Appendix Accounting Under Special Situations - Guidance From Us Gaap

Appendix Accounting Under Special Situations—Guidance From Us Gaap

A number of specialized situations that are fairly common in long-term construction contracting are not addressed by international accounting standards. To provide guidance on certain of these matters, the following interpretations are offered, based on existing practice under US GAAP.

Joint Ventures and Shared Contracts

Many contracts obtained by long-term construction companies are shared by more than one contractor. When the owner of the contract puts it up for bids, many contractors form syndicates or joint ventures to bid on and obtain a contract under which each contractor could not perform individually.

When this transpires, a separate set of books is maintained for the joint venture. If the percentages of interest for each venture are identical in more than one contract, the joint venture might keep its records almost like another construction company. Usually, the joint venture is for a single contract and ends on completion of that contract.

A joint venture is a form of a partnership, although a partnership for a limited purpose. An agreement of the parties and the terms of the contract successfully bid on will determine the nature of the accounting records. Income statements are usually cumulative statements showing all totals from the date of contract determination until the reporting date. Each venturer records its share of the amount from the venture's income statement less its previously recorded portion of the venture's income as a single line item similar to the equity method for investments. Similarly, balance sheets of the venture give rise to a single line asset balance of investment and advances in joint ventures. In most cases, footnote disclosure is similar to the equity method in displaying condensed financial statements of material joint ventures.

Under international standards (IAS 31), a venturer's interest in a joint venture may be accounted for by either the proportionate consolidation or the equity method of accounting. See Chapter 10 for a detailed discussion of joint venture accounting.

Accounting for Change Orders

Change orders are modifications of specifications or provisions of an original contract. Contract revenue and costs should be adjusted to reflect change orders that are approved by the contractor and customer. According to US GAAP, the accounting for the change order depends on the scope and price of the change. If the scope and price have both been agreed on by the customer and contractor, contract revenue and cost should be adjusted to reflect the change order.

According to US GAAP, accounting for unpriced change orders depends on their characteristics and the circumstances in which they occur. Under the completed-contract method, costs attributable to unpriced change orders should be deferred as contract costs if it is probable that total contract costs, including costs attributable to the change orders, will be recovered from contract revenues. Recovery should be deemed probable if the future event or events are likely to occur.

According to US GAAP, the following guidelines should be followed when accounting for unpriced change orders under the percentage-of-completion method:

1. Costs attributable to unpriced change orders should be treated as costs of contract performance in the period in which the costs are incurred if it is not probable that the costs will be recovered through a change in the contract price.

2. If it is probable that the costs will be recovered through a change in the contract price, the costs should be deferred (excluded from the cost of contract performance) until the parties have agreed on the change in contract price, or alternatively, they should be treated as costs of contract performance in the period in which they are incurred, and contract revenue should be recognized to the extent of the costs incurred.

3. If an adjustment to the contract price will be made in an amount that will exceed the costs attributable to the change order, this may be given recognition under certain circumstances. Specifically, if the amount of the excess can be reliably estimated, and if realization is probable, then the original contract price should be so adjusted. However, since the substantiation of the amount of future revenue is difficult, revenue in excess of the costs attributable to unpriced change orders should only be recorded in circumstances in which realization is assured beyond a reasonable doubt, such as circumstances in which an entity's historical experience provides such assurance or in which an entity has received a bona fide pricing offer from a customer and records only the amount of the offer as revenue.

Accounting for Contract Options

According to US GAAP, an addition or option to an existing contract should be treated as a separate contract if any of the following circumstances exist:

1. The product or service to be provided differs significantly from the product or service provided under the original contract.

2. The price of the new product or service is negotiated without regard to the original contract and involves different economic judgments.

3. The products or services to be provided under the exercised option or amendment are similar to those under the original contract, but the contract price and anticipated contract cost relationship are significantly different.

If the addition or option does not meet the foregoing circumstances, the contracts should be combined. However, if the addition or option does not meet the criteria for combining, they should be treated as change orders.

Accounting for Claims

These represent amounts in excess of the agreed contract price that a contractor seeks to collect from customers for unanticipated additional costs. The recognition of additional contract revenue relating to claims is appropriate if it is probable that the claim will result in additional revenue and if the amount can be estimated reliably. US GAAP specifies that all of the following conditions must exist for the probable and estimable requirements to be satisfied:

1. The contract or other evidence provides a legal basis for the claim; or a legal opinion has been obtained, stating that under the circumstances there is a reasonable basis to support the claim.

2. Additional costs are caused by circumstances that were unforeseen at the contract date and are not the result of deficiencies in the contractor's performance.

3. Costs associated with the claim are identifiable or otherwise determinable and are reasonable in view of the work performed.

4. The evidence supporting the claim is objective and verifiable, not based on management's "feel" for the situation or on unsupported representations.

When the foregoing requirements are met, revenue from a claim should be recorded only to the extent that contract costs relating to the claim have been incurred. When the foregoing requirements are not met, a contingent asset should be disclosed in accordance with US GAAP governing contingencies.