Understanding accounting for construction contracts (IAS 11)

IAS 11: CONSTRUCTION CONTRACTS

Objective of IAS 11

The objective of IAS 11 is to prescribe the accounting treatment of revenue and costs associated with construction contracts.

Definitions

1.      Contract

It’s an agreement between two people, where one party undertakes to deliver an item and the other to pay for the delivery of the items.

2.      Construction Contracts

A construction contract is a contract specifically negotiated for the construction of an asset or a group of interrelated assets. The relationship of the assets is in terms of design, technology or functions of their ultimate purpose.

3.      Contract Revenue

It’s the amount specified in the contract subject to variations in contract work, incentive payments and any claims that give rise to revenue. That is, contract revenue comprises:

1)      The initial amount of revenue agreed in the contract

2)      Variations in contract work and claims to the extent that:

·         It’s probable that they will result in revenue

·         They are capable of being measured reliably

3)      Incentive payments which are additional payments made to the contractor if performance standards are met or exceeded when the contract is sufficiently advanced that:

·         It is probable that specified performance standards will be met/exceeded and

·         The amount of the incentives can be measured reliably

NB: The contract revenue is reduced by the amount of any penalties arising from delays caused by the contractor in the completion of the contract

4.      Claim

Is the amount that the contractor seeks to reclaim (refund) from the customer as reimbursement for the costs not included in the contract price. Claims may arise due to errors in design or customer caused delays.

5.      Contract Costs

Contract costs comprises of:

1)      Costs that relate directly to the specific contract

2)      Costs that are attributable to contract activity in general and can be allocated to the contract. Eg, insurance, cost of design and technical assistance not directly related

3)      Such other costs as are specifically chargeable to the customer under terms of the contract. Eg, development costs (Capitalized) and administration costs etc

NB: Costs that relate directly to a specific contract include the following:

·         Site labour costs including site supervision

·         Costs of materials used in construction

·         Depreciation of plant and equipment used on the contract

·         Costs of moving plant and equipment and other materials to and from the site

·         Cost of hiring plant and equipment

·          Cost of design and technical assistance that are directly related to the contract

·         Claims from 3^rd parties

Recognition of Contract Revenue and Costs

Recognition depends upon whether the outcome of the contract can be measured reliably.

1.      Where the outcome can be estimated reliably

·         If the expected outcome is a profit: Revenues and costs should be recognized according to the stage of completion of the contract

·         If the expected outcome is a loss: The whole loss should be recognized immediately (loss to completion)

2.      Where the outcome cannot be estimated reliably

·         Revenue should be recognized only to the extent of the contract costs incurred that’s probable to be recovered

·         Contract costs should be recognized as an expense in the period in which they are incurred

NB: An expected loss on such a construction contract (if it arises) should be recognized as an expense immediately

Example 1

The following information relates to a construction contract:

Estimated contract revenue         $800,000

Cost to date                                 $320,000

Estimated costs to complete        $280,000

Estimated stage of completion        60%

Required

What amount of revenue, costs and profit should be recognized in the income statement?

Example 2

Take the same contract (example 1 above) but now assume that the business is not able to reliably estimate the outcome of the contract although it’s believed that all costs incurred will be recoverable from the customer.

Required

What amount should be recognized for revenue, costs and profits in the income statement?

Reliable Estimate of Contract Revenue

A reliable estimate of the outcome of a construction contract can only be met when certain conditions have been met. These conditions will be different for a Fixed Price and Cost Plus Contracts.

Conditions for a Fixed Price Contract

1.      Probable that economic benefits of the contract will flow to the entity

2.      Total contract revenue can be reliably measured

3.      Stage of completion at the period end and costs to complete the contract can be reliably measured

4.      Costs attributable to the contract can be identified clearly and reliably measured

Conditions for a Cost Plus Contract

1.      Probable that economic benefits of the contract will flow to the entity

2.      Costs attributable to the contract (whether or not reimbursed) can be identified clearly and be reliably measured

Determination of stage of completion of the contract

IAS 11 indicates several ways in which the percentage of completion of a contract maybe arrived at.

1.      Proportion of Contract Cost

% of  completion	=	Cost incurred to date	x 100
		Total contract costs

2.      Survey of work carried out

% of  completion	=	Work Certified	x 100
		Contract Price (Revenue)

3.      Physical proportion of the contract work completed

Presentation of Financial Statements

Extract Income Statement

Revenue                         xx        x%

Cost: - To date              (xx)       x%

          -To complete      (xx)       x%

Profit or Loss                 xx         x%

Extract Statement of Financial Position

The following figures may appear in the statement of financial position:

1)      Gross amount due from customers (asset)

2)      Gross amount due to customers (liability)

The calculation which may result in an asset or liability is as follows:

Cost Incurred (to date)                xx

Add: Recognized profit              xx

Less: Recognized losses            (xx)

Less: Progress billings               (xx)

Gross amount due to/from         (xx)/ xx

Disclosure Requirements of IAS 11

1)      The amount of contract revenue, recognized as revenue in the period

2)      The methods used to determine contract revenue in the period (fixed or cost plus)

3)      The methods used to determine stage of completion

4)      The aggregate amount of costs incurred and recognized profits (less recognized losses) to date

5)      The amount of advances received

6)      The amount of retentions

Example

The main business of S Ltd is construction contracts. At the end of September 2003, there is an uncompleted contract on the books, details of which are as follows:

Contract B

Date commenced                                                     01/04/2001

Expected completion                                               23/12/2003

Final contract price                                                     $290,000

Cost to 30/09/2003                                                      $210,400

Value of work certified to 30/09/2003                        $230,000

Progress billings 30/09/2003                                       $210,000

Cash received to 30/09/2003                                       $194,000

Estimated costs to completion 30/09/2003                    $20,600

Required

Prepare calculations showing amount to be included in the Income Statement and Statement of Financial Position as at 30/09/2003

Understanding IAS 18 Revenue

IAS 18: REVENUE

Objective of IAS 18

The objective of IAS 18 is to prescribe the accounting treatment for revenue arising from certain types of transactions and events.

Classification of Revenue

1.      Sale of goods

2.      Rendering of services

3.      Others e.g Interests, Dividends and Royalties

Definitions

1.      Revenue

The gross inflow of economic benefits (cash, receivables, other assets) arising from the ordinary operating activities of an entity (such as sales of goods, sales of services, interest, royalties, and dividends).

2.      Fair Value

Is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

3.      Interests

Is the charge for the use of cash or cash equivalents or amounts due to the entity.

4.      Royalties

Are charges for the use of intangible NCA of an entity. Such as patents, computer software, trademarks etc.

5.      Dividends

Are distributions of profits to holders of equity investments in proportion with their holdings of each class of capital

Measurement of Revenue

Revenue should be measured at the fair value of the consideration received or receivable. An exchange for goods or services of a similar nature and value is not regarded as a transaction that generates revenue. However, exchanges for dissimilar items are regarded as generating revenue.

If the inflow of cash or cash equivalents is deferred, the fair value of the consideration receivable is less than the nominal amount of cash and cash equivalents to be received, and discounting is appropriate. This would occur, for instance, if the seller is providing interest-free credit to the buyer or is charging a below-market rate of interest. Interest must be imputed based on market rates.

Recognition of Revenue

Recognition, as defined in the IASB Framework, means incorporating an item that meets the definition of revenue (above) in the income statement when it meets the following criteria:

1. It is probable that any future economic benefit associated with the item of revenue will flow to the entity, and
2. The amount of revenue can be measured with reliability

IAS 18 provides guidance for recognising the following specific categories of revenue:

1.      Sale of Goods

Revenue arising from the sale of goods should be recognised when all of the following criteria have been satisfied:

1. The seller has transferred to the buyer the significant risks and rewards of ownership
2. The seller retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold
3. The amount of revenue can be measured reliably
4. It is probable that the economic benefits associated with the transaction will flow to the seller, and
5. The costs incurred or to be incurred in respect of the transaction can be measured reliably

2.      Rendering of Services

For revenue arising from the rendering of services, provided that all of the following criteria are met, revenue should be recognised by reference to the stage of completion of the transaction at the balance sheet date (the percentage-of-completion method):

1. The amount of revenue can be measured reliably;
2. It is probable that the economic benefits will flow to the seller;
3. The stage of completion at the balance sheet date can be measured reliably; and
4. The costs incurred, or to be incurred, in respect of the transaction can be measured reliably.

When the above criteria are not met, revenue arising from the rendering of services should be recognised only to the extent of the expenses recognised that are recoverable (a "cost-recovery approach".

3.      Others: Interest, Royalties, Royalties and Dividends

For interest, royalties and dividends, provided that it is probable that the economic benefits will flow to the enterprise and the amount of revenue can be measured reliably, revenue should be recognised as follows:

1. Interest: using the effective interest method as set out in IAS 39
2. Royalties: on an accruals basis in accordance with the substance of the relevant agreement
3. Dividends: when the shareholder's right to receive payment is established

Disclosure

1. Accounting policy for recognising revenue
2. Amount of each of the following types of revenue: sale of goods, rendering of services, interest, royalties, dividends. Within each of the above categories, the amount of revenue from exchanges of goods or services

Accruals concept and matching concept applications

Unearned Revenue in subscription sale

A liability exists when a customer pays in advance. Only the realized period revenue should appear in the current year’s profit and loss with the remaining portion taken to the balance sheet as a liability.

Unearned Revenue in service contract sales

Divide the entire sales Revenue into two components, the asset sale and the servicing sale. The contract service revenue is not earned by the end of year 1 if it’s a 3 year contract. A liability should be created by DR sales account and CR the liability/provision account for the two year unearned revenues for serving.

Example 1

On 1^st October, 2001 a company received total subscription in advance of $288,000 for 12 months publications of a magazine. At the year end the company had produced and dispatched 3 of 12 publications. The total cost of producing one issue of the magazine is estimated at $20,000.

Required

Using the traditional approach to revenue recognition how the company should treat the subscription in the a/c for the year ended 31^st December, 2001.

Example 2

On 1^st July, 2003, Company A signs a contract with a customer under which company A delivers off the shelf IT system on that date and then provides support services for the next 3 years. The contract price is $740,000. The cost of support services is estimated at $60,000 per annum and company A normally makes a profit margin of 25% on such work. Company A makes up financial statements to 31^st December each year.

Required What revenue should be recognized in the financial statements for the year ended 31^st December, 2003

Sale and Lease back of Non Current Assets.

The purported sale of a non current asset should be carefully examined to identify whether risks and rewards have been transferred to the buyer (Bank). If in fact the firm has transferred risks and rewards then a sale is recognized and a profit or loss on disposal exists. However if the firm still retains risks and rewards of ownership, then no sale is recognized. It is a creative accounting model to reduce gearing as the liability is now conveniently converted to a sale. To correct the anomaly, CR Loan (To show the substance of the transaction) and Dr Sales Account that had been erroneously CR. The correct DR is the Bank account. 

Errors in accounts & suspense accounts

ERRORS ON ACCOUNTS

There are two types of errors in accounts:

·         Errors that don’t affect the trial balance

·         Errors that affect the trial balance

Errors that don’t affect the trial balance

The trial balance produced from the accounts appears to be okay/correct, i.e the debits are the same as the credits.  However, on taking a close check on the balances and transactions posted, errors may have been made and therefore the balances shown on the trial balance may be incorrect i.e. under/over stated.

There are 6 main types of errors that don’t affect the trial balance if made on both accounts. i.e a debit and a credit entry.

These are explained as follows:

a)      Error of omission

Here, a transaction is completely omitted from the accounts and therefore the double entry is not made at all. e.g. a sales invoice of $.40,000 is not posted in the sales daybook therefore no entry is made in the receivables’ control account and the sales account i.e. both debit of $.40,000 in Receivables’ control account and credit of $.40,000 in the sales account are not made.

The effect of the error is that it understates both the receivables and the sales.

To correct this error, the transaction is posted in the books by:

Debiting Receivables               $.40,000

Crediting sales                                         $.40,000

b)     Error of Commission

This error occurs when a transaction is posted to a wrong account but the account is of the same class.  Example: a credit sale to T. Brown is posted to L. Brown account for an amount of $.20,000.  Instead of a debit to T. Browns’ account it is made to L.Browns’ account and the corresponding credit in the sales account is correct.

Although the debit entry is made into the wrong account, the two accounts are of the same class i.e. debtors/ Receivables.

To correct this error atransfer is made from L. Browns’ account to T. Browns’ by:

                                                                                    $.                        

                   (i)            Debit T. Browns’ a/c                       20,000

                 (ii)            Credit L Browns’ a/c                                       20,000

c)      Error of principle

In this type of error a transaction is posted not only to the wrong account but also of a different class. i.ebreaking the rules of an accounting principle or concept. e.g. Motor vehicle purchased for $.400,000 is posted to the motor vehicle expenses a/c.  (Instead of debiting motor vehicles, we debited motor vehicle expenses a/c and the credit entry in the cashbook is correct)

The motor vehicles account is a non-current asset, and motor vehicles expenses a/c is an expense account.  Therefore a capital expenditure has been posted as revenue expenditure.

To correct this error a transfer is made from the motor expenses account to the motor vehicles a/c by:

                                                                                       $      

                               (i)            Debit Motor vehicles a/c         400,000

                             (ii)            Credit Motor expenses a/c                       400,000

d)     Complete reversal of entries

A transaction is posted to the correct accounts but to the wrong sides of the accounts i.e. a debit is posted as a credit and a credit is posted as a debit.  Example: cash drawn from the bank of $.15,000 for business use is posted as a debit in the bank account and credit in cash in hand.

To correct this error, two entries are made in the relevant accounts:

                   (i)            Correct the error

                 (ii)            Post the transaction correctly

The entries will therefore be as follows:

                   (i)            Debit Cash in hand by     $.15,000

Credit bank by                                 $.15,000

To correct the error of $. 15,000 posted in the wrong sides of these account

                 (ii)            Debit cash by                  $.15,000

Credit bank by                                 $.15,000

To post the entries correctly

e)      Error of Original entry

Here a transaction is posted to the correct accounts but the amount posted is not correct i.e. it is either under/over stated.  In some cases, this is known as a transposition error e.g. cash received from a debtor of $.98,000 is credited/posted to the customer’s account as $.89,000.

To correct this error, the amount understated or overstated is posted to these accounts to reflect the correct balance.  In this case, we will:

                                                                                  $.                          

Debit cash book                                      9,000

Credit debtors                                          9,000

f)       Compensating Errors

These are errors that tend to cancel out each other i.e. if the effect of one error is to understate the debits or credits then another error may take place to overstate the debits or credits by the same amount, hence canceling out each other. E.g. if the balance c/d of the purchases a/c is $.398,000 but shown in the trial balance as $.389,000 and another error carried to the trial balance of fixture amounting to $.454,000 instead of $.445,000:

                                                  $.

Purchases                                398,000

                                                389,000

                                                  (9,000)

                                               

   $.

Fixtures                                   445,000

                                (454,000)

                                                   9,000

This type of error is corrected by use of a suspense account.

g)      Slide error

e.g, a credit sale of S13,000 is written as $130.00. the effect will be to understate sales and receivables by $12,870.

To correct the error, Dr. Receivables                       12,870

                                 Cr. Sales                                                 12,870

Illustration 1

Give the journal entries needed to record the corrections of the following.  Narratives are required.

a)        Extra capital of $. 10,000 paid into the bank had been credited to Sales account.

b)       Goods taken for own use $.700  had been debited to General Expenses.

c)        Private insurance $. 89 had been debited to Insurance account.

d)       A purchase of goods from C Kelly  $.857 had been entered in the books as $.587.

e)        Cash banked $. 390 had been credited to the bank column and debited to the cash column in the cashbook.

f)        Cash drawings of $. 400 had been credited to the bank column of the cashbook.

g)       Returns inwards $. 168 from M Mardock had been entered in error in J Mardock’s account.

h)       A sale of a motor van $. 1,000 had been credited to Motor Expenses.

 

Errors That Affect The Trial Balance And The Suspense Account

These types of errors are reflected on the trial balance because the debits will not be same as the credits.  The debits may be more than the credits and vice versa.

Examples include:

1.        Transaction is posted on one side of the accounts only i.e. only a debit entry or a credit entry. (omission error on one account)  Example cash received from a debtor is debited to the cashbook and no other entry is made in the account, i.e. no credit entry on the debtor’s a/c.

2.        A transaction is posted on one side of both the accounts i.e. two debits or two credits.  Example a payment to a creditor of Ksh.30,000 is credited in the cashbook and also credited in the creditor’s accounts.

3.        A transaction is posted correctly but different amounts i.e. debit is not the same as the credit.  Example – cash received from a debtor of Ksh.45,000 is debited in the cashbook as Ksh.45,000 and credited as Ksh. 54,000 in the debtor’s a/c.

4.        Error on balances of accounts – i.e. understatement or overstatement of an account balance due to mathematical errors.

5.        Balance on an account is shown on the wrong side of the account when opening the ledger accounts or when taken up to the trial balance.  Example Bal c/d in the cash book for cash at bank of Ksh. 200,000 is shown as a credit i.e. an overdraft, instead of a debit in the trial balance.  The balance may also be brought down as an overdraft instead of a debit balance in the trial balance.

6.        A balance is omitted from the trial balance on the accounts in total.

To correct the above errors, the appropriate or the adjusting entries are made through an account called a suspense account.

The difference in the accounts is posted to this account and the entries to correct the accounts are posted here.  The balance to be shown on the suspense accounts depends on which side the error is shown on the trial balance.

If the debits > credits, then an amount is included on the credit side of the trial balance so that the debits = credits.  This is a credit balance and will be taken to the suspense account on the credit side.

Example:

                                                                DR                          CR

                Total                                        24,000                     20,000

                Suspense                                 -                                 4,000

                                                                24,000                     24,000

                                 Suspense a/c

	Ksh		Ksh
		Difference as per T/B	4,000

If the credits are more than the debits this is a debit balance and therefore we require an amount to be added to the total of the debits for the two sides to be same.  This debit balance is posted to the debit side of the suspense a/c.

DR                          CR

                Total                                        26,000                     30,000

                Suspense                                 4,000                       -

                                                                30,000                     30,000

                                             Suspense a/c

	Ksh		£
Difference as per T/B	4,000

Posting the correct entries should eliminate the balance on the suspense account.

In some cases, after checking for all errors that can affect the trial balance, the suspense a/c has a balance.  This balance depends on whether it is a credit or debit and whether it is material or not for purposes of proper accounting treatment. The following is the recommended approach:

Balance	Material	Not Material
Debit	Show as an asset (eg) other debtors	Charge in P& L as an expense
Credit	Show as a liability (eg) other creditors	Report as income in P&L

USES OF SUSPENSE ACCOUNT

i)         When the trial balance does not balance (eg due to transposition, commission or omission errors made on one account only – discussed above)

ii)       When a bookkeeper does not know where to post one side of a transaction. Eg when a business receives cash banked directly to the bank from a source which is unknown: Dr. Cashbook; Cr. Suspense A/c. eventually, when the cheque is confirmed it was from a debtor: Dr.suspence A/c; Cr. Receivables a/c.

N/B: suspense accounts are only temporary. Postings to suspense account are only made when the bookkeeper doesn’t know yet what to do, or when an error has occurred. Mysteries must be solved, and errors must be corrected. Under no circumstances should there still be a suspense account when it comes to preparing the statement of financial position of a business. The suspense account must be cleared and all the correcting entries made before the final accounts are drawn up.

Illustration1

A bookkeeper extracted a trial balance on 31 December 2012 that failed to agree by Ksh.330,000, a shortage on the credit side of the trial balance.  A suspense account was opened for the difference.

In January 2013 the following errors made in 2012 were found:

       (i)            Sales daybook had been undercast by Ksh.100,000.

     (ii)            Sales of Ksh.250,000 to J Chumo had been debited in error to J Chuma account.

    (iii)            Rent account had been undercast by Ksh.70,000.

    (iv)            Discounts received account had been under cast by Ksh.300,000.

     (v)            The sale of a motor vehicle at book value had been credited in error to Sales account Ksh.360,000.

You are required to:

a)        Show the journal entries necessary to correct the errors.

b)       Draw up the suspense account after the errors described have been corrected.

c)        If the net profit had previously been calculated at Ksh.7,900,000 for the year ended 31 December 2002, show the calculations of the corrected net profit

EFFECT OF AN ERROR ON NET PROFIT AND TOTAL ASSETS

In some cases, the correction of an error might have an effect in the net profit (in the income statement) or net assets (in the Statement of Financial Position). i.e increase or decrease Net profit and net assets.

Illustration3

On 31 December 2011, an inexperienced bookkeeper working for Wanji, a sole trader extracted a trial balance.  Due to errors committed by the bookkeeper, the trial balance failed to balance by Sh 369,400.  He placed the difference in a suspense account as shown below:

Wanji trial balance as at 31 December 2011

	Sh	Sh
Non-current Assets – cost	832,000
Stocks:
1 January 2011	148,000
31 December 2011		98,800
Trade debtors		76,000
Prepayments		10,000
Trade creditors	34,600
Bank overdraft		15,200
Accruals		16,000
Drawings	359,600
Capital		1,054,000
Sales	1,043,200
Provision for depreciation		166,400
Purchases		733,000
Operating expenses	126,000
Provision for doubtful debts		3,800
Discounts received	5,000
Discounts allowed		5,800
Suspense account	________	369,400
	2,548,400	2,548,400

Investigations carried out after preparing the above trial balance detected the following errors:

1.          The total of the sales daybook for December 2011 was overcast by Sh 25,700.

2.          On July 2011, the business purchased office equipment for Sh 40,000.  These were debited to purchases account.  Depreciation on the equipment is at the rate of 10% per annum on cost and based on the period (months) of usage in the year.

3.          A payment to a creditor by cheque of Sh. 8,500 was erroneously credited to the creditor’s account.

4.          A payment of Sh. 4,500 for telephone expenses was debited to telephone account as Sh 5,400.

5.          An amount of Sh 15,000 received from a debtor was not posted to the debtor’s account from the cashbook.

6.          Purchases daybook for October 2011 was under cast by Sh 28,000.

Assume the business had reported a net profit of Sh 85,800 before adjusting for the above errors.

Required:

(a)        The adjusted trial balance and the correct balance of the suspense account.   (6 marks)

(b)        Journal entries to correct the errors (Narrations not required)                                       (6 marks)

(c)        Suspense account starting with the balance determined in the adjusted trial balance in (a) above.                                                                                                                                                                                        (4 marks)

(d)        The adjusted net profit for the year.                                                                                 (4 marks)