Module No. 2 Construction Contracts

 

Module

No.2 Revenue Recognition: Long  – 

LM01 ACPC0213 

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Introduction

 

Construction Contracts  Introduction  PAS 11 defines Constructions Contract as a contract specifically negotiated for the construction of asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology or function or their ultimate purpose or use. Example of construction contracts include those pipelines, airlines and other similar assets. 

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Lesson Proper Lecture Notes:  Notes:   2 Types of Construction Contract 1.  Fixed Price Contract – is a contract in which 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 cost.  cost.   2.  Cost – Plus Contract – 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 rate. Combining and Segmenting Construction Contract The provision of the standard usually are applied to individual construction contracts. Sometime, it becomes necessary to account for a group of related contracts as one or to segment in separate parts, one contract so that the substance of the transactions be properly reflected rather than its form A. A.   Segmenting one contract –  when a contract covers for the construction of each asset shall sha ll  be considered a separate contract when:  when:  asset   1.  1.  Separate proposals have been made for each asset  2.  2.  Each asset has been subject to separate negotiation and both contractor and customer were able to accept or reject that part of the contract to each asset and identifiable  3.  3.  The cost and revenues of each asset are separately identifiable  B.  B.  Segmenting Contract are Combined –  when a group of contract, each with a single or even with different customers, shall be treated as a single contract when:  when:   1.  1.  The group of contracts is negotiated as single package.  package.  2.  2.  The contracts are so closely interrelated that they are effectively part of one project with one overall profit margin and  and  3.  3.  The contracts are performed either concurrently or in a continuous process. pro cess.   Recognition of Contract Revenue and Contract Cost 1.  1.  Contract Revenue – It is comprised of Initial Contract Price agreed in the contract together with (1)Variation in the Contract, (2) Claims Claims/penalty, /penalty, and (3) Incentives Incentives payments to the extent that is probable that they will result in revenue and they are capable of being reliably measured. 3 | Page 

 

2.  2.  Contract Cost - It is comprised of (1) cost that relate directly to the specific contract (2) costs that are attributable to contract activity in the specifically chargeable under the terms of the contract. Methods of Realizing Profit in Construction Accounting 1.  Percentage of Completion Method – used when the outcome of the construction contract can be estimated reliably contract revenue and cost associated with the contract should be recognized as revenue and expenses, respectively, by reference to the stage of completion of the contract activity at activity  at the balance sheet date.  date.  To be able to estimate the outcome of a contract reliably, the entity must be able to make a reliable estimate of total contract revenue the stage of completion, and the costs to complete the contact. Different Method of Measuring Stage of Completion A. A.   Input Measures - this - this are made in relation to the costs or effort devoted to a contract. contract.   1.  Cost to Cost Method –  it is computed based on the proportion of contract cost incurred for the work performed to date bear to the total estimated costs to complete the contract.  contract. 

Stage of Completion %= Cost Incurred to date Total estimated cost to complete the contract. 2.  2.  Effort Expended Method – this is based on survey of work performed.  performed.  B.  B.  Output Measure - These are made in terms of result achieved. This is based on the completion of physical proportion of the contract work. Architect or Engineer are sometimes asked to evaluate jobs and estimate what percentage of job or contract is completed.   completed. Value of work completed in proportion to total contract price. The value of the work may be determined by conducting surveys of work performed. Stage

of

Completion

%=

Value of Work Completed as total Excepted Production or Usage

complete

Physical units of work completed in comparison with the total number of unit to be completed under the contract. 4 | Page 

 

Stage of Completion %= Physical Units of Work Completed Total Number of Units as per Contract 1.  1.  Proportional Costs Approach - the cost incurred computed under the method may not equal to the actual costs incurred.  incurred.   2.  2.  Actual Cost Approach –  the cost incurred computed under this method should be equal to the cost actually incurred.  incurred.  Note: The proportional cost and actual cost approach are equally acceptable, but since the actual Note: The costs approach gross profit varies from period to period would occur if the cost to cost method are used, then the proportional cost approach is preferable. pref erable. 2. Cost Recovery Method / Zero Profit Method - this method is used when the outcome of the construction contract cannot be reliably measured. When this method is used: a.  Revenue should be recognized only to the extent of the contract cost incurred that is probable will be recoverable; and  b.  Contract cost should be recognized as an expense in the period in which they are incurred. Recognition of Anticipated Losses When it is probable that total contract cost will exceed total contract revenue, the anticipated loss should be recognized as an expenses (or loss) immediately. The amount of loss is determined irrespective of: 1.  Whether or not the work has commenced on the contract 2.  The stage of completion of contract activity 3.  The amount of profit expected to arise on other contract which are not treated as a single construction contract.

Contract Cost that relate to future activity The cost of materials that have been delivered to but set aside for in the contract but not yet installed, used or applied during the construction are excluded in computing the cost incurred to date

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Note: the progress payment and advances from customers often do not reflect the work performed. Contract Retention These are amounts of progress billings which are not paid until satisfaction of conditions specified in the contract for the payment of such amounts or until defects have been rectified Progress Billing These are amounts billed for work performed on a contract whether or not they have been paid  by the customer. Advances from customers These are amounts received by the contractor before the related work is performed Mobilization Fes This is part of contract price which is normally billed by the contractors to fund the initial phase of the construction and deductible on the subsequent billings. PFRS 15 Revenue from Contracts with Costumers PFRS 15 supersedes PAS 11 Construction Contracts Definition: is a contract specifically negotiated for the construction of an asset or combination of assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate use. Summary of the Revenue Recognition Principle under PFRS 15 The entity recognizes revenue by applying the following steps: 1.  1.  Identify the contract with the customer The contract is with the customer and collectability of the consideration is probable. Note: A contract with a customer is accounted for only when all of the following criteria are met: a.  Contract is approved (in writing, orally or in accordance with other customary business practice)  practice)  by both parties and are committed to perform their respective obligations.  b.  The entity can identify each party’s rights regarding the goods or services to be transferred.   transferred. 6 | Page 

 

c.  The entity can identify the payment terms for the goods or services to be transferred. d.  The contract has commercial substance ( the risk , timing of the amount of entity’s future cash flow is expected to change as a result of the contract); and e.  The consideration is probable of collection. In collection.  In evaluating whether collectability of an amount of consideration is probable, an entity shall consider only the customer’s ability and intention to pay that amount of consideration when it is due. When the contract with the customer does not meet the criteria and an entity receives consideration from the customer, the entity shall recognize the consideration received as revenue only when either of the following events has occurred: a.  The entity has no remaining obligation to transfer goods or services and the consideration received is non-refundable.  b.  The contract has been terminated and the consideration received is non-refundable Any consideration received from such contract is recognized as liability and will be recognized as revenue only when either of the following events above has occurred. Depending on the facts and circumstances relating to the contract, the liability recognize represents the entity’s obligation to either transfer goods or services in the future or refund the consideration received. COMBINATION OF CONTRACTS An entity shall combine two or more contracts entered into at or near the same time with same customer (or related parties of the customer) and account for the contracts as a single contract if one or more of the following criteria are met: a.  The contract are negotiated as a package with a single commercial objective;  b.  The amount of consideration to be paid in one contract depends on the price or performance of the other contract. c.  The goods or service promised in the contracts (or some goods or services promised in each of the contract) are a single performance obligation. CONTRACT MODIFICATIONS A contract modification is a change in the scope or price (or both) of both) of a contract that is approved  by the parties to the contract. A contract modification may be described as a change order, a variation or an amendment. It exist when the parties to a contract approve a modification that 7 | Page 

 

either creates new or changes existing enforceable rights and obligations of the parties to the contract. An entity shall account for a contract modification as a separate contract if both of the following conditions are present: a.  The scope of the contract increases because of the addition of promised of goods or services that are distinct and  b.  The price of the contract increase by an a n amount of consideration that reflects that entity’s stand-alone selling price of the additional promised goods or services and any appropriate adjustments to that price to reflect the circumstances of the particular contract. If the contract modification is not accounted for as separate contract, an entity shall account for the promised goods or services not yet transferred at the date of the contract modification in whichever of the following ways is applicable a pplicable a.  It shall account for the contract modification as if it were termination of the existing contract and the creation of new contract, if the remaining goods or services are distinct from the goods or services transferred on or before that date o off the contract modifications. The amount of consideration to be allocated to the remaining performance obligations is the sum of: i. 

ii. 

The consideration promised by the customer (including amounts already received from the customer) that was included in the estimate of transaction price and that had not been recognized as revenue and The consideration promised as part of the contract modification.

 b.  It shall account for contract modification as if it were a part of the existing contract if the remaining goods or services are not distinct and, therefore, form part of a single performance obligation that is partially satisfied at the date of the contract modification. c.  If the remaining goods or services are a combination of items (a) and (b), then the entity shall account the effects of the modification on the unsatisfied (including partially satisfied) performance obligations in the modified contract in a manner that is consisted with the objectives of the standard. 2.  2.  Identify the performance obligation in the contract

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A contract include promised to transfer goods or services to a customer. If those goods or services are distinct, the promised are performance obligations and are accounted for separately. At contract inception, an entity shall assess the goods or services promised in a contract with a customer and shall identify as a performance obligation each promise to transfer to the customer either: a.  A good or service (or a bundle of goods or services) that is distinct; or  b.  A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer. A promise good or services is distinct: I.  I.  The costumer can benefit from the good or services either on its own or together with the other resources that are readily available to customer.  customer.   A customer can benefit from good or services if the goods or services could be used, consumed, sold for an amount that is greater that scrap value or otherwise held in a way that generates economic benefits. II. II.   The promise to transfer the good or service is separately identifiable from other promises in promises  in the contract  contract  A promise to transfer a good or service to a customer is separately identifiable if identifiable if the good or service: a.  It is not an input to produce or deliver the combined output specified by the customer.  b.  The goods or services does not significantly modify or customize another good or service promised in the contract. c.  Is not highly dependent or highly interrelated with other goods or services. For example, the fact that a customer could decide to not purchase the good or service in the contract. Note: if a promised good or service is not distinct, an entity shall combine that good or service with other promised goods or services until services  until it identifies a bundle of goods or services that is distinct. This would result to treating all promised of goods or services in a contract as a single performance obligation. Satisfaction of Performance Obligations An entity shall recognize revenue when (or as) the entity satisfies a performance obligations by transferring goods or services to a customer. An asset is transferred when (or as) the customer obtains control of the asset.

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The entity shall determine at a contact inception whether it satisfies the performance obligation over time or point in time. A. A.   Performance obligation is satisfied satisfied OVER TIME if one of the following criteria is met: 1.  1.  The customer simultaneously receives and consumes the benefit  benefit   provided by the entity’s performance. 2.  2.  The entity’s performance creates or enhances an asset that the customer controls controls as the assets is created or enhanced.  enhanced.   3.  3.  The entity’s performance does not create an asset with alternative use to the entity and entity  and the entity has enforceable rights to payment for performance completed to date. An asset created by an entity’s performance does not have an alternative used to the entity is either restricted contractually from readily directing the assets for another use during the creation or enhancement of that asset or limited practically from readily directing the asset in its completed state for another an other use. The assessment of whether an asset has an alternative use to the entity is made at the contract inception. B.  Performance Obligation satisfied at a point in time. If the entity cannot demonstrate that a performance obligation is satisfied over time, then it is presumed it is satisfied at a point in time. The entity shall consider the indicators of transfer of control, which include but not limited to the following: a.  The entity has a present right to payment for the asset  b.  The customer has legal title to the asset c.  The entity has transferred physical possession of the asset d.  The customer has the significant risks and rewards of ownership of the asset e.  The customer has accepted the asset. 2  Determine the transaction price The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services except mount collected on behalf of the third parties (for example, some sales sal es taxes). The transaction price can be a fixed amount of customer consideration, but it may sometimes include variable consideration or consideration in a form other than cash. The transaction price is also adjusted for the effects of the time value of money if the contract includes a significant financing component and for any consideration payable to the customer.

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If the consideration is variable, an entity estimate the amount of consideration to which it will be entitled in exchange for the promised goods or services. The estimated amount of variable consideration will be included in the transaction price only to the extent that it is highly probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved. Transaction Price It is the amount of consideration to which the entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on  behalf of third parties (for example, some sales sales taxes). Transaction price consists of a.  a.  The CONTRACT PRICE and b.  b.  Any SUBSEQUENT VARIATION IN THE CONTRACT PRICE that is probable that they will result in revenue and they are capable of being measured reliably.

In determining the transaction price, an entity shall consider the effects of all of the following: i.  i.  Variable Consideration may vary because of discount, rebates, refunds, credits price concessions, incentives, performance bonuses, penalties or other similar consideratio n is contingent items.  It can also vary if an entity’s entitlement to the consideration items. on the occurrence or non-occurrence of a future event.  event.  The entity shall estimate amount of variable consideration by consideration  by using either of the following methods: a.  The Expected Value –  the expected value is the sum of all probabilityweighted amounts in a range of possible considerations amounts. It is appropriate estimate if an entity has a large number of contracts with similar characteristics.   characteristics.  b.  The most likely Amount – the mostly likely amount is the single amount in a range of possible consideration amounts. It is appropriate estimate if the contract has only two possible outcomes (for example, an entity either achieves a performance bonus or not) ii.  ii. 

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Constraining estimates of variable consideration It shall only include in the transaction price some or all of an amount of variable consideration only to the extent that it is highly probable that a significant

 

reversal in the amount of cumulative revenue recognized will recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved. iii.   iii.

The existence of significant financing component in the contract an entity shall adjust the promised amount of consideration for the effects of the time value of money if the timing of payments agreed to by the parties to the contract provides the customer or the entity with significant benefit of financing the transfer of goods or services to the customer

iv. iv.  

Non-cash consideration The entity shall measure the non-cash consideration (or promise of non-cash consideration at fair value) If the customer contributes materials, equipment or labor to facilitate an entity’s fulfilment of the contract, the entity shall assess whether it obtains control of those contributed goods or services. The entity shall account the contributed goods or services as non-cash consideration received from customer.

v.  v. 

Consideration payable to customer It includes cash amount that an entity pays, or expect to pay, to the customer. It also includes credit or other items (for example coupon or voucher) that can be applied against the amount owed to the entity. It shall be accounted as a reduction of the transaction price and therefore, of revenue unless the payment to the customer is in exchange for a distinct good or service that the customer transfer to the entity.

Two types of Contract A.  Fixed Price Contract –  a contract in which the contractor agrees to a fixed amount of contract price or fixed rate per unit of output, which in some cases is subject to cost escalation clauses.  clauses.   B.  B.  Cost Plus Contract - a contract in which the contractor is reimbursed for allowable or otherwise defined costs plus a percentage of these costs or fixed fee.  fee.  1.  1.  Cost plus variable fee contract = Reimbursed costs + (Reimbursable costs x rate %)  %)   2.  2.  Cost plus fixed fee contract = Reimbursed costs + fixed fee (ie. 1M reimbursable cost + 5M)  5M)  Cost plus contract is used in case it is difficult for the contractor to quote the contract price because a.  It is not possible to accurately estimate the scope of the project. proje ct. 12 | Page 

 

 b.  There have been no prior similar project that can be used as a basis for price quotation 4.  4.  Allocate the transaction price to the performance obligations in the contract The allocation is based on the relative stand-alone prices of the distinct goods or services promised in the contract. The entity shall determine the stand-along selling price at contract inception of the distinct goods or services underlying each performance obligation in the contract and allocate the transaction price in proportion to those standalone selling prices. The stand-alone selling price –  is the price at which a promised good or service can be sold separately to a customer. If there is only one performance obligation in a ccontract, ontract, the transaction shall be allocated only to a single performance obligation 5.  5.  recognize revenue when the performance obligation is satisfied An entity recognizes revenue when (or as) it satisfies a performance obligation by transferring a promised goods or services to a customer (which is when the customer obtains control of that good or service). The amount of revenue recognized is the amount allocated to the satisfied performance obligation A. A.   Revenue is recognized Over Time –  revenue is recognized as the entity progresses towards the complete satisfaction of obligation.  obligation.  B.  B.  Revenue is recognized at a point in time –  revenue is recognized when the entity completely satisfies the performance obligation.  obligation.   No revenue is recognized during the contraction period because period because the the performance obligation is satisfied at a point in time. The whole transaction price is recognized as revenue when the construction is completed and the control over the promised  goods is transferred to the customer . -  The cost incurred each year during the period are deferred and recognized in full only when the related is recognized   - 

Note: REVENUE IS MEASURED AT THE AMOUNT OF THE TRANSACTION PRICE  ALLOCATED TO THE THE SATISFIED PERFORMANCE PERFORMANCE OBLIGATION OBLIGATION REASONABLE MEASURE OF PROGRESS

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Revenue for a performance obligation satisfied obligation  satisfied over time is recognized only if the entity can reasonably measure its progress towards the complete satisfaction of the performance of obligation. If the entity cannot be reasonably measure outcome of a performance obligation, but the entity expects to recover the costs incurred in satisfying the performance obligation, the entity shall recognized revenue ONLY TO THE EXTENT OF THOSE COST INCURRED (ZERO PROFIT METHOD) until such time that it can reasonably measure the outcome of the performance obligation can be reasonably measured. Methods of Measuring Percentage of Completion They entity shall use a single method of measuring progress consistently for each performance perfo rmance obligation satisfied over time and shall re-measure its progress at the end of each reporting. A. A.   INPUT METHOD – It recognize revenue base on the effort or inputs expended relative to the total expected inputs needed to fully satisfy a performance obligation. Example of inputs are  are  Incurred  1.  Cost Incurred  2.  2.  Resource Consumed  Consumed  3.  3.  Labor hours expended  expended  4.  4.  Machine hours used  used  B.  B.  OUTPUT METHOD –  this is made in terms of results achieve. This is based on the completion of physical proportion of the contract work. Architects or Engineers are sometime asked to evaluate jobs and estimate what percentage of job or contract is completed.   completed. 1.  1.  Surveys of performance completed to date  date  2.  2.  Appraisals of results achieved, milestones reached, time elapsed and units produced or units delivered.  delivered.  COST INCURRED IN FULFILLING THE CONTRACT –  capitalize or recognized as assets if ALL of the following criteria are met: A.  The cost are directly related to a contract contract or specificall specifically y identifiable a.  Direct Materials  b.  Direct labor c.  Other costs that are incurred only because an entity entered into the contract, for example 1.  Payment to subcontractor 2.  Costs of moving plant, equipment and materials to and from the contract site 3.  Cost of design and technical assistance that are directly related to the contract. 14 | Page 

 

d.  Costs that are explicitly chargeable to customer under the contract  contract   e.  Allocations of costs that relate directly to the contract or to contract activities: 1.  Insurance 2.  Depreciation of plant and equipment used on the contract 3.  Cost of design and technical assistance that are not directly related to a specific contract 4.  Cost of contract management and supervision 5.  Borrowing costs capitalized in accordance with PAS 23 6.  Other construction overheads B.  The costs generate or enhance resources that will be used in satisfying the performance obligation C.  Costs that expected to be recovered (reimbursed costs) COSTS RECOGNIZED AS EXPENSES WHEN INCURRED 1.  1.  General administration costs for which reimbursed is not specified in the contract. 2.  2.  Costs of wasted materials, labor or other resources that were not reflected in the price of the contract. 3.  Depreciation of idle plant and equipment that is not used on a particular pa rticular contract. 4.  4.  Cost that relate to satisfied or partially satisfied performance obligation in the contact (i.e. Cost that relate to past performance) 5.  5.  Cost for which an entity cannot distinguish whether the costs relate to unsatisfied performance obligation or to satisfied or partially satisfied performance obligation.  obligation.   costs   6.  6.  Selling costs or marketing costs  7.  7.  Research and Development costs for which reimbursed is not specified in the contract. Note: Any INCIDENTIAL INCOME FROM THE CONSTRUCTION that is not included in contract revenue shall be accounted for as REDUCTION OF CONTRACT COSTS (i.e. Income from the sale of excess materials, scrap and gain on sale of plant and equipment at the end of the contract shall be accounted for as reduction of contract costs.)

ADJUSTMENT TO THE MEASURE OF PROGRESS UNDER INPUT METHOD 1.  1.  When a cost incurred does not contribute to an entity’s progress in satisfying the performance obligation  obligation  Example: The entity excludes from the measurement of its progress the costs of significant inefficiencies such as wasted materials, labor and other resources that were not reflected in the contract price.

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2.  2.  When a cost incurred does not contribute to an entity’s progress in sa tisfying the performance obligation.  obligation.  a.  Advance payments to subcontractors for the subcontracted work has not yet been started.   started.  b.  Cost of materials that have been delivered to a contract site or set aside for use in a contract but not yet installed, used or applied during the contract performance. CONTRACT LIABILITY VS. CONTRACT ASSET When either party to a contract has performed, an entity shall present the contract in the statement of financial position as a contract asset or contract liability, depending on the relationship  between the entity’s performance and the customer’s payment. An entity shall present any unconditional rights to consideration separately as RECEIVABLE. CONTRACT LIABILITY – is an entity’s obligation to transfer goods or services to custo mer for which the entity received consideration for the amount is due from the customer. It is recognized when: a.  The entity receives a consideration before good or service is transferred to the customer.  b.  The entity has an unconditional right to the considerations before the goods or services is transferred to the customer. CONTRACT ASSET – an entity’s right to consideration in exchange for goods and services that the entity has transferred to a customer when the right is conditioned on something other than the passage of time (for example, the entity’s future performance).  performance).   A contract asset (excluding (excluding amount recognized as a receivable) is recognized when the goods go ods or services is transferred to the customer before the consideration is received or become due. RECEIVABLE –  is an entity’s right to consideration that is unconditional. It is unconditional uncon ditional if only the passage of time is required before payment of consideration is due. For example, an entity would recognize a receivable if it has a present right to payment even if the amount may  be subject to refund in the future. The entity shall account for a receivable in accordance with PFRS 9.

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DMCI Construction Company was awarded a contract to construction a new sewage system for MWSS for a price of P6,000,000. The original estimate of cost to complete the contract was P4,200,000. The contract provides for periodic billings. Information on the contract follows: 2030 Cost incurred to date Estimated cost to complete Progress billings

500,000 2,000,000 400,000

2031 2,340,000 260,000 4,350,000

2032  2032  2,650,000 1,250,000

At the contract inception, DMCI assess its performance obligation in the contract and determines that the promised of goods and services as a single performance obligation satisfied overtime in accordance with PFRS 15. DMCI concludes that an input measure using “cost to cost method” provides the appropriate measure of progress towards complete satisfaction of the performance obligation. I FRS15 Req. 1. 1. Identify which whether the statements are true or false under IFRS15 a.  The total realized gross profit in 2032 is P290,000  b.  The total construction in progress net of progress billings to be presented in the financial statement in year 2030 is P800,000 c.  The total contract revenue to be credited in year 2031 is P5,400,000 d.  The total construction in progress in year y ear 2031 is P5,400,000 Assuming at the contract inception, DMCI assess its performance obligation in the contract and determines that the promised of goods and services as a single performance obligation satisfied overtime in accordance with PFRS 15. However, DMCI determines that the outcome of the performance obligation cannot be reasonably measured but expects to recover the contract costs incurred. Req. 2 Identify 2 Identify which whether the statements are true or false under IFRS15 IF RS15 a.  The total construction in progress not of progress billing to be presented in the financial statement in the year 2030 is P100,000 17 | Page 

 

 b.  The total realized gross profit in year 2032 is P3,350,000 c.  The total construction in progress in year y ear 2031 is P2,340,000 d.  The contract cost to be credited in year 2030 is P500,000 DMCI retains control over the asset created in the contract. This prevents the client from simultaneously receiving and consuming the benefits provided by the entity’s performance as the entity performs. Therefore, DMCI determines that the performance obligation is satisfied at a point in time. Req. 3. 3. Identify which whether the statements are true or false under IFRS15 I FRS15 a.  The contract revenue recognized in year 2030 is P500,000.  b.  The contract cost recognized in the year y ear 2030 is P1,750,000. c.  The contract revenue recognized in the year 2032 is P6,000,000 d.  The realized gross profit in the year 2032 is P3,350,000

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