Construction contract_Existing and Proposed Accounting Standards

Norlayalina

Adi Iskandar

Ruzzana

Construction Contract

CONSTRUCTION CONTRACT

A contract negotiated between parties of which, generally the owner (or developer) and the

contractor of an asset (or group of interrelated assets).

MFRS111

• Definition:

“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”

MFRS111

• Recognizing revenue under construction contract

• Derived from the initial amount of revenue agreed in the contract and variations in contract work, claims and incentive payments to the extent it is probable that they will result in revenue and they are capable of being reliably measured

MFRS111

• Issue – progress of a long-term project• To determine the right timing to recognize

revenue

‘when the outcome of a contract can be estimated reliably, revenue shall be recognized by reference to the stage of completion’

Long-Term ConstructionAccounting Methods

1) Terms of contract must be certain, enforceable.2) Certainty of performance by both parties3) Estimates of completion can be made reliably

1) To be used only when the percentage method is inapplicable [uncertain]2) For short-term contracts

Percentage-of-CompletionMethod

Completed ContractMethod

Revenue Recognition Before Delivery

MFRS111

• Method:1) Percentage of completion

- contract revenue is matched with the contract costs incurred in reaching stage of completion- contract revenue recognized as revenue in profit or loss in accounting period which work is performed- stage of completion determined by reference to the contract costs that reflect to the work performed incurred to date

PERCENTAGE OF COMPLETION

• Basis for revenue recognition in long-term construction contracts – span over than one accounting period

• Accountant need a basis to apportion the total contract revenue between the multiple accounting periods


• Formula:(i) Revenue recognized

(ii) Percentage of work complete

Percentage of Work Completed in the Period

Total Contract Value

Expenditures Incurred from Inception to Date

Total Estimated Costs for the Contract

Costs incurred to date = Percent completeMost recent estimated total costs

1

Estimated total revenue x Percent complete = Revenue to be recognized to date

2

Total revenue to be recognized to date less Revenue recognized in PRIOR periods = Current period revenue

3

Current Period Revenue less current costs = Gross profit4

Percentage-of-Completion: Steps


• The seller can recognize some gain or loss related to a project in every accounting period in which the project continues to be active

• Works best when it is reasonably possible to estimate the remaining costs to complete a project

• It should not be used if when there are significant uncertainties about the percentage of completion or the remaining costs to be incurred


• Measurement:1) Cost-to-cost method. This is a comparison of the contract cost incurred to date to the total expected contract cost. The cost of items already purchased for a contract but which have not yet been installed should not be included in the determination of the percentage of completion of a project, unless they were specifically produced for the contract. Also, allocate the cost of equipment over the contract period, rather than up-front, unless title to the equipment is being transferred to the customer.


2) Efforts-expended method. This is the proportion of effort expended to date in comparison to the total effort expected to be expended for the contract. For example, the percentage of completion might be based on direct labor hours, or machine hours, or material quantities


3) Units-of-delivery method. This is the percentage of units delivered to the buyer to the total number of units to be delivered under the terms of a contract. It should only be used when the contractor produces a number of units to the specifications of a buyer. The recognition is based on: – For revenue, the contract price of units delivered– For expenses, the costs reasonably allocable to the

units delivered


• The same measurement should be used for similar types of contracts – improve consistency of the method

• Commonly used – at least some indication of economic activity that spills over into the income statement prior to project completion

2) Completed contract- revenue and expenses are not recognized until contract is completed and the title is transfer to the client

COMPLETED CONTRACT

• Prior to completion, this method does not yield any useful information for the reader of a company’s financial statements.

• However, the delay in income recognition allows a business to defer the recognition of related income taxes.

• since revenue and expense recognition only occurs at the end of a project, the timing of revenue recognition can be both delayed and highly irregular.

COMPLETED CONTRACT

• used under the following circumstances: When it is not possible to derive dependable

estimates about the percentage of completion of a project; or

When there are inherent hazards that may interfere with completion of a project; or

When contracts are of such a short-term nature that the results reported under the completed contract method and the percentage of completion method would not vary materially.

COMPLETED CONTRACT

• If there is an expectation of a loss on a contract, record it at once even under the completed contract method; do not wait under the end of the contract period to do so.

Overview on New Proposed Standard

IFRS 15 “Revenue from Contracts with Customers”The new standard in detail by Standard Setters and technical accountants

• The long awaited revenue recognition standard recently issued will have a major impact for all firms and their advisers.

• ‘Walk through’ of the new revenue standard from experts involved in its construction.

• The 5 steps for recognizing revenue from contracts with customers and identify which contracts are within the scope of the new standard.

• Factors to consider when applying the new revenue standard retrospectively and how the standard will affect client’s figures (including reported profit/loss).

• How ‘variable consideration’ should be recognized.• How to account for revenue from licenses, how credit risk affects

collectability and how this impacts on revenue recognition.

Revenue Recognition – New

1. Identify contracts with customer2. Identify the separate performance

obligations within the contract3. Determination of price4. Allocation of price to separate performance

obligation5. Recognize revenue upon satisfaction of

performance obligation

1. Identify contract

• Various forms -> written, oral or implied• All of these conditions must exist:

a. Commercial substanceb. Parties agreed to the provisions

and committed in satisfying their obligations

c. Enforceable rightsd. Terms & payment methods

• Segmented or combinedTo identify combined – entered

simultaneously, negotiated together, activities are consequent or concurrent.

To identify separated – goods purchased separately, if bought together -> no discounts.

Change orders? Separate or combined?

1. Identify contract

2. Separate Performance Obligation

• If contract is more > 1 goods/services, then each is a separate performance obligations subject to:-

Another entity may provides similar separately;

Goods can be sold off separately, distinct function and margin

• Eg. Say, Construction > 3 years, can the design service be treated as a separate performance obligation?


Design services are distinct and can be sold separately, hence -> satisfy the criteria, treated as separate Performance Obligation

What about buying of materials or equipment?

Buying of materials/equipment – no real Performance Obligation, thus to combined with other performance obligation

• Site preparation?• Actual construction? Construction

Management?• Highly specialized interior build-out?


o One PO – can be contracted separately, distinct profit margin, high risk

o Treated as one PO as very interrelated although maybe subcontracted. Difficult to separate risk between the two.

o Regarded as separate, contracted separately distinct profit margin

High Level Judgment & Very Subjective

3. Price determination

• Some are clearly stated, if for a fixed amount• Some long term contract -> price may varies

due to performance incentives, liquidated damage, change orders

• TO also consider -> collectability, non cash consideration, PV

• What if the contract price is uncertain?

Defer revenue until can estimate reasonably

4. Price Allocation

• Must reflect risk involved• Price and allocation -> updated

throughout, instead of single gross margin on the project

5. Recognition – Performance Obligation

• Amount of revenue = amount of price allocated

• Cost -> charged to each PO as incurred• Change of control – contract complete.• Transfer of legal title? Contract complete?


• Continuous transfer• Output method – units delivered/produced,

milestone, engineering survey relative to total goods/service

• Input method – effort expended relative to total effort to be expended

Preferable

• What if price changes after a performance obligation was recognised?

• What if the developer and contractor is the same party? How about the transfer of control?


o The portion of price change attributable to the PO can be recognized.

o Transfer of control may not be seen as taken place. Recognised only once the contract is completed

COMPLIANCE TO MFRS 111 BY MALAYSIAN COMPANIES

Annual Report 2012

HIGH

LIGH

TS

Annual Report 2013HIG

HLIGHTS

Annual Report 2012

HIGHLIG

HTS

INCONSISTENCIES IN DISCLOSURE

• Variation and claim • Determining stage of

completion for long term contract

• Disclosure of significant judgment

ISSUE

• Halliburton-reported practice booking cost overruns on construction project

• Raytheon - reported provide insufficient write off for unexpected losses and booking revenues from inactive long term contracts

FASB initiative to improve reporting by

• Eliminating inconsistencies of financial reporting disclosure from long term contract.

• Provide guidance-not provide only basic disclosures

• Standardization-opt for different progress measurement method

• selecting input method rather than output method

Reporting issues in construction contract

• percentage of completion method over completed contract method (whenever possible)

• input method or output method• Disclosure of revenue recognition policies• Consideration to measure performance

Cost determination

• Input measures-based on effort and resources applies

• Output measures-based on number of unit completed ;– Units of production method– Units of delivery method

Construction contract_Existing and Proposed Accounting Standards

Economy & Finance

Transcript of Construction contract_Existing and Proposed Accounting Standards