LONG TERM CONSTRUCTION CONTRACTS PROF MIRANDA

Construction contract - a contract specifically negotiated for the construction of an asset or a combination
of assets that are closely interrelated or interdependent in terms of their design, technology and function
or their ultimate purpose or use.

Fixed price contract - a construction contract in which the contractor agrees to a fixed contract price, or
a fixed rate per unit of output, which in some cases is subject to cost escalation clauses.

Cost plus contract - a construction contract in which the contractor is reimbursed for allowable or
otherwise defined costs, plus a percentage of these costs or a fixed fee.

Contract revenue - includes (a) Initial amount of revenue agreed in the contract; and (b) Variations in
contract work, claims and incentive payments: to the extent that it is probable that they will result in
revenue; and they are capable of being reliably measured.

The variations are included in the revenue when:

(a) It is probable that the customer will approve the variation/amount of revenue arising from variation
and (b) the amount of revenue can be measured reliably

The claims are included in the revenue only when:

(a) Negotiations have reached the advanced stage and it is probable that the customer will accept the
claim and (b) the amount probable to be accepted by the customer can be measured reliably

Incentive payments are included in the revenue when:

(a) The contract is sufficiently advanced that it is probable that the specified performance standards will
be met or exceeded and (b) the amount of incentive payments can be measured reliably

Contract costs - are (a) Costs specifically related to the contract; (b) general costs attributable to the
contract; and (c) such other costs specifically chargeable to the customer under the terms of the contract
(administrative costs, development costs etc.)

Examples of specific costs are:

a) site labor costs, including site supervision;
b) costs of materials used in construction;
c) depreciation of plant and machinery used on the contract;
d) costs of moving plant, equipment and materials to or from the site;
e) costs of hiring plant and equipment
f) costs of design and technical assistance that is directly related to the contract;
g) the estimated costs of rectification and guarantee work, including expected
warranty costs; and
h) claims from third parties

The above stated costs will be reduced any incidental income such as from sale of surplus materials,
wastes etc.

Costs that may be attributable to contract activity in general and can be allocated to specific
contracts include:
a) insurance;
b) costs of design and technical assistance that are not directly related to a specific contract; and
c) construction overheads

Examples of costs excluded from the contract costs are:

a) general administrative and development costs for which is reimbursement is not specified in
the contract;
b) selling costs;
Method of Recognizing Revenue in Construction Accounting:

A. Percentage of Completion (POC) Method - When the outcome of a construction contract can be
estimated reliably, contract revenue and contract costs associated with the construction contract
shall be recognized as revenue and expenses respectively by reference to the stage of completion
of the contract activity at the end of the reporting period.

Measuring Stage of Completion.

 Cost-to-cost Method - The proportion that contract costs incurred to date bears to
estimated total contract cost or Input method.
 Efforts-expended method - proportion of effort expended to date in comparison to the
total effort expected to be expended for the contract. Might be based on direct labor
hours, or machine hours, or material quantities.
 Survey of Work Performed Method (Output method)
 Completion of a Physical Proportion of Contract Work (also called units-of-work
performed) method. (Output method)

Note: Progress payments and advances received from customers often do not reflect the work
performed.

B. Cost Recovery Method – This method is used when the outcome of a contract can’t be estimated
reliably then:
a. Revenue shall be recognized to the extent of contract costs incurred that is probable will be
recoverable; and
b. Contract costs shall be recognized as an expense (costs of construction) in the period in which
they are incurred.

Recognition of expected or anticipated losses

When it is probable that total contract costs will exceed total contract revenue, the expected (or
anticipated) loss shall be recognized as an expense (or loss) immediately. The amount of such a
loss is determined irrespective of:
(a) Whether work has commenced on the contract;
(b) The stage of completion of contract activity; or
(c) The amount of profits expected to arise on other contracts which are not treated as a single
construction contract.

Illustration 1. Percentage of completion (POC)

ABC Construction Co. entered into a fixed price contract for the construction of a private road for XYZ, Inc.
ABC determines the stage of completion of construction contracts using the "cost to cost" method. The
estimated total contract cost is P10M. The following were the actual costs incurred by ABC during the first
year of the construction:

Costs on negotiating the contract (charged immediately as expense) 100,000

Cost of materials used in construction 3,000,000
Cost of materials purchased but not used in construction 500,000
Site labor costs 1,000,000
Site supervision costs 200,000
Depreciation of equipment used in construction 120,000
Depreciation of idle construction equipment 60,000
Costs of moving plant, equipment, and materials to and from the contract site 40,000
Cost of hiring plant and equipment 140,000
Advance payments to subcontractors (subcontracted work is not yet started) 20,000
Requirement: Compute for the POC of the contract as of the end of the first year. 45%
Illustration 2. Percentage of completion (POC)

ABC Construction Co. entered into a fixed price contract for the construction of a building for XYZ, Inc.
ABC determines the stage of completion of construction contracts using the "cost to cost" method.

The estimated total contract cost are as follows:

Estimated costs of design and technical assistance that are directly related to the
contract 200,000
Estimated costs of design and technical assistance that are not directly related to
the specific contract (properly allocated) 50,000

Estimated costs of materials to be used in the construction 5,500,000

Estimated costs of construction labor 2,800,000

Estimated costs of rectification and guarantee work, including expected warranty
costs 300,000
Estimated administrative costs expected to be reimbursed in accordance with
contractual agreement 130,000

Estimated insurance costs during construction 20,000

Estimated construction overheads 1,000,000

Estimated marketing costs for selling condominium units 100,000

Estimated total contract costs 10,100,000

The following were the actual costs incurred by ABC during the first year of the construction:

Costs of design and technical assistance that are directly related to the contract 100,000
Costs of design and technical assistance that are not directly related to the specific
contract (properly allocated) 25,000

Costs of materials used in the construction 3,000,000

Costs of construction labor 1,500,000

Administrative costs expected to be reimbursed in accordance with contractual
agreement 120,000

Administrative costs not expected to be reimbursed 30,000

Research and development costs for which reimbursement is not specified in the
contract 1,800,000

Insurance costs during construction 15,000

Construction overheads 240,000

Marketing costs 200,000

Total costs incurred to date 7,030,000

Requirement: Compute for the POC of the contract as of the end of the first year. 50%
Illustration 3. Percentage of completion (POC) - Estimated cost to complete

ABC Construction Co. entered into a contract for the construction of a flyover for XYZ, Inc in 2021.
Information on costs is as follows:

2021 2022
Cost incurred to date 400,000 1,500,000
Estimated cost to complete 1,600,000 375,000

Requirement: Compute for the POC of the contract as of December 31, 2021 and 2022. 20% and 80%

Illustration 4: Efforts-expended method

ABC Co. is contracted to construct an amusement park for XYZ, Inc. ABC subcontracted a large portion of
the contract. ABC uses the efforts-expended method in determining the stage of completion of the
contract. Information on efforts expended on the contract is shown below:

2021 2022
Total direct labors hours to date 400 1,500
Estimated direct labors hours to complete 1,600 375

Requirement: Compute for the POC of the contract as of December 31, 2021 and 2022. 20% and 80%

Illustration 5. Percentage of completion (POC) - Journal Entries

ABC Construction Co. entered into a fixed price contract for the construction of a gymnasium for XYZ, Inc.
The contract price is P9M. Construction was started in 2021 and was completed early in 2023. The
following transactions occurred during the construction period.

2021

a. Incurred total contract costs of P2,760,000

b. Billed XYZ for 50% of the contract price.
c. Collected 90% of the progress billing; 10% was retained by XYZ to be reverted to ABC upon
completion of the contract. The amount retained shall be used to rectify any unsatisfactory work to be
determined at the completion of the contract.
d. Estimated costs to complete as of December 31, 2021 are P4,140,000.

2022
e. Incurred total contract costs of P3,540,000.
f. Billed XYZ for 30% of the contract price.
g. Collected 90% of the progress billings after 10% retention by XYZ
h. Estimated costs to complete as of December 31, 2022 are P700,000

2023
i. Incurred total contract costs of P500,000.
j. Billed XYZ for the remaining 20% of the contract price. All receivables from XYZ were collected.
k. The construction contract was completed and ownership over the completed gymnasium was
transferred to XYZ, Inc.

Requirements:
a. Compute for the gross profit to be recognized in each year. 840K, 960K, 400K
b. Compute for the contract revenue to be recognized in each year. 3.6M, 4.5M, 900K
Illustration 6. ZERO PROFIT METHOD - Journal Entries
On January 1, 2021, ABC Construction Co. entered into a fixed price contract for the construction of a
specialized equipment for XYZ, Inc. The contract price is P9M. Construction was started in 2021 and was
completed early in 2023. The following transactions occurred during the construction period.

2021
a. Incurred total contract costs of P2,760,000
b. Billed XYZ for 50% of the contract price.
c. Collected 90% of the progress billing; 10% was retained by XYZ to be reverted to ABC upon completion
of the contract. The amount retained shall be used to rectify any unsatisfactory work to be determined
at the completion of the contract.
d. The outcome of the contract cannot be estimated reliably.

2022
e. Incurred total contract costs of P3,540,000.
f. Billed XYZ for 30% of the contract price.
g. Collected 90% of the progress billings after 10% retention by XYZ .
h. The outcome of the contract cannot be estimated reliably.

2023
i. Incurred total contract costs of P500,000.
j. Billed XYZ for the remaining 20% of the contract price. All receivables from XYZ were collected.
k. The construction contract was completed and ownership over the completed gymnasium was
transferred to XYZ, Inc.

Requirements:
a. Compute for the gross profit to be recognized in each year. ZERO, ZERO, 2.2M
b. Compute for the contract revenue to be recognized in each year. 2760K, 3540K, 2.7M

Illustration 7: EXPECTED LOSS - First year of contract

In 2021, ABC Co. started work on a P10M fixed price contract. All costs incurred are expected to be
recoverable. Information on the construction as of year-end is shown below:

Costs incurred 6,000,000

Estimated costs to complete 5,800,000

Requirement: Compute the profit and loss to be recognized by ABC in 2021. 1.8M LOSS

Illustration 8: EXPECTED LOSS - Second year of contract

In 2021, ABC Co. started work on a P1M fixed price contract. All costs incurred are recoverable. The
contract was completed in 2023. Information on the construction is shown below:

2021 2022 2022

Cost incurred to date 200,000 825,000 950,000
Estimated cost to complete 600,000 275,000 -
Estimated total contract costs 800,000 1,100,000 950,000
Progress billings to date 350,000 700,000 1,000,000

Requirement:
a. Compute the profit and loss to be recognized in each year under POC method. 50K, (150K), 150K
b. Compute for the contract revenue to be recognized in each year. 250K, 500K, 250K
c. Compute for the gross amounts of due from (due to) customers for contract work in each year. (100K),
25K, ZERO
d. Compute the profit and loss to be recognized in each year under Zero profit method. ZERO, (100K),
150K

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