Revenue Recognition - Contract with Customers: Construction Accounting 1. Introduction Generally, componies recognize revenue at the point of sole because that is when the performance obligation is satistied. Though, as indicated in IFRS (PFRS) 15, wherein under certain circumstances, companies recognize revenue over time. Under certain situations, companies recognize fevenue over time. |t should be noted that the most notable framework in revenue recognition in which revenue may be Fecognized over time is long-term construction contract accounting. Property developers and construction companies are typical for their contracts with customers of a long-term nature.The biggest challenge is to decide whether the company should recognize revenue over time (spread during individual years of construction) orat the point of time (one-time at the completion of a contract} For property developers and construction companies, especially one situation is crucial: when the entity's performance does not create an asset with alternative use to the entity and the entity has an enforceable right to payment for pertormance completed to date, then the revenve is recognized over time. ll. Construction Contract A construction contract is 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. Types of Construction Contract (or Contract Pric: 1, Fixed price contract 2. Cost plus contract lll. Construction Revenue Construction revenve is the total amount of consideration receivable under the contract. in the early stages of a contract, the contract revenue will offen be an estimate of what the final amount will be, as it may be dependent on the outcome of future events. ‘Contract revenue may alter where it Is possible for the contractor to make claims against the customer, of a third party, for costs that were not originally included in the contract.NW. Contract revenue comprises: The initial amount of revenue agreed in the contract i The variations in contract work and claims, to the extent that: = Itis probable that they will result in revenue - They are capable of being reliably measured. Contract revenue is reduced by the amount of any penalties arising from delays caused by the contractor in the completion of the contract. The result is that the construction revenue is measurable at fair value. \n the case of any variation, claim, or incentive payment, two factors should be assessed to determine whether or not contract revenue should be recognized: 1, It is probable that the customer will accept the variation or claim, or that the contract is sufficiently advanced that the performance criteria will be met; and 2. The amount of the revenue can be rellably measurable. Construction Costs PERS (IFRS) 15 states that the following cost must be capitalized: 1, The incremental costs of obtaining a contract 2. The cost of fulfilling a contract if they do not fall within the scope of another standard {such as PAS (IAS) 2 - Inventories] and the entity expects them to be recovered 3. Companies divide cost fo fulfil a contract or fulfilment costs (contract acquisition costs) into two categories: Those that give rise to an asset. Those that are expensed as incumed. The capitalized costs will be amortized os revenue is recognized. This means that they will be expensed to cost of construction/sales as the contract progresses. General contract activity costs should be allocated systematically and rationally, ond all costs with similar characteristics should be treated consistently. The allocation should be based on the normal level of construction activity, Borrowing cost may be attributed in this way. Method of Revenue Recognition in Construction Accounting Revenue recognition depends on the performance obligation(s): ‘Over Time / Percentage of Completion Point in Time / Cost Recovery Method or Zero-Proft Approach ‘A company recognizes revenue over time if at least one of the following three cattera is met: 1. The customer simultaneously receives and consumes the sellers work as tis performed of the Goods or services while the cone nenns tne ama e.g. monthly payroll processing service). 2, The customer controls as the asset as It created or ne company's performance creates or enhances on asear raneed be when asset (e. E55 OF when a contractor builds an extension into a customer's Sin PennaThe company has a right to payment for its expects 10 fulfil the contract ox pears Perfommanc completed to date, and it tt erterion 1, 2 or 3 Is met, then a company recogni reasonably estimate its progress toward satisfaction of ihe performance obligations. Company recognizes revenues and gross profits each period based upon the progress of the constructior paoressotth n—relerred to as the percentage-ot-completion (Over + If the criteria for recognition are not met, the company recognizes revenues ond gross profit at a POINT IN TIME. i.e., when the contract is completed. Or if progress cannot be reliably measured then revenue can only be recognized up to the recoverable costs incurred. + Then, the company recognizes revenues and gross profit when the contract is completed, referred to os the cost-recovery (zero-profit/point in time) method. This method recognizes revenue only to the extent of costs incurred that are expected to be recoverable. Only atter all costs are incurred is gross profit recognized. Percentage-of-Completion (Over Time) _ The percentage-of-completion method is an application of the accrual assumption. this method is used when the outcome of the construction.contract can be estimated reliably. contract revenue and contract costs associated with the construction contract should be recognized as revenue and expenses, respectively, by reference fo the stage of completion of the contract activity at the end of the reporting period. Measuring the Percentage-ot-Completion (Over Time) ‘The percentage-of-completion approach avoids the mismatch between costs being ognized as they are incurred and revenue only being recognized when the contract completed. This would not reflect commercial substance, because the contractor revenues as the project activity progresses. practice to measure the earnings process. us methods are currently used in i p a they can be conveniently grouped into two ing on the nature of the contract. gories: Input and output measures. Input Measures/Cost Basis. Input measures etlorts devoted to a contract. input ts to soltisty Be ot recognize revenue on the basis of the efforts or inpu! oo Jative to the total expected inputs. the perf e obligation rel e Examples of input gmethodsincludestabor-nours worked, costs incurred, time elapsed and resources consumed Revenue can be recognized on a s throughout the performance period. ‘are made in relation to the costs or traight-line basis if inputs are used evenlyVi. nit Of Input hip between a UI . umed relations thod and sever. They ore baled’ onan a oat used cost-lo-cost me! a Ind proc vey i Yariations of efforts-expended metnods id). tract costs incurred). 2. Cost-to-cost method (Proportion of Cony TT ected casts is opplied to The percentage that costs incurredbeat 10 folal exPOT ET ee ate the Conroc! price to determine the revenue fo Be Pree arnings to date, 15 10 the expected net income on the project ps ods are based on some ©. Efforts-expended methods. The efforts-expende ours, labor pesos. machine measure of work performed. They include OPC! NOU Tee oF Completion is hours, or material qyontties Si early Co ee GoRbaeh the ratio ed i similar to the use Sine eben ehoted to date to the estimated fotal efforts to be expended on the entire contract 2. Output Measures/Sales Basis Output measures are made in terms of results achieved. pee Examples of output methods include: surveys of wi ae aah or Performance compieted, to date (the valve of “work certi lo date may be a measure used to identify the degree of completion nd therefore revenve fo be recognized in profit or loss); units produced or delivered, tons produced, storey's of a building completed, appraisats of results achieved, kilometers of a highway completed, contract, milestones reached or ‘Achieved.time elapsed and values added Architects and engineers are sometimes asked fo evaluate jobs and estimate the Percentage of a job completed (surveys of work performed). These estimates are, in reality, output measures and usually ore bosed on the physical progress made on the contract. This may be appropriate for the construction of buildings. Cost Recovery Method/Zero-Prottt Approach (Point in Time) Cost recovery method(point in time) of Construction accounting (zero-profit approach) is used when the contract's outcome lat Rate cannot be reliably estimated. iment below should be followed: ly estimated. The treatment 1. Recognize revenue only to the extent of contract costs to be recoverable; ond Incurred which are expected 2 Recognize contract costs as on expense in the period they In other words, the cost recovery profit approach involves reco, Y are incurred, eflect the situation neo 'y estimated, but itis tik Inn pong as aproach tthe beginning of a contract, ie. ely to recover the costs, Recognition of Expected or Anticipated Losses, When it is probable that total contract costs will exPecied loss should Be recognized as an expense eee" !O10l Contract revenue, the immediately,The amount of such G loss is determined iespective of! @. Whether or not work has commenc v ed on the contract; b. The sloge of competion of contact actviy: or ¢. The amount of profits expected to arise on 0 i other cont as a single construction contract, SN RTGe OA he vil. Changes in Estimates The percentage of completion method is applied on a cumulative basis in each accounting period to the current estimates of contract revenue and contract costs. Therefore, the effect of a change in the estimate of contract revenue or contract costs, or the effect of a change in estimate of the outcome of a contract, is accounted for as @ change in accounting estimate (see PAS No. 8, Accounting Changes). The changed estimates are used in the determination of the amount of revenue and expenses 7 recognized In the income statement in the period in which the change is made and in subsequent periods. Vill. Contract Retentions Retentions are amounts of progress billings which are not paid until the satisfaction of ‘conditions specified in the contract for the payment of such amounts or until defects have been rectitied, Progress billings are amounts billed for work performed on a contract whether or not they have been paid by the customer. Advances are amounts received by the contractor before the related work is performed. IX, Financial Statement Presentation a. Percentage-of-Completion (Over Time) Current asset - Contract Asset. It comprises of total costs incurred on the contract. plus the cumulative recognized profit (or less cumulative recognized loss), less Brogress billings (i.e.. the amounts actually invoiced to customers for work Berlormed on a contract whether or not they have been paid by the customers) . Corent lability - Contract Liabilly. It comprises of progress bilings tess fotal costs ncuned on the contraci, plus cumulative recognized profit (or less cumulative recognized l0s3). : Method (Point in Time) ri ot rec asset Contract “asset, It comprises of total costs incurred on the contract, ‘the amounts actually invoiced to customers for work ether or not they have been paid by the customers). omprises of progress billings less total costs less progress billings (i.e. ormed on a contract wi Curent liability - Contract Liability. It c incurred on the contract. &