Accounting for

Long Term
Construction Contracts
 A construction contract is defined in PAS 11 as a
contract specifically negotiated for the construction of an asset or
Nature of a combination of assets that are closely interrelated or
interdependent in terms of their design, technology and function
Construction or their ultimate purpose or use.
Contracts Examples are construction of roads, bridges, buildings,
aircrafts, machineries and equipments.
 Types of Construction Contracts
Fixed price contract is a construction contract in which a contractor agrees to
Fixed a fixed contract price, or a fixed cost per unit of output, which in some cases
Price is subject to cost escalation clauses.
Contract

Cost-plus contract is a construction contract wherein the contractor is

Cost Plus
reimbursed for allowable or otherwise defined costs, plus a percentage of
Price
these costs or a fixed fee.
Contract

Remember that it is possible that a contract contains characteristics of both types, such as a cost-plus contract
with an agreed maximum price.
 Construction Revenue and Contract Cost
Contract revenue is the initial amount of revenue agreed in the contract and variations in
Construction contract work, claims and incentive payments. The initial amount of revenue is the bid price
submitted by the contractor during the bidding process and is usually called contract price.
Revenue

Contract costs are costs incurred in the construction of the project. These are grouped as
Construction follows:
Cost
a. Costs that relate directly to the specific contract (such as direct material, direct
labor and variable overhead);

b. Costs that are attributable to contract activity in general and can be allocated
to the contract (such as depreciation, insurance, indirect labor, cost of design, cost of
hiring plant and equipment)

c. Such other cost as are specifically chargeable to the customer under the terms of
the contract (such as general administration costs and development costs for which
reimbursement is specified in the terms of the contract).
 Construction Contract Terminologies
• Contract price - price agreed upon by the contractor and the client for the construction of a specific
project. It represents the contract revenue.

• Cost incurred to date - the cumulative cost of construction incurred by the contractor from the time the
project started up to a particular statement financial position (balance sheet) date.

• Estimated cost to complete - the additional cost of construction reasonably expected to be incurred to
complete the project. The engineer makes an estimate of the cost to complete the project at every statement of
financial position date.

• Total estimated cost - the sum of the cost incurred to date and the estimated cost to complete. It is the total
estimated cost upon completion of the project.

• Total estimated gross profit - the excess of the contract price over the total estimated cost.

• Total estimated (anticipated) loss - the excess of the total estimated cost over the total contract price.
 Accounts used by a construction company

Account Title Used Nature of Account Normal Balance

Construction in Progress Asset (Inventory) Debit
Accounts Receivable Asset (Receivable) Debit
Progress Billings on
Liability (Unearned Revenue) Credit
Construction Contract
Revenue from Long-term
Revenue Credit
Construction Contracts
Cost of Long term
Expense Debit
Construction Contracts
 Construction Activities
1. Construction Materials XXX
Cash XXX
To record purchase of construction materials.

2. Construction in Progress XXX

Construction Materials XXX
To record cost of materials incurred in construction.

3. Construction in Progress XXX

Payroll XXX
To record cost of construction labor.

4. Construction in Progress XXX

Cash XXX
To record payment of construction overhead costs.
 Construction Activities

5. Construction in Progress XXX

Accrued Expenses/ Various Accounts XXX
To record other construction overhead costs.

6. Accounts Receivable XXX

Progress Billings on Construction Contracts XXX
To record billings to customers.

7. Cash XXX
Accounts Receivable XXX
To record collections from customers.
 Contract revenue is measured at the fair value of the consideration
Measurement received or receivable. The measurement of contract revenue,
however, may be affected by some uncertainties that depend on the
of Contract outcome of future events and estimates made may need to be revised
as events occur and uncertainties are resolved. Some items that may
Revenue affect the measurement of revenue are variations in contract work,
claims and incentives.
 Recognition of Contract
Revenue and Expenses
PAS No. 11 provides the following guidelines in the recognition of contract revenue and expenses:

Percentage-of-Completion Method. When the outcome of a construction contract can be estimated reliably, and the
contract revenue and contract costs associated with the construction contract should be recognized as revenue and
expenses by reference to the stage of completion of the contract activity at the statement of financial position date.
Simply stated, the revenue is recognized under the “as earned approach” based on the proportion of the work done

Cost Recovery Method. When the outcome of a construction contract cannot be estimated reliably:

a) Revenue should be recognized only to the extent of contract costs incurred that it is probable will be recoverable;
and
b) Contract costs should be recognized as expense in the period in which they are incurred
 In case a fixed price contract, the outcome of construction contract can be estimated reliably when all of the
following conditions are satisfied:

1. Total contract 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 a reasonable assurance as to the collectability of the contract price);
3. Both the contract costs to complete the contract and the stage of contract completion at the statement of
financial position date can be measured reliably; and
4. The contract costs attributable to the contract can be clearly identified and measured reliably so that actual
contract costs incurred can be compared with prior estimates.

In the case of a cost-plus contract, the outcome of a construction contract can be estimated reliably when all
of the following conditions are satisfied:

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); and
2. The contract costs attributable to the contract, whether or not specifically reimbursable, can be clearly
identified and measured reliably,
 Percentage of Completion Method

Under the percentage-of-completion method, the contractor recognizes revenue, cost of revenue and gross
profit as the work progresses proportionate to the work completed. Thus, contract revenue is recognized
as revenue in the income statement in the accounting period in which the work is performed while the
costs are usually recognized as an expense in the accounting period in which the related revenue is
recognized, that is, in the period the work to which they relate is performed. Any anticipated loss,
however, should be recognized in full in the period it is determined. Operating expenses are
recognized in the income statement in the period they are incurred.
Since the recognition of profit is made periodically based on the progress of work toward completion, the
measurement of percentage-of-completion is very important.
PAS No. 11 provides that the stage of completion of a contract may be determined using any of the following methods:

1. The proportion that contract costs incurred for the work performed to date bear to the total estimated costs
(cost-to-cost method). This is the most popular method whereby the basis of measurement is the ratio of the costs
incurred to date to the total estimated cost.
2. Surveys of work performed (architect’s or engineer’s estimates).
3. Completion of a physical proportion of the contract work (architect’s or engineer’s estimates).

In applying the percentage-of-completion method, the following procedures are followed:

1. A schedule is prepared showing total estimated cost, total estimated gross profit (loss), and the percentage of
completion at the end of each accounting period.
2. A schedule is prepared showing the computation of revenue, cost of revenue, and gross profit to be recognized each
year.

At the end of each accounting period, a journal entry is prepared to record the revenue, cost of revenue, and gross profit
recognized for that period. Another entry is prepared upon completion of the project to close the balances of the
Construction in Progress and Progress Billings on Construction Contracts accounts.
Following are the pro-forma journal entries:

1. To record recognized revenue, cost of revenue and gross profit:

Cost of Long Term Construction Contracts XXX
Construction in Progress XXX
Revenue from Long Term Construction Contracts XXX

2. To record recognized revenue, cost of revenue and anticipated loss:

Cost of Long Term Construction Contracts XXX
Construction in Progress XXX
Revenue from Long Term Construction Contracts XXX

3. To close the balances of construction in progress and progress billings on construction contracts:
Progress Billings on Construction Contracts XXX
Construction in Progress XXX
Illustrative Problem A: The Quality Builders Co. is awarded a contract in 2014 to construct a ten-storey
building at a total contract price of P40,000,000. The project is completed in three years. The company
uses the cost-to-cost method in estimating the percentage of work completed. Data relating to the project
follow

Estimated Cost to Billings to

Year Cost Incurred Collections
Complete Customers
2014 P 8,000,000 P 24,000,000 P 7,000,000 P 6,000,000
2015 10,000,000 12,000,000 14,000,000 13,000,000
2016 13,000,000 19,000,000 21,000,000
Step 1 – Prepare a schedule of total estimated cost, total estimated gross profit and percentage of
completion using the cost-to-cost method.

2006 2007 2008

a. Contract price P 40,000,000 P 40,000,000 P 40,000,000
b. Cost incurred to date P 8,000,000 P 18,000,000 P 31,000,000
c. Estimated cost to
24,000,000 12,000,000 ____-_____
complete
d. Total estimated cost (b
P 32,000,000 P 30,000,000 P 31,000,000
+ c)
e. Total estimated gross
P 8,000,000 P 10,000,000 P 9,000,000
profit (a - d)
f. Percentage of
25% 60% 100%
completion (b ÷ d)
 Step 2 – Determine the amount of revenue, cost of revenue and profit to be recognized each year.

Recognized in Prior To be Recognized in

2014 To Date
Year/s Current Year
Recognized revenue
P10,000,000 - P10,000,000
(P40,000,000 x 25%)
Cost of revenue
__8,000,000 - __8,000,000
(P32,000,000 x 25%)
Gross profit
P 2,000,000 - P 2,000,000
(P8,000,000 x 25%)
 Step 2 – Determine the amount of revenue, cost of revenue and profit to be recognized each year.

Recognized in prior To be recognized in

2015 To date
years current year
Recognized revenue
P24,000,000 P10,000,000 P14,000,000
(P40,000,000 x 60%)
Cost of revenue
_18,000,000 __8,000,000 _10,000,000
(P30,000,000 x 60%)
Gross profit
P 6,000,000 P 2,000,000 P 4,000,000
(P10,000,000 x 60%)
 Step 2 – Determine the amount of revenue, cost of revenue and profit to be recognized each year.

Recognized in prior To be recognized in

2016 To date
years current year
Recognized revenue
P40,000,000 P24,000,000 P16,000,000
(P40,000,000 x 100%)
Cost of revenue
_31,000,000 _18,000,000 _13,000,000
(P31,000,000 x 100%)
Gross profit
P 9,000,000 P 6,000,000 P 3,000,000
(P9,000,000 x 100%)
 Key observations from the illustration
1. The three components of income were computed based on the following formulas:

(a) Recognized revenue = Contract price x percentage of completion

(b) Cost of Revenue = Total estimated cost x percentage of completion
(c) Gross Profit = Total estimated gross profit x percentage of completion, or
= (a) - (b)

2. Under the cost-to-cost method, cost of revenue is equal to actual cost incurred.

3. The amount of revenue to be recognized in the current year is the revenue to date less the amount recognized in
prior year/s.

4. If the engineer’s or architect’s estimate is used in determining the percentage of completion, the same formula
given in (a) will be used. However, the cost of revenue may not equal actual cost incurred.
 Key observations from the illustration

5. The gross profit recognized each year is debited to the account “Construction in Progress” thereby increasing
the balance of the said account. Therefore, the balance of the Construction in Progress account is composed of the cost
incurred to date and the gross profit to date. The balance also represents the revenue to date.

6. 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 be equal to the total contract revenue since both contract costs and gross profit or 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.
The entries to record the construction activities and the recognition of revenue, cost of revenue, and
gross profit each year are as follows:

2014 2015 2016

Debit Credit Debit Credit Debit Credit
Construction in progress 8,000,000 10,000,000 13,000,000
Cash, Materials, etc. 8,000,000 10,000,000 13,000,000
To record costs incurred.

Accounts Receivable 7,000,000 14,000,000 19,000,000

Progress Billings on Construction 7,000,000 14,000,000 19,000,000
Contracts
To record billings in customers

Cash 6,000,000 13,000,000 21,000,000

Accounts Receivable 6,000,000 13,000,000 21,000,000
To record collections from
customers
 2014 2015 2016
Debit Credit Debit Credit Debit Credit
Cost of Long-Term Construction 8,000,000 10,000,000 13,000,000
Contracts
Construction in Progress 2,000,000 4,000,000 3,000,000

Revenue from Long-Term 10,000,000 14,000,000 16,000,000

Construction Contracts
To record periodic profit on the
project.

Progress Billings on Construction 40,000,000

Contracts
Construction In Progress 40,000,000

To close the balances of the

two accounts upon completion
of the project.
 Financial Statement Presentation and Disclosure

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 the construction activities are classified as current.

Accounts Receivable – current asset

Construction in Progress & Progress Billings, net – either current asset or current liability
CIP > PB – current asset
PB > CIP – current liability

Using the data in Illustrative Problem A, a portion of the statements of financial position prepared at the end of 2014 and 2015 appear
below:

2014 2015
Current Assets
Accounts Receivable 1,000,000 2,000,000
Construction in Progress 10,000,000 24,000,000
Less Progress Billings 7,000,000 3,000,000 21,000,000 3,000,000
 Financial Statement Presentation and Disclosure

At the end of 2016, all of the three preceding accounts will have zero balances as far as the particular project is concerned.

On the other hand, partial income statements prepared for the years 2014, 2015 and 2016 appear as follows:

2014 2015 2016

Revenue from long-term construction P10,000,000 P14,000,000 P16,000,000
contracts
Less: Cost of long-term construction 8,000,000 10,000,000 13,000,000
contracts
Gross Profit 2,000,000 P4,000,000 P3,000,000
 Financial Statement Presentation and Disclosure

PAS 11 requires the following information to be disclosed in the financial statements of the contractor, either parenthetically
or in the notes to financial statements:

1. The amount of contract revenue recognized as revenue in the period;

2. The methods used to determine the contract revenue recognized in the period;
3. The methods used to determine the stage of completion of contracts in progress;
4. The aggregate amount if costs incurred and recognized profits (less recognized losses) to date for each contract in
progress;
5. The amount of advances received for each contract in progress; and,
6. The amount of retentions for each contract in progress. Retentions are amounts of progress billings which are not paid
until the satisfaction of conditions specified in the contract for payment of such amounts or until defects have been
rectified.
 Anticipated Loss in Long Term
Construction Contracts
When it is probable that total contract costs for a particular project will exceed total contract revenue. The expected or anticipated loss
should be recognized as expense immediately irrespective of:

1. whether or not work has commenced on the contract;

2. the stage of completion of contract activity; or
3. the amount of profits expected to arise on other contracts.

Illustrative Problem B. Assume the following information pertaining to a project accepted by Quality Builders Co. at a total contract
price of P20,000,000:

2014 2015 2016

Cost incurred P6,000,000 P10,000,000 P9,000,000
Estimated cost to complete 12,000,000 8,000,000 -
 Anticipated Loss in Long Term
Construction Contracts
The total estimated gross profit (loss) at the end of each year is computed as follows:

2014 2015 2016

Contract price P20,000,000 P20,000,000 P20,000,000
Cost incurred to date P6,000,000 P16,000,000 P25,000,000
Estimated cost to complete 12,000,000 8,000,000
Total estimated cost P18,000,000 P24,000,000 P25,000,000
Total estimated gross profit
(loss) P2,000,000 (P4,000,000) (P5,000,000)

The profit (loss) to be recognized each year will be determined as follows:

a) Determine percentage of completion at the end of each year:
2014 = 6,000,000/18,000,000 = 33 1/3%
2015 = 16,000,000/24,000,000 = 66 2/3%
2016 = 25,000,000/25,000,000 = 100%
b) Determine revenue, cost of revenue and gross profit (loss) at the end of each year

To be recognized in
2014 To date Recognized in prior years
current year
Recognized revenue(20,000,000 x 33 1/3%) P6,666,667 - P6,666,667
Cost of revenue (18,000,000 x 33 1/3%) 6,000,000 - 6,000,000
Gross Profit (P2,000,000 x 33 1/3%) P666,667 - P666,667

Recognized in prior years To be recognized in

2015 To date
current year
Recognized revenue (20,000,000 x 66 2/3%) P13,333,333 P6,666,667 P6,666,667
Cost of revenue 17,333,333* 6,000,000 11,333,333
Gross Profit (loss) (P4,000,000) P666,667 P4,666,667

*P4,000,000 (loss) + P13,333,333 (revenue) = P17,333,333

To be recognized in
2016 To date Recognized in prior years
current year
Recognized revenue (20,000,000 x 100%) P20,000,000 P13,333,333 P6,666,667
Cost of revenue (actual) 25,000,000 17,333,333 7,666,667
Gross Profit (loss) (P5,000,000) (P4,000,000) (P1,000,000)
c) The journal entries to record the profit (loss) at the end of the each year follows:

2014
Cost of Long-term Construction Contract 6,000,000
Construction in Progress 666,667
Revenue from Long-term Construction Contract 6,666,667

2015
Cost of Long-term Construction Contract 11,333,333
Construction in Progress 4,666,667
Revenue from Long-term Construction Contract 6,666,667

2016
Cost of Long-term Construction Contract 7,666,667
Construction in Progress 1,000,000
Revenue from Long-term Construction Contract 6,666,667
 Cost Recovery Method
a) Used when the outcome of a contract cannot be estimated reliably.
b) Revenue is recognition - only to the extent of the contract costs incurred.
c) Amount of collection is greater than the total costs incurred — revenue = costs incurred

Recognize loss immediately:

a) If total contract costs will exceed total contract revenues
b) Contract costs are not probable of being recovered.

Recovery of contract cost is not probable if:

a) Contracts that have questionable validity.
b) Contracts under pending of litigation or legislation.
c) Contracts relating condemned or excoriated properties.
d) Inability of contactor to neither complete the contract nor meet its obligations.
e) Insolvency of customers.
Illustrative Problem C

Assume the same information in Illustrative Problem A and with the following additional information:

1) In 2014, the outcome of the project cannot be estimated reliably because there is no reasonable assurance as to the collectability of
the contact price. The amount that is probable of being recovered is only P8, 000, 000, the cost incurred during the year.
2) In 2015, however, this uncertainty does not exist anymore.

Step 1 – Prepare a schedule of total estimated cost, total estimated gross profit and percentage of completion using the cost-to-cost
method.

2014 2015 2016

a. Contract price P40,000,000 P40,000,000 P40,000,000
b. Cost incurred to date P 8,000,000 P 18,000,000 P31,000,000
c. Estimated cost to complete __P 24,000,000__ __12,000,000__ ______-______
d. Total estimated cost ( b+ c) 32,000,000 P 30,000,000 P31,000,000
e. Total estimated gross profit ( a- d) P8,000,000 P 10,000,000 P 9,000,000
f. Percentage of completion 25% 60% 100%
 Step 2 – Determine the amount of revenue, cost of revenue and profit to be recognized each year.

To be recognized this
2014 To Date Recognized in prior year/s
year
Recognized revenue P8,000,000 - P8,000,000
Cost of revenue 8,000,000 - 8,000,000
Gross profit P 0 - P0

2015 To Date Recognized in prior year/s To be recognized this year

Recognized revenue (P 40,000,000 x 60%) P24,000,000 P8,000,000 P16,000,000
Cost of revenue (P 30,000,000 x 60%) 18,000,000 8,000,000 10,000,000
Gross profit (P 10,000,000 x 60%) P 5,500,000 P 2,500,000 P 3,000,000

2016 To Date Recognized in prior year/s To be recognized this year

Recognized revenue (P40,000,000 x 100%) P40,000,000 P24,000,000 P16,000,000
Cost of revenue (P31,000,000 x 100%) 31,000,000 18,000,000 13,000,000
Gross profit (P9,000,000 x 100%) P 9,000,000 P 6,000,000 P 3,000,000
Key Observations:

1. 2014 – Probable recovery of cost of P 8,000,000: revenue is also P 8,000,000.

a. If recoverable amount is only P 6,000,000, revenue is only P 6,000,000 (P
2,000,000 -recognized as a loss).
b. If the amount recoverable is P 10,000,000, revenue is only P 8,000,0000
(recognize only to the extent of recoverable contract costs incurred).
2. The percentage of completion in 2014 is disregarded in the computation of recognized revenue.
3. 2015 – Outcome of contract can already be estimated reliably, change from the cost recovery method
to the percentage-of-completion method.
4. Journal entries are similar under the percentage-of-completion method except for the amount of
revenue and profit 2014 -2016.