ACCA Paper F7. Financial Management. theexpgroup.com

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1 Thank you for downloading this extract from our ExPedite notes to accompany your free online Course in a Coffee Break. To download a free complete set of our ExPress notes please visit Good luck with your F7 studies. ACCA Paper F7 Financial Management For exams in 2010

2 Chapter 4 Construction Contracts Construction contracts A construction contract is defined by IAS 11 as a contract specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use. Contracts often take a number of accounting periods to complete, with the contractor only being paid a profit at the completion of the project. In the absence of IAS 11, contractors may show years of no profit, or losses, followed by a bonanza year of profits at the completion of the project. The aim of IAS 11 is fairly to match activity and profit over the life of the contract. IAS 11 is focused on the profit and loss figures far more than the statement of financial position figures. IAS 11 does not apply to provision of services, nor is there any minimum length of the contact, as long as it spans an accounting period. The aim of IAS 11 is to strike an appropriate balance between imprudently recognising profits before they are reasonably certain to be earned and mismatching costs and revenues with unfair recognition of profits. Page 4.1

3 Fixed price Yes Yes ExPedite Notes Summary of accounting treatment for construction contacts The summary diagram below gives the scenarios that are likely to arise in the paper F7 exam. Is the contract for mark up or for fixed price? Mark up Recognise profit as costs are incurred Is the contract expected to be profit making? No Recognise expected loss in full when apparent Is the outcome of the contract reasonably certain? No Match revenues to equal costs to show no profit, no loss Recognise attributable profit as it is earned, based on % completion Page 4.2

4 Estimating stage of completion IAS 11 allows any reasonable method as an accounting policy choice for estimating the method of completion. Common methods include: Work certified Total expected revenue Costs incurred Total expected costs The most common method in the exam is the work certified basis. Approach Step 1: Step 2: Step 3: Step 4: Step 5: Step 6: Identify whether the contract is expected to be profit making or loss making, by looking at expected total revenues and costs. Work out % completion. Take % completion x expected total revenues = cumulative recognised turnover on contract Take % completion x expected total costs = cumulative recognised cost of contract For a loss making contract, add a provision for losses to costs to reach total expected costs Complete SOFP figures, using proforma workings below (which are also disclosure notes to the financial statements required by IAS 11). Review and self-test 1: Olympique $ 000 Value of contract 1,000 Work certified to date 700 Costs incurred to date 680 Expected costs to complete 70 Progress payments invoiced 800 Cash received 630 Expected profit Total revenue Total expected costs Total expected profit/ loss Page 4.3

5 Revenue recognised Costs recognised Profit recognised Statement of financial position figures to date Costs incurred to date Add: Profit recognised to date Total due on contract Less: Progress payments invoiced Amount recoverable on contract Trade receivables Review and self-test 2: Niland Niland Co is constructing a swimming pool for a local authority, under a construction contract. The contract is expected to take two years to complete and is for a fixed price of $10 million. Niland Co assumes all the risk of cost over-runs. You are given these figures for two years: Year 1 Year 2 $ 000 $ 000 Total revenue 10,000 10,000 Costs to date 2,000 4,000 Expected costs to complete 6,200 5,700 Work certified to date 1,800 7,800 Progress payments invoiced 1,750 4,100 Cash received 1,600 3,800 % complete (1) In each year, costs to date include inventory of raw materials of 200. Page 4.4

6 (2) At the end of year 2, it began to look likely that late completion penalties of $150,000 would reduce the amount of the contract s price. (3) Completion is estimated by reference to work certified. Total expected outcome Year 1 Cumulative Year 2 Total revenue Total costs Total profit Revenue recognised Costs recognised Profit recognised SOFP figures to date Costs incurred Profit recognised Total due on contract Less: PP invoiced Amount recoverable Year 1 Year 2 Inventory Trade receivables Page 4.5

7 Review and self-test 3 Dimmo has contracted to build a television studio and editing suite for DigiCo for an agreed price of $10 million. The contract was expected to take two years to complete at its inception. At the first year end to occur during the construction period (31.12.x1), the following latest estimates are available: Year 1 $ 000 Total revenue 4,000 Costs to date 1,800 Expected costs to complete 2,700 Work certified to date 1,600 Progress payments invoiced 1,600 Cash received 1,450 During the following year, the construction contract was completed, with these final cumulative figures available during the year ended x2: Year 2 $ 000 Total revenue 4,000 Costs to date 4,350 Expected costs to complete 0 Work certified to date 4,000 Progress payments invoiced 4,000 Cash received 3,800 Required Show the presentation of the above contract in the financial statements of Dimmo for the years ended x1 and x2. Total expected outcome Year 1 Cumulative Year 2 Total revenue Total costs Total profit Page 4.6

8 Revenue recognised Costs recognised Profit recognised SOFP figures to date Costs incurred Profit recognised Total due on contract Less: PP invoiced Amount recoverable Year 1 Year 2 Inventory Trade receivables Page 4.7

9 Solution to review and self-test 1 (All figures $ 000s) Expected profit Total revenue 1,000 Total expected costs (750) Total expected profit/ loss 250 Revenue recognised (70% x 1,000) 700 Costs recognised (balance) (525) Profit recognised 175 Statement of financial position figures to date Costs incurred to date 680 Add: Profit recognised to date 175 Total due on contract 855 Less: Progress payments invoiced (800) Amount recoverable on contract 55 Trade receivables ( ) 170 Solution to review and self-test 2 (all figures $ 000s) Total expected outcome Year 1 Cumulative Year 2 Total revenue 10,000 9,850 Total costs (8,200) (9,700) Total profit 1,800 Revenue recognised 1,800 (78% x 9,850) = 5,883 7,683 Costs recognised (1,800) (7,566) (5,766) Profit recognised Page 4.8

10 SOFP figures to date Year 1 Year 2 Costs incurred 1,800 3,800 Profit recognised Total due on contract 1,800 3,917 Less: PP invoiced (1,750) (4,100) Amount recoverable 50 (183) Inventory Trade receivables Note: To allow for the inventory incorrectly included within cost of sales: Costs incurred to date each period reduced by 200 Costs to complete each period increased by 200. Year 1 completion = 1,800/10,000 = 18% Year 2 completion = 7,800/ 10,000 = 78% Page 4.9

11 Solution to review and self-test 3 (all figures $ 000s) Total expected outcome Year 1 Cumulative Year 2 Total revenue 4,000 4,000 Total costs (4,500) (4,350) Total profit (500) (350) Revenue recognised 1,600 4,000 2,400 Costs recognised (2,100) (4,350) (2,250) Profit recognised (500) (350) 150 SOFP figures to date Year 1 Year 2 Costs incurred 1,800 4,350 Profit recognised (500) (350) Total due on contract 1,300 4,000 Less: PP invoiced (1,600) (4,000) Amount recoverable (300) 0 Inventory 0 0 Trade receivables Page 4.10