1. IAS 11 - Construction Contracts

2. Academic Resource Center Revenue recognition including construction contracts Page 2 Recognition before delivery – construction contracts General Construction accounting applies to building construction as well as the construction of other assets. Expected contract losses are recognized in income as soon as it becomes probable that the entity will experience a loss on the contract. Similar IFRSUS GAAP Costs directly related to a contract, which are incurred in securing the contract, are included as part of the contract costs if they can be identified and measured separately, and it is probable that the contract will be obtained and the costs are recoverable. Similar

3. Academic Resource Center Revenue recognition including construction contracts Page 3 IFRS ► Contracts are classified as fixed-price or cost-plus contracts. ► Time-and-materials-type contracts would most likely be classified as cost-plus contracts. ► Units-of-production contracts would most likely be classified as fixed-price contracts. ► Contracts are segmented if certain criteria are met. These criteria are different from the criteria under US GAAP. US GAAP ► Contracts can be classified as fixed-price, cost-plus, time-and-materials and units-of-production contracts. ► Contracts may be segmented if certain criteria are met, but it is not required. Recognition before delivery – construction contracts General

4. Academic Resource Center Revenue recognition including construction contracts Page 4 Recognition before delivery – construction contracts Percentage-of-completion method Both input and output methods are acceptable for determining the stage of completion of a given project. Similar IFRSUS GAAP

5. Academic Resource Center Revenue recognition including construction contracts Page 5 IFRSUS GAAP ► The criteria for using the percentage-of- completion method (ASC 605-35-25-56 and 57) are as follows: ► The entity must have the “ability to make reasonably dependable estimates.” These estimates are defined as relating to “estimates of the extent of progress toward completion, contract revenues, and contract costs.” ► “Contracts executed by the parties normally include provisions that clearly specify the enforceable rights regarding goods or services to be provided and received by the parties, the consideration to be exchanged, and the manner and terms of settlement.” Recognition before delivery – construction contracts Percentage-of-completion method

6. Academic Resource Center Revenue recognition including construction contracts Page 6 IFRS ► Per IAS 11.22, the percentage-of-completion method can be used “when the outcome of the construction contract can be estimated reliably.” If the criteria for using the percentage-of-completion method are not met, then the entity recognizes revenue to the extent that costs are incurred (as long as the costs are likely to be recovered) and recognizes costs as incurred. The criteria of reliable estimation are defined differently, depending on the type of contract. US GAAP ► Criteria, continued: ► “The buyer can be expected to satisfy all obligations under the contract. ► The contractor can be expected to perform all contractual obligations.” Recognition before delivery – construction contracts Percentage-of-completion method

7. Academic Resource Center Revenue recognition including construction contracts Page 7 IFRS ► According to IAS 11.23, the criteria for fixed price contracts are as follows: “Total contract revenue can be measured reliably; “It is probable that the economic benefits associated with the contract will flow to the entity; “Both the contract costs to complete the contract and the stage of contract completion at the end of the reporting period can be measured reliably; “The contract costs attributable to the contract can be clearly identified and measured reliably so that actual contract costs incurred can be compared with prior estimates.” US GAAP Recognition before delivery – construction contracts Percentage-of-completion method

8. Academic Resource Center Revenue recognition including construction contracts Page 8 IFRS ► According to IAS 11.24, the criteria for cost- plus contracts are as follows: “It is probable that the economic benefits associated with the contract will flow to the entity; and “The contract costs attributable to the contract, whether or not specifically reimbursable, can be clearly identified and measured reliably.” US GAAP Recognition before delivery – construction contracts Percentage-of-completion method

9. Academic Resource Center Revenue recognition including construction contracts Page 9 Summary of criteria for using percentage-of-completion method US GAAPIFRS – fixed-price contractIFRS – cost-plus contract Ability to measure the progress toward completion, revenues and costs reliably. ► Total contract revenue can be measured reliably. ► Stage of completion can be measured reliably. ► Contract costs can be measured reliably. Contract costs can be measured reliably. Contract contains enforceable rights dealing with goods or services provided, consideration to be exchanged and manner and terms of settlement. No specific requirement. Buyer and seller are both expected to be able to perform their obligations. It is probable that economic benefits will flow to the entity.* * If there is an expected loss on the contract, there is some risk that the counterparties to the contract may not perform their obligations.

10. Academic Resource Center Revenue recognition including construction contracts Page 10 IFRS ► The revenue-cost approach is allowed. ► The gross-profit approach is not allowed. US GAAP ► With respect to contracts that are profitable, both revenues and costs can be recognized according to the project’s stage of completion. This is often referred to as the revenue-cost approach. ► An entity can also recognize expenses as actually incurred and recognize revenue based on the estimated gross-profit percentage earned during the period. This is often referred to as the gross-profit approach. Recognition before delivery – construction contracts Percentage-of-completion method

11. Academic Resource Center Revenue recognition including construction contracts Page 11 Revenue-cost and gross-profit approach example Example 5 – revenue-cost and gross-profit approach A company enters into a contract with expected revenues of $5.6 million and expected costs of $4.9 million. The contract is 30% complete in the first year, 65% complete in the second year and 100% complete in the third year. The costs incurred for the three years are $1.4 million, $1.65 million and $1.85 million, respectively. ►Using the revenue-cost approach, compute the revenues and costs that will be recognized each year under US GAAP and IFRS. ►Using the gross-profit approach, compute the revenues and costs that will be recognized each year under US GAAP and IFRS.

12. Academic Resource Center Revenue recognition including construction contracts Page 12 Revenue-cost and gross-profit approach example Example 5 solution: The revenue-cost approach is acceptable under both US GAAP and IFRS. YearRevenuesCosts One$5,600,000 x 30% = $1,680,000$4,900,000 x 30% = $1,470,000 Two($5,600,000 x 65%) - 1,680,000 = $1,960,000($4,900,000 x 65%) - 1,470,000 = $1,715,000 Three($5,600,000 x 100%) - (1,680,000 + 1,960,000) = $1,960,000($4,900,000 x 100%) - (1,470,000 + 1,715,000) = $1,715,000 The gross-profit approach is acceptable under US GAAP but is not acceptable under IFRS. Estimated total gross profit = $5.6 million less $4.9 million = $700,000 YearCostsGross ProfitsRevenues One$1,400,000$700,000 x 30% = $210,000$1,400,000 + $210,000 = $1,610,000 Two$1,650,000($700,000 x 65%) - $210,000 = $245,000$1,650,000 + $245,000 = $1,895,000 Three$1,850,000($700,000 x 100%) - ($210,000 + $245,000) = $245,000$1,850,000 + $245,000 = $2,095,000

13. Academic Resource Center Revenue recognition including construction contracts Page 13 IFRS ► The completed-contract method is not permitted. If the criteria for using the percentage-of-completion method are not met, then the entity recognizes revenue to the extent that costs are incurred (as long as the costs are likely to be recovered) and recognizes costs as incurred. US GAAP ► If the percentage-of-completion criteria aren’t met, then the completed-contract method is used. ► The AICPA Accounting Trends and Techniques for 2009 reported that of 500 companies sampled for 2008, 113 had long-term construction contracts. Of these 113 companies, 17 used completed- contract accounting. Recognition before delivery – construction contracts Completed-contract method

14. Academic Resource Center Revenue recognition including construction contracts Page 14 Example 6 – revenue on construction contract ALNP Construction Company (ALNP) has entered into a contract with total expected revenue of $5.6 million. ALNP expects that total costs will be $4.9 million. Below are the costs, billings and cash collections for each of the three years of the contract (amounts in millions). ► Prepare all necessary journal entries for the three years under the four scenarios on the next slide. Use construction in progress (CIP) as a clearing account for your journal entries. ► Also provide the balances of the various accounts that will be reported on the financial statements each year. Year 1Year 2Year 3 Costs this year$1.40$1.65$1.85 Billings this year$1.30$2.40$1.90 Cash collected this year$1.00$2.20$2.40 Revenue on construction contract example Based on surveys of the stage of completion, it was determined the contract was 30% complete in year 1, 65% complete in year 2 and 100% complete in year 3.

15. Academic Resource Center Revenue recognition including construction contracts Page 15 Revenue on construction contract example Example 6 (continued): Four scenarios: 1.The company reports using IFRS and meets the criteria necessary to use the percentage-of- completion method. ALNP uses the revenue-cost approach. 2.The company reports using US GAAP and meets the criteria necessary to use the percentage- of-completion method. ALNP uses the gross-profit approach. 3.The company reports using US GAAP and does not meet the criteria necessary to use the percentage-of-completion method. 4.The company reports using IFRS and does not meet the criteria necessary to use the percentage-of-completion method. ALNP is not able to reliably estimate its revenue until the final year of the contract.

16. Academic Resource Center Revenue recognition including construction contracts Page 16 Revenue on construction contract example Example 6 solution: The first scenario uses the percentage-of-completion, revenue-cost approach since that is the only approach allowed using IFRS. The second scenario uses the percentage-of-completion, gross-profit approach, which is allowed under US GAAP, but not IFRS. The third scenario uses the completed-contract method. The fourth scenario uses the method whereby the entity recognizes revenue to the extent that costs are incurred and recognizes costs as incurred. Journal entries and account balances are shown on the next slides.

17. Academic Resource Center Revenue recognition including construction contracts Page 17 ($ amounts in millions) Year 1Year 2Year 3Total Costs this year$1.40$1.65$1.85$4.90 Billings this year$1.30$2.40$1.90$5.60 Cash collected$1.00$2.20$2.40$5.60 Percentage complete30%65%100% Revenue on construction contract example Example 6 solution (continued): For each scenario:

18. Academic Resource Center Revenue recognition including construction contracts Page 18 Example 6 solution (continued): Scenario 1: Percentage-of-completion, revenue-cost approach Year 1Year 2Year 3Total Revenue to date $1,680,000$3,640,000$5,600,000 Costs to date $1,470,000$3,185,000$4,900,000 Gross profit to date $ 210,000$ 455,000$ 700,000 Revenues this year $1,680,000$1,960,000 $5,600,000 Costs this year $1,470,000$1,715,000 $4,900,000 Gross profit this year $ 210,000$ 245,000 $ 700,000 Revenue on construction contract example

19. Academic Resource Center Revenue recognition including construction contracts Page 19 Example 6 solution (continued): Year 1Year 2Year 3 CIP 1,400,0001,650,0001,850,000 Cash 1,400,0001,650,000 1,850,000 To record costs incurred. A/R 1,300,0002,400,0001,900,000 Billings on CIP 1,300,0002,400,0001,900,000 To record billings. Cash 1,000,0002,200,0002,400,000 A/R 1,000,0002,200,0002,400,000 To record collections. Note: All amounts are in dollars. Revenue on construction contract example

20. Academic Resource Center Revenue recognition including construction contracts Page 20 Example 6 solution (continued): Year 1Year 2Year 3 CIP 210,000245,000 Construction expense 1,470,0001,715,000 Construction revenue 1,680,0001,960,000 To recognize revenue and expense. Billings on CIP 5,600,000 CIP 5,600,000 To record completion of contract. Note: All amounts are in dollars. Revenue on construction contract example

21. Academic Resource Center Revenue recognition including construction contracts Page 21 Balance sheet account balances at December 31 Year 1Year 2Year 3 Assets: Cash $ (400,000)$ 150,000$700,000 A/R 300,000 500,000 CIP 1,610,0003,050,000 Billings on CIP (1,300,000)(3,700,000) Costs and recognized profit in excess of billings 310,000 Liabilities: Billing in excess of costs and recognized profits 195,000 Equity: Retained earnings (ignoring effects of taxes) 210,000 455,000 700,000 Revenue on construction contract example Example 6 solution (continued):

22. Academic Resource Center Revenue recognition including construction contracts Page 22 Income statement accounts for the year ended December 31 Year 1Year 2Year 3Cumulative Revenues $1,680,000$1,960,000 $ 5,600,000 Expenses (1,470,000) (1,715,000) (4,900,000) Net income (ignoring taxes) $ 210,000$ 245,000 $ 700,000 Revenue on construction contract example Example 6 solution (continued):

23. Academic Resource Center Revenue recognition including construction contracts Page 23 Example 6 solution (continued): Scenario 2: Percentage-of-completion, gross-profit approach Year 1Year 2Year 3Total Revenue to date $1,610,000$3,505,000$5,600,000 Costs to date $1,400,000$3,050,000$4,900,000 Gross profit to date $ 210,000$ 455,000$ 700,000 Revenues this year $1,610,000$1,895,000$2,095,000$5,600,000 Costs this year $1,400,000$1,650,000$1,850,000$4,900,000 Gross profit this year $ 210,000$ 245,000 $ 700,000 Revenue on construction contract example

24. Academic Resource Center Revenue recognition including construction contracts Page 24 Example 6 solution (continued): Year 1Year 2Year 3 CIP 1,400,0001,650,0001,850,000 Cash 1,400,0001,650,000 1,850,000 To record costs incurred. A/R 1,300,0002,400,0001,900,000 Billings on CIP 1,300,0002,400,0001,900,000 To record billings. Cash 1,000,0002,200,0002,400,000 A/R 1,000,0002,200,0002,400,000 To record collections. Note: All amounts are in dollars. Revenue on construction contract example

25. Academic Resource Center Revenue recognition including construction contracts Page 25 Example 6 solution (continued): Year 1Year 2Year 3 CIP 210,000245,000 Construction expense 1,400,0001,650,0001,850,000 Construction revenue 1,610,0001,895,000 2,095,000 To recognize revenue and expense. Billings on CIP 5,600,000 CIP 5,600,000 To record completion of contract. Note: All amounts are in dollars. Revenue on construction contract example

26. Academic Resource Center Revenue recognition including construction contracts Page 26 Revenue on construction contract example Example 6 solution (continued): Balance sheet account balances at December 31 Year 1Year 2Year 3 Assets: Cash $ (400,000)$ 150,000$700,000 A/R 300,000 500,000 CIP 1,610,0003,050,000 Billings on CIP (1,300,000)(3,700,000) Costs and recognized profit in excess of billings 310,000 Liabilities: Billing in excess of costs and recognized profits 195,000 Equity: Retained earnings (ignoring effects of taxes) 210,000 455,000 700,000

27. Academic Resource Center Revenue recognition including construction contracts Page 27 Income statement accounts for the year ended December 31 Year 1Year 2Year 3Cumulative Revenues $1,610,000$1,895,000 $2,095,000$ 5,600,000 Expenses (1,400,000) (1,650,000) (1,850,000) (4,900,000) Net income (ignoring taxes) $ 210,000$ 245,000 $ 700,000 Revenue on construction contract example Example 6 solution (continued):

28. Academic Resource Center Revenue recognition including construction contracts Page 28 Example 6 solution (continued): Scenario 3: Completed contract Year 1Year 2Year 3 CIP 1,400,0001,650,0001,850,000 Cash 1,400,0001,650,000 1,850,000 To record costs incurred. A/R 1,300,0002,400,0001,900,000 Billings on CIP 1,300,0002,400,0001,900,000 To record billings. Cash 1,000,0002,200,0002,400,000 A/R 1,000,0002,200,0002,400,000 To record collections. Note: All amounts are in dollars. Revenue on construction contract example

29. Academic Resource Center Revenue recognition including construction contracts Page 29 Example 6 solution (continued): Year 1Year 2Year 3 Billings on CIP 5,600,000 Construction expense 4,900,000 Construction revenue 5,600,000 CIP 4,900,000 To record completion of contract. Note: All amounts are in dollars. Revenue on construction contract example

30. Academic Resource Center Revenue recognition including construction contracts Page 30 Balance sheet account balances at December 31 Year 1Year 2Year 3 Assets: Cash $ (400,000)$150,000$700,000 A/R 300,000 500,000 CIP 1,400,0003,050,000 Billings on CIP (1,300,000)(3,700,000) Unbilled contract costs 100,000 Liabilities: Billing in excess of costs 650,000 Equity: Retained earnings (ignoring effects of taxes) 700,000 Revenue on construction contract example Example 6 solution (continued):

31. Academic Resource Center Revenue recognition including construction contracts Page 31 Income statement accounts for the year ended December 31 Year 1Year 2Year 3 Revenues $5,600,000 Expenses (4,900,000) Net income (ignoring taxes) $ 700,000 Revenue on construction contract example Example 6 solution (continued):

32. Academic Resource Center Revenue recognition including construction contracts Page 32 Scenario 4: Recognize revenues to extent costs are incurred and recognize costs as incurred: (assume reliability not reached until last year of contract) Year 1Year 2Year 3 CIP 1,400,0001,650,0001,850,000 Cash 1,400,0001,650,000 1,850,000 To record costs incurred. A/R 1,300,0002,400,0001,900,000 Billings on CIP 1,300,0002,400,0001,900,000 To record billings. Cash 1,000,0002,200,0002,400,000 A/R 1,000,0002,200,0002,400,000 To record collections. Note: All amounts are in dollars. Revenue on construction contract example

33. Academic Resource Center Revenue recognition including construction contracts Page 33 Year 1Year 2Year 3 Construction expense 1,400,0001,650,0001,850,000 Construction revenue 1,400,0001,650,000 1,850,000 To record revenue and expense. Billings on CIP 5,600,000 CIP4,900,000 Construction revenue 700,000 To record completion of contract. Note: All amounts are in dollars. Revenue on construction contract example Example 6 solution (continued):

34. Academic Resource Center Revenue recognition including construction contracts Page 34 Balance sheet account balances at December 31 Year 1Year 2Year 3 Assets: Cash $ (400,000)$ 150,000$700,000 A/R 300,000 500,000 CIP 1,400,0003,050,000 Billings on CIP (1,300,000)(3,700,000) Unbilled contract costs 100,000 Liabilities: Billing in excess of costs 650,000 Equity: Retained earnings (ignoring effects of taxes) 700,000 Revenue on construction contract example Example 6 solution (continued):

35. Academic Resource Center Revenue recognition including construction contracts Page 35 Income statement accounts for the year ended December 31 Year 1Year 2Year 3 Revenues $1,400,000$1,650,000 $2,550,000 Expenses 1,400,000 1,650,000 (1,850,000) Net income (ignoring taxes) $– $ 700,000 Revenue on construction contract example Example 6 solution (continued):

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