Construction Contract

1. Construction Contract

2. Question 1: Construction contract Suppose that a contract is started on 1st January 2001, with an estimated completion date of 31st December 2002. The final contract price is $2m.In the first year, to 31st December 2001: • (a) Cost incurred amounted to $800,000. • (b) Half the work on the contract was completed. • (c) Certificate of work completed have been issued, and if it is satisfactory, to issue certificates. This will then be the notification to the customer that progress payments are due to the contractor. • Progress payments are commonly the amount of valuation on the work certificates issued minus a precautionary retention of 10%. • (d) It is estimated with reasonable certainty that further costs to completion in 2002 will be $800,000. ** Required: What is the expected profit in 2001 and what entries would be made for the contract at 31 December 2001 if: • (a)profits are deferred until the completion of the contract? • (b)a proportion of the estimated revenue and profit is credited to profit or loss in 20x1?

3. Question 1: Answer Expected Profit in 2001: Entries: Cash* *Question states” (a) Cost incurred” rather than “Cost Unpaid”

4. Question 1: Answer (Con’t) Dr WIP 800,000 Cr cash 800,000 Student answer is also acceptable as they comply with accounting standard. *Price = sales meaning Entries: The proportion of the estimated revenue and profit is credited to profit in 20X1. SOL: Dr. Cost of sales $800,000 Cr. Cash $800,000 Dr. Account receivable $1,000,000 Cr. Sales $1,000,000

5. Question 2 Example: Profitable contract with reliably estimated outcome Andy Co has a fixed price contract to build a tower block. The initial amount of revenue agreed is $220 millions. At the beginning of the contract on 1 January 20X9 the initial estimate of the contract costs is $200 millions. At the end of 20X9 the estimate of the total costs has risen to $202 millions. During 20Y0 the customer agrees to a variation which increases expected revenue from the contract by $5 millions and causes additional costs of $3 millions. At the end of 20Y0 there are materials stored on site for use during the “following” period which cost $2.5 millions. It is decided to determine the stage of completion of the contract by calculating the proportion that contract costs incurred for work to date bear to the latest estimated total contract costs. The contract costs incurred at the end of each year were 20X9: $52.52 million, 20Y0: $154.2 million (including materials in store), 20Y1 $205 millions. ** Required: Calculate the stage of completion for each year of the contract and show how revenues, costs and profits will be recognised in each year.

6. Question 2: Answer Stage of Completion 154.20* 50.80 (205m – 154.2m) 205.00 ($52.52 / $202) 74% 18,000 ($154.2-$2.5)/$205 20,000 20,000 Material stored on site for use next year *The contract cost incurred at the end of year = accumulated figure (20x9 +20y0) If you feel the question not clear, you could double check by 205 –52.52. The contract cost incurred during that year = not accumulated figure

7. Question 2: Answer (Con’t) X neither 225m*26%=108m nor 202m*26%= ($225m x 74%) 166.5 151.7 14.8 109.30 99.18 10.12 ($205m x 74%) X 154.2 That is incurred but not completion 154.2-52.52-2.5 166.5 151.70 14.80 58.5 53.30 5.20

8. Question 2: Explain in three scenario First year Second year Third year 26% 48% 26% If the total revenue is $220m, then $220m * 48% $220m *26% $220m *26% If the total revenue is $225m, then $225m * 48% $225m *26% $225m *26% If the total revenue is change from $220m to $225m meanwhile, then $220m *26% $225m * 48% $225m *26% ($225m *74%)= ($220m*26% +225m*48%) ($225m *74%)= ($225m*26% +225m*48%) Assumption: second year total sales correct To solve the problem regard change in total estimation on total revenue or cost, Please use the schedule that I teach you. Please refer the power point for format.

9. Question 3: Background Dr receivable Cr Progress billing 2.4 Construction contracts in the statement of financial position The accounting treatment of construction contracts is profit or loss driven. Any amount included in the statement of financial position is a balancing amount, calculated as: • Where an amount due from customers is calculated, this is normally shown within inventories. • Where an amount due to customers is calculated, this is normally shown as ‘payments on account’ within payables. • Any amount invoiced but unpaid is shown as a receivable*.

10. Question 3 Change in estimates HKAS 8- the effect of any change in the estimate of contract revenue, costs or the outcome of a contract should be treated as a “change in accounting estimate”. Example: Change in estimates The example below shows the effect of a change in estimate of costs on the figures that appear in the statement of comprehensive income and statement of financial position Junket Co enters into a three- year contract. Estimated total revenue = $100,000 Estimated total cost= $ 70,000 However, during Year 2 , management revises its estimate of total costs incurred and thus the outcome of the contract. As a result, during Year 2, a loss is recognized on the contract for the year, even though the contract will still be profitable overall. This case is not total overall loss. This case is overall profit

11. Question 3 (Con’t) (60,000+20,000) Change in estimate (42,000+28,000) 60,000 80,000 100,000*0.6 -42,000 100,000*0.25 -(80,000-20,000) 100,000*0.15 -(60,000-42,000) Not 80,000*0.15 Progress billing of 50,000 , 30,000 and 20,000 are made on the last day of each year, and are received in the first month of the following year. The asset at the end of each year is. (a) Prepare schedule between Year 1 and Year 3 and disclosure. 100,000*0.75 -80,000*0.75

12. Question 3: Answer

13. Question 3: Answer (Con’t) *Disclosure represents “accumulate amount”. It is not just that current year amount. $60,000* $80,000 $20,000(23,000-3,000) $15,000(18,000-3,000) $75,000 $60,000 $100,000 $80,000 ($5,000) 0 --- ($5,000) In addition, at each year end, the company recognizes a “Trade Receivable” for the amount outstanding at the end of the year of of $50,000, $30,000 and $20,000. (Dr AR Cr Progress Billings)

14. Question 3: Explain in three scenario First year Second year Third year 60% 15% 25% If the total cost is $70,000, then $70,000 * 15% $70,000 *25% $70,000 *60% If the total revenue is $80,000 m, then $ 80,000 * 15% $ 80,000 *25% $ 80,000 *60% If the total revenue is change from $70,000 to $80,000 meanwhile, then $70,000 *26% $80,000m * 15% $80,000 *25% ($80,000 *75%)= ($70,000*60% +80,000*15%) ($80,000 *75%)= ($80,000*60% +80,000*15%) Assumption: second year total sales correct To solve the problem regard change in total estimation on total revenue or cost, Please use the schedule that I teach you. Please refer the power point for format.

15. Double entry for 3 years • Material Purchases • Dr WIP –FP 42,000 (Y1) , 18,000 (Y2) ,20,000 (Y3) • Cr Cash 42,000 (Y1) , 18,000 (Y2) ,20,000 (Y3) • Recognized in I/S • Cr Contract revenue –I/S 60,000 (Y1) , Cr15,000 (Y2) , 25,000 (Y3) • Dr Contract cost -I/S 42,000 (Y1), Dr18,000 (Y2),20,000 (Y3) • Dr WIP -FP 18,000 (Y1) , Cr 3,000 (Y2) , Dr 5,000 (Y3) -- Balance figure • Progress • Dr AR 50,000 (Y1),30,000 (Y2) ,20,000 (Y3) • Cr Progress Billing 50,000 (Y1),30,000 (Y2), 20,000 (Y3)

16. Question 4: Self test question 1 The main business of Hing Yip Co is construction contracts. At the end of September 20x9 there is an uncompleted contract on the books, details of which are as follows: Contract A • Date commenced: 1 April 20x7 • Expected completion date: 23 December 20x9 • Final Contract price $420,000 • Costs to 30 September 20x9 $315,000 • Value of work certified to 30 September 20x9 $357,000 • Progress billings to 30 September 20x9 $310,000 • Cash received to 30 September 20x9 $298,000 • Estimated costs to completion at 30 September 20x9 $30,600 ** Prepare calculations showing the amount to be included in the statement of financial position at 30 September 20x9 in respect of above contract, assuming that the stage of completion is assessed based on work certified.

17. Question 4: Self test question 1: Answer Stage of Completion: $357,000 / $420,000*100% = 85% Dr. Contract Cost $315,000 Contract WIP $42,000 Cr. Contract Revenue $357,000 Dr. Cash $298,000 Accounts Receivable $12,000 Cr. Progress Billings $310,000 Dr. Contract WIP $315,000 Cr. Cash $315,000 You can not make double entry as the information is not sufficient. For example, you don’t know the previous double entry. So how can you know the % of work you complete this year. The estimated final profit is: Final contract price 420,000 Less: costs to date 315,000 estimated future costs 30,600 Estimated final profit 74,400 No accumulated figure in double entry Attributable profit = Estimated profit x Work certified*/Total contract price $74,400 total profit x $357,000/$420,000 = $63,240 Estimated accumulated profit at Sept 2009 *Notified customer

18. Question 4: Answer (Con’t) $ Costs to date 315,000 Attributable profit 63,240 Less: Progress billings 310,000 Amount due from customers 68,240

19. Question 5: Self-test question 2 Aero company has the following information in respect of a construction contract: Total contract price-----------------------------$100,000 Cost incurred to date---------------------------$48,000 Estimated cost to completion-----------------$32,000 Progress billings---------------------------------$58,000(of which $50,000 has been received) Percentage complete (cost basis)-----------60% ** Required: • Prepare relevant extracts from the statement of comprehensive income and statement of financial position • Show how the statement of financial position would differ if progress billings were $64,000 (of which $50,000received)

20. Self-test question 2 Question 5: Answer Or Accounts Receivable (48,000+12,000)

21. Question 5: Answer (Con’t) Self-test question 2 Or Accounts Receivable $48,000+$12,000

22. Question 6:Exam practice: • (a) “It is not prudent to recognize profit on outstanding work in progress in construction contracts. Revenue and cost should be recognized upon completion of the construction work.’ • At 30 June 2009, Vertical Construction Company ("VC") had a fixed price constructioncontract in progress, named Waterfall Golf Villa, a project to construct 80condominium units. 60 units have been completed and the remaining 20 units areexpected to be completed in the last quarter of 2009. A survey of completedconstruction work will be carried out upon completion of all units. Construction wasbegun in April 2008 and the outcome of the contract could not be estimated reliably at30 June 2008. According to the original bid estimate, VC would have a profit marginof 20%. Based on the actual costs incurred and the latest information, there will bean increase in the estimated total costs because of a 15% increase in the price ofconstruction material. However, a loss is not anticipated. An instalment contractsum for the construction has been received by VC in accordance with the contractedpayment schedule. • Required: • (B)Explain how VC should account for this construction contract in the financialstatements for the year ended 30 June 2009.(7 marks)

23. Question 6:Exam practice answer • (a) “It is not prudent to recognize profit on outstanding work in progress in construction contracts. Revenue and cost should be recognized upon completion of the construction work.’ • Answer:The statement is incorrect. • Paragraph 37 of the Framework for the Preparation and Presentation of FinancialStatements states that "...Prudence is the inclusion of a degree of caution in the exercise ofthe judgments needed in or making the estimates required under the conditions ofuncertainty... However, the exercise of prudence does not allow, for example, the creation of • hidden reserves or excessive provision, the deliberate understatement of assets orincome, ... because the financial statements would not be neutral and therefore, not havethe quality of reliability." • HKAS 11.22 states that when the outcome of a construction contract can be estimatedreliably, contract revenue and contract costs associated with the construction contract shallbe recognised as revenue and expenses respectively by reference to the stage ofcompletion of the contract activity at the end of reporting period.

24. Question 6:Exam practice answer • HKAS 11.25 states that the recognition of revenue and expenses by reference to the stageof completion of a contract is often referred to as the percentage of completion method. • Under this method, contract revenue is matched with the contract costs incurred inreaching the stage of completion, resulting in the reporting of revenue, expenses and profitwhich can be attributed to the proportion of work completed. • This method provides useful information on the extent of contract activity and performanceduring a period. • Even when the outcome of a construction contract cannot be estimated reliably, revenueshall be recognised only to the extent of contract costs incurred that it is probable will berecoverable and contract costs shall be recognised as an expense in the period in whichthey are incurred.(HKAS 11.32) • Under both circumstances, an expected loss on the construction contract shall berecognised as an expense immediately when it is probable that total contract costs willexceed total contract revenue. (HKAS 11.22, 32 and 36)

25. Question 6:Exam practice answer • B)It is considered that the outcome of the Waterfall Golf Villa construction contract can be estimated reliably as: • (a) the total contract revenue can be measured reliablyevidence/indicator: contract sum has been agreed upfront between VC and theemployer. • (b) it is probable that the economic benefits associated with the contract will flow to theentity.evidence/indicator: VC has collected the contracted instalment from the employer ontime. • (c) both the contract costs to complete the contract and the stage of contract completionat the end of reporting period can be measured reliably. • evidence/indicator: the information given indicated that VC has reassessed the totalcosts against with the original bid estimate and forecast that the total cost wouldincrease because the price of construction material has been 15% higher than theprice in the budget. Besides, it is stated that 60 units have been completed and theremaining 20 units are expected to be completed in the last quarter of 2009. • (d) the contract costs attributable to the contract can be clearly identified and measuredreliably so that actual costs incurred can be compared with prior estimates.evidence/indicator: same as (c).

26. Question 6:Exam practice answer • B)The stage of completion of the contract may be determined by reference to:(a) the proportion that contract costs incurred for work performed to date bear to therevised estimated total contract costs. • (b) completion of a physical proportion of the contract work (i.e. 60 units completed and20 units in progress). • For the year ended 30 June 2009, the contract revenue and contract costs shall berecognised as revenue and expenses respectively by reference to the stage of completionas determined above at 30 June 2009 less the contract revenue and contract costs thatwere recognised in the prior year. • For the year ended 30 June 2008, revenue should have been recognised only to the extentof contract costs incurred that it is probable will be recoverable and contract costs shouldhave been recognised as an expense in the prior year in which they were incurred. • For financial statements presentation, where contract costs incurred to 30 June 2009 plusrecognised profits exceed (less than) progress billings, the surplus is shown as amountsdue from (to) customers for contract work. Amounts billed for work performed but not yetsettled by the customer are included in the statement of financial position as receivable,while amounts received before the related work is performed are included as a liability, asadvances received.