the Progress Billings is reported in the statement of financial position as follows: 

Current asset – Contract Asset. It comprises of total costs incurred on the contract, plus the cumulative recognized profit (or less cumulative recognized loss), less progress billings (i.e., the amounts actually invoiced to customers for work performed on a contract whether or not they have been paid by the customers).



Current liability – Contract Liability. It comprises of progress billings less total costs incurred on the contract, plus cumulative recognized profit (or less cumulative recognized loss).

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Week No. 5: CONSTRUCTION ACCOUNTING Cost Recovery Method/Point In Time

During the life of the contract, the difference between the Construction-In-Progress and the Progress Billings is reported in the statement of financial position as follows: 

Current asset – Contract Asset. It comprises of total costs incurred on the contract, less progress billings (i.e., the amounts actually invoiced to customers for work performed on a contract whether or not they have been paid by the customers).



Current liability – Contract Liability. It comprises of progress billings less total costs incurred on the contract.

Financial Statement Presentation – Multiple Contracts When companies have more than one project going at a time and costs exceed billings on some contracts and billings exceeds cost on others. In such case, the company segregates the presentation of the said contracts. The asset portion includes only those contracts on which costs and recognized profits exceed billings. While, the liability side includes only those on which on which billings exceed costs and recognized profits. Separate disclosures of the peso volume of billings and costs are preferable to a summary presentation for the difference.

I – Performance Obligations 1. Inting Corporation constructs highly specialized communication satellites. A customer in Hong Kong recently placed an order for a cable TV satellite at a price of P20 million. The order was placed in April 20x6, and the satellite is to be delivered in one year. The customer has guaranteed to pay in full at the end of 20x6, regardless of progress or cancellation. Inting uses ―proportion of time‖ as its measure of progress toward completion. When should Inting recognize revenue: at completion, or as the construction is performed? a. Over time c. No revenue recognized b. Point in time d. No performance obligation 2. DJD Construction is constructing a building for Hotel Dian. Under the construction agreement,if for any reason DJD can’t complete construction, Hotel Dian would own the partially completed building and could hire another construction company to complete the job. When should DJD recognize revenue: as the building is constructed, or after construction is completed? a. Over time c. No revenue recognized b. Point in time d. No performance obligation 3. Crown Construction Company entered into a contract with Star Hotel for building a highly sophisticated, customized conference room to be completed for a fixed pr...