AFAR2: Accounting for Special Transactions

Long Term Construction Contracts

Construction Contract – is 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 or their ultimate purpose
or use.

Types of Construction Contracts

1. Fixed price contract – the contractor agrees to a fixed contract price or a fixed rate per unit of output, which in
some cases are subject to cost escalation clauses.
2. Cost plus contract – the contractor is reimbursed for allowable or otherwise defined costs, plus a percentage of
these costs or a fixed fee.

Recognition of Construction Revenue and Construction Costs

I. Construction Revenue

- It is the total amount of consideration receivable under the contract. It comprises the following:

a. Initial contract price agreed in the contract (+)

b. Variations in contract work and claims, to the extent that it is (1) probable that they will result in revenue and (2) they are
capable of being reliably measured. (+/-)
c. Incentive payments (+)
d. Any penalties arising from delays caused by the contractor in the completion of the contract reduce the contract
revenue. (-)

II. Construction Costs

It is comprised of

a. Costs that relate directly to the specific contract;

b. Costs that are attributable to contract activity in general and can be allocated to contracts (e.g., insurance, cost of
design and technical assistance, construction overheads); and
c. Other costs chargeable to the customer under the terms of the contract.

Notes:

• General and admin expenses, costs of waste resources, and research and development are expensed as incurred
unless those are chargeable to the customer.
• Costs relating to future activity, such as cost of materials that have been delivered to but set aside or not yet installed,
used or applied during the construction are excluded in computing the cost incurred to date.
• Any incidental income from the construction that is not included in contract revenue shall be accounted for as
reduction of contract costs.

Methods of Realizing Profit in Construction Accounting (Revenue Recognition OVER TIME)

1. Percentage of Completion Method (POC)

- used when the outcome of the construction contract can be estimated reliably
- Contract revenue and cost should be recognized as revenue and expenses, respectively, by reference to the stage of
completion of the contract activity at the end of reporting period.

Different Methods of Measuring Stage of Completion

A. Input measures – these are related to the costs or efforts devoted to a contract
• Cost-to-cost method
Cost incurred to date
Stage of Completion (%) =
Total estimated cost to complete the contract

• Efforts-expended methods – based on some measure of work performed (e.g., labor hrs., machine hrs.)

B. Output Measures – these are made in terms of results achieved.

Architects and/or engineers are sometimes asked to evaluate jobs and estimate what percentage of job or
contracts is completed.
2. Cost Recovery Method / Zero-Profit Approach – used when the outcome of the construction contract cannot be
reliably measured.

Under this method:

1. Recognize revenue only to the extent of the contract cost incurred which are expected to be recoverable; and
2. Recognize contract costs as an expense in the period they are incurred.

Long term Contract Losses

Types of losses Description Accounting Treatment

1. Loss in current period on a profitable
contract
2. Loss on an unprofitable contract
(Anticipated Contract Losses)
- happens when during the
construction, there is a significant
increase in the estimated total contract
costs, but the total contract price is still
GREATER than the total contract costs
- happens when it is probable that total
contract costs will EXCEED total
contract revenue
- Under the POC, it is treated as a
change in accounting estimate,
hence the adjustment is recorded
as a loss in the current period.
- Under Cost Recovery, no loss is
recognized because the contract
is still expected to result in a
profit.
- Under both methods, the entire
loss should be recognized when
the loss is first anticipated.

Pro-forma journal entries in the books of the contractor

Transactions Account Debit Credit

1. To record construction costs incurred Construction in Progress (CIP) XXX
Cash/AP XXX
2. To record progress billings Accounts Receivable XXX
Progress Billings XXX
3. To record collections Cash XXX
Accounts Receivable XXX
4. To recognize revenue, costs and gross profit
(A) Under POC method CIP XXX
Construction Costs XXX
Construction Revenue XXX

(A) Under Cost Recovery method Construction Costs XXX

Construction Revenue XXX
5. Upon completion of the construction Building/Other assets XXX
CIP XXX
6. Turnover to the customer Progress Billings XXX
Building/Other assets XXX

Financial Statement Presentation

Construction in Progress XX
Progress Billings (XX) >> Progress billings are amounts billed for work performed on a contract
Net amount XX/(XX)

If the net amount is positive (CIP > PB) – presented as Contract Asset
If the net amount is negative (CIP < PB) – presented as Contract Liability

Note: Upon completion, CIP = PB

Terms related to Construction Contracts

1. Contract Retention – this is part of the billings which may be withheld by the customer until the project is completed and
accepted to conform to the acceptable standards.

Pro-forma entry:
 Cash XX
Contract Retention XX
AR XX

2. Mobilization Fee – this is part of contract price which is normally billed by the contractor to fund the initial phase of the
construction and deductible on the subsequent billings.

Pro-forma entry:

Cash XX
Advances from customer XX
3. Change orders – are modifications of an original contract, which effectively change the provisions of the contract. Change
orders are often unpriced, that is, the work to be performed is defined, but the adjustment to the contract price is to be
negotiated later. If it is probable that a contract price change will be negotiated to at least recover the increased costs, the
increased costs may be included with the incurred costs of the period and the revenue may be increased by the same
amount.

SAMPLE PROBLEMS

PROBLEM 1: In 2019, PARAGON Construction Company agreed to construct an apartment building at a price of P2,000,000.
The information relating to the costs and billings for the contract is as follows:

2019 2020 2021

Direct and allocable costs to date P560,000 P1,200,000 P1,570,000
Estimated costs yet to be incurred 1,040,000 400,000 -
Customer billings each year 750,000 560,000 730,000
Collection of billings each year 560,000 640,000 840,000
During 2020, the customer agrees to a variation with increases expected revenue from the contract by P40,000 and causes
additional costs of P20,000. At the end of 2020, there are materials stored on site for use in 2021 which cost P16,000 during
the period.

Requirements:
1. Prepare journal entries each year using (a) percentage-of-completion method, and (b) cost recovery method.
2. Determine the following:

Percentage of Completion Method Cost Recovery Method

2019 2020 2021 2019 2020 2021
Revenue
Construction Costs
Gross Profit
CIP
Progress Billings
Contract Asset/(Contract
Liability)

PROBLEM 2: On January 1, 2018, RETENTION Carpenters accepted a long-term construction project for an initial contract
price of P1,000,000 to be completed on June 30,2020. On January 1, 2019, the contract price was increased to P1,500,000
by reason of change in the design of the project. The outcome of the construction contract can be estimated reliably. The
project was completed on December 31, 2020 which resulted to penalty amounting to P200,000. The entity provided the
following data concerning the direct costs related to the said project for 2018 and 2019:

2018 2019
Costs during the year 440,000 680,000
Remaining estimated costs to complete at year end 660,000 280,000
1. What is the realized gross profit for the year ended December 31, 2019?
2. What is the balance of CIP on December 31, 2019?

PROBLEM 3: On January 1, 2021, BREAKDOWN Company enters into a contract with a customer to build a customized
asset. The promise to transfer the asset is a performance obligation that is satisfied over time because the customer
controls the asset during construction. The promised consideration is P6,235,000, but that amount will be increased by
P10,000 for each day before 30 September 2023 that the asset is complete.

The entity commonly includes performance bonus in its contracts and based on prior experience, estimates the following
completion outcomes:

Completed by: Probability

29 September 2023 65%
28 September 2023 25%
27 September 2023 5%
26 September 2023 5%
In addition, upon completion of the asset, a third party will inspect the asset and assign a rating based on metrics that are
defined in the contract. If the asset receives a specified rating, the entity will be entitled to an incentive bonus of P150,000.
BREAKDOWN Company determines that based on prior experience, the asset constructed will achieve the specified rating.

Data for the three-year construction period follows:

2021 2022 2023

Costs incurred each year 1,782,000 2,148,000 1,570,000
Estimated costs to complete 3,618,000 1,570,000
Contract billings each year 1,200,000 1,900,000
Cash collections each year 1,000,000 1,800,000 3,615,000
Operating expenses 100,000 90,000 70,000
Included in the cost incurred in 2022 is materials costing P80,000 but was only used during the third quarter of 2023.

Upon completion on 27 September 2023, the third party inspected the asset and determined that the rating was achieved
for the incentive bonus.

Questions:

1. The amount of variable consideration to be included as part of the transaction price as of the inception of the contract.
2. The amount of revenue, gross profit and net income to be reported in 2021, 2022 and 2023.

PROBLEM 4. DOS Construction was contracted to construct a national museum for P50,000,000 in 2022. The project is to
be completed in three years and the stipulation of the contract were as follows:

• 15% mobilization fee is to be deducted from the last billing of the contract.
• 10% retention on all billings
• Payment of progress billings shall be made in 20 days after acceptance

DOS uses cost-to-cost method in estimating the POC. As of the year 2022, 45% of the contract price has been realized as
revenue. As to billings made, 40% of the contract price has been presented and accepted. All progress billings accepted
were paid by the client except for the last billing which was equivalent to 5% of the contract price that was accepted last
December 24,2022.

How much was paid by the client to DOS in 2022?