SOLVAY BRUSSELS SCHOOL OF ECONOMICS & MANAGEMENT

ADVANCED ACCOUNTING COURSE

CASE 1 - B

REVENUE RECOGNITION

LONG TERM CONTRACTS

MEGAPIER COMPANY

(Examination of 25/1/2007)

Academic Year 2006 - 2007 1

 SOLVAY BRUSSELS SCHOOL OF ECONOMICS & MANAGEMENT

ADVANCED ACCOUNTING COURSE

Long term contract and general accounting - MegaPier Company

 The European company MegaPier is a construction company specialized in large civil

engineering projects. It is currently building the new industrial harbour of the Emirate of
Rabotan.

 MegaPier was successful in obtaining this contract thanks to a competitive pricing, but also
because it accepted a very aggressive construction deadline. In case the deadline would not be
met, heavy penalties will be due by MegaPier to the client, the Rabotan Port Authority. Further,
MegaPier also had to accept to face a currency exposure, since the billings to the client are U.S.
dollars denominated, while the MegaPier functional and reporting currency is the Euro.

 As at December 31, 2005, the accounts trial balance of MegaPier was as follows:

Debit (Credit) balance

- P.P.&E. (Cost) 4.000.000
- P.P.&E. (Accumulated depreciation) (800.000)
- Other long term investments 6.800.000
- Current trade receivables (USD 50.000.000) 47.000.000
- Other current receivable 10.700.000
- Cash 159.850.000
227.550.000

- Capital (50.000.000)
- Reserves (5.000.000)
- Retained earnings (21.050.000)
- Long term subordinated loan (150.000.000)
- Current liabilities – accrued interest charges (1.500.000)
(227.550.000)

 The other current receivable balance was linked only to the harbour construction and was made
of the following:

- Harbour project costs

o Direct costs (materials, payroll and
depreciation 221.500.000
o Financial expenses 10.500.000
232.000.000
- Profit margin recognized 24.000.000
- Billings to Rabotan Port Authority (245.300.000)
10.700.000

 The contract with the Rabotan Port Authority includes the following clauses:

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 - the delivery date is April 1, 2007; any delay leads to a USD 200.000 penalty (sale price
reduction) per week delay;
- the contractual sale price is USD 382.000.000;
- the billings and payments calendar is as follows (in USD):
Amount Billing Payment by the client
50.000.000 12 October 2004 Already collected
50.000.000 7 March 2005 Already collected
50.000.000 10 July 2005 Already collected
50.000.000 10 November 2005 31 January 2006
70.000.000 30 August 2006 10 January 2007
112.000.000 Upon delivery of the completed works 4 weeks after billing
382.000.000

 The subordinated loan has been entered into on October 31, 2004, in order to finance the
Rabotan harbour project. It is bearing an interest cost of 6% per annum, payable annually at the
end of October. The capital amount (and the last interest tranche until December 31, 2006) will
be reimbursed on January 1, 2007.

 The following accounting principles have been decided upon by the Board of Directors of
MegaPier:
- the company applies the IFRS/IAS standards;
- the result on long term construction contracts is recognized based on the percentage of
completion method;
- the percentage of completion is determined based on the following ratio:

direct costs incurred =x%

estimated total direct costs on the contract

where direct costs are defined as materials + payroll + depreciation

- P.P.&E. being made of construction site equipment (cranes, trucks, etc.), it is accounted for
using IAS 16 – Cost Model, and depreciated straightline over a 10 year period; the
depreciation expense is allocated to the project costs prorata temporis until completion and
delivery of the works;
- for accounting purposes, the interest expenses on debts financing the construction works are
accounted for as being part of the project costs;
- transactions in foreign currencies are accounted for in EUROS based on the exchange rate
of the day of the transaction; on balance sheet date, unrealized exchange differences, if any,
are recorded under the financial income or expenses.

 MegaPier has also had the following additional transactions in 2006:

a) In relation with the Rabotan Harbour Project:

- Purchase of materials: EUR 47.000.000, of which 7.000.000 unpaid yet as at December
31, 2006;
- Payroll expenses (all paid during the course of 2006): EUR 9.000.000;
- On December 31, 2006, the construction management engineers submit their report on
the completion of the harbour project: it is now certain that, in 2007:
o on top of the depreciation expense, the cost of materials and payroll will be EUR
42.000.000;

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 o as a result of delays at suppliers’ and in starting up the finishes, the completion and
delivery of the harbour project will be delayed by 12 weeks (3 months).

b) Other 2006 activities:

- MegaPier has provided project management services to other clients. These services
have been billed EUR 18.000.000, of which EUR 12.000.000 already collected as at
December 31, 2006. The receivable of EUR 6.000.000 includes an amount of EUR
4.000.000 that is assessed as being fully unrecoverable. Although in serious financial
trouble, the related clients are not bankrupt yet in 2006.

 Other information:

a) USD exchange rates:

31 January 2006: 1,21 USD/EUR

30 August 2006: 1,15 USD/EUR
31 December 2006: 1,06 USD/EUR
2007: for estimation purposes, USD income/costs after 31 December
2006 are to be translated using the 1,06 USD/EUR rate of year end
2006.

b) Income taxes:
- The corporate income tax rate is 34%;
- Collection losses on client accounts are tax deductible only in the year when a client is
officially put in bankruptcy.
- As of January 1, 2006, MegaPier had a EUR 20.000.000 tax loss carryforward.

You are requested:

A. to compute:
 the % of completion of the Rabotan Harbour Project as at December 31, 2006;
 the overall result on the contract and the profit or loss on the contract to be recorded
in 2006;
B. to record the accounting journal entries for all transactions and operations of MegaPier in
2006, including year end current income tax, as applicable.

All amounts are rounded to the nearest Euro. VAT is to be neglected.

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MODEL SOLUTION

A. Computation of the % of completion, of the total project result, and of the project profit
or loss to record in 2006.

Total costs:
 Direct costs as at 1/1/2006 221.500.000
 Direct costs incurred in 2006:
- Materials 47.000.000
- Payroll 9.000.000
- Depreciation 400.000
277.900.000
 Capitalized financial expenses:
- 6% of 150 mio in 2006 9.000.000
- Recorded on 1/1/2006 10.500.000
297.400.000
 Costs to be incurred in 2007:
- Materials and payroll 42.000.000
- Depreciation: (April 1 + 3 months = 6 months) 200.000
42.200.000
TOTAL 339.600.000

→ % of completion = 277.900.000 = 86,8 %

(339.600.000 – 19.500.000)

Total revenue:
 Advances billed 1/1/2006 245.300.000
 Billing 30/8/06: 70.000.000 USD x 1/1,15 60.869.565
 Billing on completion: 112.000.000 USD x 1/1,06 105.660.377
 Penalty for delays:
200.000 USD x 1/1,06 x 12 weeks = (2.264.151)
Net revenue 409.565.791

Gross margin on contract: 69.965.791

To be recognized cumulatively as at 31/12/2006: x 86,8% 60.730.307

Already recorded on 1/1/2006 24.000.000
Profit to record in 2006 36.730.307

Alternatively:
Profit to record 38.994.458
Provision for penalty (2.264.151)
36.730.307

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Question 1 – Answers

B. MegaPier 2006 accounting journal entries

N° DT/CR Description Amount

DT CR
1 DT Cash 41.322.314
DT Financial expense (realized exchange 5.677.688
difference)
CR Current trade receivable 47.000.000
To record the collection on January 30, 2006
(50.000.000 USD x 1/1,21 = 41.322.314
EUR)
2 DT Current trade receivable (client) 60.869.565
CR Inventory of C.I.P. 60.869.565
To record the billing on 30/8/2006
(70.000.000 USD x 1/1,15 = 60.869.565
EUR)
3 DT Financial expenses 7.500.000
DT Current liabilities – accrued interests 1.500.000
CR Cash 9.000.000
To record the payment of interests on loan on
October 31, 2006
4 DT Materials expenses 47.000.000
CR Suppliers 47.000.000
DT Suppliers 40.000.000
CR Cash 40.000.000
To record the purchase of materials in 2006
5 DT Payroll expenses 9.000.000
CR Cash 9.000.000
To record the 2006 payroll expenses
6 DT Depreciation expense 400.000
CR Accumulated deprecation 400.000
To record the 2006 depreciation
7 DT Financial expenses 1.500.000
CR Accrued liability 1.500.000
To accrue for the interests on the loan
(1/11/2006 until 31/12/2006)
8 DT Inventory of C.I.P. 65.400.000
CR OR Sales or (acceptable as student solution): 65.400.000
CR Financial expenses 9.000.000
CR Materials expenses 47.000.000
CR Payroll expenses 9.000.000
CR Depreciation expense 400.000
To capitalize the 2006 project expenses in
inventory of C.I.P.
9 DT Inventory of C.I.P. 36.730.307
CR Operating income 36.730.307
To record the 2006 project profit recognition

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10 DT Other current receivable 41.260.742
CR Inventory of C.I.P. 41.260.742
To reclassify the net inventory of C.I.P. as at
31/12/2006 (entry 8 and 9 – entry 2)
11 DT Long term subordinated loan 150.000.000
CR Current (short term) subordinated loan 150.000.000
To reclassify the long term loan due on
1/1/2007
12 DT Trade receivable 5.168.171
CR Financial income (unrealized exchange gain) 5.168.171
To adjust the USD receivable to the year end
rate at 31/12/2006
(USD 70.000.000 x 1/1,06 = EUR 66.037.736
vs. 60.869.565 = EUR 5.168.171)
13 DT Trade receivables 18.000.000
CR Sales 18.000.000
DT Cash 12.000.000
CR Trade receivables 12.000.000
To record the billing and collection of other
services in 2006
14 DT Bad debt expense 4.000.000
CR Trade receivable (bad debt reserve) 4.000.000
To reserve for bad debtors
15 DT Current tax expense 11.635.069

CR Current tax liability 11.635.069

To record the 2006 current tax

Taxable basis:
Entry Profit (loss)
1 (5.677.688)
9 36.730.307
12 5.168.171
13 18.000.000
54.220.790
Tax loss (20.000.000)
34.220.790
x 34 %
Current tax 11.635.069

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