18 Construction Contracts (MFRS 111) Intermediate Accounting 14th Edition Kieso, Weygandt, and Warfield

Learning Objectives Define a construction contract and discuss the role of accounting concepts in the recognition of profit. Describe the acceptable methods of determining the stage (percentage) of completion of a contract. Apply the percentage-of-completion method for construction contracts. Apply the completed-contract method for construction contracts. Identify the proper accounting for losses on long-term contracts. Prepare financial statement extracts for construction contracts.

Construction contracts Construction contract = specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of design, technology, function or their ultimate purpose or use. Fixed cost contracts = contractor & customer agree to a fixed price or fixed rate per unit Cost plus contracts = contractor paid the total cost incurred + a specific percentage of the project cost or a fixed fee as his profit LO 1 Define a construction contract .

Combining/Segregating construction contracts Generally, each contract is treated as a single contract But there are alternatives A single contract that covers a number of assets: Construction of each asset is treated as a separate contract, when: Separate proposals are submitted for each asset Each asset is negotiated separately & the contractor & customer can accept/reject the contract for each part of the asset Revenue & costs for each component can be identified LO 1 Define a construction contract .

Combining/Segregating construction contracts Construction of a group of assets treated as a single contract: Regardless of whether it is with a single or several customers, treated as a single contract, when: The group of contracts were negotiated as a single contract The contracts are closely related and are in effect part of a single asset with an overall profit margin The contracts are performed concurrently or in a continuous sequence. LO 1 Define a construction contract .

Combining/Segregating construction contracts Construction of an additional asset: Treated as a separate contract, when: The asset differs significantly in terms of design, technology or function from the asset/s of the original contract, OR The contract price for the additional asset/s is negotiated independently of the original contract price LO 1 Define a construction contract .

Combining/Segregating construction contracts Example: ZEE is going to build Ampang Sentral, which comprises a shopping mall from the ground floor to the 4th floor and offices from the 5th floor to the 40th floor. Tenders were invited & Conlay Bhd was awarded the contract for RM300bn. The project is expected to take 3 years to complete. Is the construction of the shopping mall & office separate contracts? Answer: A single contract. Subject to a single negotiation/tender process. Revenue/costs cannot be separately identified. LO 1 Define a construction contract .

Contract Revenue Measured at the fair value of consideration received/ receivable Contract price comprises of initial agreed price Variations to the price due to variations in contract work, claims & incentive payments Changes to contract price are caused by: Increase: Cost excalations, variations & claims Decrease: penalties due to delays caused by contractor Changes: where the contract is expressed as a fixed price per unit of output & the no. of units changes LO 1 Define a construction contract .

Contract Revenue: Variations & Claims Changes to the scope of work requested by the customer May increase/decrease contract price Only recognised as part of contract price if: It is probable that customer will approve the change to contract price Amount can be measured reliably LO 1 Define a construction contract .

Contract Revenue: Variations & Claims Amounts that the contractor seeks to collect from customer or third party for costs not included in the contract price E.g. arising from delays caused by customer or errors in specifications Only included in revenue if: It is probable that the customer will accept the claim when negotiations have reached an advanced level Amount can be measured reliably LO 1 Define a construction contract .

Contract Costs = Costs incurred on construction activity from the date of securing the contract till final completion Costs incurred in securing the contract: may be included, if separately identifiable & measured reliably, and it is probable that contract can be obtained. If already expensed off, cannot be included in contract cost when contract subsequently obtained. LO 1 Define a construction contract .

Contract Costs Comprises: 1. Costs directly attributable to contract Site labour costs (including supervision) Materials used Depreciation of PPE (including moving costs of P&E and material to & from sites Plant hiring costs Cost of design Technical assistance costs Estimated rectification & guarantee work Third party claims * These costs can be reduced by incidental income, e.g. sale of excess material LO 1 Define a construction contract .

Contract Costs Comprises: 2. Costs attributable to the contract, but need to be allocated to it These costs are incurred for a number of activities but have to be allocated to specific contracts E.g. insurance, design costs, construction overhead Costs are allocated based on the normal level of activity 3. Costs that are specifically chargeable to the customer E.g. development costs LO 1 Define a construction contract .

Contract Costs Comprises: Borrowing costs incurred on funds borrowed may be included (Covered next week). Should NOT include: General admin expenses Development costs not claimable from customer Selling costs Depreciation of idle plant LO 1 Define a construction contract .

Recognition of contract revenue/costs First, determine the outcome of the contract Fixed cost contracts, outcome can be estimated reliably when: Total contract revenue can be measured reliably Probable that economic benefits will flow to entity Costs to complete & stage of completion can be measured reliably Contract costs can be identified & measured reliably, so that actual costs incurred can be compared with prior estimates. Cost plus contracts, outcome can be estimated reliably when: Contract costs can be identified & measured reliably LO 2

Percentage of completion method Revenue & expenses are recognised as the contract progresses, based on the amount of work completed Total contract revenue > costs  allocate profit by reference to stage of completion E.g. Contract price = RM30 million estimated total costs = RM25 million By the end of 1st year, 40% of the work was completed. Total profit = RM5 million In 1st year, revenue = 40% x RM30m = RM12m In 1st year, costs = 40% x RM25m = RM10m In 1st year, profit = RM2m LO 2

Percentage of completion method Total contract costs > revenue  loss is recognised immediately E.g. Contract price = RM30m Estimated total costs = RM32m By the end of 1st year, 40% of the work was completed. Total loss = RM2m  needs to be recognised in full regardless of stage of completion In the 1st year, revenue = 40% x RM30m = RM12m In the 1st year, cost = 40% x RM32m = RM12.8m In 1st year, loss = RM0.8m In the 1st year, add a provision for loss of RM1.2m LO 2

Percentage of completion method Not all work done & costs incurred up to the reporting date will be recognised as revenue/expenses Costs could have been incurred which relate to future activity Costs incurred but not recognised as expenses in the current period  shown as assets (amount due from customer) Advances from the customer/material bought for the next phase  shown as liabilities Costs incurred for a specific period, e.g. rectification work, has to be charged for that period only LO 2

Percentage of completion method Determining the percentage of completion Cost to date/(Cost to date + Estimated cost to completion) x 100; OR Cost to date/Estimated total costs x 100 Surveys of work performed Physical proportion of contract work completed LO 2

Percentage of completion method If contract outcome cannot be estimated Revenue recognised is limited to the amount of costs incurred if it is probable that the costs will be recovered Revenue recognised = costs incurred In other words, zero profit is recognised for the period. If initially the outcome could not be reliably estimated, but later the outcome could be determined  revenue/expenses should be recognised based on % of completion LO 2

Progress billings Progress billings are used when a contractor sends invoices to a client multiple times during the course of a project instead of sending a single bill. This is often the process used in a lengthy construction project, since various situations can arise during the course of such projects that can change billing estimates from their original starting point. LO 2

Progress billings Amount due from customers (Asset) = Costs incurred + recognised profit – recognised losses – Progress billings More work done/costs incurred than payment received Amount due to customers (Liability) = Progress billings – (costs incurred + recognised profit – recognised losses) More cash received than work done/costs incurred LO 2

Progress billings E.g. The costs incurred by a project, for the stage completed, was RM12 million and profit recognised was RM1.1 million. Progress billings to date was RM11 million. In the financial statements: Costs incurred RM12m + profit recog. RM1.1m = RM13.1m Amount due from customer = RM13.1m – RM11m = RM2.1m LO 2

Progress billings E.g. The costs incurred by a project, for the stage completed, was RM12 million. Of this, RM500,000 was for the next stage of the project. Profit recognised was RM1.1 million. Progress billings to date was RM11 million. In the financial statements: Costs incurred RM11.5m + profit recog. RM1.1m = RM12.6m Amount due from customer = RM12.6m – RM11m = RM1.6m RM500,000 incurred for the next project stage will be disclosed as a current asset. LO 2

Worked example 1 Illustration: Casper Construction Co. A) Prepare the journal entries for 2014, 2015, and 2016 LO 3 Apply the percentage-of-completion method for long-term contracts.

Worked example 1 Illustration: LO 3 Apply the percentage-of-completion method for long-term contracts.

Worked example 1 Illustration: Journal entries LO 3 Apply the percentage-of-completion method for long-term contracts.

Worked example 1 Illustration: Presentation in the financial statements LO 3 Apply the percentage-of-completion method for long-term contracts.

Worked example 1 Illustration: Notes to the financial statements LO 3 Apply the percentage-of-completion method for long-term contracts.

Long-Term Contract Losses Illustration: Loss on Profitable Contract Casper Construction Co. b) Prepare the journal entries for 2014, 2015, and 2016 assuming the estimated cost to complete at the end of 2015 was $215,436 instead of $170,100. LO 5 Identify the proper accounting for losses on long-term contracts.

Long-Term Contract Losses Illustration: Loss on Profitable Contract LO 5 Identify the proper accounting for losses on long-term contracts.

Long-Term Contract Losses Illustration: Loss on Profitable Contract LO 5 Identify the proper accounting for losses on long-term contracts.

Long-Term Contract Losses Illustration: Loss on Unprofitable Contract Casper Construction Co. c) Prepare the journal entries for 2014, 2015, and 2016 assuming the estimated cost to complete at the end of 2015 was $246,038 instead of $170,100. LO 5 Identify the proper accounting for losses on long-term contracts.

Long-Term Contract Losses Illustration: Loss on Unprofitable Contract $675,000 – 683,438 = (8,438) cumulative loss Plug LO 5 Identify the proper accounting for losses on long-term contracts.

Long-Term Contract Losses Illustration: Loss on Unprofitable Contract LO 5 Identify the proper accounting for losses on long-term contracts.

Revenue recognised based on value of work done/surveys On 1 Jan X1, Rose Enterprise signed a contract with Thorne to construct a refinery which was scheduled to take 3 years to complete. The agreed price was RM150m and the estimated cost was RM130m. The following data were compiled for the year ended 31.12.x1:

Revenue recognised based on value of work done/surveys % of completion = 67,500/150,000 = 45% Revenue recognised = 45% x 150m = 67.5m Cost recognised = 45% x 133m = 59.85m Profit recognised = RM67.5m – 59.85m = RM7.65m Amount due from customers: Costs to date RM63m + Recog. Profit RM7.65m – Progress billings RM60.75m = RM9.9m

Disclosures in Financial Statements Should include: Contract revenue recognised in the period Contract cost recognised in the period Method used to determine contract revenue Method used to determine stage of completion of contract in progress For each contract: Aggregate costs incurred & recognised profits Amount of advances received Amount of retentions Gross amount due from/to customer Any contingent liabilities/assets

Class exercise

Class exercise Robotics Construction entered into a contract to bore a tunnel. The agreed contract price was RM3m. The following table shows the position of the contract at the end of years x1, x2 & x3: Year X1 RM’000 X2 X3 Variation to the contract price (increase) 400 Cumulative costs incurred to date 945 1,800 3,100 Estimated costs yet to be incurred 2,155 1,200 - Progress billings to date 800 1,900 3,000 The company recognises profit based on cost incurred to total estimated cost. Prepare extracts of the statements of comprehensive income & financial position for years x1 & x2.

Class exercise Robotics Construction entered into a contract to bore a tunnel. The agreed contract price was RM3m. The following table shows the position of the contract at the end of years x1, x2 & x3: Year X1 RM’000 X2 X3 Variation to the contract price (increase) 400 Cumulative costs incurred to date 945 1,800 3,100 Estimated costs yet to be incurred 2,155 1,200 - Progress billings to date 800 1,900 3,000 The company recognises profit based on cost incurred to total estimated cost. Prepare extracts of the statements of comprehensive income & financial position for years x1 & x2.