AFAR 2 Module CH 7 PDF

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CHAPTER 7 TITLE REVENUE CONTRACTS CUSTOMERS: CONSTRUCTION ACCOUNTING WITH B. DEVELOPMENTAL ACTIVITIES INTRODUCTION 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 the...

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CHAPTER #

7

TITLE

REVENUE RECOGNITION– CONTRACTS CUSTOMERS: CONSTRUCTION ACCOUNTING

WITH

B. DEVELOPMENTAL ACTIVITIES INTRODUCTION 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. Construction contracts are generally long-term, thus, the primary issue in its accounting is the timing of recognition of contract revenue and contract costs Construction contracts include:  Contracts for rendering services which are directly related to the construction of the asset.  Contracts for the destruction or restoration of assets, and the restoration of the environment following the demolition of the assets. TRANSACTION PRICE In construction contracts, the transaction price normally consists the following:  The contract price; and  Any subsequent variations in the contract to the extent that it is probable that they will result in revenue and they are capable of being measured reliably. Two Types of Construction Contract / Contract Price 1. Fixed Price Contract – a construction contract in which the contractor agrees to a fixed contract price, or a fixed rate per unit 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 otherwise defines costs, plus percentage of these costs or a fixed fee. a. Cost-plus-variable-fee Contract – the contractor is reimbursed for agreed costs with no provision for fixed fee. Instead, the fee is determined by applying an agreed percentage to the total reimbursable costs. The total contract price is the sum of reimbursable costs and the percentage based on these costs. b. Cost-plus-fixed-fee Contract – the contractor is reimbursed for agreed costs plus fixed fee. The total contract price is the sum of reimbursable cost and the fixed fee. REVENUE RECOGNITION Revenue recognition depends on the performance obligations: A. Overtime/ Percentage of completion if any of the following criteria is met:  Customer simultaneously receives and consumes all of the benefits.  The entity work creates or enhances an asset controlled by the customer.  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. B. Point in time/ Cost recovery method, if none of the criteria above is met. Method of recognizing revenue: Percentage of completion (Overtime) -when the outcome of the construction contract can be estimated reliably, contract revenue and contract costs associated with the contract should be recognized as revenue and expenses, respectively, by reference to the stage of completion (progress). 

Methods of Measuring Progress: o Input Methods/ Cost Basis - recognise revenue on the basis of the entity’s efforts or inputs to the satisfaction of a performance obligation.  Cost-to-cost 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 cost incurred bear to total expected costs is applied to the contract price to determine the revenue to be recognized to date as well as the expected net income on the project in arriving at earnings to date.

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 Includes (but not limited to) labor hours, labor pesos, machine hours, or material quantities  The ratio of the measure of work performed over the estimated total estimated measure of work will determine the percentage of completion to be used in computing the revenue. Output Methods/ Sales Basis - recognise 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. It include methods such as surveys of performance completed to date, appraisals of results achieved, milestones reached, time elapsed and units produced or units delivered.  Proportional Cost Approach – the cost incurred computed under this method may not equal to the actual costs incurred.  Actual Cost Approach – the cost incurred completed under this method should be equal to cost actually incurred.

Cost recovery method/Zero profit method (Point in time) - when the outcome of the construction contract cannot be estimated reliably. The following treatment must be followed:  Recognize revenue only to the extent of contract cost incurred which are expected to be recoverable  Recognize contact cost as an expense in the period they are incurred. CONTRACT COSTS Construction costs include the following: 

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Cost that relate directly to specific contract:  Direct labor cost (Site labor costs and supervision)  Direct materials used in construction  Depreciation of plant and equipment used on the construction  Cost of moving the materials, plant and equipment to and from the site  Cost of hiring plant and equipment  Design and technical assistance that are directly related to contract  Estimated costs of rectification and guarantee work, including expected warranty work  Claims from third parties Costs that are attributable to contract activity in general and can be allocated to the contract:  Insurance  Cost of design and technical assistance not directly related to a specific contract  Construction overheads Costs that is explicitly chargeable to the customer under the contract. It may include general administration costs and development costs. Other costs that are incurred only because an entity entered into the contract such as payments to subcontractors.

The following costs are to be recognized as expenses when incurred:  general and administrative costs (unless those costs are explicitly chargeable to the customer under the contract);  costs of wasted materials, labour or other resources to fulfill the contract hat were not reflected in the price of the contract;  costs that relate to satisfied performance obligations (or partially satisfied performance obligations) in the contract (ie costs that relate to past performance); and  costs for which an entity cannot distinguish whether the costs relate to unsatisfied performance obligations or to satisfied performance obligations (or partially satisfied performance obligations). PRESENTATION During the life of the contract, the difference between the Construction in Progress and the Progress Billings is recognized in the statement of financial position as follows:  

Contract Asset (Current Asset) = excess of Construction in Progress over Progress Billings Contract Liability (Current Liability) = excess of Progress Billings over Construction in Progress

 Construction in Progress - It comprises of total costs incurred on the contract, plus the cumulative recognized profit, if any, or less cumulative recognized loss.  Progress Billings – the amount actually invoiced to customers for work performed on a contract whether or not they have been paid by the customer.

ILLUSTRATION VVL Construction Company agrees to build a large office building for JK Towers for a total contract price of P5,000,000. JK Towers will make annual payments to VVL but the amount of these payments cannot exceed the direct costs incurred by VVL. The contract is signed on October 1, 2020 and VVL’s year-end is December 31. The contract provides JK with final inspection right to ensure compliance with the contract terms prior accepting the completed project. Additional Information: Total contract price Total Anticipated Costs (at 10/2020) Item Cost incurred each year Estimated cost to complete (at year end) Progress billings each year Progress Payments received each year

2020 P1,350,000 3,150,000 400,000 275,000

P5,000,000 4,500,000 2021 P2,250,000 400,000 2,000,000 2,100,000

2022 P400,000 2,600,000 2,625,000

Total P4,000,0 5,000,0 5,000,0

Cost-to-cost (Percentage of Completion) Method: Step 1: Identify the contract with a customer.  The contract is a construction contract. Step 2: Identify the separate performance obligations within a contract.  The performance obligation is to construct a large office building for JK Towers. Step 3: Determine the transaction price.  The Transaction Price is P5,000,000 Step 4: Allocate the transaction price. With only one performance obligation, VVL allocates the entire transaction price to the construction of office building. Step 5: Recognize Revenue when (or as) each performance obligation is satisfied. CASE 1: Using Percentage of Completion Method (Over time) 2020 Total Contract Price P5,000,000 Cost Incurred to Date 1,350,000 Estimated Cost to Complete 3,150,000 Total Estimated Costs to Complete (4,500,000) Expected Gross Profit 500,000 x % of Completion 30% Gross Profit Earned to Date 150,000 Profit Earned in Prior Years Gross Profit Earned This Year P150,000

2021 P5,000,000 3,600,000 400,000 (4,000,000) 1,000,000 90% 900,000 (150,000) P750,000

2022 P5,000,000 4,000,000 (4,000,000) 1,000,000 100% 1,000,000 (900,000) P100,000

Supporting Computation: Cost Incurred This Year Cost Incurred in the Previous Years Cost Incurred to Date Divided by: Total Estimated Costs to Complete Percentage of Completion Journal Entries: 2020 Construction in Progress

2020 P1,350,000 1,350,000 4,500,000 30%

2021 P2,250,000 1,350,000 3,600,000 4,000,000 90%

1,350,000 Cash

1,350,000

To record cost incurred in 2020. Accounts Receivable

400,000 Progress Billing

To record progress billing in 2020.

400,000

2022 P400,000 3,600,000 4,000,000 4,000,000 100%

Cash

275,000

Accounts Receivable To record collection of billing in 2020.

275,000

Construction in Progress Cost of Construction

150,000 1,350,000

Construction Revenue To record recognition of revenue in 2020.

1,500,000

2021 Construction in Progress

2,250,000 Cash

2,250,000

To record cost incurred in 2021. Accounts Receivable

2,000,000 Progress Billing

2,000,000

To record progress billing in 2021. Cash

2,100,000

Accounts Receivable To record collection of billing in 2021.

2,100,000

Construction in Progress Cost of Construction

750,000 2,250,000

Construction Revenue To record recognition of revenue in 2021.

3,000,000

2022 Construction in Progress

400,000 Cash

400,000

To record cost incurred in 2022. Accounts Receivable

2,600,000 Progress Billing

2,600,000

To record progress billing in 2022. Cash

2,625,000

Accounts Receivable To record collection of billing in 2022.

2,625,000

Construction in Progress Cost of Construction

100,000 400,000

Construction Revenue To record recognition of revenue in 2022.

500,000

Progress Billings

5,000,000

Construction in Progress To eliminate inventory account in 2022.

5,000,000

Presentation: Construction in Progress Progress Billings Contract Asset (Liability)

2020 1,500,000 (400,000) 1,100,000

2021 4,500,000 (2,400,000) 2,100,000

2022 -

CASE 2: Using Cost Recovery Method (Point in Time) Construction Revenue Cost Incurred This Year Gross Profit Earned This Year Journal Entries: 2020 Construction in Progress

2020 P1,350,000 1,350,000 P0

2021 P2,250,000 2,250,000 P0

1,350,000

2022 1,400,000 400,000 P1,000,000

Cash

1,350,000

To record cost incurred in 2020. Accounts Receivable

400,000 Progress Billing

400,000

To record progress billing in 2020. Cash

275,000

Accounts Receivable To record collection of billing in 2020.

275,000

Cost of Construction

1,350,000

Construction Revenue To record recognition of revenue in 2020.

1,350,000

2021 Construction in Progress

2,250,000 Cash

2,250,000

To record cost incurred in 2021. Accounts Receivable

2,000,000 Progress Billing

2,000,000

To record progress billing in 2021. Cash

2,100,000

Accounts Receivable To record collection of billing in 2021.

2,100,000

Cost of Construction

2,250,000

Construction Revenue To record recognition of revenue in 2021.

2,250,000

2022 Construction in Progress

400,000 Cash

400,000

To record cost incurred in 2022. Accounts Receivable

2,600,000 Progress Billing

2,600,000

To record progress billing in 2022. Cash

2,625,000

Accounts Receivable To record collection of billing in 2022.

2,625,000

Construction in Progress Cost of Construction

1,000,000 400,000

Construction Revenue To record recognition of revenue in 2022.

1,400,000

Progress Billings

5,000,000

Construction in Progress To eliminate inventory account in 2022.

5,000,000

Presentation: Construction in Progress Progress Billings Contract Asset (Liability)

2020 1,350,000 (400,000) 950,000

2021 3,600,000 (2,400,000) 200,000

2022 -

RECOGNITION OF EXPECTED AND ANTICIPATED LOSSES 

When it is probable that total contract costs will exceed total contract revenue, the expected or anticipated

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loss should be recognized as an expense (or loss) immediately. Estimated losses on long-term contracts must always be recognized fully in the accounting period when loss estimate was made irrespective of: o whether or not the work has commenced on the contract; o the stage of completion of the contract activity; or o the amount of profits expected to arise on other contracts which are not treated as a single construction contract.

CASE 3: Loss in the year of revision of estimated costs but profit in total contract. Revising the illustration given above, assume that at the end of 2021, the estimated cost to complete was increased to P1,200,000 and this was the actual cost incurred in 2022. 3.a. Using Percentage of Completion Method (Over time) Total Contract Price Cost Incurred to Date Estimated Cost to Complete Total Estimated Costs to Complete Expected Gross Profit x % of Completion Gross Profit Earned to Date Profit Earned in Prior Years Gross Profit Earned This Year

2020 P5,000,000 1,350,000 3,150,000 (4,500,000) 500,000 30% 150,000 P150,000

2021 P5,000,000 3,600,000 1200,000 (4,800,000) 140,000 75% 105,000 (150,000) P(45,000)

2022 P5,000,000 4,800,000 (4,800,000) 140,000 100% 140,000 (105,000) P35,000

Supporting Computation: 2020 P1,350,000 1,350,000 4,500,000 30%

Cost Incurred This Year Cost Incurred in the Previous Years Cost Incurred to Date Divided by: Total Estimated Costs to Complete Percentage of Completion To record revenue recognition: Construction in Progress Cost of Construction

2021 P2,250,000 1,350,000 3,600,000 4,800,000 75%

2022 P1,200,000 3,600,000 4,800,000 4,800,000 100%

150,000 1,350,000

Construction Revenue To record recognition of revenue in 2020. Cost of Construction

1,500,000

2,250,000

Construction in Progress Construction Revenue To record recognition of revenue in 2021. Construction in Progress Cost of Construction

45,000 3,000,000

35,000 1,200,000

Construction Revenue To record recognition of revenue in 2022.

1,235,000

3.b. Using Cost Recovery Method (Point in Time) Construction Revenue Cost Incurred This Year Gross Profit Earned This Year

2020 P1,350,000 1,350,000 P0

To record revenue recognition: Cost of Construction

2021 P2,250,000 2,250,000 P0

1,350,000

Construction Revenue To record recognition of revenue in 2020. Cost of Construction

1,350,000

2,250,000

Construction Revenue To record recognition of revenue in 2021. Construction in Progress

2022 1,400,000 1,200,000 P200,000

2,250,000

200,000...