Big Picture in Focus: ULOc.

Apply the Accounting procedures for Long-term

Costruction Contracts

Metalanguage

Below are the essential terms that you are going to encounter in the pursuit of
ULOc:

1. Long term construction. These contracts are construction projects that extend
thru more than one accounting period Usually, these are construction projects fbr
the government.
2. Construction Contract. PAS I l defines construction contract as 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 their ultimate purpose or use.
3. Fixed Price Contract. This is a construction contract in which the contractor
agrees to a fixed contract price, or a fixed rate permit of output, which in some
cases is subject to cost escalation clauses.
4. Cost Plus Contract. This is a construction contract in which the contractor is
reimbursed for allowable or otherwise defined costs, plus a percentage of these
costs or a fixed fee.
5. Contract Revenue. Revenue from long term construction contracts is measured
at the fair value of the consideration or receivable. This include the initial amount
of revenue agreed in the contract

Essential Knowledge

Usually, these are construction projects for the government. Example "these
projects is the construction of water dams, bridges, flyover, and the metro railway transit.
On many long-term construction projects, the buyer and seller (contractor) agree in
advance on the contract price. In agreeing to the contract price, the construction
company must have some reasonable basis for estimating the cost to be incurred under
the contract so as to assure a satisfactory return. In agreeing to perform the contract
work, the construction company must feel that the probability of collecting the contract
price from the buyer is sufficiently high to warrant the investment of capital and labor
services. Under these conditions, the criteria for revenue recognition are met prior to
completion of the contract. Recognition of revenue during the period of construction is
therefore justified in most cases. The focus of the discussion will be on the accounting
procedures to determine the revenue to be recognized each year of construction.

Contract Revenue.
This include the initial amount of revenue agreed in the contract. This amount may
increase or decrease from one period to the next. For example:
 a. A contractor and a customer may agree to change the scope of the work to be
performed under the contract. Such as, changes in the specifications design of the
asset and changes in the duration of the contract.
b. The amount of revenue agreed may increase as a as a result of cost escalation
clauses.
c. The amount of contract revenue may decrease as a result of penalties arising
caused by the contractor in the completion of the contract; or
d. When the contract price involves a fixed price per unit of output, contract revenue
increases as the number of units is increased.

Construction revenue may also include incentive payments to the contractor for early
completion of the contract when the contract is sufficiently advanced that it is probable
that the specified performance standards be met or exceeds; and the amount of the
incentive payment can be measured reliably.

Contract Cost

Contract costs are costs that relate directly to the specific contract; are attributable to
contract activity in general and can be allocated to the contract; and are specifically
chargeable to the customer under the terms of the contract. Examples of contract costs
are
a. Site labor costs, including site supervision.
b. Costs of materials used in construction.
c. Depreciation of plant and equipment used on the contract.
d. Costs of moving plant, equipment and materials to and from the contract site.
e. Costs of hiring plant and equipment.
f. Costs of design and technical assistance.
g. The estimated costs of rectification and guarantee work, including expected
warranty costs.
h. Claims from third parties
i. Insurance
j. Construction overheads.
k. General administrative costs and development costs for which reimbursement is
specified in the terns of the contract.

Types of Contract Costs.

Contract costs can be broken down into two categories: costs incurred to date and
estimated costs to complete.

Costs incurred to date. These include precontract costs and costs incurred after
contract acceptance. Precontract costs are costs incurred before a contract has been
entered into, with the expectation that the contract will be accepted and these costs will
thereby be recoverable through billings. The criteria for recognition of such costs are:

1. They are capable of being identified separately.

 2. They can be measured reliably.
3. It is probable that the contract will be obtained.

Precontract costs include costs of architectural designs, cost of securing the contract, and
any other costs that are expected to be recovered if the contract is accepted. Contract
costs
incurred after the acceptance of the contract are costs incurred toward the completion of
the project and are also capitalized in the Construction in Progress (CIP) account. The
contract does not have to be identified before the capitalization; it is only necessary that
there be an expectation of the recovery of the costs. Once the contract has been
accepted, the precontract costs become contract costs incurred to date. However, if the
precontract costs are already recognized as an expense in the period in which they are
incurred, they are not included in contract costs when the contract is obtained in a
subsequent period.

Estimated costs to complete. These are the anticipated cost of materials, labor,
subcontracting costs, and indirect costs (overhead) required to complete a project at a
scheduled time. They are composed of the same elements as the original total estimated
contract costs and would be based on prices expected to be in effect when the costs are
incurred. The latest estimates should be used to determine the progress toward
completion.
Accounting for contract costs is similar to accounting for inventory. Costs as incurred
would be recorded in the Construction in Progress account. Construction in Progress
account would include both direct and indirect costs but would usually not include general
and administrative expenses or selling expenses since they are not normally identifiable
with a particular contract and should therefore be expensed.

Computation and Recognition of Construction Revenue

Determining the amount of revenue earned is particularly difficult in the area of long-term
construction contracts. Even if the revenue is collectible and earned through production,
the amount that has been earned and the related costs associated with the earning
process may still not be determinable. The amount of revenue and expenses recognized
each accounting period during the production process relate to the degree of completion
of the project and to the remaining costs and effort to be incurred in finishing the project.

Two basic methods are used to account for long-term construction contracts: the
percentage-of-completion method and the zero-profit method.

Percentage-of-Completion Method. This method is to be used when the outcome of the

construction contract can be estimated reliably, that is, the estimate of costs to complete
and the extent of progress toward completion of long-term contracts are reasonably
dependable.
Under this method, gross profit is recognized as construction progresses. In practice,
contractors use two basic methods to measure the progress of the construction.
 1. Input measures (cost to cost method). This method is used if the contract calls
for one large project rather than several separate projects. Under this method the
degree of completion is determined by computing the ratio of the costs already
incurred to the total estimated costs to complete the project. The percentage of
completion is then applied to the estimated gross profit (contract price less total
estimated costs) to determine the gross profit to be recognized to date. Some of
the costs incurred, particularly in the early stages of the contract should be
excluded in using this method, because they do not relate directly to the work
performed on the contract. These include such items as payments to
subcontractors in advance for work that has set to be performed; and fabricated
materials that has been delivered to the contract site but not yet installed, used or
applied during contract performance, unless the materials have been made
specifically for the contract. However, this estimation is required in reporting
income, regardless of how the percentage of completion is computed.
2. Output measures (units of delivery). The progress is based on the results
achieved. Under this method revenue is recognized when certain phases of the
project are completed and accepted by the buyer. This method is useful in
contracts for the construction of several condominium units. Income is recognized
when a particular unit is completed and delivered and accepted by the buyer,
although the entire project is not yet finished. Thus, if a construction company signs
a contract for ten condominium units and completes three units at the end of the
first year and accepted by the buyers, then 30% of the total revenue provided under
the contract should be recognized.

Zero Profit Method. In cost-plus contracts, the contractor is assured of no loss. If the
contractor is protected in this manner but is unable to make reasonable estimates of the
percentage of completion, PAS No. 11 recommends this method. This method is
described as the percentage-of-completion method based on a zero-profit margin. Under
this method, revenue is recognized in an amount exactly equal to costs incurred until
reasonable objective estimates of the percentage of completion are available.

The computation in Illustration shows that the only difference between the two methods
is the timing of the recognition of gross profit on the contract. Both methods ultimately
result in the recognition of the same total amount of gross profit, P 1,000,000.

It should be noted that under the percentage of completion method, a revised

estimate of the cumulative percentage of completion is computed each year. The
percentage is applied to the expected gross profit (which will also vary as revised
estimates of expected costs to be incurred is made). The difference between the
cumulative gross profit and the gross profit recognized in the previous year(s) is the
current year's gross profit.
Under the zero-profit method, the recognition of profit is deferred until the project is
completed, but revenue is recognized equal to the total costs incurred to date in 20A
and 20B.

Alternative Procedure
 The realized gross profit under the percentage-of-completion method may also be
computed using the formula below.

20A 20B 20C

Contract Price 5,000,000 5,000,000 5,000,000
Multiply by percentage of completion 30% 90% 100%
Value of contract earned 1,500,000 4,500,000 5,000,000
Less: Cost incurred to date 1,350,000 3,600,000 4,000,000
Gross profit earned to date 150,000 900,000 1,000,000
Less: Gross profit earned in prior years --- 150,000 900,000
Gross profit earned this year P 150,000 750,000 P 100,000
=============================
Illustrative Journal Entries

The accounting entries for each contract year using both the Percentage of Competition
and Zero Profit methods are presented:
From the journal entries and T-accounts, the following should be noted:
1. Actual cost incurred are debited to the Construction in Progress account under
both methods.
2. Billings of customers and collections from customer are treated identically under
both methods
3. Under the zero-profit method, in 20A and 20B Construction Revenue is recognized
equal to the costs incurred each year, thereby, recognizing a zero-gross profit. The
total gross profit on the contract, P 1,000,000 is debited to Construction in Progress
only in 20C, the year of completion.
4. On the other hand, revenue is recognized each year by debiting the Construction
in Progress account, under the percentage of completion method. When the
contract is completed and the customer has been fully billed, the amount in the
Construction in Progress account (actual total costs incurred plus cumulative
income recognized) should be equal to the amount in the account, Contract
Billings (contract price).
5. The Construction in Project account under both methods is removed from the
books by debiting Contract Billings account and crediting Construction in Progress
account, thereby closing the two accounts.

Companies may employ account titles and contain other minor variations, but the
procedures illustrated here are representative of the two methods.

ACCOUNTS JOURNAL ENTRIES

EVENT ZERO PROFIT METHOD PERCENTAGE -OF-
COMPLETION
Dr. Cr. Dr. Cr.
20A
Contract signed No entry.
Cost incurred Contraction in progress 1,350,000 1,350,000
Cash 1,350,000 1,350,000
Progress Billings Accounts Receivable 400,000 400,000
Contract Billings 400,000 400,000
Billing Collections Cash 275,000 275,000
Accounts Receivable 275,000 275,000
Revenue Construction in Progress -------------- 150,000
Recognition Cost of Construction 1,350,000 1,350,000
Construction revenue 1,350,000 1,500,000
20B
Cost incurred Contraction in progress 2,250,000 2,250,000
Cash 2,250,000 2,250,000
Progress Billings Accounts Receivable 2,000,000 2,000,000
Contract Billings 2,000,000 2,000,000
Billing Collections Cash 2,100,000 2,100,000
Accounts Receivable 2,100,000 2,100,000
Revenue Construction in Progress -------------- 750,000
Recognition Cost of Construction 2,250,000 2,250,000
Construction revenue 2,250,000 2,250,000
20C
Cost incurred Contraction in progress 400,000 400,000
Cash 400,000 400,000
Progress Billings Accounts Receivable 2,600,000 2,600,000
Contract Billings 2,600,000 2,600,000
Billing Collections Cash 2,625,000 2,625,000
Accounts Receivable 2,625,000 2,625,000
Revenue Construction in Progress 1,000,000 100,000
Recognition Cost of Construction 400,000 400,000
Construction Revenue 1,400,000 500,000
Elimination of Contract Billings 5,000,000 5,000,000
inventory Construction in progress 5,000,000 5,000,000

Financial Statement Presentation

Statement of Financial Position:

Inventory:
Construction in progress XX
Less: Contract Billings XX
Excess XX
==

Anticipated Loss on Long Term Construction Projects

An increase in the total cost may result in a loss in the year the estimate was revised.
When it is probable that total contract costs will exceed the total contract revenue, the
expected loss must be recognized immediately in the period in which the
loss becomes evident, both under the zero-profit method and the percentage of
completion method.

This represents the difference between the Construction in Progress account and the
Contract Billings as shown below:

Construction in Progress Pxx

 Less: Contract Billings xx
Costs in excess of billings (current asset) Pxx
====
Or
Billings in excess of costs (current liability) (xx)
====
Under the zero-profit method, the Construction in Progress account before the year of
completion is equal to the costs incurred to date. In the year of completion, the
Construction in Progress account is composed of cost incurred to date and gross profit
earned.
On the other hand, under the percentage completion method, the Construction in
Progress account contains costs incurred to date and gross profit earned to date.

In the year of completion, the balance of the Construction in Progress account should
be equal to the balance of the Contract Billings account.

Self-Help: You can also refer to the sources below to help you further understand
the lesson:
* Heidhues, E., Patel, C, & Epstein, M. ( 2012). Studies in managerial and financial
accounting, 23: Globalization and contextual factors in accounting: The case of
Germany. Emerald Group Publishing Limited.

*Bragg, S. ( 2010). Wiley regulatory reporting: Wiley revenue recognition: rules and
scenarios. Wiley.