Lesson 3: LONG TERM CONSTRUCTION CONTRACTS

Objectives:

At the end of the lesson, you will be able to:

a. Learn about long-term construction contracts (LTCC);
b. Differentiate the percentage of completion method and the zero profit
method in accounting for LTCC; and
c. Know its presentation in the financial statements.

Long term construction contracts are construction projects that extend thru more than one accounting
period. Examples of these projects is the construction of water dams, bridges, flyover, and metro railway
transit.
Construction contract may be classified into:
a. Fixed Price Contract
b. Cost Plus Contract- This is a construction contract in which the contractor is reimbursed for
allowable or otherwise defined costs, plus a percentage of these costs or a fixed fee.
Contract Revenue- measured at the fair value of the consideration received or receivable. Construction
revenue may also include incentive payments.
Contract Cost- costs that relate directly to the specific contract; are attributable to contract activity in
general and can be allocated to the contract; and are specifically chargeable to the customer under the
terms of the contract.
Types of Contract Cost
Cost incurred to date- These include precontract costs and costs incurred after contract acceptance.
Precontract costs are cost incurred before the contract has been entered into, with the expectation that
the contract will be accepted and these costs will thereby be recovered through billings. On the other hand,
contract costs are cost incurred toward the completion of the project and are also capitalized in the
Construction in Progress (CIP) account.
Estimated Cost to complete- these are the anticipated cost of materials, labor, subcontracting costs, and
indirect cost (overhead) required to complete a project at a scheduled time. The latest estimate should be
used to determine the progress towards completion.
Construction in Progress (CIP) account would include both direct and indirect costs but would usually not
include general and administrative expenses or selling expenses since they are not normally identifiable
with a particular contract and should therefore be expensed.
Subcontractor Cost
The amount billed to the principal contractor for work done by the subcontractor should be included in
contract costs.
Cost of Materials Purchases in Advance of Their Use
Such costs should not be treated as costs incurred for purposes of computing the percentage of
completion ratio until the materials have been physically used in production.
Combining and Segmenting Contracts
A group of contracts, whether with a single customer or with several customers, should be combined and
treated as a single contract if the group of contracts
a. Are negotiated as a single package
b. Require such closely interrelated construction activities that they are, in effect, part of a single
project with an overall profit margin.
c. Are performed concurrently or in a continuous sequence.
Segmenting a contract is a process of breaking up a larger unit into smaller units for accounting purposes.
A contract may cover a number of assets.
Computation and Recognition of Construction Revenue
The amount of revenue and expenses recognized each accounting period during the production process
relate to the degree of completion of the project and to the remaining costs and effort to be incurred in
finishing the project.
Two basic methods are used to account for long-term construction contracts:
1. Percentage-of-completion- under this method, gross profit is recognized as construction
progresses. In practice, contractors, use two basic methods to measure the progress of the
construction.
a. Input Measures (cost to cost method). This method is used if the contract calls for one large
project rather than several separate projects. This method is used in the illustrations.
b. Output Measures (units of delivery). The progress is based on the results achieved. This
method is useful in contracts for the construction of several condominium units.
The percentage of completion method is preferable when reasonably dependable estimates of the
degree of completion can be made.
2. Zero Profit Method- If the contractor is protected in this manner but is unable to make reasonable
estimates of the percentage of completion, PAS No. 11 recommends this method. Under this
method, the recognition of profit is deferred until the project is completed.
Illustrative Problem
AMG Construction Company agrees to build a large office building for PG Towers for a total contract price
of P 5,000,000. PG Towers will make annual payments to AMG, but the amounts of these payments
cannot exceed the direct costs incurred by AMG. The contract is signed on October 1, 2018 and AMG’s
year end is December 31. The contract provides PG with a final inspection right to ensure compliance with
the contract terms prior to accepting the completed project.
Total Contract Price P 5,000,000
Total Anticipated Costs (as at 10/2018) 4,500,000
Item 2018 2019 2020 Total
Cost incurred each year 1,350,000 2,250,000 400,000 4,000,000
Estimated Cost to complete (at year end) 3,150,000 400,000 - -
Progress billings each year 400,000 2,000,000 2,600,000 5,000,000
Progress payments received each year 275,000 2,100,000 2,625,000 5,000,000

Required:
1. Gross Profit to be realized for each year using the percentage of completion method and zero profit
method.
2. Journal entries to record the transactions using the percentage of completion method and zero
profit method.

Percentage-of-Completion
2018 2019 2020
Total Contract Price 5,000,000 5,000,000 5,000,000

Cost Incurred to Date 1,350,000 3,600,000 4,000,000

Estimated Cost to Complete 3,150,000 400,000 -
Total Estimated Costs 4,500,000 4,000,000 4,000,000
Expected Gross Profit 500,000 1,000,000 1,000,000

% of Completion (1,350/4,500) 30% 90% 100%

Gross profit earned to date 150,000 900,000 1,000,000
Less: Gross Profit earned in prior years 150,000 900,000
Gross profit earned this year 150,000 750,000 100,000

Zero Profit Method 2018 2019 2020

Construction Revenues 1,350,000 2,250,000 1,400,000
Cost incurred each year 1,350,000 2,250,000 400,000
Gross Profit Earned this Year - - 1,000,000
 Zero Profit Method Percentage-of-Completion
Date Event Accounts Dr. Cr. Dr. Cr.
2018 1 Contract Signed No entry necessary to record contract commitment

2 Cost Incurred Construction in Progress 1,350,000 1,350,000

Cash 1,350,000 1,350,000

3 Progress Billings Accounts Receivable 400,000 400,000

Contract Billings 400,000 400,000

4 Billing Collections Cash 275,000 275,000

Accounts Receivable 275,000 275,000

5 Revenue Recognition Construction in Progress 150,000

Cost of Construction 1,350,000 1,350,000
Construction Revenue 1,350,000 1,500,000

2019 6 Cost Incurred Construction in Progress 2,250,000 2,250,000

Cash 2,250,000 2,250,000

7 Progress Billings Accounts Receivable 2,000,000 2,000,000

Contract Billings 2,000,000 2,000,000

8 Billing Collections Cash 2,100,000 2,100,000

Accounts Receivable 2,100,000 2,100,000

9 Revenue Recognition Construction in Progress - 750,000

Cost of Construction 2,250,000 2,250,000
Construction Revenue 2,250,000 3,000,000

2020 10 Cost Incurred Construction in Progress 400,000 400,000

Cash 400,000 400,000

11 Progress Billings Accounts Receivable 2,600,000 2,600,000

Contract Billings 2,600,000 2,600,000

12 Billing Collections Cash 2,625,000 2,625,000

Accounts Receivable 2,625,000 2,625,000

13 Revenue Recognition Construction in Progress 1,000,000 100,000

Cost of Construction 400,000 400,000
Construction Revenue 1,400,000 500,000

14 Elimination of Contract Billings 5,000,000 5,000,000

Inventory Construction in Progress 5,000,000 5,000,000

The excess of the Construction in Progress account over the Contract Billings is treated as a current asset
(due from customer). If the contract provided for billings is in excess of costs incurred, the Construction in
Progress account could be less than the Contract Billings account. In this case, the difference is presented
as a current liability labeled due to customers or another appropriate title.
Anticipated Losses on Long-Term-Construction Projects
In some cases, the total estimated costs is increased due to increase in the costs of construction materials.
When a loss on the total contract is anticipated, that is, the total estimated costs are expected to exceed
the total revenue from the contract, PAS 11 require reporting the loss in its entirety immediately when the
loss is first anticipated.
Illustration:
Case 1: Loss in the year of revision of estimated costs but profit in total contract. Revising the data
above, assume that at the end of 2019, the estimated cost to complete was increased to P 1,260,000 and
this was the actual cost incurred in 2020.
Required: The gross profit (loss) to be recognized each year using the percentage of completion method
and zero profit method.

Percentage-of-Completion
2018 2019 2020
Total Contract Price 5,000,000 5,000,000 5,000,000

Cost Incurred to Date 1,350,000 3,600,000 4,860,000

Estimated Cost to Complete 3,150,000 1,260,000 -
Total Estimated Costs 4,500,000 4,860,000 4,860,000
Expected Gross Profit 500,000 140,000 140,000

% of Completion (1,350/4,500) 30% 75% 100%

Gross profit earned to date 150,000 105,000 140,000
Less: Gross Profit earned in prior years 150,000 105,000
Gross profit earned this year 150,000 (45,000) 35,000

Zero Profit Method 2018 2019 2020

Construction Revenues 1,350,000 2,250,000 1,400,000
Cost incurred each year 1,350,000 2,250,000 1,260,000
Gross Profit Earned this Year - - 140,000

Case 2: Loss in the year of revision of total estimated costs but overall loss on the contract. Assume
the same data in the previous illustration, except that in 2019 the estimated cost to complete were P
1,500,000 instead of P 400,000, assume also that actual cost equaled expected costs in 2020.
Required: The gross profit (loss) to be recognized each year using the percentage of completion method
and zero profit method.
Cost Incurred to Date 1,350,000 3,600,000 5,100,000
Estimated Cost to Complete 3,150,000 1,500,000 -
Total Estimated Costs 4,500,000 5,100,000 5,100,000
Expected Gross Profit 500,000 (100,000) (100,000)
Percentage of Completion to date 30% 70% 100%

Under the zero profit method, the anticipated loss is to be recognized immediately at the end of 2019
because there is an overall loss on the contract, the following entry would be made.

2019
Cost of Construction 2,250,000
Construction in Progress 100,000
Construction Revenue 2,150,000

2020
Cost of Construction 1,500,000
Construction Revenue 1,500,000

Gross Profit (Loss) to be Recognized Each Year Under Zero Profit Method
2018- 0
2019- (100,000)
2020- 0
Under the percentage of completion method, the cumulative cost to be deducted from the cumulative
recognized revenue plus the total anticipated loss.

To Date Recognized- Recognized-

Prior Years Current Year
2018 Construction Revenue (P 5,000,000 x 30%) 1,500,000 1,500,000
Cost of Construction (actual cost) 1,350,000 1,350,000
Gross Profit 150,000 150,000

2019 Construction Revenue (P 5,000,000 x 70%) 3,500,000 1,500,000 2,000,000

Cost (revenue plus total anticipated loss) 3,600,000 1,350,000 2,250,000
Gross Profit (Loss) (100,000) 150,000 (250,000)

2020 Construction Revenue 5,000,000 3,500,000 1,500,000

Cost (actual cost) 5,100,000 3,600,000 1,500,000
Gross Profit (Loss) (100,000) (100,000) -

The entry to record the total loss at the end of 2019 would be as follows:

2019
Cost of Construction 2,250,000
Construction in Progress 250,000
Construction Revenue 2,000,000
Contract Retention
The contract Retention account is presented in the statement of financial position as a current asset. Upon
completion of the project, the balance of this account once paid by the customer will be closed by debiting
Cash and Crediting Contract Retention account.

EVALUATION
1. Ernel Construction has consistently used the percentage of completion method. On January 10,
2017, Ernel began work on P3,000,000 construction contract. At the inception date, the estimated
cost of construction was P2,250,000. The following data relate to the progress of the contract:
Income recognized at December 31, 2017 P 300,000
Costs incurred January 10, 2017 through December 31, 2017 1,800,000
Estimated cost to complete, December 31, 2017 600,000
In its income statement for the year ended December 31, 2017, what amount of gross profit should
Ernel report?

2. The following information pertain to the building contract of Orlando Construction Company,
wherein the fixed contract price is P80 million

2016 2017 2018

Estimated Costs P20.1million P30.15 million P16.75million
Progress Billings 10 million 25million 45million
Cash Collection 8million 23million 49million

Assume that all costs are incurred, all billings to customers are made, and all collections from
customers are received within 30 days of billing, as planned. Under the percentage of completion
method of revenue recognition is used, how much is the income from construction for the year
2018?

3. JC Construction, Inc. has consistently used the percentage of completion method of recognizing
income. During 2018 JC started work on a P3,000,000 fixed price construction contract. The
accounting records disclosed the following data for the year ended December 31, 2018:

Cost incurred P930,000

Estimated Cost to Complete 2,170,000
Progress Billings 1,100,000
Collections 700,000
How much loss should JC have recognized in 2018?

4. CAT Corporation was tapped to build two private power plants in Toril and Samal. The following
information relates to these projects, which were started in 2018:

Toril Samal
Contract Price P10,500,000 P7,500,000
Costs incurred to date 6,000,000 7,000,000
Estimated Costs to complete 3,000,000 1,000,000
Billings during the year 3,750,000 6,750,000
Collections during the year 2,250,000 6,250,000
What is the gross profit (loss) of CAT for 2018 if the percentage of completion is used?
 5. During 2017, Isabelita Corporation started a construction job with a total contract price of 600,000.
Any costs incurred are expected to be recoverable. The job was completed on December 15,
2018. Additional data are as follow:

2017 2018
Actual Cost incurred P225,000 P255,000
Estimated remaining cost 225,000 -
Billed to customers 240,000 360,000
Received from customers 225,000 375,000
Under the cost recovery methods of construction accounting (zero profit approach) what amount
should Isabelita recognize as gross profit for 2017 and 2018?

6. Diaz Company entered into a construction agreement in 2017 for the rip-rapping of Pier 4. The original
contract price was P 9,600,000 but a change order was issued in 2018 increasing the contract price by P
480,000. Diaz uses the percentage of completion method of revenue recognition on long-term
construction contracts. The following information’s are obtained on the project of 2017 and 2018.

2017 2018
Cost incurred to date P 4,920,000 P 8,640,000
Estimated Costs to complete 4,920,000 2,160,000
Billings made 5,280,000 3,520,000
Cash Collections 4,380,000 7,500,000
What is the gross profit (loss) of Diaz on the project for 2018?

7. Philip Construction company started a project with a contract price of P80 million. The cost incurred
to date is P12,000,000 and the estimated cost to complete is still P48million. Under the cost to cost
basis, how much is the income from construction?

8. Enrille’s construction is in its fourth year of business. Enrille performs long-term construction projects
especially in Agusan and accounts for them using the percentage of completion method. Enrille
built an apartment building at the price of P1,000,000. The costs and billings for this contract for the
first three years

2016 2017 2018

Cost incurred to date 320,000 600,000 790,000
Estimated costs yet to be incurred 480,000 200,000 0
Customers billing to date 150,000 410,000 1,000,000
Collections of billings to date 120,000 340,000 950,000
Determine the income from construction in 2017.

9. Jessica Construction has consistently used the percentage of completion method. On January 10,
2017, Jessica began work on P 3,000,000 construction contract. At the inception date, the
estimated cost of construction was P 2,250,000. The following data relate to the progress of the
contract:
Income recognized at December 31, 2017 P 300,000
Cost incurred Jan. 10, 2017 through Dec. 31, 2018 1,800,000
Estimated costs to complete, December 31, 2018 600,000
What percent was completed in 2018?
10. Jhim Construction Company has consistently used the percentage of completion method of
recognizing income. During 2017, Jhim started work on a 3,000,000 construction contract which
was completed in 2018. The accounting record provided the following data:

2017 2018
Progress Billing 1,100,000 1,900,000
Cost incurred each year 900,000 1,800,000
Collection 700,000 2,300,000
Estimated costs to complete 1,800,000 0
How much income should Jhim have recognized in 2018?

11. Francis Construction Company has consistently used the percentage of completion method of
recognizing income. During 2017, Francis entered into a fixed price contract to construct an office
building for P10,000,000 information relating to the contract is as follow:

12/31/2017 12/31/2018
Percentage of completion 20% 60%
Estimated costs of completion 7,500,000 8,000,000
Income recognized (cumulative) 500,000 1,200,000
Contract cost incurred during 2018 were?