Unit 5 - Student Version PART 2 JJM0

8/4/2019 Unit 5 - Student Version PART 2 JJM0

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Unit 5 - Lecturer version 1

Outcome 5.4Prepare contract accounts, calculate

profit and value work in progress Contract costing is applied to relatively large cost units

that take a considerable length of time to complete.

There are two types of construction contracts:

A fixed price contract is a construction contract inwhich the contractor agrees to a fixed contract price,or a fixed rate per unit of output, which in some casesis subject to cost escalation clauses.

A cost plus contract is a construction contract inwhich the contractor is reimbursed for allowable orotherwise defined costs, plus a percentage of thesecosts or a fixed fee.


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Outcome 5.4

Because of the nature of the activity undertaken inconstruction contracts, the date at which the contractactivity is entered into and the date when the activity is

completed usually fall into different accounting periods. Therefore, the primary issue in accounting for

construction contracts is the allocation of contractrevenue and contract costs to the accounting periods in

which construction work is performed. For the purposes of cost identification and recording the

duration of a project is considered to run from the date thecontract is signed until the project is substantially completeand handed over to the client.


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Outcome 5.4

Costs incurred by an enterprise before a contract is signedare usually viewed as period costs and written off as such.

If, however, the costs can be directly identified with a futureproject and there is reasonable certainty that the contract willproceed, then the pre-contractcosts can be accumulated andviewed as project costs.

The project costs normally incurred can be classified into twogroups, namely contract costs and general costs.

Contract costs can be classified in two categories, namely directcontract costs that are incurred for a specific project andindirect contract costs in connection with general projectactivities.

General costs are those costs incurred in order for the enterpriseto function.


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Outcome 5.4Characteristics of contract costing

A contract number is assigned to every separate contract.

Most of the material is ordered specifically for thecontract.

It will thus be debited directly to the contract from thesuppliers invoices.

Material drawn from a central warehouse that servesnumerous contracts will, as in job cost systems, berequested by means of material requisitions.

Most of the other contract costs will also be direct costs,for example labour and subcontractors employed on aspecific contract only.

Head office costs must be allocated to the contracts on a

suitable basis.


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Head office expenses will originate in respect of thepreparation of tenders for contracts, material acquisitionand labour administration.

They will therefore tend to be related the primary costs ofcontracts and a primary cost recovery rate can be usedquite effectively for the apportionment of head office coststo contracts.


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Machinery and equipment costs can be charged to a contract in twoways:

If the equipment is going to be used for a particular contract for a longtime the entire cost is charged to the contract. Upon completion of thecontract the contract costs are credited with any machinery andequipment costs recovered, for example from the proceeds ofequipment sold or the value at which it is transferred to anothercontract. If the contract extends beyond one financial period themachinery and equipment debited to the contract must be revalued at

the end of each financial period. The difference in value at thebeginning and the end of the financial period is the depreciation costfor that period.

A hire basis may be used. The rent for each piece of equipment ischarged to a contract, usually on the basis of a machine hour rate


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Outcome 5.4Important terminology

Contract revenue

Contract revenue comprise of the initial amount of revenue agreed in thecontract, and variations in contract work, claims and incentive paymentsto the extent that it is probable that they will result in revenue, and they

are capable of being reliably measured IAS 11(AC 109). Variations in contract work

An instruction by the customer for a change in the scope of the work tobe performed under the contract.

Claims

An amount that the contractor seeks to collect from the customer oranother party as reimbursement for costs not included in the contractprice.

Incentive payments

Additional amounts paid to the contractor if specified performance

standards are met or exceeded.


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Progress payments

It is general practice in the construction industry to makeprogress payments during the course of the contract.

This is done according to certificates that are issued by theclient's supervising architect.

Certified work

In order to make the progress payments, confirmation isrequired that work to a certain sales value has been

completed, and that some payment is now due.

Retention money

It is general practice for a customer to withhold a certainpercentage of each progress payment as protection against

defective work.


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Uncertified work (WIP)

This is the value of the work performed between thelast certification date and the financial year-end.

Material on siteMaterial ordered specifically for the contract is valued

at cost and forms part of inventory.


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Contract costs

Contract costs, according to IAS 11 (AC109), shouldcomprise:

costs that relate directly to the specific contract,

costs that are attributable to contract activity in generaland can be allocated to the contract, and

such other costs as are specifically chargeable to thecustomer under the terms of the contract, e.g. some

general administration costs and development costs forwhich reimbursement is specified in the terms of thecontract.

Contract costs include the costs attributable to a contract forthe period from the date of securing the contract to the finalcompletion of the contract.


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Contract costs

However, costs that relate directly to a contract and areincurred in securing the contract are also included as

part of the contract costs if they can be separatelyidentified and measured reliably and it is probable thatthe contract will be obtained.

When costs incurred in securing a contract are

recognised as an expense in the period in which theyare incurred, they are not included in contract costswhen the contract is obtained in a subsequent period.


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Profit determination

When the outcome of a construction contract can beestimated reliably, contract revenue and contract

costs associated with the construction contract shouldbe recognised as revenue and expenses respectivelyby reference to the stage of completion of the contractactivity at the balance sheet date.

The stage of completion should be determined basedon the work performed on the contract at the balancesheet date.


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Profit determination

The stage of completion of a contract may bedetermined in a variety of ways:

The proportion that contract costs incurred for workperformed to date compared to the estimated totalcontract costs (Cost incurred to date / Estimatedtotal contract cost).

Surveys of work performed (Value of certified work /Total contract price).

Completion of a physical proportion of the contractwork.


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Contract revenueDuring the early stages of a contract it is often the case

that the outcome of the contract cannot be estimatedreliably.

Nevertheless, it may be probable that the enterprise willrecover the contract costs incurred.

Therefore, contract revenue is recognised only to theextent of costs incurred that are expected to berecoverable.

As the outcome of the contract cannot be estimatedreliably, no profit is recognised.

When it is probable that total contract costs willexceed total contract revenue, the expected lossshould be recognised as an expense immediately.


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DisclosureAn enterprise should disclose:

the amount of contract revenue recognised asrevenue in the period,

the methods used to determine the contractrevenue recognised in the period,

the methods used to determine the stage ofcompletion of contracts in progress.


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Outcome 5.4

Which of the following are characteristics of job costing?

A. Customer-driven production.

B. Complete production possible within a single

accounting period.C. Homogeneous products.

Which of the following are characteristics of contracting

costing?A. Customer-driven production. .

B. Production over a long period of time

C. Homogeneous products


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Outcome 5.4

Which of the following costs can be classified as contractcosts:

i. Site labour costs, including site supervision

ii. Costs of moving plant, equipment and materials to andfrom the contract site

iii. Selling costs

iv. Costs of design and technical assistance that is

directly related to the contract

a) i & ii c) All of the above

b) i, ii & iv d) None of the above


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Outcome 5.4Activity 1

The following information was taken from the records of aconstruction company at the end of their financial period:

A BContract price 550 000 800 000Work certified 300 000 400 000Cost of work certified 250 000 250 000Cost of uncertified work 50 000 60 000Cash received 200 000 250 000Total expected cost(including costs incurred)

350 000 700 000


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The percentage of completion method (based oncosts) is used to calculate profit on contracts, but onlyonce contracts are 30% or more completed.

REQUIRED:

Calculate the profit/loss that can be brought intoaccount for the financial period under review for each

of the contracts in the records of the constructioncompany.


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Outcome 5.4Activity 1 - Solution

Total expected profit: ContractA B

Contract price 550 000 800 000Total expected costs 350 000 700 000

200 000 100 000

Profit for the financial period under review: ContractA B

Cost of work certified 250 000 250 000

Cost of uncertified work 50 000 60 000Costs to date 300 000 310 000

Total expected costs 350 000 700 000Percentage of completion 86% 44%Profit that can be brought into account 172 000 44 000


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Outcome 5.4Activity 2 - Profit determination according

to the completed contract method

During the past two years Lomax Construction hasworked on two projects, namely Project 2 with a contractprice of R300 000 and Project 3 with a contract price of

R1 000 000. At the end of the financial year ended 31 December

19x8 Project 2 was completed and handed over, whileProject 3 was still at an initial stage.

The enterprise calculates profits only when projects arecomplete and the contract price has been received or isreceivable.


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Further details in respect of the two projects for the past year are asfollows:

REQUIRED: Show how the details will be recorded in the ledger.

Project 2 Project 3R R

Material used 80 000 20 000Apportionment of depreciation on machinery

(not included in overheads) 13 000 12 000Labour costs 130 000 15 000Overheads allocated 40 000 20 000Work certified by architects 300 000 -Cash received 300 000 -No retention money is outstanding

in use


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PROJECT 2

Material 80 Debtors:Project 2(work certified)

300

Depreciation 13Labour 130Overheads 40Profit 37

300 300


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PROJECT 3

Material 20 Balance b/f 67Depreciation 12

Labour 15Overheads 20

67 67

Balance b/d 67Material Labour Overheads


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Outcome 5.4Activity 3 - Application of percentageof completion method

Year 1 Year 2 Year 3R R R

Contract price 1 000 000 1 000 000 1 000 000Work in progress @ cost price 80 000 595 000 860 000Estimated future costs 720 000 255 000 -Estimated total costs 800 000 850 000 860 000Percentage of completion:(according to cost price basis)

Year 1 80 000 x 100800 000 1

Year 2 595 000 x 100

850 000 1Year 3 860 000 x 100

860 000 110% 70% 100%


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REQUIRED:

To apply the percentage determined above in two ways inorder to determine the periodic profit figure.

(No retention money is outstanding)


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Method 1: Apply % of completion to the profit per contract.

Step 1: Determine estimated profits that can be takenon the total contract.

Step 2: Determine % of completion

Year 1 Year 2 Year 3Total contract price 1 000 1 000 1 000Total estimated costs (800) (850) (860)

Profit 200 150 140

Year 1 Year 2 Year 3Costs to date 80 595 860Total estimated costs 800 850 860

= 10% = 70% = 100%


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Step 3: Determine total profit which can be taken to date,i.e. profit x % of completion.

Step 4: Determine the profit that may be taken for the

particular year.

Year 1 Year 2 Year 3200 x 10% 150 x 70% 140 x 100%= 20 = 105 = 140

Year 1 Year 2 Year 3

20 105 20 140 105

= 20 = 85 = 35


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Method 2: Apply % of completion to the contract price

Step 1: Apply % of completion to the contract price.

Step 2: Calculate % of total contract price which has

already been completed.

Year 1 Year 2 Year 3

Costs to date 80 595 860Total estimated costs 800 850 860

= 10% = 70% = 100%

Year 1 Year 2 Year 31 000 x 10% 1 000 x 70% 1 000 x 100%= 100 = 700 = 1 000


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Method 2: Apply % of completion to the contract price

Step 3: Calculate total profit taken to date, i.e

Step 4: Determine profit that may be taken for the specific

year

Year 1 Year 2 Year 3Completed portion

of contract price

100 700 1 000

Less:Costs to date

80 595 860

Total profit to date 20 105 140

Year 1 Year 2 Year 3Total profit to be taken 20 105 140Less: Profit takenin previous years

0 20 105

20 85 35


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Outcome 5.4Question 5.4

RAU Construction is involved in three different contracts and atthe end of the financial year the details of these contracts areas follows:


Contract A B CTotal contract price 800 000 3 000 000 600 000Costs to date 600 000 2 550 000 150 000Expected additional costs

to complete contract220 000 - 250 000

Work certified to date 350 000 2 250 000 50 000Payments received todate 375 000 1 490 000 10 000


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REQUIRED:

a) Calculate the profit (according to the completed contract

method) that should be brought into account in thefinancial statements.

b) Calculate the profit (according to the percentage ofcompletion method based on costs) that should be

brought into account in the financial statements.

Unit 5 - Lecturer version

32


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a)


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Completed contract methodContract price Cost Profit/(Loss)

Contract A Incomplete - (20 000)Contract B 3 000 000 2 550 000 450 000Contract C Incomplete - -

430 000


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b)


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Percentage of completion methodContract

price Total cost Profit/(loss) %Complete Profit/(loss)A 800 000 820 000 (20 000) 600/820 (20 000)B 3 000 000 2 550 000 450 000 2550/2550 450 000C 600 000 400 000 200 000 150/400 75 000

505 000


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Outcome 5.4Oct 2008 Q3 Part B

Thornfield Ltd is a building contractor. During its financial yearending 30 June 2008, it started two new contracts. Informationrelating to these contracts as at 30 June 2008 was as follows:


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Contract 1 Contract 2Date contract commenced 1 July 2007 1 January 2008

R RContract price 210 000 215 000Expenditure to 30 June 2008:Materials and subcontracted work 44 000 41 000Direct wages 80 000 74 500General expenses 3 000 1 800Position at 30 June 2008:

Materials on hand at cost 3 000 3 000Accrued expenses 700 600Value of work certified 150 000 110 000Estimated cost of work completed but notcertified 4 000 6 000Plant and machinery allocated to contracts 16 000 12 000


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The plant and machinery allocated to the contracts was installedon the dates the contracts commenced. The plant and machineryis expected to have a working life of four yeas in the case ofcontracts 1 and three years in the case of contract 2, and is to be

depreciated on a straight line basis assuming nil residual values.

Since the last certification of work on contract 1, faulty work hasbeen discovered which is expected to cost R10 000 to rectify. No

rectifications work has been done prior to 30 June 2008.

In addition to expending directly attributable to contracts,recoverable central overheads are estimated to amount 2% of thecost of direct wages.


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Thornfield Ltd has an accounting policy of taking two thirds ofthe profit attributable to the value of work certified on a contract,once the contract is one third completed. Anticipated losses on

contracts are provided in full.

Progress claims equal to 80% of the value of work certified havebeen invoiced to customers.

REQUIRED

Prepare contract accounts for each contract for the year to 30June 2008, calculating any attributable profit or loss on eachcontract.Unit 5 - Lecturer version

38

1 2 1 2


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Financial Management 2BOutcome 5.4 6 Oct 2008 Q3 Part B - Solution

1 2 1 2R R R R

Plant on site 16 000 12 000 Materials stock c/f 3 000 3 000Materials 44 000 41 000 Cost of work not certified

c/f 4 000 6 000Wages 80 000 74 500 Plant on site c/f 12 000 10 000Generalexpenses 3 000 1 800 Cost of work certified 136 300 112 390Centraloverheads 1 600 1 490Accrued

expenses c/f 700 600

Provision forfaulty work c/f 10 000

155 300 131 390 155 300 131 390Cost of workcertified b/f 136 300 112 390 Attributable salesrevenue 145 433 110 000Profit takenthis period

9 133 Loss taken 2 390145 433 112 390 145 433 112 390

Cost of workcertified b/f 4 000 6 000 Accrued expenses b/f 700 600Material stockb/f (P)3 000 (P)3 000 Provision for faulty workb/f 10 000Plant on site (P)12 000 (P)10 000 39


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Profit calculations:

Contract 1: 2/3 x R13 700Contract 2: The loss to date (R112 390 R110 000) is

written off


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In an attempt to attract more tourists to a beautiful partof our country, Ydel Ltd was awarded a contract tobuild a freeway.

The estimated contract price is R102 million andincludes a budgeted profit of R27 million.

The duration of the contract from beginning to end isfive years, except in the event of unforeseen problems.

Work commenced on 1 April 19x0.

The following information is available for the three yearperiod ended 31 March 19x3:


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R'000Work certified to date 50 000Progress payments by client: 40 000Costs:Planning, estimate and fees for land surveyor 2 000Materials delivered to building sites 15 000Materials returned from building sites 500Direct wages paid 8 000Costs related to labour 1 000Rent of machinery 3 500Costs of building site offices:

rent 156salaries 1 200

Allocated head office costs 750Direct contract costs 1 804


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The certified work to date includes all work to 31 March 19x3.Costs of work not certified are therefore nil.

The plant and machinery that were specially obtained for this

contract by the contractors have been in constant use sincethe start of the contract. These assets are expected to have abreak-up value of R500 000 after completion of the five-yearcontract. Depreciation is calculated at R1 500 000 perannum.


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The costs of material on the building site are estimated atR400 000 on 31 March 19x3. Direct wages owing on 31March 19x3 amount to R55 000.

Management regards the contract as approximately half-completed, and it is estimated that it will be completed onschedule.

In the two previous financial years no profits on the

contracts were included in the company's financialstatements. However, the directors now wish to indicatethe appropriate profit for the degree of completion as at31 March 19x3 in the financial records.


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REQUIRED:

1.a) Indicate the contract account for the three year periodended 31 March 19x3; you can assume that the

directors' estimate of the % of completion is correct;

b) Calculate three alternative profit figures that shouldalso be acceptable to the directors;

(State clearly which basis you use to calculate

the % of completion.)

2. Explain why it is regarded as desirable thatcontractors show a portion of the profit on completedcontracts.


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Outcome 5.4Question 5.7 Solution (a)

CONTRACT ACCOUNTR000 R000

Plant and machinery 8 000 Plant and machinery (C1) 3 500Planning, surveyor fees- 2 000 Material returns 500Material 15 000 Material inventory b/f 400Labour

8 000

Debtors

50 000

Cost related to labour 1 000Hire of machinery 3 500Building site office:- Rent 156- Salaries

1 200

- Head office cost 750- Direct costs 1 804Wages owing 55Profit & Loss (C2) 13 500 WIP b/f 565

54 965 54 96546


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Outcome 5.4Question 5.7 Solution

CALCULATION

C1 8 000 - (1 500 x 3) = R3 500

C2 27 000 x 0.5 = R13 500

C3 54 965 - 13 500 - 3 500 - 500 - 400 = 37 065



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Outcome 5.4Question 5.7 Solution (b)

i)

(ii) 50/102 x 27 000 = R13 235

(iii) Both (i) and (ii) could also for the sake of conservatism bemultiplied by cash received/certified i.e. 40/50 = 80%


R'000Contract price 102 000WIP @ cost price (C3) 37 065Estimated future costs 37 935Total costs (102 - 27) 75 000% of completion 37 065/75 000

= 49.42%Profit: 49,42% x 27 000

= R13 343


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Outcome 5.4Question 5.7 Solution (2)

Matching principle: Income and expenses match overthe course of the term.

Comparability: Profit figures per period more even.



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Outcome 5.4Question 5.8Conservatism in profit determination

LX Construction Limited signed a contract on 2 January 19x4 for theerection of an office building at a total contract price of R2,5 million.

The company has estimated that it will cost R1,5 million to complete theproject.

On 31 December 19x4, the close of the company's financial year, costsof R1,1 million have already been incurred.

On the same date the value of the certified work amounted to R1,75million.

The client has paid this amount, less 5% retention that, under theagreement, is payable three months after the completion of the contract.

It is the policy of LX Construction Limited to account for profits using thepercentage of completion method and taking into consideration the cashreceived.



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REQUIRED:

a) Determine the profit/loss on the contract for 19x4;

b) Show the information applicable to the contract in thebalance sheet of the company on 31 December 19x4.



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Outcome 5.4Question 5.8 Solution (a)

Determination of profit that has to be brought to book.


Contract price 2 500 000Estimated costs 1 500 000

1 000 00031/12/x4 Costs incurred/Total costs 1 110 000/1 500 000 = 74%% of profit = 0,74 x 1 000 000

= 740 000Cash received/Cash receivable = 1 662 500/1 750 000

= 0,95% (i.e. 5% retentions) Profit to be brought to book = 0,95% x 740 000

= 703 000


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Outcome 5.4Question 5.8 Solution (b)

DISCLOSURE


BALANCE SHEET ON 31 DECEMBER 19x4Operating assetsDebtors for retentions on long-term constructioncontracts 87 500Contract in progress 100 000Operating liabilitiesCreditors xProvision for contingencies 37 000


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NOTES

ACCOUNTING POLICY

1.3 Construction contracts

Profits on long-term contracts are recognised according to the percentage

of completion method. The percentage of completion is determined withreference to the ratio of costs to date to total estimated costs, taking intoaccount cash received.

1.4 Contracts in progress

Long-term contracts in progress are valued at contract costs plus profitrecognised to date.

Contract costs consist of material, labour and carrying costs that can beallocated to individual contracts.

The value of long-term contracts calculated in this manner are decreasedby the anticipated losses, progress payments received, progress paymentsreceivable as well as retentions.



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Contracts in progress

Turnover

Turnover represents work certified on long-term contractsduring current periods.

Contract to date 1 110 000Profit calculated to date 703 000Provision for contingencies 37 000

1 850 000Work certified 1 750 000Cash received 1 662 500Retentions (5% x 1 750 000) 87 500

100 000

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Unit 5 - Student Version PART 2 JJM0

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