10.2 Long-Term Construction Contracts: Measuring Progress, Contract Balances, and Losses

Long-Term Construction Contracts: Measuring Progress, Contract Balances, and Losses

Long-term construction contracts are the classic over-time revenue problem in AFAR (syllabus topic 4.1.2.9). This section measures progress with output and input methods, applies the cost-to-cost formula with its exclusions, presents contract assets and contract liabilities, and handles contracts that become less profitable or loss-making, with a three-year worked example.

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1. Long-Term Construction Contracts: Methods of Measuring Progress

For performance obligations satisfied over time, revenue is recognized by measuring progress toward complete satisfaction of the obligation. PFRS 15 categorizes progress measurement into two primary families:

1. Output Methods

Output methods recognize revenue based on direct measurements of the value to the customer of the goods or services transferred to date relative to the remaining goods or services promised:

• Surveys of performance completed by independent engineers or architects;
• Appraisals of results achieved;
• Milestones reached;
• Units produced or units delivered.

Limitation: Output methods may not be representative if the output selected fails to measure goods or services for which control has transferred (e.g., work-in-progress that has not yet reached a formal milestone).

2. Input Methods (The Cost-to-Cost Method)

Input methods recognize revenue based on the entity's efforts or inputs toward satisfying a performance obligation relative to total expected inputs. In the CPALE, the cost-to-cost method is the predominant input method tested.

$\text{Percentage of Completion} = \frac{\text{Cumulative Incurred Contract Costs to Date}}{\text{Total Estimated Contract Costs}}$

$\text{Total Estimated Contract Costs} = \text{Cumulative Incurred Costs to Date} + \text{Estimated Costs to Complete}$

Mandatory Exclusions from the Cost-to-Cost Formula

To ensure that inputs faithfully depict the transfer of control, the following costs must be excluded from both the numerator (costs incurred to date) and denominator (total estimated costs) when calculating the percentage of completion:

• Abnormal Inefficiencies: Substantial wasted materials, idle labor, strike-related down-time, or scrap costs that were not anticipated in the contract price. These costs are expensed immediately in profit or loss.
• Uninstalled Materials: Materials delivered to the job site that the contractor controls but has not yet installed, used, or applied in construction (e.g., elevators, structural steel, or electrical transformers stored on site). If uninstalled materials are significant and the customer obtains control upon delivery, revenue is recognized on those materials only to the extent of costs incurred (i.e., zero gross profit recognized on uninstalled materials).

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2. Contract Asset vs. Contract Liability Mechanics

Under PFRS 15, the relationship between cumulative revenue recognized (or cumulative costs incurred plus cumulative recognized gross profit) and cumulative progress billings dictates balance sheet presentation.

                         Contract Asset vs. Contract Liability
                                           │
                 ┌─────────────────────────┴─────────────────────────┐
                 ▼                                                   ▼
   CIP > Progress Billings                             Progress Billings > CIP
   Cumulative Revenue > Billings                       Billings > Cumulative Revenue
        NET CONTRACT ASSET                                 NET CONTRACT LIABILITY
   "Gross amounts due from customers"                  "Gross amounts due to customers"

Definitions and Accounting Terminology

• Construction in Progress (CIP): An inventory/asset accumulation account debited for actual contract costs incurred and debited for recognized gross profit (or credited for recognized gross loss).
• Progress Billings: A contra-construction account credited when billings are rendered to the client according to contractual progress or milestones.
• Contract Asset: An entity's right to consideration in exchange for goods or services that the entity has transferred to a customer when that right is conditioned on something other than the passage of time (e.g., future performance or final certification). On the statement of financial position, a net debit balance (CIP minus Progress Billings > 0) is presented as a Contract Asset.
• Contract Liability: An entity's obligation to transfer goods or services to a customer for which the entity has received consideration (or an amount is due) from the customer. A net credit balance (Progress Billings minus CIP > 0) is presented as a Contract Liability (or Unearned Contract Revenue).
• Accounts Receivable: Recognized when an invoice or billing represents an unconditional right to consideration, where only the passage of time is required before payment is due.

$\text{Net Balance} = \text{Construction in Progress (Costs + Cumulative Gross Profit)} - \text{Progress Billings}$

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3. Accounting for Contract Losses

PFRS 15, in conjunction with PAS 37 (Provisions, Contingent Liabilities and Contingent Assets), establishes uncompromising rules for contract losses.

Scenario A: Profitable Contract Overall, Current Period Loss

If revised cost estimates reduce the overall anticipated contract gross profit, but the total contract remains profitable (Total Contract Price > Total Estimated Costs):

• The cumulative gross profit to date is recomputed using the new, lower overall profit percentage.
• The current period gross profit is computed as: $\text{Cumulative Gross Profit to Date} - \text{Prior Years' Cumulative Recognized Gross Profit}$.
• This calculation frequently yields a negative gross profit (a gross loss) for the current period, adjusting for over-recognition in prior years.

Scenario B: Unprofitable Contract (Onerous Contract / Total Expected Loss)

When current estimates indicate that Total Estimated Contract Costs exceed Total Contract Price, the contract has become an onerous contract.

The Absolute PFRS Rule: The entire expected contract loss must be recognized immediately in full in the period in which the loss becomes evident, regardless of the percentage of completion!

$\text{Total Expected Loss} = \text{Total Estimated Contract Costs} - \text{Contract Price}$

$\text{Current Period Loss Recognized} = \text{Total Expected Contract Loss} + \text{Prior Years' Cumulative Recognized Gross Profit}$

Balance Sheet Effect of Expected Losses

The provision for the contract loss is credited directly to Construction in Progress (CIP). If the accumulated loss write-down causes the net contract balance to become a credit, or if Progress Billings exceed the reduced CIP, the excess is presented as a Provision for Onerous Contracts (Contract Liability).

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4. Comprehensive Worked Example: PFRS 15 Cost-to-Cost, Contract Asset/Liability & Full Contract Loss

On February 1, 2024, Makati Infrastructure Builders Corp. enters into a non-cancellable contract to construct an elevated expressway bypass for the Department of Public Works and Highways (DPWH) for a fixed contract price of PHP 30,000,000. The contract qualifies for revenue recognition over time under PFRS 15.

Contract Operational Data (2024 to 2026):

Contract Data                        2024              2025              2026
Costs incurred during the year   PHP 7,200,000    PHP 11,800,000     PHP 12,000,000
Estimated costs to complete        16,800,000        13,000,000                  0
Progress billings during year       8,000,000        12,000,000         10,000,000
Cash collections during year        6,500,000        11,500,000         12,000,000

Special Condition in 2025: Severe subsoil instability in late 2025 required foundational redesign, driving cumulative costs incurred to PHP 19,000,000 and estimated costs to complete to PHP 13,000,000 (Total estimated costs = PHP 32,000,000). Total contract price remains PHP 30,000,000.

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Year 1 (2024) Calculations:

1. Total Estimated Costs: $\text{Total Costs} = \text{PHP }7{,}200{,}000 + \text{PHP }16{,}800{,}000 = \text{PHP }24{,}000{,}000$
2. Total Expected Contract Profit: $\text{Total Expected Profit} = \text{PHP }30{,}000{,}000 - \text{PHP }24{,}000{,}000 = \text{PHP }6{,}000{,}000$
3. Percentage of Completion: $\text{POC}_{2024} = \frac{\text{PHP }7{,}200{,}000}{\text{PHP }24{,}000{,}000} = 30.00\%$
4. Revenue and Gross Profit Recognized in 2024: $\text{Revenue}_{2024} = 30\% \times \text{PHP }30{,}000{,}000 = \text{PHP }9{,}000{,}000$ $\text{Cost of Construction}_{2024} = \text{PHP }7{,}200{,}000$ $\text{Gross Profit Recognized}_{2024} = \text{PHP }9{,}000{,}000 - \text{PHP }7{,}200{,}000 = \text{PHP }1{,}800{,}000$
5. Balance Sheet Presentation at December 31, 2024: $\text{CIP Balance} = \text{Costs Incurred (PHP 7,200,000)} + \text{Profit (PHP 1,800,000)} = \text{PHP }9{,}000{,}000$ $\text{Progress Billings} = \text{PHP }8{,}000{,}000$ $\text{Net Balance} = \text{PHP }9{,}000{,}000 - \text{PHP }8{,}000{,}000 = \text{PHP }1{,}000{,}000 \text{ (Debit)}$ Presentation: Net Contract Asset of PHP 1,000,000.

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Year 2 (2025) Calculations (Full Contract Loss Scenario):

1. Cumulative Costs Incurred to Date: $\text{Cumulative Costs} = \text{PHP }7{,}200{,}000 + \text{PHP }11{,}800{,}000 = \text{PHP }19{,}000{,}000$
2. Total Estimated Costs: $\text{Total Costs} = \text{PHP }19{,}000{,}000 + \text{PHP }13{,}000{,}000 = \text{PHP }32{,}000{,}000$
3. Total Expected Contract Loss: $\text{Expected Total Loss} = \text{PHP }30{,}000{,}000 - \text{PHP }32{,}000{,}000 = -\text{PHP }2{,}000{,}000$
4. Gross Loss to Recognize in 2025: Because the entire expected loss of PHP 2,000,000 must be recognized immediately: $\text{Current Loss Recognized} = \text{Total Expected Loss (PHP 2,000,000)} + \text{2024 Profit Recognized (PHP 1,800,000)} = \text{PHP }3{,}800{,}000$
5. Revenue Recognized in 2025:
   • Physical completion percentage based on cost inputs: $\text{POC} = \frac{\text{PHP }19{,}000{,}000}{\text{PHP }32{,}000{,}000} = 59.375\%$
   • Cumulative Revenue to Date: $59.375\% \times \text{PHP }30{,}000{,}000 = \text{PHP }17{,}812{,}500$.
   • 2025 Revenue = Cumulative Revenue PHP 17,812,500 - 2024 Revenue PHP 9,000,000 = PHP 8,812,500.
   • 2025 Construction Expense = Revenue PHP 8,812,500 + Recognized Loss PHP 3,800,000 = PHP 12,612,500.
6. Balance Sheet Presentation at December 31, 2025: $\text{Cumulative Costs Incurred} = \text{PHP }19{,}000{,}000$ $\text{Less: Cumulative Net Loss to Date} = (\text{PHP }2{,}000{,}000)$ $\text{CIP Net Carrying Amount} = \text{PHP }17{,}000{,}000$ $\text{Cumulative Progress Billings} = \text{PHP }8{,}000{,}000 + \text{PHP }12{,}000{,}000 = \text{PHP }20{,}000{,}000$ $\text{Net Balance} = \text{CIP (PHP 17,000,000)} - \text{Billings (PHP 20,000,000)} = -\text{PHP }3{,}000{,}000 \text{ (Credit)}$ Presentation: Net Contract Liability of PHP 3,000,000.

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Year 3 (2026) Calculations (Completion):

1. Cumulative Costs Incurred: $\text{PHP }19{,}000{,}000 + \text{PHP }12{,}000{,}000 = \text{PHP }31{,}000{,}000$.
2. Actual Final Contract Loss: $\text{PHP }30{,}000{,}000 - \text{PHP }31{,}000{,}000 = -\text{PHP }1{,}000{,}000$.
3. Gross Profit / Adjustment Recognized in 2026:
   • Since PHP 2,000,000 loss was recognized cumulatively through 2025, and actual final loss is only PHP 1,000,000, a gross gain of PHP 1,000,000 is recognized in 2026.
   • 2026 Revenue = PHP 30,000,000 - PHP 17,812,500 = PHP 12,187,500.
   • 2026 Construction Expense = PHP 12,187,500 - PHP 1,000,000 = PHP 11,187,500.