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