Revenue and Construction Contracts

LO: Understand the requirements in AASB 118 for the recognition

and measurement of revenue from sale of goods and rendering of
services

AASB 118 defines revenue as:

- The gross inflow of economic benefits during the period;
- Arising in the course of the ordinary activities of an
entity;
- When those inflows result in increases in equity;
- Other than increases relating to contributions from
equity participantsx

Recognition and measurement of revenue:

- Revenue shall be measured at (AASB 118):
- The fair value of the consideration received or
receivable
- The amount of revenue will usually be cash (or cash
equivalents) received or receivable
- When goods or service are exchanged for others of a
similar nature and value:
- It does not give rise to revenue

Where the revenues arise from the sale of goods, there are
additional recognition requirements (AASB 118: 14):
- The entity has transferred to the buyer the
significant risks and rewards of ownership of the
goods;
- The entity retains neither continued managerial
involvement to the degree usually associated with

ownership nor effective control over the goods

sold;
The amount of revenue can be measured reliably;
It is probable that the economic benefits
associated with the transaction will flow to the
entity; and
The costs incurred or to be incurred can be
measured reliably.

When the outcome of a transaction involving the rendering of

services can be estimated reliably, revenue associated with
the transaction shall be recognised by reference to the stage
of completion of the transaction at the end of the reporting
period.
When the outcome of the transaction involving the rendering
of services cannot be estimated reliably, revenue shall be
recognised only to the extent of the expenses recognised that
are recoverable.

The outcome of a transaction can be estimated reliably when

all the following conditions are satisfied (AASB 118:20):
The amount of revenue can be measured reliably;
It is probable that the economic benefits associated with
the transaction will flow to the entity;
The stage of completion of the transaction at the end of
the reporting period can be measured reliably; and
The costs incurred for the transaction and the costs to
complete the transaction can be measured reliably.

The timing of the recognition of revenue

- The possibility of recognising revenue during various
phases of the earnings cycle and its effects on financial
statements
- Traditional historical-cost, transaction-based system of
accounting
- Definition and recognition criteria of income in the
Framework

ABC is a chartered accounting firm. On 1 June 2013, ABC entered

into an agreement to undertaken some preliminary work for the
year end statutory audit of Hudson Limited. ABC has performed the
audit of Hudson Ltd since 2005 and has only experienced minimal
budget overruns to date.
It is anticipated that the auditing work will be completed on 30
August 2013. At that time, ABC will bill Hudson Ltd based on actual
hours worked for the project, and the bill will be paid one month
after the date of billing.
The salary of the ABC staff member (Audit senior) is $60 per hour.
The budgeted hours and work in progress (WIP) hours (actual to

date) for the audit engagement as at 30 June 2013 are as follows

(WIP hours mean that the hours worked are accumulated to WIP
account):
Staff
member

Hourly charge
rate

Budgeted
hours

WIP
hours

Audit
senior

$200

120

40

Determine how to account for the revenue arising from this

engagement.
Issues to be considered:
This is a transaction involving the rendering of services.
The timing of the recognition of revenue: at the inception of
the agreement? at the completion of the work? at the time of
billing? Or at the time when the cash payment is received?
Shall we recognise revenue on 30 June 2013? And how? Is it
probable that ABC will complete the project successfully at the
time?
Remember, according to AASB118, the revenue is recognised
gradually, rather than all at one critical point, as is the case
for revenue from the sale of goods.
If we were to recognise revenue on 30 June 2013, will we also
recognise expense?

Conditions to be satisfied (AASB118:20)

The amount of revenue can be measured reliably?
It is probable that the economic benefits associated with
the transaction will flow to the entity?
The stage of completion of the transaction at the end of
the reporting period can be measured reliably? and
The costs incurred for the transaction and the costs to
complete the transaction can be measured reliably?

LO : Understand the requirements of AASB 111

A construction contract is a contract specifically negotiated for

the construction of an asset or a combination of assets that
are closely interrelated or inter-dependent in terms of their
design, technology and function or their ultimate purpose or
use.
A cost plus contract 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.

A fixed price contract is a construction contract in which

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

AASB 111 identifies the revenue arising from a construction

contract as comprising:
The initial amount of revenue agreed in the contract;
and
Variations in contract work, claims and incentive
payments:
- To the extent that it is probable that they will
result in revenue; and
- They are capable of being reliably measured.

AASB 111 identifies the costs arising from a construction

contract as comprising:
- (a) costs that relate directly to the specific contract;
- (b) costs that are attributable to contract activity in
general and can be allocated to the contract; and
- (c) such other costs as are specifically chargeable to the
customer under the terms of the contract.

The timing of recognising revenue for construction contracts

and its effects on financial statements
- Inception of construction contract
- Billings on construction contract
- Receipt of cash
- During construction
- Completion of construction contract
How should the amount of revenue be determined?

Recognition of contract revenue and expenses

When the outcome of a construction contract can be
estimated reliably, contract revenue and contract costs
associated with the construction contract shall be
recognised as revenue and expenses respectively by
reference to the stage of completion of the contract
activity at the end of the reporting period.
When the outcome of a construction contract cannot be
estimated reliably:
- Revenue shall be recognised only to the extent of
contract costs incurred that it is probable will be
recoverable; and
- Contract costs shall be recognised as an expense
in the period in which they are incurred.

LO: Understand the percentage-of-completion method of accounting

for construction contracts

AASB 111 requires the use of the percentage-of-completion

method when:
- The outcome of a construction contract can be
estimated reliably
- Recognises profit during the construction period
Cost-plus contract:
- The contractor is reimbursed for allowable or otherwise
defined costs, plus a percentage of those costs or a
fixed fee
Fixed-price contract:
- The contractor agrees to a fixed contract price, or a
fixed rate per unit of output
For fixed-price contracts, the outcome of the contract can be
estimated reliably when (AASB 111: 23):
- Total contract revenue can be measured reliably;
- It is probable that economic benefits from the contract
will flow to the entity;
- Both costs to complete the contract and stage of
completion can be measured reliably; and
- Contract costs can be clearly identified and measured
reliably so actual contract costs incurred can be
compared with prior estimates
The stage of contract completion may be determined in a
number of ways including:
- The proportion that contract costs incurred for work
performed to date bear to the estimated total contract
costs
- Surveys of work performed or
- Completion of a physical proportion of the contract work

The general journal entries for each of the years during the contract
when the outcome can be estimated reliably:
Step 1: Record the construction costs
Dr Construction-in-progress
Cr Materials; Cash; etc
Step 2: Record the progress billing
Dr Accounts receivable
Cr Billings on construction-in-progress
Step 3: Record the receipt of cash
Dr Cash
Cr Accounts receivable

Step
-

4: record the revenues and expenses

Calculation of the percentage of completion
Revenue recognised for the year is calculated either by:
Adding the profit to be recognised for the period to the
costs incurred during the period (profit to be recognised

for the period = the % of completion x estimated total

profit the profit recognised in previous years); Or
- Multiplying the total estimated revenue by the
percentage of completion less the revenue recognised in
previous years.
- The journal entry:
Dr Construction expense
Dr Construction-in-progress
Cr Construction revenue
The general journal entries when the contract is completed:
Repeat the same steps 1 4
Step 5: To close off the construction-in-progress and
billings accounts:
Dr Billings on construction-in-progress
Cr Construction-in-progress

If the conditions are not satisfied, i.e. the contract outcome

cannot be reliably estimated:
- Revenue is to be recognised only to the extent that it is
probable that contract costs incurred will be
recoverable.
- Contract costs must be recognised as an expense in the
period in which they are incurred.

The general journal entries for each of the years during the contract
when the outcome cannot be estimated reliably:
Step 1: Record the construction costs
Dr Construction-in-progress
Cr Materials; Cash; etc
Step 2: Record the progress billing
Dr Accounts receivable
Cr Billings on construction-in-progress
Step 3: Record the receipt of cash
Dr Cash
Cr Accounts receivable
(Note that these journal entries are the same as those
where the outcome of the construction contract can be
estimated reliably)

Step 4: record the revenues and expenses

- The costs incurred during the year is recognised as an
expense. If the costs are expected to be recovered,
construction revenue equals to the costs would also be
recognised. The revenue and expense items will cancel
each other out to produce a nil profit recognised for the
year.
- The journal entry:

Dr Construction expense
Cr Construction revenue
The general journal entries when the outcome can be determined
reliably (in this case at the end):
Repeat the same steps 1 3
Step 4: record the revenues and expenses
- As the job is now completed and the contract outcome is
known, the profit on the contract can be recorded. The
total profit for the contract is recognised as an increase
in construction-in-progress, and the actual costs for the
year is recognised as expense, and revenue for this year
is calculated by adding the total profit to the costs
incurred for the year.
- The journal entry:
Dr Construction expense
Dr Construction-in-progress
Cr Construction revenue

Step 5: To close off the construction-in-progress and

billings accounts:
Dr Billings on construction-in-progress
Cr Construction-in-progress

The idea that estimated costs to complete change. Accountant

does not know in 2015 what will happen in 2016.
Difference between revenue and billings.
Idea of Construction-in-progress as inventory with profit added
in.
Total revenue over the term of contract is the contract price.