I.
II.
Introduction
A. Construction and Franchising Industries
1. Are among the fastest growing industries in the country
2. Construction Industries
a. Undeveloped property are converted either as:
1. Subdivisions; or
2. Condominium Buildings
b. Several roads and bridges are being built in various parts of the country
3. Franchising Industries
a. Several successful entities grant other entities and individuals to:
1. Operate using their trade names
2. Sell their products
b. Such an arrangement is called franchising
B. Transactions of a Construction of Company (or Contractor) and the Franchisor
1. Examples
a. Acquisition of Plant Assets
b. Materials
c. Payment of Operating Expenses
2. Accounted for in the same manner as those of a manufacturing firm or a
merchandising firm
C. Activities of a Construction Company
1. Incurrence of Material, Labor, and Overhead Costs
2. Billings to Customers
3. Collections from Customers
4. Recognition of:
a. Revenue
b. Cost of Revenue
c. Gross Profit
D. Transactions that are Peculiar to the Franchisor
1. Receipt of Initial Franchise Fee
2. Rendering of Services to the Franchisee:
a. Initial
b. Continuing
Long-Term Construction Contracts
A. Nature and Types of Construction Contracts
1. Nature
a. Procedures in a Construction Project
1. Contractors are invited to bid for the project;
2. The specifications of the project are given to the bidders;
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3. Bidders will prepare an estimate of the costs that will be incurred on the
project;
4. Bid Price = Cost Estimates + Desired Profit;
5. The contract is awarded to the lowest bidder; or the contractor that bids the
lowest contract price based on the specification submitted by the contractee
or client
b. Construction Contract as Provided in PAS 11
1. Definition
a. Contract specifically negotiated for the construction of an asset (building
or a ship) or a combination of assets that are closely interrelated or
interdependent in terms of their (1) design, (2) technology, (3) function,
or their ultimate (4) purpose or (5) use
[complex pieces of plant or equipment]
b. As stated in paragraph 5:
1. Contracts for rendering of services which are directly related to asset
construction, such as
a. Project Managerial Services
b. Architectural Services
2. Contracts for:
a. Asset Destruction
b. Asset Restoration
c. Environment Restoration Following Asset Demolition
2. Treatment Guidelines (Single or Group)
a. When a contract covers a number of assets, the construction of each
asset should be treated as a separate construction contract when:
1. Separate proposals have been made for each asset
2. Each asset has been subject to separate negotiation and the
contractor and the customer have been able to accept or reject the
part of the contract relating to each asset
3. The costs and revenues of each asset can be identified
b. A group of contracts, whether with a single customer or with several
customers, should be treated as a single construction contract when: 1.
The group of contracts is negotiated as a single package
2. The contracts are so closely interrelated that they are, in effect, part
of a single project with an overall profit margin
3. The contracts are performed concurrently or in a continuous
sequence
c. A contract may provide for the construction of an additional asset at the
option of the customer or may be amended to include the construction of
an additional asset. The construction of an additional asset when:
1. The asset differs significantly in design, technology or function from
the asset or assets covered by the original contract
2. The price of the asset is negotiated without regard to the original
contract price
2. Types
a. Fixed Price Contract
1. Contractor agrees to a fixed:
a. Contact Price; or
b. Rate Per Unit of Output
2. In some cases, the agreed upon price or unit rate is subject to cost escalation
clauses, which may provide for an increase in the original contract price if (a)
prices of construction materials or (b) costs of labor increase by a certain
percentage subsequent to contract signing
b. Cost-Plus Contract
1. Contractor is reimbursed for:
a. Allowable or otherwise defined costs;
b. Plus:
1. A percentage of allowable or otherwise defined costs; or
2. A fixed fee
2. Some contracts, however, contain characteristics of both types, such as a cost
plus contract with an agreed maximum price
B. Contract Revenue and Contract Costs
1. Contract Revenue
a. PAS No. 11 defines contract revenue as the initial amount of revenue agreed in
the contract and variations in contract work, claims, and incentive payments.
b. Composition:
1. Bid (Contract) Price
a. Initial amount of revenue agreed in the contract
b. Submitted by the contractor during the bidding process
2. Variations in Contract Work
a. Instruction by the customer for a change in the scope of the work to be
performed under the contract
b. It may:
1. Increase the original contract revenue
2. Decrease the original contract revenue
c. It includes changes in:
1. Asset Specifications
2. Asset Design
3. Contract Duration
d. Included in contract revenue when:
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1. It is probable that the customer will approve (a) the variation and
(b) the amount of revenue arising from the variation
2. The amount of revenue can be measured reliably
3. Claims
a. Amount that the contractor seeks to collect from (1) the customer or (2)
another party as reimbursement for costs excluded in the contract price
b. May arise from:
1. Customer Caused Delays
2. Disputed Variations in Contract Work
3. Errors in:
a. Specifications
b. Design
c. Included in contract revenue when:
1. Negotiations have reached an advanced stage such that it is probable
that the customer will accept the claim
2. The amount of the probable claim can be measured reliably
4. Incentive Payments
a. Additional amount paid to the contractor if
1. Specified Performance Standards are:
a. Met
b. Exceeded
2. The Contract is Completed Early
b. Included in contract revenue when:
1. The contract is sufficiently advanced that it is probable that the
specified performance standards will be (a) met or (b) exceeded
2. The amount of incentive payment can be measured reliably
2. Contract Costs
a. Costs that are incurred in the construction project
b. Contract Cost Groups:
1. Costs that relate directly to the specific contract
a. Site Labor Costs, including Site Supervision
b. Cost of Materials Used in Production
c. Depreciation of Plant and Equipment Used on the Contract
d. Costs of Moving Plant, Equipment and Materials To and From the
Contract Site
e. Costs of Hiring Plant and Equipment
f. Costs of Design and Technical Assistance that is Directly Related to the
Contract
g. Estimated Costs of Rectification and Guarantee Work, including
Expected Warranty Costs
h. Claims from Third Parties
2. Costs that are attributable to contract activity in general and can be
allocated to the contract a. Insurance
b. Costs of Design and Technical Assistance that is Indirectly Related to the
Contract
c. Construction Overheads such as Cost of Preparing and Constructing Personnel Payroll
3. Such other costs as are specifically chargeable to the customer
(reimbursable) under the terms of the contract a. General Administration
Costs
b. Development Costs
C. Construction Contract Terminologies
1. Contract Price
a. Price agreed upon by the contractor and the client for the construction of a
specific project
b. Represents Contract Revenue
2. Cost Incurred To Date – actual cumulative construction costs incurred by the contractor
from the time the project started up to a particular balance sheet date
3. Estimated Cost To Complete
a. Additional construction costs reasonably expected to be incurred to complete the
project
b. Made by engineers at every balance sheet date
4. Total Estimated Cost
a. Cost Incurred To Date + Estimated Cost to Complete
b. Total Estimated Cost upon completion of the project
5. Total Estimated Gross Profit
a. Contract Price – Total Estimated Cost; where CP > TEC
b. Excess of contract price over total estimated cost
6. Total Estimated (Anticipated) Loss
a. Total Estimated Cost – Contract Price; where TEC > CP
b. Excess of total estimated cost over contract price
D. Accounts Used By a Construction Company
Account Title Used
Construction in Progress
Accounts Receivable
Progress Billings on Construction Contracts
Revenue from Long-Term Construction
Contracts
Cost of Long-Term Construction Contracts
Nature of Account
Asset (Inventory)
Asset (Receivable)
Liability [Deferred (Unearned)
Revenue]
Revenue
Expense
Normal
Balance
Debit
Debit
Credit
Credit
Debit
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1. Measured at the fair value of the consideration:
a. Received
b. Receivable
2. Affected by some uncertainties that depend on the outcome of future events
3. Estimates may need to be revised as:
a. Events occur
b. Uncertainties are resolved
4. Some items that affect measurement of revenue, as previously discussed
a. Variations in Contract Work
b. Claims
c. Incentives
G. Recognition of Contract Revenue and Expenses
1. PAS no. 11 Guidelines
a. When the outcome of a construction contract can be estimated reliably:
1. Use the percentage-of-completion method
2. How to tell when construction contract outcomes are reliably
estimable (NOTE: ALL CONDITIONS MUST BE SATISFIED) a. Fixed Price
Contract
1. Total (a) contract and (b) revenue can be measured reliably
2. It is probable that the economic benefits associated with the contract
will flow to the enterprise (i.e., there is reasonable assurance as to
the collectability of the contract price)
3. Both (a) the contract costs to complete the contract and (b) the stage
of completion at the statement of financial position date can be
measured reliably
4. The contract costs attributable to the contract can be (a) clearly
identified and (b) measured reliably so that actual contract costs
incurred can be compared with prior estimates
b. Cost-Plus Contract
1. It is probable that the economic benefits associated with the contract
will flow to the enterprise (i.e., there is reasonable assurance as to
the collectability of the contract price)
2. The contract costs attributable to the contract, whether or not
specifically reimbursable, can be clearly identified and measured
reliably
b. When the outcome of a construction contract cannot be estimated reliably:
1. Use the cost recovery method
2. Revenue should be recognized only to the extent of contract costs incurred
that it is probable will be recoverable
3. Contract costs should be recognized as expense in the period in which they
are incurred
c. The completed contract method is not generally accepted under PAS No 11
2. Percentage-of-Completion Method
a. Recognition Guidelines
1. Contract Revenue, Cost of Contract Revenue, and Gross Profit
a. Recognized by contractor as the work progresses proportionate to the
work completed
b. Recognized as revenue (expense) in the income statement in the
accounting period in which the work is performed (related revenue is
recognized)
2. Anticipated loss
a. Should be recognized in full in the period it is determined
b. Occurs when Contract Price < Total Estimated Cost
3. Operating expenses – recognized in the income statement in the period they
are incurred
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b. Determining the Percentage of Completion of the Contract
1. Input Method
a. Also known as Cost-to-cost Method
b. The proportion that contract costs incurred for work performed to date
bear to the estimated total contract costs
c. Most popular method whereby the basis of measurement is the ratio of
cost incurred to date to the total estimated cost
d. Cost of revenue is equal to actual cost incurred
2. Output Method
a. Also known as Architect’s or Engineer’s Estimates
b. Based on:
1. Surveys of work performed
2. Completion of a physical proportion of the contract work
c. Cost of revenue may not equal actual cost incurred
c.
Procedures Followed in Applying the Percentage-of-Completion Method (At the
End of Each Accounting Period)
1. A schedule is prepared showing the total estimated costs, total estimated gross
profit (loss), and the percentage of completion
2. A schedule is prepared showing the computation of revenue, cost of revenue, and gross profit to be
recognized
(a)
(b)
(c)
Recognized Revenue
Cost of Revenue
Gross Profit (Loss)
= Contract Price x Percentage of Completion
= Total Estimated Cost x Percentage of Completion
= Gross Profit (Loss) x Percentage of Completion, or (a) - (b)
3. A journal entry is prepared to record:
a. Revenue, Cost of Revenue, and Gross Profit (Loss) recognized for that
period
b. Upon completion of the project, to close the balances of:
1. Construction in Progress
2. Progress Billings on Construction Contracts
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d. Key Theories
1. The Construction in Progress account
a. The gross profit (loss) recognized each year is debited (credited) to the
account, thereby increasing (decreasing) its balance
b. Balance:
1. Is composed of:
a. Cost incurred to date
b. Gross profit (loss) to date
2. Also represents the revenue to date
2. The amount of revenue, cost of revenue, and gross profit (loss) to be
recognized in the current year are the respective balances to date less the
amount recognized in prior year/s. In the case the anticipated losses,
immediate recognition (or recognition in full) is required
3. Upon completion of the project and full billings to the customer, the balance
of the Progress Billings on Construction Contract will be equal to the total
contract revenue. On one hand, the balance of the Construction in Progress
account will also equal to the total contract revenue since both contract costs
and gross profit (loss) on the contract are recorded in the account. The
balances of these two accounts relating to a particular project must be closed
upon completion of such project
e. Financial Statement Presentation and Disclosures
1. Financial Statement Presentation
a. Since the operating cycle of a construction company that emphasizes
long-term construction contracts is generally more than one year, the
statement of financial position (balance sheet) accounts related to
construction activities are classified as current
b. Accounts Receivable is reported as a current asset
c. Balance of Construction in Progress and Progress Billings on
Construction Contracts
1. Are reported net, either as current asset or as current liability
2. When the balance of Construction in Progress is more than (less than)
the balance of the Progress Billings on Construction Contracts
account, they are reported under the current assets (liabilities)
section
3. The balances of the two accounts for individual projects must be
determined for proper financial statement presentation
4. A net debit balance in one project must not be offset against a net
credit balance in another project
2. Disclosures (either parenthetically or in the notes, as required by PAS No 11)
a. Amount of:
1. Contract revenue recognized as revenue in the period
2. Advances received for each contract in progress
3. Retentions [amount of progress billings which are not paid until (a)
the satisfaction of conditions specified in the contract for payment of
such amounts or until (b) defects have been rectified] for each
contract in progress
b. Methods Used To Determine:
1. Contract revenue recognized in the period
2. Stage of completion of contracts in progress
c. Aggregate Amount of:
1. Costs Incurred To Date For Each Contract in Progress
2. Recognized Profit (Less Recognized Losses) To Date For Each
Contract in Progress
f. Anticipated Loss on Long-term Construction Contracts
1. When it is probable that total contract costs for a particular project will
exceed total revenue, the expected or anticipated loss should be recognized
as expense immediately, that is, in the period it is determined
2. PAS No. 11, paragraph 37 provides that the amount of loss is determined
irrespective of:
a. Whether or not work has commenced on the contract
b. The stage of completion of contract activity
c. The amount of profits expected to arise on other contracts
g. Accounting For Contract Change Orders
1. Contract Change Orders
a. Instances when modifications in the original contract price are made as
intended by either (a) the contractor or (b) the customer
b. Include Changes in:
1. Specifications
2. Designs
3. Method of Performance
4. Manner of Performance
5. Facilities
6. Equipment 7
7. Materials
8. Etc.
2. Accounting Treatment
a. Affected elements:
1. Contract Price
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2. Cost of Construction
b. Considered as changes in estimates that will affect:
1. Current Period
2. Current and Future Periods
3. Cost Recovery Method
a. Used when the outcome of a contract cannot be estimated reliably
b. Revenue is recognized only to the extent of the contract costs incurred that is
probable of recovery (may be < actual cost incurred to date)
1. If Actual Cost Incurred To Date > Probably Recoverable Contract Costs, the
difference would be recognized as a loss
2. If Actual Cost Incurred To Date < Probably Recoverable Contract Costs, the
difference would be ignored since recognizing such would lead to a gross
profit, which would violate the cost recovery (zero-profit) method
c. Examples of circumstances in which the recoverability of contract costs may not
be probable, as enumerated by PAS No. 11
1. Contracts which are not fully enforceable, that is, their validity is seriously in
question
2. Contracts in which their completion is subject to the outcome of pending
litigation or legislation
3. Contracts relating to properties that are likely to be condemned or
expropriated
4. Contracts wherein customers are unable to meet their obligations
5. Contracts where contractor is unable to complete the contract or otherwise
meet its obligations under the contract
d. When the uncertainties that prevented the reliable estimation of the outcome of
the contract no longer exist, revenue and expenses associated with the
construction contract should be recognized using the percentage-of-completion
method
e. Journal entries for the cost recovery method is the same as in percentage-of
completion method, except for the amount of revenue and profit to be
recognized