Construction contract Appendix chapter 18.pptx

Chapter 18 Appendix A, B

1. ACCOUNTING FOR CONSTRUCTION CONTRACT Presented by Group 3

2. CONTENT 01. Definition 02. Percentage-of-Completion 03. Cost recovery (Zero-profit) 04. Long term contract loss

3. REVENUE RECOGNITION OVER TIME 01. Under certain circumstances companies recognize revenue over time. The most notable context in which revenue may be recognized over time is long-term construction contract accounting. Definition

4. Long term contracts frequently provide that seller (builder) may bill purchaser at intervals. REVENUE RECOGNITION OVER TIME Examples: Development of military and commercial aircraft Weapons-delivery systems Space exploration hardware A group of buildings, bridges, miles of roadway (e.g. Beltway 5 surrounding Hanoi, going through 7 provinces) 01.

5. REVENUE RECOGNITION OVER TIME A company satisfies a performance obligation and recognizes revenue over time if at least one of three criteria is met: The customer simultaneously receives and consumes the benefits as the seller performs The company's performance creates or enhances an asset the customer controls as the asset is created or enhanced The performance doesn't create an asset with alternative use. In addition to this alternative use element, at least one of the following criteria must be met: a. Another company could pick up where this company left off without needing to redo most of the work. In other words, if someone else took over the project, they wouldn't have to start from scratch b. The company has the right to be paid for the work it has already completed, and it's confident it can finish the job as agreed 01.

6. METHOD 1: PERCENTAGE OF COMPLETION 02.

7. The percentage‐of‐completion method recognizes revenues, costs, and gross profit as a company makes progress toward completion on a long‐term contract. METHOD 1: PERCENTAGE OF COMPLETION The reason behind such recognition to defer recognition of these items until completion of the entire contract is: to misrepresent the efforts (costs) and accomplishments (revenues) of the accounting periods during the contract. The question is: How to measure the progress toward completion? Since it is hard to make reasonably accurate estimates of completion and the final gross profit, there are 2 common methods that companies use: Cost-to-cost and units-of-delivery methods. 02.

8. Under this basis, a company measures the percentage of completion by comparing costs incurred to date with the most recent estimate of the total costs required to complete the contract. Here is the formula for Cost-to-cost basis: METHOD 1: PERCENTAGE OF COMPLETION COST-TO-COST BASIS Costs Incurred to Date Most Recent Estimate of Total Costs Percent Complete Percent Complete Estimated Total revenue (or Gross profit) Revenue (or Gross Profit) to be recognized to Date

9. METHOD 1: PERCENTAGE OF COMPLETION COST-TO-COST BASIS Costs Incurred to Date Most Recent Estimate of Total Costs Percent Complete Percent Complete Estimated Total revenue (or Gross profit) Revenue (or Gross Profit) to be recognized to Date Revenue (or Gross Profit) to be recognized to Date Revenue (or Gross Profit) recognized in prior periods Current period Revenue (or Gross profit)

10. METHOD 1: PERCENTAGE OF COMPLETION COST-TO-COST BASIS Example: The company H ardhat is a construction company and has a contract to construct a £4,500,000 bridge at an estimated cost of $4,000,000 . The contract is to start in July 2019 , and the bridge is to be completed in October 2021 . The following data pertain to the construction period. Note that by the end of 2020 , Hardhat has revised the estimated total cost from £4,000,000 to £4,050,000. 2019 2020 2021 Costs to date 1,000,000 2,916,000 4,050,000 Estimated costs to complete 3,000,000 1,134,000 - Progress billings during the year 900,000 2,400,000 1,200,000 Cash collected during the year 750,000 1,750,000 2,000,000

11. 2019 2020 2021 Contract price 4,500,000 4,500,000 4,500,000 Less estimated costs: Less estimated costs: Less estimated costs: Less estimated costs: Costs to date 1,000,000 2,916,000 4,050,000 Estimated costs to complete 3,000,000 1,134,000 - Estimated total costs 4,000,000 4,050,000 4,050,000 Estimated total gross profit 500,000 450,000 450,000 Percent complete 25% 72% 100% METHOD 1: PERCENTAGE OF COMPLETION COST-TO-COST BASIS Note that by the end of 2020 , Hardhat has revised the estimated total cost from £4,000,000 to £4,050,000.

12. 2019 2019 2020 2020 2021 2021 Dr Construction in Process 1,000,000 1,916,000 1,134,000 Cr Materials, cash, payables, ect.  1,000,000 1,916,000 1,134,000 METHOD 1: PERCENTAGE OF COMPLETION COST-TO-COST BASIS (1) TO RECORD THE COSTS OF CONSTRUCTION: 2019 2020 2021 Costs to date 1,000,000 2,916,000 4,050,000

13. 2019 2019 2020 2020 2021 2021 Dr Account Receivables 900,000 2,400,000 1,200,000 Cr Billings on Construction in Process 900,000 2,400,000 1,200,000 METHOD 1: PERCENTAGE OF COMPLETION COST-TO-COST BASIS (2) TO RECORD PROGRESS BILLINGS: 2019 2020 2021 Progress billings during the year 900,000 2,400,000 1,200,000

14. 2019 2019 2020 2020 2021 2021 Dr Cash 750,000 1,750,000 2,000,000 Cr Accounts Receivable 750,000 1,750,000 2,000,000 METHOD 1: PERCENTAGE OF COMPLETION COST-TO-COST BASIS (3) TO RECORD COLLECTIONS: 2019 2020 2021 Cash collected during the year 750,000 1,750,000 2,000,000

15. REVENUE, COST AND PROFIT BY YEARS: To Date Recognized in Prior Years Recognized in Current Years 2019 2019 2019 2019 Revenues (4,500,000 * 25%) 1,125,000 1,125,000 Costs 1,000,000 1,000,000 Gross profit 125,000 125,000 Percent complete 25% 25% 25% METHOD 1: PERCENTAGE OF COMPLETION COST-TO-COST BASIS

16. REVENUE, COST AND PROFIT BY YEARS: To Date Recognized in Prior Years Recognized in Current Years 2020 (Percent complete - 72%) 2020 (Percent complete - 72%) 2020 (Percent complete - 72%) 2020 (Percent complete - 72%) Revenues (4,500,000 * 72%) 3,240,000 1,125,000 2,115,000 Costs 2,916,000 1,000,000 1,916,000 Gross profit 324,000 125,000 199,000 2021 (Percent complete - 100%) 2021 (Percent complete - 100%) 2021 (Percent complete - 100%) 2021 (Percent complete - 100%) Revenues (4,500,000 × 100%) 4,500,000 3,240,000 1,260,000 Costs 4,050,000 2,916,000 1,134,000 Gross profit 450,000 324,000 126,000 METHOD 1: PERCENTAGE OF COMPLETION COST-TO-COST BASIS

17. 2019 2019 2020 2020 2021 2021 Dr Construction in Process (Gross profit) 125,000 199,000 126,000 Dr Construction Expenses 1,000,000 1,916,000 1,134,000 Cr Revenue from Long-term contracts 1,125,000 2,115,000 1,260,000 (1) RECOGNIZE REVENUE AND GROSS PROFIT: 2019 2020 2021 Costs recognized in Current Years 1,000,000 1,916,000 1,134,000 Revenue 1,125,000 2,115,000 1,260,000 Gross profit 125,000 199,000 126,000 METHOD 1: PERCENTAGE OF COMPLETION COST-TO-COST BASIS

18. 2021 2021 2021 2021 2021 2021 Dr Billings on construction in Process 4,500,000 4,500,000 4,500,000 Cr Construction in Process 4,500,000 4,500,000 4,500,000 (2) TO RECORD COMPLETION OF THE CONTRACT: METHOD 1: PERCENTAGE OF COMPLETION COST-TO-COST BASIS

19. Financial Statement Presentation- Percentage-of-Completion Revenue from long term contracts (calculated by using percent complete ) Costs of construction (to date, incurred in the year) Gross profit In the Income statement , we will record the following accounts:

20. For example: Hardhat Construction Financial Statement Presentation- Percentage-of-Completion 2019 2020 2021 Costs to date 1,000,000 2,916,000 4,050,000 Estimated costs to complete 3,000,000 1,134,000 - Estimated total cost 4,000,000 4,050,000 4,050,000 Progress billings during the year 900,000 2,400,000 1,200,000 Cash collected during the year 750,000 1,750,000 2,000,000

21. For example: Hardhat Construction Financial Statement Presentation- Percentage-of-Completion Income Statement 2019 2020 2021 Revenue from long term contracts 1,125,000 2,115,000 1,260,000 Costs of construction 1,000,000 1,916,000 1,134,000 Gross profit 125,000 199,000 126,000

22. Financial Statement Presentation- Percentage-of-Completion If that amount is a debit , companies report it as a current asset. If it is a credit , they reports it as a current liability. In the Statement of financial position , we will disclose the difference between the Construction in Process and the Billings on Construction in Process accounts.

23. Computation of Unbilled Contract Price at 12/31/19 Contract revenue recognized to date (£4,500,000 × £1,000,000/£4,000,000) £1,125,000 Billings to date (900,000) Unbilled revenue £ 225,000 Financial Statement Presentation- Percentage-of-Completion At the year end 2019 , the company calculated the unbilled contract price as followed: Continue with Hardhat Construction Subtracting the balance in the Billings account from Construction in Process avoids double-counting the inventory.

24. Financial Statement Presentation- Percentage-of-Completion For year ended 31/12/2019: Billings < Construction in Process Example with Hardhat Construction Statement of Financial Position (12/31) Current assets Inventory Construction in process Less: Billings Costs and recognized profit in excess of billings Accounts receivable (£900,000 - £750,000) 2019 £225,000 150,000 £1,125,000 900,000

25. Financial Statement Presentation- Percentage-of-Completion For year ended 31/12/2020: Billings > Construction in Process Example with Hardhat Construction Statement of Financial Position (12/31) Current assets Accounts receivable (£150,000+£2,400,000-£1,750,000) Current liabilities Billings Less: Construction in Process Billings in excess of costs and recognized profit 2020 £800,000 60,000 £3,300,000 3,240,000

26. Note 1. Summary of significant accounting policies. Long-Term Construction Contracts. The company recognizes revenues and reports profits from long- term construction contracts, its principal business, under the percentage-of-completion method of accounting. These contracts generally extend for periods in excess of one year. The amounts of revenues and profits recognized each year are based on the ratio of costs incurred to the total estimated costs. Costs included in construction in process include direct materials, direct labor, and project-related overhead. Corporate general and administrative expenses are charged to the periods as incurred and are not allocated to construction contracts. Financial Statement Presentation- Percentage-of-Completion Besides, the company must disclose the accounting policies in the notes to financial statements:

27. COST-RECOVERY (ZERO-PROFIT) METHOD 03.

28. Cost-Recovery (Zero-Profit) Method A very conservative revenue recognition approach Revenue collection is uncertain Long-Term Construction Contracts

29. COST-RECOVERY (ZERO-PROFIT) METHOD Revenue is not recognized until all associated costs are recovered Prioritizing cost recovery over revenue recognition Ensuring revenue is not recognized until it is virtually certain that it will be realized

30. Exa To Date Recognized in Prior Years Recognized in Current Years Hardhat Construction would report the following revenues and costs for 2019–2021 EXAMPLE Revenues (Cost incurred) 1,000,000 1,000,000 Costs 1,000,000 1,000,000 Gross Profit Revenues (Cost incurred) 2,916,000 1,000,000 1,916,000 Costs 2,916,000 1,000,000 1,916,000 Gross Profit Revenues (Cost incurred) 4,500,000 2,916,000 1,584,000 Costs 4,050,000 2,916,000 1,134,000 Gross Profit 450,000 450,000 2019 2020 2021

31. Journal Entries Record construction costs incurred during the year Construction in Process 1,000,000 Cash/Materials/Payables 1,000,000 Construction Expenses 1,000,000 Revenue from Long-Term Contracts 1,000,000 Record contract revenue and related costs 2019 Record invoices issued during the year Accounts Receivable 900,000 Billings on Construction in Process 900,000

32. Current assets Inventories Construction in process Less: Billings Costs and recognized profit in excess of billings Accounts receivable 1,000,000 900,000 100,000 150,000 Statement of Financial Position (2019) Record invoices issued during the year Accounts Receivable 900,000 Billings on Construction in Process 900,000 Journal Entries 2019 Record cash received from customers during the year Cash 750,000 Accounts Receivable 750,000

33. Journal Entries Record construction costs incurred during the year Construction in Process 1,916,000 Cash/Materials/Payables 1,916,000 Construction Expenses 1,916,000 Revenue from Long-Term Contracts 1,916,000 Record contract revenue and related costs 2020

34. Journal Entries Record invoices issued during the year Accounts Receivable 2,400,000 Billings on Construction in Process 2,400,000 2020 Statement of Financial Position Current liabilities Billings Less: Construction in process Billings in excess of costs and recognized profits 384,000 2020 3,300,000 2,916,000 Record cash received from customers during the year Cash 1,750,000 Accounts Receivable 1,750,000

35. Journal Entries Record construction costs incurred during the year Dr. Construction in Process 1,134,000 Cr. Cash/Materials/Payables 1,134,000 Dr. Construction Expenses 1,134,000 Cr. Revenue from Long-Term Contracts 1,134,000 Dr. Construction in Process (Gross profit) 450,000 Cr. Revenue from Long-Term Contracts 450,000 Record contract revenue and profit 2021 Contruction Contract Completed Record invoices issued during the year Dr. Accounts Receivable 2,000,000 Cr. Billings on Construction in Process 2,000,000

36. Dr. Cash 2,000,000 Cr. Accounts Receivable 2,000,000 Record cash received from customers during the year Contruction Contract Completed Billings on Construction in Process and Construction in Process accounts are closed to reflect that the project has ended Dr. Billings on Construction in Process 4,500,000 Cr. Construction in Process 4,500,000 Journal Entries 2021

37. Percentage-of-Completion Cost-Recovery 2019 125,000 2020 199,000 2021 126,000 450,000 Comparison of Gross Profit recognized under 2 method

38. Income Statement 2019 2020 2021 Revenue from long-term contracts 1,000,000 1,916,000 1,584,000 Costs of construction 1,000,000 1,916,000 1,134,000 Gross profit 450,000 Income statement

39. Statement of Financial Position Current liabilities Billings Less: Construction in process Billings in excess of costs and recognized profits 384,000 2019 2020 3,300,000 2,916,000 Current assets Inventories Construction in process Less: Billings Cost in excess of billings Account receivables 2021 1,000,000 900,000 100,000 150,000 800,000

40. Note 1. Summary of significant accounting policies. Long-term Construction Contracts. The company recognizes revenues and reports profits from long-term construction contracts, its principals business, under the cost-recovery method . These contract generally extend for periods in excess of one year. Contract costs and billings accumulated during the periods of construction, and revenues are recognized only to the extent of costs incurred that are expected to be recoverable. Only after all costs are incurred is net income recognized. Costs included in construction in process include direct material, direct labor, and project-related overhead. Corporate general and administrative expenses are charged to the periods as incurred. The company must disclose the accounting policies in the notes to financial statements Cost-Recovery (Zero-Profit) Method

41. LONG-TERM CONTRACT LOSSES 04. Long-Term Contract Losses Loss in the current period on a profitable contract Loss on an unprofitable contract 1 2

42. Loss in the Current Period Definition Significant increase in estimated costs during construction. Profitability Contract remains profitable overall. Applicable Methods Percentage-of-completion method only. Timing of Recognition Loss is recognized in the current period, adjusting excess gross profit from previous periods Reason for Loss Recognition Due to a change in accounting estimates. LONG-TERM CONTRACT LOSSES

43. Loss in the Current Period Loss on an Unprofitable Contract Definition Significant increase in estimated costs during construction. Estimated that the contract will result in an overall loss at completion. Profitability Contract remains profitable overall. Contract expected to result in a total loss. Applicable Methods Percentage-of-completion method only. Both percentage-of-completion and cost-recovery methods. Timing of Recognition Loss is recognized in the current period, adjusting excess gross profit from previous periods Entire expected loss is recognized immediately in the current period. Reason for Loss Recognition Due to a change in accounting estimates. To avoid overstatement of current and future income (conservatism principle). LONG-TERM CONTRACT LOSSES

44. Loss in the current period on a profitable contract Assume that on December 31 2O20, Hardhat estimates the costs to complete the bridge contract at 1,468,962 instead of 1,134,000. Assuming all other data are the same as before, Hardhat would compute the percentage complete and recognize the loss: 2020 - Original Estimates 2020 - Revised Estimates Contract price 4,500,000 4,500,000 Cost to date (12/31/20) (1) 2,916,000 2,916,000 Estimated cost to complete (2) 1,134,000 1,468,962

45. Loss in the current period on a profitable contract 2020 - Original Estimates 2020 - Revised Estimates Contract price 4,500,000 4,500,000 Cost to date (12/31/20) (1) 2,916,000 2,916,000 Estimated cost to complete (2) 1,134,000 1,468,962 Estimated total costs (3) = (1) + (2) 4,050,000 4,384,962 Percent complete (4) Revenue recognized to the date (5) = (1) * (4) 3,240,000 2,992,500

46. To Date (12/32/20) Recognized in Prior Years (2019) Recognized in Current Years Revenues (Cost incurred) 2,992,500 1,125,000 1,867,500 Costs 2,916,000 1,000,000 1,916,000 Gross Profit (Loss) 76,500 125,000 (48,500) Loss in the current period on a profitable contract Example with Hardhat Construction

47. To Date (12/31/20) Recognized in Prior Years (2019) Recognized in Current Years 2,992,500 Revenues (Cost incurred) 1,125,000 1,867,500 2,916,000 Costs 1,000,000 1,916,000 76,500 Gross Profit (Loss) 125,000 (48,500) Loss in the current period on a profitable contract Dr: Construction Expense Cr: Construction in Process (loss) Cr: Revenue from Longterm Contract 1,916,000 48,500 1,867,500

48. Loss on an Unprofitable Contract Under the percentage-of-completion method Under the cost-recovery method

49. 2019 2020 2021 Costs to date 1,000,000 2,916,000 4,050,000 Estimated costs to complete 3,000,000 1,134,000 - Estimated total cost 4,000,000 4,050,000 4,050,000 Progress billings during the year 900,000 2,400,000 1,200,000 Cash collected during the year 750,000 1,750,000 2,000,000 2019 Original Estimates 2020 Revised Estimates Contract price 4,500,000 4,500,000 Estimated costs to complete 3,000,000 1,640,250 Estimated total cost 4,000,000 4,556,250* Estimated gross profit 500,000 Estimated loss (56,250) Loss on an Unprofitable Contract Come back with Hardhat Construction

50. Contract price 4,500,000 Percent complete x 64% Revenue recognizable to date 2,880,000 Less: Revenue recognized in 2020 1,125,000 Revenue recognized in 2020 1,755,000 Since the company must recognize losses as soon as they are estimable, Hardhat Construction has to account for the entire expected loss of £56,250 in 2020, along with reversing the £125,000 profit that was recognized in 2019 Under the percentage-of-completion method Loss on an Unprofitable Contract *Cost to date (31/12/2020) 2,916,000 Estimated total costs 4.556,250 Estimated cost to complete 1,640,250 Percent complete: 2,916,000/4,556,250 = 64% Percent complete: 2,916,000/4,556,250 = 64%

51. Revenue recognized in 2020 (computed above) Total losses recognized in 2020: Reversal of 2019 gross profit Total estimated loss on the contract Construction cost expensed in 2020 £1,755,000 181,250 £1,936,250 £125,000 56,250 Example with Hardhat Construction Loss on an Unprofitable Contract Hardhat Construction would record the long-term contract revenues, expenses, and loss in 2020 as follows. Construction Expenses 1,936,250 Construction in Process (loss) 181,250 Revenue from Long term Contracts 1,755,000 Under the percentage-of-completion method

52. Example with Hardhat Construction Hardhat also would recognize the contract loss of 56,250 through the following entry in 2020 (the year in which the loss first became evident) : Loss from Long-Term Contracts 56,250 Construction in Process (loss) 56,250 Loss on an Unprofitable Contract Under the cost-recovery method

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