OVERVIEW
Objective
¾
To describe and explain the accounting treatment for construction contracts.CONSTRUCTION CONTRACTS
PRESENTATION AND DISCLOSURE RECOGNITION
AND MEASUREMENT
¾ Definitions
¾ Key issue
¾ Revenue
¾ Contract costs
¾ The rules ¾ Calculations
1
CONSTRUCTION CONTRACTS
1.1
Definitions
¾
A construction contract is a contract specifically negotiated for the construction of: an asset; or
a combination of assets that are:
−
closely interrelated; or−
interdependentin terms of their design, technology and function or their ultimate purpose or use.
¾
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.¾
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.¾
Construction contracts include: Contracts for the rendering of services which are directly related to
the construction of the asset, for example, those for the services of project managers and architects; and
Contracts for the destruction or restoration of assets, and the
restoration of the environment following the demolition of assets.
¾
Contrast this with speculative building work without a firm sale contract.This is work-in-progress and is valued at the lower of cost and net realisable value.
1.2
Key issue
Revenue and profit recognition
¾
Contracts may last several years. Costs are incurred, and customer is billed, over duration of contract.¾
Potential treatments (not under IFRS, but technically): Recognise all revenue and related costs in statement of comprehensive income only
Commentary
“Completed contract” method” is dominant under some GAAPS – but it is not IFRS.
Recognise revenue and costs in statement of comprehensive income as contract
progresses.
¾
Accruals and prudence Should recognise revenues and costs as they are earned and incurred.
Should only recognise profits when cash realisation is reasonably certain, but make
provision for costs and losses when foreseen.
Prudence may conflict with accruals.
¾
IAS 11 requires that the costs and revenues associated with a contract should be recognised in the statement of comprehensive income as the contract activity progresses.1.3
Revenue
¾
Contract revenue should comprise: 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.Commentary
Variations may arise if, for example, actual inflation is greater than that assumed when the contract commenced.
¾
Contract revenue is measured at the fair value of the consideration received or receivable.Commentary
If deferred, fair value should be discounted (i.e. present value of amount receivable).
Examples
A contractor and a customer may agree variations or claims that increase or decrease
contract revenue in a period subsequent to that in which the contract was initially agreed.
The amount of revenue agreed in a fixed price contract may increase as a result of
cost escalation clauses.
The amount of contract revenue may decrease as a result of penalties arising from
delays caused by the contractor in the completion of the contract.
When a fixed price contract involves a fixed price per unit of output, contract
revenue increases as the number of units is increased.
1.4
Contract costs
¾
Contract costs comprise: Costs that relate directly to the specific contract;
Costs that are attributable to contract activity in general and can be allocated to the
contract; and
Such other costs as are specifically chargeable to the customer under the terms of
the contract.
¾
Costs that relate directly to a specific contract include: 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, equipment and materials to and from the contract site; Costs of hiring plant and equipment;
Costs of design and technical assistance that is directly related to the contract; The estimated costs of rectification and guarantee work, including expected
warranty costs; and
2
RECOGNITION AND MEASUREMENT
2.1
The rules
2.1.1
General
¾
Contracts should be considered on a contract by contract basis.Commentary
There is no “offset” of profits/losses until the final presentation in the financial statements.
¾
In certain circumstances: two or more contracts may be combined to be considered as one;
Commentary
When they are negotiated as a package, closely inter-related and performed concurrently or in a continuous sequence.
a contract may be “segmented” into two or more separate contracts.
Commentary
When there are separate proposals/negotiations such that segments can be individually accepted/rejected and separately identifiable costs/revenues.
¾
The impact that a contract will have on the financial statements depends on the estimate of the future outcome of the contract.¾
The rules in IAS 11 provide for three possibilities, arising on contract review. Contracts which are expected to make a profit and where the outcome is reasonably
certain. Revenue and cost will be recognised in the statement of comprehensive income resulting in some profit being taken.
Contracts where a loss is expected. The exercise of prudence requires that this loss
be recognised immediately and in full.
Contracts where the outcome cannot be assessed with reasonable certainty.
2.1.2
Specific
¾
When it is probable that total contract costs will exceed total contract revenue, the expected loss should be recognised as an expense immediately.¾
When the outcome of a construction contract cannot be estimated reliably: Revenue should be recognised only to the extent of contract costs incurred that it is
probable will be recoverable; and
Contract costs should be recognised as an expense in the period in which they are
incurred.
Situation How is
revenue measured?
How are costs
measured? Commentary
Profit is being
taken By reference to the stage of (percentage) completion method
The costs incurred in reaching the stage of completion are included within cost of sales.
Often this is achieved by applying the percentage completion to the total costs that are expected to occur over the life of the contract.
Revenue exceeds costs therefore profit is recognised.
If the same % completion is applied to revenue and costs then this will result in that percentage of the total estimated profit being recognised
Loss making
contracts By reference to the stage of (percentage) completion method
As a balancing figure to interact with the revenue that has been recognised and generate the required loss.
Loss may be recognised at any stage of a contract. For example an entity may have signed a contract that it knows will make a loss. In such a case the loss should be recognised when the contract is signed.
Contracts where the outcome is uncertain
To equal the
cost figure The costs incurred in the period should be expensed
Revenue = costs
The usual source of
¾
The accounting should be performed so as to recognise revenue and costs that have arisen in the period. This is done by calculating the amounts in total that should be recognised by the year end and then adjusting them for what has been recognised in earlier years.2.1.3
Meaning of “can be estimated reliably”
¾
In the case of a fixed price contract, the outcome of a construction contract can be estimated reliably when all the following conditions are satisfied: total contract revenue can be measured reliably;
it is probable that the economic benefits associated with the contract will flow to the
entity;
both the contract costs to complete the contract and the stage of contract completion
at the end of the reporting period can be measured reliably; and
the contract costs attributable to the contract can be clearly identified and measured
reliably so that actual contract costs incurred can be compared with prior estimates.
¾
In the case of a cost plus contract, the outcome of a construction contract can beestimated reliably when all the following conditions are satisfied:
it is probable that the economic benefits associated with the contract will flow to the
entity; and
the contract costs attributable to the contract, whether or not specifically
reimbursable, can be clearly identified and measured reliably.
2.1.4
Stage of completion
¾
The recognition of revenue and expenses by reference to the stage of completion of a contract is often referred to as the percentage of completion method. Contract revenue is matched with the contract costs incurred in reaching the stage
of completion, resulting in the reporting of revenue, expenses and profit which can be attributed to the proportion of work completed.
This method provides useful information on the extent of contract activity and
performance during a period. The standard does not specify a single method for calculating the percentage of completion. Methods include:
−
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.¾
Note that: amounts billed are irrelevant in determining revenue to be taken to the statement of
comprehensive income; and
costs incurred by the year end (and therefore appearing in the cost accounts) may
be an irrelevant figure in determining cost of sales.
¾
IAS 11 applies to construction contracts as defined. IAS 18 Revenue requires a similar approach for contracts for the provision of a service.2.2
Calculations
2.2.1
Basics
¾
Make all calculations on contract by contract basis. There is no netting-off of profits on, or assets relating to, one contract against losses or liabilities on another.¾
Steps to obtain figures for the statement of comprehensive income.(a) Calculate total expected profit
$
Contract price X
Less Costs to date (X)
Estimated future costs (X) ___
X ___
(b) Calculate the stage of completion
Acceptable methods include
Sales basis Cost basis
Value of work done to date Costs to date Total sales value Total costs
(IAS 11does not specify a method).
(c) Calculate revenue and costs for the year
(i) Calculate attributable revenue and costs to date (using proportion above) (ii) Deduct any revenue and costs taken in earlier periods.
Example 1
Tanner Ltd – year ended 31 December 2007
$
Costs to date 1,500
Future expected costs 1,000
Work certified to date 1,800
Expected sales value 3,200
Revenue taken in earlier periods 1,200
Cost taken in earlier periods 950
Required:
Calculate the figures to be taken to the statement of comprehensive income in respect of revenue and costs year ended 31 December 2007 on both:
(i) a sales basis; and (ii) a cost basis.
Proforma solution
(a) Calculate total expected profit
$ Revenue
Less Contract costs to date
Future expected costs ______
Total expected profit
______
(b) Calculate percentage completion
(c) Calculate revenue/costs for the year
(1) To date (2) Prior (1) To date (2) Prior period $ period $
Revenue
Cost of sales
_____ _____
Profit
_____ _____
(1) Calculate attributable revenue and costs to date
(2) Deduct any revenue and costs taken in earlier periods.
2.2.2
A complication
¾
In the above example the costs have been measured using the same percentage as that used to calculate the revenue.¾
This assumes that both costs and revenues arise evenly over the life of the contract. This may not be the case. IAS 11 says that the costs that must be measured as those incurred in reaching the stage of completion of the contract.Illustration 1
Tanner Ltd – year ended 31 December 2007
$ Costs to date (including a rectification cost of $50) 1,500
Future expected costs 1,000
Work certified to date 1,800
Expected sales value 3,200
Revenue taken in earlier periods 1,200
Cost taken in earlier periods 950
Percentage complete (cost basis as before) 60%
Required:
Calculate the figures to be taken to the statement of comprehensive income in respect of revenue and costs year ended 31 December 2007 on a costs basis. The total costs that are expected to arise over the life of the contract are $2,500. These are made up of two types of cost:
$
Rectification costs 50
Other costs (which arise over the life of the contract) 2,450
To date Prior period This period
Revenue 60% × 3,200 = 1,920 1,200 720
Costs
Rectification 50 – (50)
Other costs 60% × 2,450 = 1,470 950 (520) ____ 150 ____
The % completion could be reworked as =
+1,000
450 , 1
450 ,
1 59%
2.3
Recognition
¾
The basic double entry for each contract is quite straightforward.¾
When costs are actually incurred on the contract:Dr Contract account X
¾
When amounts are billed:Dr Receivables X
Cr Contract account X
¾
To recognise revenue:Dr Contract account X
Cr Revenue X
¾
To recognise costs:Dr Cost of sales X
Cr Contract account X
Commentary
This transfers revenues and costs that have been accumulated in the contract account to the statement of comprehensive income over the duration of the contract.
¾
When payments on account are received/when billings are settled:Dr Cash X
Cr Receivables X
Illustration 2
$
Revenue to be recognised 1,250
Costs to date 1,080
Costs to be recognised 1,000
Billings 640
Contract account
$
Costs incurred 1,080
Revenue recognised 1,250 ______ 2,330 ______
Balance b/d 690
$
Receivables 640
Costs recognised 1,000
Balance c/f 690
Commentary
The balance could be negative (a credit balance). This depends on the interaction between the amount invoiced/actual costs and the amounts recognised as revenue and costs.
3
PRESENTATION AND DISCLOSURE
Note
¾
An entity should disclose: the amount of contract revenue recognised as revenue in the period; the methods used to determine the contract revenue recognised in the
period; and
the methods used to determine the stage of completion of contracts in
progress.
1
¾
An entity should disclose each of the following for contracts in progress at the end of the reporting period: the aggregate amount of costs incurred and recognised profits (less
recognised losses) to date;
the amount of advances received; and the amount of retentions.
2
¾
An entity should present: the gross amount due from customers for contract work as an asset; and the gross amount due to customers for contract work as a liability.
3
¾
The gross amount due to or from customers is the net amount of: costs incurred plus recognised profits; less
the sum of recognised losses and progress billings.
¾
Note that it is also the sum of the balances on the contract account.Illustration 3
Using the figures from Illustration 2:
$
Contract revenue recognised as revenue in the period: ______ 1,250 1 Contract costs incurred and recognised profits
(less recognised losses) to date (W) ______ 1,330 2
Gross amounts due from customers
for contract work (W) ______ 690 3
WORKING $
Costs incurred to date 1,080
Recognised profits/(less losses) to date ______ 250
1,330 W1
Less: progress billings (640)
______
Gross amount due from/(to) customers 690 W2
______
Example 2
Company X
Contracts as at 31 December 2007:
A B C
$000 $000 $000
Contract value 100 100 80
Costs to date 40 2 75
Estimated costs to complete 30 58 25
Billings 15.6 − 67
Date started during the year 1 Jan 1 Nov 1 Jan
% completion 45% 3% 80%
Required:
Proforma solution 2
WORKINGS
A B C $000
Revenue Costs of sales
____________
Recognised profit/(loss)
____________
Disclosures
Contract revenue recognised as revenue in the period:
____________ Contract costs incurred and recognised profits
(less recognised losses) to date:
____________ Gross amounts due from customers for contract work:
____________ Gross amounts due to customers for contract work
____________
FOCUS
You should now be able to:
¾
define a construction contract and discuss the role of accounting concepts in the recognition of profit;¾
describe the acceptable methods of determining the stage (%) of completion of a contract;EXAMPLE SOLUTIONS
Solution 1
(a) Calculate total expected profit
$
Revenue 3,200
Less Contract costs to date (1,500)
Future expected costs (1,000) ______ 700 ______
(b) Percentage completion
Sales basis Costs basis
200 , 3
800 ,
1 = 56.25%
500 , 2
500 ,
1 = 60%
(c) Calculate revenue and costs for the year
To date Prior To date Prior
period $ period $ Revenue 3,200 × 0.5625 1,800 – 1200 = 600 3,200 × 0.6 1,920 – 1200 = 720
= 1,800 = 1,920
Cost of sales 2,500 × 0.5625 1,406 – 950 = (456) 2,500 × 0.6 1,500 – 950 = (550)
= 1,406 = 1,500
______ ______
Profit 144 170
______ ______
Solution 2
W1 W2 W3 $000
Revenue 45 2 64 111
Cost of sales 31.5 2 84 (117.5)
____ ___ ___ _____
Recognised profit/(loss) 13.5 − (20) (6.5)
____ ___ ___ _____
Contract revenue recognised as revenue in the period: 111
Contract costs incurred and recognised profits
(less recognised losses) to date 110.5
Gross amounts due from customers for contract work (37.9 + 2) 39.9
WORKINGS
A B C Total
Contract costs incurred 40 2 75 117
Recognised profit/(loss) 13.5 – (20) (6.5)
____ ___ ___ _____
53.5 2 55 110.5
Billings (15.6) (67) (82.6)
____ ___ ___ _____
37.9 2 (12) 27.9
____ ___ ___ _____
(1) Contract A − Profit making
Contract account
$
Costs incurred 40
Revenue recognised 45
–––– 85 ––––
Balance b/d 37.9
$
Billings 15.6
Costs recognised 31.5
Balance c/f 37.9
–––– 85 ––––
Grossamount owed by customer = 37.9
(2) Contract B − too soon to take profit
Contract account
$
Costs incurred 2
Revenue recognised 2
–– 4 ––
Balance b/d 2
$
Billings 0
Costs recognised 2
Balance c/f 2
–– 4 ––
(3) Contract C − loss making contract
Contract account
$
Costs incurred 75
Revenue recognised 64
Balance c/f 12
––– 151 –––
$
Billings 67
Costs recognised 84
––– 151 –––
Balance b/d 12
