Friday, November 9, 2012

Long term construction contracts


http://training.ey.hu/images/upload/file/usgaap_text.pdf


1. Accounting issue
The accounting issue is one of revenue recognition
1.1   Authoritative Pronouncement
ARB 45 – long term construction type contracts
SOP 81-1 – long term construction type contracts
1.2   Illustration
A company enters into a contract to construct a football stadium. The contract iw worth $200 million dollars and will last for three years. The expected costs have been estimated as follows:
Year 1                                   $80 million
Year 2                                   $60 million
Year 3                                   $40 million
Overall estimated profit $20 million
The question is whether to recognise any profit and revenue only when the contract is completed and the stadium is delivered? This would be prudent but would not reflect the earnings of the business in the income statement.
Alternatively the profit could be allocated, together with a proportion of revenue, to each of the three years of the project. This could be match income-to-income earning activities but would it be prudent?
1.3   Definition
There is no formal definition of a qualifying long-term contract within US GAAP but this treatment may apply to contracts where
(a)    Gross profit is taken on a % complete basis
(b)   Inventories and receivables are material and the contract duration is expected to be more than 12 months
(c)    Ownership effectively passes to the customer throughout the course of the contract
2. Completed contract method
For those contracts when the future costs cannot be reliably estimated or if the contract is anticipated to be loss making
    2.1 Accounting treatment
Direct costs and overheads are booked to a construction-in-progress account (asset)
Billings are charged to a billings in advance account (liability)
Individual contract balances should be netted off at the balance sheet date
At completion the total costs and income and transferred to net income
2.2  expected losses
These should be recognize in full over the duration of the contract. The loss should be recorded in net income and deducted from the construction-in-progress account.



3. Percentage of completion method
This method should be used for those contracts which are profitable and for which
amounts of future costs can be reliably estimated.

3.1 Accounting treatment
In addition to the recognition of costs as for completed contracts method, each year an
amount of gross profit should be added to the construction asset.
This profit may be calculated either as a percentage of costs incurred to date, by the
value of certified work compared to the total contract value or some other reasonable
basis.

3.2 Losses on contracts
The percentage complete method is not available for loss making contracts. In addition
any losses on contracts should be recognized at the point of recognition. You will also
need to cancel any profits previously recognized.

3.3 Illustration
Able Inc has entered into a fixed price contract worth $10m. The estimated costs of the
contract are as follows:
Year     1            2          3
Costs   2,000,000   5,000,000    1,000,000
The contract qualifies to be accounted for on a percentage of completion basis as
follows: 


Year 1
Revenue recognized based on cost incurred
$
$ 2 , 000 , 000
$10m x
2,500,000
$ 8 , 000 , 000
Costs incurred                                              (2,000,000)
Gross profit                                                    500,000
Construction in progress asset
$(2,000,000 + 500,000)                                      2,500,000

In year 2 costs are as estimated
Revenue earned to date:
$7 , 000 , 000  x $10,000,000 =        8,750,000
                   $ 8 , 000 , 000
Less recognised in year 1                                   (2,500,000)
Year 2 revenue                                                   6,250,000
Cost incurred                                                       5,000,000
Gross profit                                                         1,250,000  
Construction in progress asset                              8,750,000
$(2,000,000 + 500,000 + 5,000,000 + 1,250,000)


The above presumes that no invoices are raised on account of work completed.

In year 3 now suppose that actual costs come to $2,000,000 with a further $2,000,000

required in year 4 when the contract will be completed.

In this situation the contract is now loss making.



Revenue (as before)                                   10,000,000
Cost year    1          2000,000
                  2          5000,000
                 3           2000,000
Estimated 
Year           4           2000,000                     (11,000,000)
Anticipate loss recognized immediately        (1000,000)
The profit taken to date must also be cancelled
Profit taken 
Year         1             500,000
                2             1250,000
                                                                  (1750,000)
Gross loss recognized in year 3                     (2750,000)
The balance sheet asset will then be restated
Balance brought forward                                8750,000
Add costs incurred                                          2000,000
                                                                    10,750,000
 Less loss provision                                         (2750,000)
Construction in progress asset                         8,000,000

Year 4 -- contract completed
Construction in progress asset b/fwd                 8000,000
Add costs incurred                                           2000,000
                                                                    10,000,000
Less invoiced contract value                           (10,000,000) 
Closing balance                                                -----





























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