Accounting for Construction Contracts (IAS 11) Week 4: Lecture 2 Topic: Accounting for Construction Contracts (IAS 11) Reference: Deegan, Aust Financial Accounting, Chapter 16. Complied By: Mrs Maheshwari Chand;T2,2013.

Construction Contracts Define Construction Contracts / jobs When is revenue / expenses incurred and recognized….. When should profit be realized – check standards (different methods of recognition), as jobs are spread over a number of years. Complied By: Mrs. Maheshwari Chand, T2,2013

Construction contracts Accounting issues result from construction projects taking several financial periods to complete Should revenue be recognised progressively throughout the contract? If so, how would the amount of revenue be determined? Complied By: Mrs. Maheshwari Chand, T2,2013

Construction contracts Deferral of revenue recognition until completion of project would result in greater volatility of reported revenues and of related profits or losses. Applies to accounting methods adopted by a contractor for all construction contracts. Construction contract defined (IAS 11, par. 3): 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 of their ultimate purpose or use. Complied By: Mrs. Maheshwari Chand, T2,2013

Construction contracts Accounting requirements; Individual construction contracts must be accounted for separately and the requirements of the standard must be applied separately to each contract. IAS 11 (par. 9): A group of contracts, whether with a single customer or with several, is to be treated as a single contract when: the group of contracts is negotiated as a single package the contracts are so closely interrelated that they are, in effect, part of a single project with an overall profit margin; and the contracts are performed concurrently or in a continuous sequence. Complied By: Mrs. Maheshwari Chand, T2,2013

Construction contracts IAS 11 requires the percentage-of-completion method to account for construction contracts Profit on construction contract is recognised in proportion to the work performed in each reporting period in which construction occurs. Construction costs plus gross profit earned to date accumulated in inventory account (construction in progress). Progress billings accumulated in contra inventory account (billings on construction in progress account). Complied By: Mrs. Maheshwari Chand, T2,2013

Construction contracts Percentage-of-completion method should be used provided that certain conditions are met that enable the outcome of the contract to be reliably estimated. IAS 11 (par. 22): When the outcome of a construction contract can be estimated reliably, contract revenue and contract costs associated with the construction contract are to be recognised as revenue and expenses respectively by reference to the stage of completion of the contract activity at the reporting date. Complied By: Mrs. Maheshwari Chand, T2,2013

Construction contracts Conditions of use of percentage-of-completion method (IAS 11, par. 23): With fixed-price contract: Total contract revenue can be measured reliably. It is probable that economic benefits arising from the contract will flow to the contractor. Both the contract costs to complete the contract and stage of contract completion as at reporting date can be measured reliably. The contract costs attributable to the contract can be clearly identified and measured reliably so that actual costs can be compared with prior estimates. Complied By: Mrs. Maheshwari Chand, T2,2013

Construction contracts Conditions of use of percentage-of-completion method (IAS 11, par. 24): With cost-plus contract: It is probable that the economic benefits arising from the contract will flow to the contractor; and The contract costs attributable to the contract, whether or not specifically reimbursable can be clearly identified and measured reliably. Complied By: Mrs. Maheshwari Chand, T2,2013

Construction contracts If conditions are not satisfied: No profit is to be brought to account until they are satisfied. At the extreme, no profit to be recognised until project completion. Note: when outcome of construction contract cannot be estimated reliably (IAS 11, par. 32): revenue is to be recognised only to the extent of contract costs incurred that it is probable will be recoverable; and contract costs are to be recognised as an expense in the period in which they are incurred. Complied By: Mrs. Maheshwari Chand, T2,2013

Construction contracts Measuring progress towards completion Percentage of completion can be measured in a number of ways (per IAS 11, par. 30): The entity uses the method that measures reliably the work performed. Depending on the nature of the contract, the methods may include: in the proportion that contract costs incurred for work performed to date bear to the estimated total contract costs surveys of work performed; or completion of physical proportion of the contract work. Progress payments and advances received from customers often do not reflect the work performed. Complied By: Mrs. Maheshwari Chand, T2,2013

Construction contracts Measuring progress towards completion Cost basis: The percentage of completion is measured by comparing costs incurred to date with the most recent estimate of the total costs to complete the contract. Only those contract costs that reflect the work performed are included in costs incurred to date. Examples of contract costs excluded are: contract costs that relate to future activity on the contract, such as costs of materials delivered or set aside but as yet not installed, used or applied payments made to subcontractors in advance of work performed. Complied By: Mrs. Maheshwari Chand, T2,2013

Construction contracts Calculation of percentage of completion (Cost method): Costs incurred to the end of the current period Most recent estimate of total costs Current period revenue or gross profit: (estimated total revenue or gross profit from the contract) multiplied by percentage complete less (total revenue or gross profit recognized in prior periods). Complied By: Mrs. Maheshwari Chand, T2,2013

Construction contracts Accounting for long-term contract losses When current estimates of total contract costs and revenues for any contract indicate that a loss is probable: Provision should be made for any foreseeable loss on the contract regardless of the amount of work already performed. Loss is to be brought to account as soon as it is foreseeable. IAS 11 (par. 36): When it is probable that total contract costs will exceed total contract revenue, the expected loss shall be recognised as an expense immediately. Complied By: Mrs. Maheshwari Chand, T2,2013

Construction contracts IAS 11 (par. 37): Expected loss (excess of total contract costs over total contract revenue) arising from a construction contract is recognised as an expense irrespective of: whether work has commenced on the project; the stage of completion of the activity; or the difference between total contract costs and total contract revenue expected to arise from other construction contracts. Complied By: Mrs. Maheshwari Chand, T2,2013

Journals for construction contracts Journal entries for construction contract accounting To record costs of construction Dr Construction in process Cr Materials, cash, payables, etc. To record billings to customers Dr Accounts receivable Cr Billings on construction in process To record collections of billings Dr Cash Cr Accounts receivable Complied By: Mrs. Maheshwari Chand, T2,2013 16-16

Journals for construction contracts To record contract revenue and contract expenses Dr Construction in process Dr Construction expenses (costs incurred) Cr Revenue from long-term contracts To record final approval of contract Dr Billings on construction in process Cr Construction in process Complied By: Mrs. Maheshwari Chand, T2,2013 16-17

Construction Contracts IAS 11: Lecture illustrative Example (PCM) Complied By: Mrs. Maheshwari Chand, T2,2013

Calculation of percentage of completion (Fixed Price method) Review Formula: % Complete = Costs incurred to the end of current period Most recent estimate of total costs Compiled by: Mrs. Maheshwari Chand continued

Recap: Journal entries for construction contract accounting To record costs of construction Dr Construction in progress Cr Materials, cash, payables, etc. To record billings to customers (progress billings) Dr Accounts receivable Cr Billings on construction in progress To record collections of billings Dr Cash Cr Accounts receivable To record contract revenue and contract expenses Dr Construction in progress (or contract costs incurred) Dr Construction expenses (costs incurred) Cr Revenue from long-term contracts To record final approval of contract Dr Billings on construction in progress Cr Construction in progress (or contract costs incurred) Compiled by: Mrs. Maheshwari Chand continued

Lets’ look at one example : AZ Contractors signed a contract on January 1, 2011, agreeing to build a warehouse for FSC at a contract price of $22,000,000. AZ estimated that construction costs would be as follows: 2011 $7,000,000 2012 $8,000,000 2013 $5,000,000 $20,000,000 The contact provided that FSC would make payments on the December 31 of each year as follows: 2011 $ 5,000,000 2012 $10,000,000 2013 $ 7,000,000 $22,000,000 Assuming: The contract was completed and accepted on December 31, 2013. Assume that actual costs and cash collections coincided with expectations. Compiled by: Mrs. Maheshwari Chand

(a) Calculate The Income to be recognised in each year: YEAR P.O.C. 2011 $0.70 2012 $0.80 2013 $0.50 $2.00 P.O.C. 2011 2012 2013 Revenue (7/20)x22 7.70 (15/20)x22- 7.70 8.8 (20/20)x22-16.50 5.5 Expense 7/20 x 20 (7) 15/20 x 20 - 7 (8.0) 20/20 x 20 - 15 (5.0) Profit 0.70 0.80 0.50 Note: All figures in $million Compiled by: Mrs. Maheshwari Chand

(b) Journal Entries P.O.C. Method 2011 2012 2013 (i) To record costs incurred Dr. Construction in progress 7 8 5 Cr. Cash, accounts payable 7 8 5 (ii) To record billings to customers 2011 2012 2013 Dr. Accounts Receivable 5 10 7 Cr. Billings on Contracts in Progress 5 10 7 Compiled by: Mrs. Maheshwari Chand

(iii) To record cash collections 2011 2012 2013 Dr. Cash 5 10 7 Cr. Accounts Receivable 5 10 7 (iv) To record periodic income recognised Dr. Construction in Progress 0.70 0.80 0.50 Dr. Construction expenses 7.0 8.00 5.0 Cr. Revenue from L.T. Contract 7.70 8.80 5.50 (or could separately show the revenue and expense) (v) To record final approval and acceptance Dr. Billings on Contracts in Progress - - 22 Cr. Construction in Progress - - 22 Compiled by: Mrs. Maheshwari Chand

Summary Income is one of the five elements specified by the NZ framework. Recognition is based on when associated inflow of economic benefits is probable and measureable Also includes the risk and rewards of ownership transferral. Where conditions apply to the sale, consideration needs to be made to see if these conditions reduce the probability of economic inflows. Different models (such as historical cost or market values) affect when revenue is recognised. Long term construction contract’s profits are applied using the percentage-of-completion method. Complied By: Mrs. Maheshwari Chand, T2,2013

End Of Lecture WEEK 4 Check class share for tutorial questions on this topic Thank You Complied By: Mrs. Maheshwari Chand, T2,2013