Question

ABC Ltd (“ABC”) entered into a contract on 1st January 20x6 to build a factory building for its customer on its customer’s land for $20 million. The completion is expected to be in two years’ time. ABC’s policy is to bill its clients based on 60% in the first year and the balance upon completion of the project. ABC has a 31st December financial year end. It has adopted FRS 115 Revenues from Contracts with Customers and adopts the input method to measure the entity’s progress towards the complete satisfaction of the performance obligations.

At the end of 20x6, ABC has incurred actual costs of $10 million on the construction project. The estimated costs that are required to complete the project was $6 million. Actual collections in 20x6 amounted to $10.5 million.

In 20x7, a modification to the contract was required. To comply with new safety regulations, the concrete flooring was to be reinforced with steel. An electronic gantry and carpark structures were also added to the existing open-air carpark area.

The contract was increased by $5 million for the reinforced concrete flooring and $1 million for the car-park structures. The additional expected costs for the reinforced flooring was $2 million and the car park structure was $800,000. The commencement of work was to start in 20x8 and the completion date is expected to be extended for an additional year in 20x8. Billings for the additional contract price will be done in 20x8.

At the end of 20x7, the actual costs incurred and paid was $8 million, fully attributable to the construction of the factory building. An estimated cost of $5 million is further required to complete the factory building and $800,000 for the car-park. $8 million were invoiced as per the original plans, and actual collections during the year amounted to $9.5 million.

At the end of 20x8, the contracts were completed. The actual costs incurred and paid during 20x8 were as estimated during the modification agreement. A final billing of $6 million was made and actual collections amounted to $4.5 million.

Required:

(a) Discuss revenue recognition under FRS 115 Revenues from contracts with customers in view of its application to construction contracts. Please include in your discussion the costs that goes into a construction contract and the issues involved.

(b) Discuss also the impact of modifications, common reasons for modifications and how modifications are treated. Explain how the modification of the contract to change the flooring and addition of the car park structure should be treated under FRS 115 Revenues from contracts with customers.

(c) Compute the revenues, expenses and profits to be recognised for each financial year ending 31st December 20x6, 20x7 and 20x8. Illustrate the accounting for this contract by preparing the necessary journal entries to record the relevant transactions for 20x6 and the final entry to record the completion of the project. Journal narratives are not required. (Answers may be rounded to the nearest thousand dollars).

Answer 1

The applcable provisions of FRS 115 on "Revenue from contracts with customers" states that  an entity shall recognise revenue when (or as) the entity satisfies a performance
obligation by transferring a promised good or service (ie an asset) to a customer. An asset is transferred when (or as) the customer obtains control of that asset.Further the amount of revenue recognised is the amount allocated to the satisfied performance obligation. A performance obligation may be satisfied at a point in time (typically for promises to transfer goods to a customer) or over time (typically for promises to transfer services to a customer). For performance obligations satisfied over time, an entity recognises revenue over time by selecting an appropriate method for measuring the entity’s progress towards complete satisfaction of that performance obligation.

As in the case of construction service providers the service shall be performed and completed over a period of time because as the part of construction completes , the service provider has the right to obtain the payment and the partly constructed property has no other use to the entity. Hence in such case the contract revenue shall also be recognised on a systematic allocation basis which includes estimating the stand-alone selling prices of promised goods or services and allocating discounts and variable consideration to a specific part of the contract (if applicable) and correspondingly measuring obligations for returns, refunds and other similar obligations.

The major costs involved in a construction contract execution are:

(a)   costs that relate directly to the specific contract ,for instance, site labour costs, including site supervision,costs of materials used in construction,depreciation of plant and equipment used on the contract,costs of hiring plant and equipment etc.

(b) General attributable overheads and specific customisation charges for the contract.

The main issue involved in case of revenue and expense recognition for construction contracts is deciding on which method to be used for determining the progress oc performance obligation. FRS 115 provides below two methods for determining the same-

i. Output method ie. recognising revenue on the basis of direct measurements of the value to the customer of the goods or services transferred to date relative to the remaining goods or
services promised under the contract. However output method would not provide a faithful depiction of the entity’s performance if the output selected would fail to measure some of the goods or services for which control has or has not been transferred to the customer.

ii. Input method- Input methods recognise revenue on the basis of the entity’s efforts or inputs to the satisfaction of a performance obligation (for example, resources consumed, labour hours expended, costs incurred, time elapsed or machine hours used) relative to the total expected inputs to the satisfaction of that performance obligation. A shortcoming of input methods is that there may not be a direct relationship between an entity’s inputs and the transfer of control of goods or services to a customer. When a cost incurred is not proportionate to the entity’s progress in satisfying the
performance obligation. In those circumstances, the best depiction of the entity’s performance may be to adjust the input method to recognise revenue only to the extent of that cost incurred.

B. t. A contract modification exists when the parties to a contract approve a modification that either creates new or changes existing enforceable rights and obligations of the parties to the contract in tèrms of its scope or price. A contract modification could be approved in writing, by oral agreement or implied by customary business practices.

If a contract modification is not accounted for as a separate contract in accordance with paragraph 20, an entity shall account for the promised goods or services not yet transferred at the date of the contract modification (ie the remaining promised goods or services) in whichever of the following ways is applicable:
(a) An entity shall account for the contract modification as if it were a termination of the existing contract and the creation of a new contract, if the remaining goods or services are distinct from the goods or services transferred on or before the date of the contract modification. The amount of consideration to be allocated to the remaining performance obligations is the sum of:
(i) the consideration promised by the customer (including amounts already received from the customer) that was included in the estimate of the transaction price and that had not been recognised as revenue; and

(ii) the consideration promised as part of the contract modification.
(b) An entity shall account for the contract modification as if it were a part of the existing contract if the remaining goods or services are not distinct and, therefore, form part of a single performance obligation that is partially satisfied at the date of the contract modification. The effect that the contract modification has on the transaction price, and on the entity’s measure of progress towards complete satisfaction of the
performance obligation, is recognised as an adjustment to revenue (either as an increase in or a reduction of revenue) at the date of the contract modification (ie the adjustment to revenue is made on a cumulative catch-up basis).
(c) If the remaining goods or services are a combination of items (a) and (b), then the entity shall account for the effects of the modification on the unsatisfied (including partially unsatisfied) performance obligations in the modified contract.

In the given case, construuction servoces for additional flooring and car park steuctures being distinctive in nature shall be considered as a separete component of a new contract formed with all three tasks to be executed and their revenure recognition shall be in accordance with part (a) above.