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2.4) Long Term Construction Contracts
Percentage of Completion Method
Completed Contract Method
Recognition of Income
Gross Profit recognized in each period of the contract on an accrual basis
Gross Profit recognized only on completion of the contract
Formula Gross Profit recognized in each year =
Cost to date ____ * Expected - Previously Total estimated costs Profit recognized profits
Gross Profit recognized on completion = Contract price - Total costs
Recognition of costs & billings
During the year:
- Both costs & gross profits/losses accumulated in a current asset called CIP (Construction-in-progress)
- Billings accumulated in a current liability called Billings account
At the end of the year:
Billings and CIP are netted on the B/S to report either:
- Current asset (CIP > Billings) - Current liability (CIP < Billings)
Same as % of completion method except that:
- Profits are not included in CIP
- Costs may include a reasonable allocation of G&A expenses for periods prior to completion
Anticipated losses
Anticipated losses are recognized immediately; amount of loss is total estimated loss on the contract plus all profits recognized previously
Anticipated losses are recognized immediately; total estimated loss on the contract is recognized in the current period
Conceptual base &
Advantages
- Based on the matching concept and is more consistent with the revenue recognition principle
- Based on the concept of conservatism - Based on final results rather than estimates
Disadvantages - Dependent on estimates - Violates the matching concept
US GAAP Criteria
Used when:
- Costs to complete and estimates of progress towards completion are reasonably dependable
- Collection is assured
Used when:
- Difficult to estimate costs to complete - Many contracts in progress (such that
approximately an equal number of projects are completed each year) - Duration of projects is small - Collections not assured IFRS If outcomes can be estimated reliably, use
Percentage of completion method;
otherwise, use Cost Recovery method where revenue recognition is limited to costs incurred
Completed contracts method is NOT allowed under IFRS
May use cost recovery method for IFRS
I/S
B/S
CIP = Cost + Profit - Loss (if any)
CIP = Cost - Loss (if any)
Need to estimate y All profits in the year of completion
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Example on Long term construction contracts:
Towers Co. has signed a long term construction contract with one of its clients for total contract price of $300,000.
Below are the estimates made, costs incurred, bills raised and amounts received each year during the contract:
2001 2002 2003 Total
Costs incurred each year . $ 70,000 $110,000 $ 93,000
Estimated costs to complete (at year-end) $200,000 $ 92,000 n/a
Progress billings each year $ 60,000 $115,000 $125,000
Collections on billings each year $ 50,000 $100,000 $150,000
1. Calculate the gross profit recognized during the 3 years of the contract under the Completed contract method and the Percentage of completion method
2. Pass J/E under both the methods
Solution - Part 1 of 2:
Gross Profit Recognized under Completed Contract Method:
2001: nil (as contract was not completed) 2002: nil (as contract was not completed)
2003: Total contract price $300,000
Total costs incurred $273,000 [$70,000 + $110,000 + $93,000]
Gross Profit on construction $ 27,000
Gross Profit Recognized under Percentage-of-Completion Method:
2001 2002 2003
Total Contract price* $300,000 $300,000 $300,000
Less costs:
Actual cost to date (cumulative)* $ 70,000 $180,000 $273,000
Estimated costs to complete $200,000 $ 92,000 n/a Estimated total costs at completion $270,000 $272,000 $273,000*
Estimated total Gross Profit $ 30,000 $ 28,000 $ 27,000*
Apportionment of Gross Profit (based on ratio of costs incurred to-date to estimated total construction costs):
2001: ($70,000/$270,000) x $30,000 $ 7,778
2002: ($180,000/$272,000) x $28,000 $ 18,529
Less: Gross Profit recognized to date $ 7,778
Gross Profit recognized in 2002 $ 10,751
2003: Total Gross Profit to be recognized (actual) $ 27,000
Less: Gross Profit recognized to date ($7,778 + $10,751) $ 18,529
Gross Profit recognized in 2003 $ 8,471
* Actual figures
y x
x+y k
Gross Profit for the year = x x [k – (x+y)] - Previously
x+y recognized gross profit k – (x+y)
Do not affect
G.P. calculations
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Solution - Part 2 of 2: Percentage ofcompletion method
Completed contract method
2001:
1. Costs of construction:
Construction in progress A/P or Cash
2. Progress billings:
Accounts receivable Progress billings 3. Collections on billings:
Cash
Accounts receivable 4. Recognition of Gross Profit:
Construction in progress Gross Profit on construction
70,000
70,000
60,000
60,000
50,000
50,000
7,778
7,778
70,000
70,000
60,000
60,000
50,000
50,000
(no profit recognized until completion) 2002:
1. Costs of construction:
Construction in progress A/P or Cash
2. Progress billings:
Accounts receivable Progress billings 3. Collections on billings:
Cash
Accounts receivable 4. Recognition of Gross Profit:
Construction in progress Gross Profit on construction
110,000
110,000
115,000
115,000
100,000
100,000
10,751
10,751
110,000
110,000
115,000
115,000
100,000
100,000
(no profit recognized until completion) 2003:
1. Costs of construction:
Construction in progress A/P or Cash
2. Progress billings (final):
Accounts receivable Progress billings
3. Collections on billings (in full):
Cash
Accounts receivable 4. Recognition of Gross Profit &
closing accumulated account balances:
Construction in progress Gross Profit on construction
Progress billings
Construction in progress
93,000
93,000
125,000
125,000
150,000
150,000
8,471
8,471
300,000
300,000
93,000
93,000
125,000
125,000
150,000
150,000
27,000
27,000
300,000
300,000
Construct
Bill
Receive Cash Gross Profit
B/S
B/S
B/S I/S
B/S
B/S Do not affect
G.P. calculations
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Example of Loss in Long term construction contracts:
Walls Co. has signed a long term construction contract with one of its clients for total contract price of $300,000.
Below are the estimates made, costs incurred, bills raised and amounts received each year during the contract:
2001 2002 2003
Total
Costs incurred each year . $ 70,000 $150,000 $ 93,000
Estimated costs to complete (at year-end) $200,000 $ 92,000 n/a
Progress billings each year $ 60,000 $115,000 $125,000
Collections on billings each year $ 50,000 $100,000 $150,000
Calculate the income (or loss) recognized during the 3 years of the contract by the Completed contract method and the Percentage of completion methods
Solution:
Gross Profit or Loss Recognized under Completed Contract Method:
2001: nil (as contract was not completed)
2002: Total contract price $300,000
Actual costs incurred - $220,000
Estimated costs to be incurred - $ 92,000 Estimated loss to be recognized immediately $ - $ 12,000
2003: Total contract price $300,000
Total costs incurred - $313,000
Total loss on construction $ 13,000
Less: Loss recognized in 2002 - $ 12,000
Loss recognized in 2003 - $ 1,000
Gross Profit or Loss Recognized under Percentage-of-Completion Method:
2001 2002 2003
Total Contract price* $300,000 $300,000 $300,000
Less costs:
Actual cost to date (cumulative)* $ 70,000 $220,000 $313,000
Estimated costs to complete $200,000 $ 92,000 n/a Estimated total costs at completion $270,000 $312,000 $313,000*
Estimated Gross Profit $ 30,000 - $12,000 - $13,000*
Apportionment of Gross Profit or Loss:
2001: ($70,000/$270,000) x $30,000 $ 7,778
2002: Estimated loss (loss not apportioned) - $12,000
Profit recognized to date - $ 7,778
Loss recognized in 2002 (entire loss recognized) - $19,778
2003: Total loss to be recognized (actual) - $13,000
Loss recognized to date ($19,778 - $7,778) $12,000
Loss recognized in 2003 - $ 1,000
* Actual figures
(70 + 150)
Loss – Recognize 100%
immediately even under Completed Contract method
J/E for in case of loss:
Loss X CIP X
Loss – Recognize 100%, not % of completion Need to
Reverse
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➢ Recap of Revenue Recognition Step 5 - An entity should recognize revenue when (or as) it satisfies a performance obligation by transferring a promised good/service to a customer. For each
performance obligation, determine if it is satisfied “over time” (typically, promises to transfer services); else, consider satisfied at a “point in time” (typically, promises to transfer goods)
• Satisfied “over time”
✓ If one of the following criteria is met:
Customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs
Entity’s performance creates or enhances an asset (e.g., work in process) that the customer controls as the asset is created or enhanced
Entity’s performance does not create an asset with an alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date
✓ For each performance obligation satisfied “over time”, an entity shall recognize revenue
“over time” by consistently applying a method of measuring the progress toward complete satisfaction of that performance obligation. Appropriate methods include:
Output methods - Recognize revenue on the basis of value of the goods/services transferred-to-date to the customer relative to the remaining goods or services promised under the contract
Input methods - Recognize revenue on the basis of the entity’s efforts/inputs (e.g., resources consumed, labor hours expended, costs incurred, time elapsed, machine hours used) relative to the total expected inputs to satisfy the performance obligation
Percentage of Completion Method = Recognize Revenue “over time”Pat Co. is constructing a building on a land parcel owned by its client Rover Co. Pat recognizes revenue
“over time” using the Percentage of Completion Method as:
▪ Pat has a right to payment at various stages
▪ Rover has legal title of the asset
▪ Rover has physical possession of the asset
▪ Rover has ongoing use and benefits of the asset Pat can use either of the below methods:
▪ Output method - Recognize revenue on the basis of direct measurement of the value to the customer of goods or services transferred to date. Under the output method, progress is measured by the result of the work performed, such as appraisal of the completed portion or milestones reached
▪ Input method - Recognize revenue on the basis of contractor’s “inputs” to the satisfaction of the performance obligation [refer earlier examples on Percentage of Completion method]
- However, note that costs incurred related to rework or wasted materials would be excluded from input measurement, as these costs do not represent the transfer of goods or services to the customer
- In addition, the cost of uninstalled materials do not represent contractor’s progress towards fulfilling its performance obligations and should, therefore, not be included in the measurement of progress towards completion calculation. While uninstalled materials are excluded from the measurement of progress, the contractor is permitted to recognize revenue equal to the cost of the uninstalled materials (excluding gross profit) under the new revenue recognition standards
Criteria generally met since customer
holds legal title. Also, ongoing use &
benefit of the asset with
customer
Percentage of Completion method
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• If not satisfied “over time”, considered satisfied at a “point in time”
✓ To determine the “point in time” at which to recognize revenue, need to consider indicators of the transfer of control, which include the following:
Entity has a present right to payment for the asset
Customer has legal title to the asset
Entity has transferred physical possession of the asset
Customer has the significant risks and rewards of ownership of the asset
Customer has accepted the asset
Completed Contracts Method = Recognize Revenue at a “point in time”
Cathy Co. is developing a property on a land parcel it owns, and has contracted to sell the same to Range Co. once the development is complete. Cathy has physical possession, legal title, and use and benefit of the property until project completion and handover to Range. Therefore, during the construction progress, Range does not gain anything from the work done. As per the contract, even though Range pays Cathy periodically for progress completed, there is no transfer of control yet. So Cathy uses the completed contract method and recognizes revenue on project completion and handover to Range.
method
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