1. Construction Contract

2. Question 1: Construction contract Suppose that a contract is started on 1 st January 2001, with an estimated completion date of 31 st December 2002. The final contract price is $2m.In the first year, to 31 st December 2001: (a) Cost incurred amounted to $800,000. (b) Half the work on the contract was completed. (c) Certificate of work completed have been issued, and if it is satisfactory, to issue certificates. This will then be the notification to the customer that progress payments are due to the contractor. Progress payments are commonly the amount of valuation on the work certificates issued minus a precautionary retention of 10%. (d) It is estimated with reasonable certainty that further costs to completion in 2002 will be $800,000. ** Required: What is the expected profit in 2001 and what entries would be made for the contract at 31 December 2001 if: (a)profits are deferred until the completion of the contract? (b)a proportion of the estimated revenue and profit is credited to profit or loss in 20x1?

3. Question 1: Answer Expected Profit in 2001: Entries: Recognized Revenue $2,000,000*50%$1,000,000 Costs$800,000 Profit$200,000 (a)Dr.Contract work in progress$800,000 Cr.Accounts Payable$800,000 Dr.Accounts Receivable $1,000,000*90% $900,000 Cr.Progress Billings (no this answer given from QP $900,000 Cash* *Question states” (a) Cost incurred” rather than “Cost Unpaid”

4. Question 1: Answer (Con’t) Entries: The proportion of the estimated revenue and profit is credited to profit in 20X1. SOL: Dr. Cost of sales $800,000 Cr. Cash $800,000 Dr. Account receivable $1,000,000 Cr. Sales $1,000,000 (b)Dr.Contract costs-I/S$800,000 Dr.Contract work in progress$200,000 Cr.Contract revenue-I/s*$1,000,000 Student answer is also acceptable as they comply with accounting standard. *Price = sales meaning Dr WIP 800,000 Cr cash 800,000

5. Question 2 Example: Profitable contract with reliably estimated outcome Andy Co has a fixed price contract to build a tower block. The initial amount of revenue agreed is $220 millions. At the beginning of the contract on 1 January 20X9 the initial estimate of the contract costs is $200 millions. At the end of 20X9 the estimate of the total costs has risen to $202 millions. During 20Y0 the customer agrees to a variation which increases expected revenue from the contract by $5 millions and causes additional costs of $3 millions. At the end of 20Y0 there are materials stored on site for use during the “following” period which cost $2.5 millions. It is decided to determine the stage of completion of the contract by calculating the proportion that contract costs incurred for work to date bear to the latest estimated total contract costs. The contract costs incurred at the end of each year were 20X9: $52.52 million, 20Y0: $154.2 million (including materials in store), 20Y1 $205 millions. ** Required: Calculate the stage of completion for each year of the contract and show how revenues, costs and profits will be recognised in each year. 5

6. Question 2: Answer Stage of Completion 20X920Y020Y1 $M Contract costs incurred to date52.52254.30205.00 Contract costs to complete149.4847.80--- Total estimated contract costs202.00 205.00 Stage of completion26%75.1%100% Estimated profit 154.20* 50.80 205.00 74% (205m – 154.2m) *The contract cost incurred at the end of year = accumulated figure (20x9 +20y0) If you feel the question not clear, you could double check by 205 –52.52. The contract cost incurred during that year = not accumulated figure Material stored on site for use next year ($52.52 / $202) ($154.2-$2.5)/$205 18,000 20,000

7. Question 2: Answer (Con’t) To DateRecognized in prior years Recognized in current year $m 20X9 Construction revenue (220*26%)57.20---57.20 Construction costs (202*26%)52.52---52.52 Profit4.68---4.68 20Y0 Construction revenue (220*75.1%)165.2257.20108.02 Construction costs (202*75.1%)151.7052.5299.18 Profit13.524.688.84 20Y1 Construction revenue (220+5)225.00165.2259.78 Construction costs205.00151.7053.30 Profit20.0013.526.48 ($225m x 74%) ($205m x 74%) 166.5 151.7 14.8 109.30 99.18 10.12 166.5 151.70 14.80 58.5 53.30 5.20 X 154.2 That is incurred but not completion 154.2-52.52-2.5 X neither 225m*26%=108m nor 202m*26%=

8. Question 2: Explain in three scenario First yearSecond yearThird year 26%48%26% If the total revenue is $220m, then $220m *26% $220m * 48%$220m *26% If the total revenue is $225m, then $225m *26% $225m * 48%$225m *26% If the total revenue is change from $220m to $225m meanwhile, then $220m *26% $225m * 48%$225m *26% ($225m *74%)= ($220m*26% +225m*48%) ($225m *74%)= ($225m*26% +225m*48%) Assumption: second year total sales correct To solve the problem regard change in total estimation on total revenue or cost, Please use the schedule that I teach you. Please refer the power point for format.

9. Question 3: Background 2.4 Construction contracts in the statement of financial position The accounting treatment of construction contracts is profit or loss driven. Any amount included in the statement of financial position is a balancing amount, calculated as:  Where an amount due from customers is calculated, this is normally shown within inventories.  Where an amount due to customers is calculated, this is normally shown as ‘payments on account’ within payables.  Any amount invoiced but unpaid is shown as a receivable*. Contract costs incurred to dateX Recognized profits less recognized lossesX/(X) Progress billing(X) Amounts due from/ to customersX/(X) 9 Dr receivable Cr Progress billing

10. Question 3 Change in estimates HKAS 8- the effect of any change in the estimate of contract revenue, costs or the outcome of a contract should be treated as a “change in accounting estimate”. Example: Change in estimates The example below shows the effect of a change in estimate of costs on the figures that appear in the statement of comprehensive income and statement of financial position Junket Co enters into a three- year contract. Estimated total revenue = $100,000 Estimated total cost= $ 70,000 However, during Year 2, management revises its estimate of total costs incurred and thus the outcome of the contract. As a result, during Year 2, a loss is recognized on the contract for the year, even though the contract will still be profitable overall. 10 This case is not total overall loss. This case is overall profit

11. Question 3 (Con’t) Year 1Year 2Year 3 $$$ Estimated total revenue100,000 Estimated total cost70,00080,000 Estimated total profit30,00020,000 Cost incurred to date42,00060,00080,000 Percentage of completion60%75%100% Recognized profit/(loss)for that year 18,000(3,000)5,000 Cumulated recognized profit18,00015,00020,000 Progress billing of 50,000, 30,000 and 20,000 are made on the last day of each year, and are received in the first month of the following year. The asset at the end of each year is. (a) Prepare schedule between Year 1 and Year 3 and disclosure. Change in estimate 60,000 80,000 100,000*0.6 -42,000 100,000*0.15 -(60,000-42,000) Not 80,000*0.15 (42,000+28,000) (60,000+20,000) 100,000*0.25 -(80,000-20,000) 100,000*0.75 -80,000*0.75

12. Question 3: Answer Change in estimates To DateRecognized in prior year Recognized in current year Year 1 Recognized revenue $100,000*60% $60,000---$60,000 Cost $70,000*60% $42,000---$42,000 Gross Profit$18,000---$18,000 Year 2 Recognized revenue $100,000*75% $75,000$60,000$15,000 Cost $80,000*75% $60,000$42,000$18,000 Gross Profit$15,000$18,000($3,000) Year 3 Recognized revenue $100,000*100% $100,000$75,000$25,000 Cost$80,000$60,000$20,000 Gross Profit$20,000$15,000$5,000

13. Question 3: Answer (Con’t) Disclosure:* Year 1Year 2Year 3 Contract costs incurred $42,000$18,000$20,000 Add: Recognized profit less recognized loss $18,000($3,000)$5,000 $60,000$15,000$25,000 Less: Progress billings $50,000$30,000$20,000 $10,000($15,000)$5,000 Included in current assets/(liabilities) Due from customers on construction contracts $10,000 --- $5,000 Due to customers on construction contracts --- ($15,000) --- $15,000(18,000-3,000) $60,000*$80,000 $20,000(23,000-3,000) $75,000 $80,000 $100,000 $60,000 ($5,000)0 --- *Disclosure represents “accumulate amount”. It is not just that current year amount. In addition, at each year end, the company recognizes a “Trade Receivable” for the amount outstanding at the end of the year of of $50,000, $30,000 and $20,000. (Dr AR Cr Progress Billings)

14. Question 3: Explain in three scenario First yearSecond yearThird year 60%15%25% If the total cost is $70,000, then $70,000 *60% $70,000 * 15%$70,000 *25% If the total revenue is $80,000 m, then $ 80,000 *60% $ 80,000 * 15%$ 80,000 *25% If the total revenue is change from $70,000 to $80,000 meanwhile, then $70,000 *26% $80,000m * 15%$80,000 *25% ($80,000 *75%)= ($70,000*60% +80,000*15%) ($80,000 *75%)= ($80,000*60% +80,000*15%) Assumption: second year total sales correct To solve the problem regard change in total estimation on total revenue or cost, Please use the schedule that I teach you. Please refer the power point for format.

15. Double entry for 3 years Material Purchases Dr WIP –FP 42,000 (Y1), 18,000 (Y2),20,000 (Y3) Cr Cash 42,000 (Y1), 18,000 (Y2),20,000 (Y3) Recognized in I/S Cr Contract revenue –I/S 60,000 (Y1), Cr15,000 (Y2), 25,000 (Y3) Dr Contract cost -I/S 42,000 (Y1), Dr18,000 (Y2),20,000 (Y3) Dr WIP -FP 18,000 (Y1), Cr 3,000 (Y2), Dr 5,000 (Y3) -- Balance figure Progress Dr AR 50,000 (Y1),30,000 (Y2),20,000 (Y3) Cr Progress Billing 50,000 (Y1),30,000 (Y2), 20,000 (Y3)

16. Question 4: Self test question 1 The main business of Hing Yip Co is construction contracts. At the end of September 20x9 there is an uncompleted contract on the books, details of which are as follows: Contract A  Date commenced: 1 April 20x7  Expected completion date: 23 December 20x9  Final Contract price $420,000  Costs to 30 September 20x9 $315,000  Value of work certified to 30 September 20x9 $357,000  Progress billings to 30 September 20x9 $310,000  Cash received to 30 September 20x9 $298,000  Estimated costs to completion at 30 September 20x9 $30,600 ** Prepare calculations showing the amount to be included in the statement of financial position at 30 September 20x9 in respect of above contract, assuming that the stage of completion is assessed based on work certified. 16

17. Question 4: Self test question 1: Answer Stage of Completion: $357,000 / $420,000*100% = 85% Dr. Contract Cost $315,000 Contract WIP $42,000 Cr. Contract Revenue $357,000 Dr. Cash $298,000 Accounts Receivable $12,000 Cr. Progress Billings $310,000 Dr. Contract WIP $315,000 Cr. Cash $315,000 The estimated final profit is: Final contract price 420,000 Less: costs to date 315,000 estimated future costs 30,600 Estimated final profit 74,400 Attributable profit = Estimated profit x Work certified*/Total contract price $74,400 total profit x $357,000/$420,000 = $63,240 Estimated accumulated profit at Sept 2009 You can not make double entry as the information is not sufficient. For example, you don’t know the previous double entry. So how can you know the % of work you complete this year. No accumulated figure in double entry *Notified customer

18. Question 4: Answer (Con’t) Hing Yip Company Statement of Financial Position (extract) Current Asset: Contract receivables $310,000 - $298,000$12,000 Due from customer on construction contract *W1$47,000 Working 1: Contract costs incurred plus attributable profits less foreseeable losses to date$357,000 Less: Progress billings to date$310,000 $47,000 $ Costs to date 315,000 Attributable profit 63,240 Less: Progress billings 310,000 Amount due from customers 68,240

19. Question 5: Self-test question 2 Aero company has the following information in respect of a construction contract: Total contract price-----------------------------$100,000 Cost incurred to date---------------------------$48,000 Estimated cost to completion-----------------$32,000 Progress billings---------------------------------$58,000 (of which $50,000 has been received) Percentage complete (cost basis)-----------60% ** Required: a) Prepare relevant extracts from the statement of comprehensive income and statement of financial position b) Show how the statement of financial position would differ if progress billings were $64,000 (of which $50,000received)

20. Question 5: Answer (a)Aero Company Statement of Comprehensive Income (extract) for the year ended Construction revenue $100,000*60%$60,000 Construction costs$48,000 Profit$12,000 Aero Company Statement of Financial Position (extract) Current Asset Due from customer on construction contract *W1$2,000 Contract receivables $58,000 - $50,000$8,000 Working 1: Contract costs incurred plus attributable profits less foreseeable losses to date$60,000 Less: Progress billings to date$58,000 $2,000 (48,000+12,000) Or Accounts Receivable Self-test question 2

21. Question 5: Answer (Con’t) (b)Aero Company Statement of Financial Position (extract) Current Asset Contract receivables $64,000 - $50,000$14,000 Current Liability Due to customer on construction contract *W1$4,000 Working 1: Contract costs incurred plus attributable profits less foreseeable losses to date$60,000 Less: Progress billings to date$64,000 ($4,000) Or Accounts Receivable $48,000+$12,000 Self-test question 2

22. Question 6:Exam practice: (a) “It is not prudent to recognize profit on outstanding work in progress in construction contracts. Revenue and cost should be recognized upon completion of the construction work.’ At 30 June 2009, Vertical Construction Company ("VC") had a fixed price construction contract in progress, named Waterfall Golf Villa, a project to construct 80 condominium units. 60 units have been completed and the remaining 20 units are expected to be completed in the last quarter of 2009. A survey of completed construction work will be carried out upon completion of all units. Construction was begun in April 2008 and the outcome of the contract could not be estimated reliably at 30 June 2008. According to the original bid estimate, VC would have a profit margin of 20%. Based on the actual costs incurred and the latest information, there will be an increase in the estimated total costs because of a 15% increase in the price of construction material. However, a loss is not anticipated. An instalment contract sum for the construction has been received by VC in accordance with the contracted payment schedule. Required: (B)Explain how VC should account for this construction contract in the financial statements for the year ended 30 June 2009. (7 marks)

23. Question 6:Exam practice answer (a) “It is not prudent to recognize profit on outstanding work in progress in construction contracts. Revenue and cost should be recognized upon completion of the construction work.’ Answer:The statement is incorrect. Paragraph 37 of the Framework for the Preparation and Presentation of Financial Statements states that "...Prudence is the inclusion of a degree of caution in the exercise of the judgments needed in or making the estimates required under the conditions of uncertainty... However, the exercise of prudence does not allow, for example, the creation of hidden reserves or excessive provision, the deliberate understatement of assets or income,... because the financial statements would not be neutral and therefore, not have the quality of reliability." HKAS 11.22 states that when the outcome of a construction contract can be estimated reliably, contract revenue and contract costs associated with the construction contract shall be recognised as revenue and expenses respectively by reference to the stage of completion of the contract activity at the end of reporting period.

24. Question 6:Exam practice answer HKAS 11.25 states that the recognition of revenue and expenses by reference to the stage of completion of a contract is often referred to as the percentage of completion method. Under this method, contract revenue is matched with the contract costs incurred in reaching the stage of completion, resulting in the reporting of revenue, expenses and profit which can be attributed to the proportion of work completed. This method provides useful information on the extent of contract activity and performance during a period. Even when the outcome of a construction contract cannot be estimated reliably, revenue shall be recognised only to the extent of contract costs incurred that it is probable will be recoverable and contract costs shall be recognised as an expense in the period in which they are incurred.(HKAS 11.32) Under both circumstances, an expected loss on the construction contract shall be recognised as an expense immediately when it is probable that total contract costs will exceed total contract revenue. (HKAS 11.22, 32 and 36)

25. Question 6:Exam practice answer B)It is considered that the outcome of the Waterfall Golf Villa construction contract can be estimated reliably as: (a) the total contract revenue can be measured reliably evidence/indicator: contract sum has been agreed upfront between VC and the employer. (b) it is probable that the economic benefits associated with the contract will flow to the entity.evidence/indicator: VC has collected the contracted instalment from the employer on time. (c) both the contract costs to complete the contract and the stage of contract completion at the end of reporting period can be measured reliably. evidence/indicator: the information given indicated that VC has reassessed the total costs against with the original bid estimate and forecast that the total cost would increase because the price of construction material has been 15% higher than the price in the budget. Besides, it is stated that 60 units have been completed and the remaining 20 units are expected to be completed in the last quarter of 2009. (d) the contract costs attributable to the contract can be clearly identified and measured reliably so that actual costs incurred can be compared with prior estimates.evidence/indicator: same as (c).

26. Question 6:Exam practice answer B)The stage of completion of the contract may be determined by reference to:(a) the proportion that contract costs incurred for work performed to date bear to the revised estimated total contract costs. (b) completion of a physical proportion of the contract work (i.e. 60 units completed and 20 units in progress). For the year ended 30 June 2009, the contract revenue and contract costs shall be recognised as revenue and expenses respectively by reference to the stage of completion as determined above at 30 June 2009 less the contract revenue and contract costs that were recognised in the prior year. For the year ended 30 June 2008, revenue should have been recognised only to the extent of contract costs incurred that it is probable will be recoverable and contract costs should have been recognised as an expense in the prior year in which they were incurred. For financial statements presentation, where contract costs incurred to 30 June 2009 plus recognised profits exceed (less than) progress billings, the surplus is shown as amounts due from (to) customers for contract work. Amounts billed for work performed but not yet settled by the customer are included in the statement of financial position as receivable, while amounts received before the related work is performed are included as a liability, as advances received.