IAS 11 – Construction Contracts

Students studying financial reporting papers will often come across the concept of accounting for construction contracts. Depending on the complexity of your financial reporting studies, accounting for construction contracts can become quite complex but with adequate question practise, they can also become very simple. The key to these types of questions is to do them in a methodical format. Accounting for constructions contracts is dealt with in IAS 11 ‘Construction Contracts’. This article will look at the core principles involved in IAS 11 and at the end of the article looks at a typical worked example. The first thing to understand is what a construction contract actually is. IAS 11 defines a construction contract as: “a contract specifically entered into for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, and function or their end use or purpose”. The principal concern of accounting for long-term construction contracts involves the timing of revenue (and thus profit) recognition. Contracts can last for several years and a standard was therefore required to deal with revenue recognition in relation to long-term construction contracts. To avoid distortions in the presentation of periodic financial statements, the percentage of completion method was developed which reports the revenues proportionally to the degree to which the projects are being completed. Percentage of completion method The percentage of completion method is a method of accounting that recognises income on a contract as work progresses by matching contract revenue with contract costs incurred, based on the proportion of work completed. The problem in dealing with the percentage of completion method lies in accurately deciphering the extent to which the projects are being finished and to assess the ability of the entity to actually bill and collect for the work done. The percentage of completion method uses the contract account to accumulate costs and to recognise income. Under the provisions of IAS 11, income is not based on advances (cash collections) or progress billings. Any advances and progress billings are based on contract terms that do not necessarily measure contract performance. Where costs and estimated earnings in excess of billings occurs, then the excess is classified as an asset. If billings exceed costs and estimated earnings, the difference is treated as a liability. There are two ways in which the stage of completion can be calculated as follows: Work certified method: Work certified to date ÷ total contract price; or Cost method: Total costs incurred to date ÷ total contract costs. Contract costs All contract costs are costs that are identifiable with a specific contract plus those that are directly attributable to contracting activity in general and can be allocated to the contract and those that are contractually chargeable to a customer. Examples of such costs could be: Costs of material used in the construction contract Wages and other labour costs directly attributable to the contract Cost of design and technical assistance Costs of hiring plant and machinery to complete the contract Depreciation charges in respect of plant and machinery used in the construction contract Rectification costs Sometimes mistakes happen and the entity will have to incur costs to put mistakes right. These are referred to as ‘rectification costs’ and should be written off to the statement of comprehensive income as soon as they are incurred. Fixed-price and cost-plus contracts IAS 11 recognises two types of construction contract that are distinguished according to their pricing arrangements: Fixed-price contracts; and Cost-plus contracts. Fixed-price contracts are contracts for which the price is not usually adjusted due to costs incurred by the contractor. Where a contractor agrees a fixed-price contract then this essentially means that the contractor agrees to a fixed contract price or a fixed rate per unit of output. These types of contracts are sometimes subject to escalation clauses. Cost-plus contracts are sub-divided into two further classifications: Cost without fee contract; and Cost plus fixed fee contract. Cost without fee contracts are where the contractor is reimbursed for allowable or otherwise defined costs with no provision for a fee. In these contracts, a percentage is usually added that is based on the foregoing costs. Cost plus fixed fee contracts are where the contractor is reimbursed for costs plus a provision for a fee. The contract price is determined by the total amount of reimbursable expenses and a fee. The fee is the profit margin which is calculated as revenue less direct costs to be earned on the contract. Recognition of contract revenue and expenses IAS 11 prohibits the use of the percentage-of-completion method if this method will not result in the financial statements reporting a reasonable level of accuracy. It follows therefore that the percentage-of-completion method can only be used where the outcome of the construction contract can be estimated reliably. Where the contract is either a fixed-price contract or a cost-plus contract, then the following criteria must be met to determine whether the outcome can be estimated reliably: If it is a fixed-price contract: It meets the recognition criteria laid down in the Framework Document which is that total contract revenue can be measured reliably and it is probable that economic benefits will flow to the entity. Both the contract costs to complete and the stage of completion can be measured reliably. Contract costs attributable to the contract can be identified properly and measured reliably so that comparison of actual contract costs with estimates can be done. If it is a cost-plus contract: It is probable that economic benefits will flow to the entity. The contract costs attributable to the contract, whether or not reimbursable, can be identified and measured reliably. Note – all conditions above must be satisfied. The outcome of the contract cannot be estimated reliably Where the outcome of a contract cannot be estimated reliably, contract revenue and costs should be recognised by reference to the stage of completion. Revenue should be recognised only to the extent of the contract costs incurred that are probable of being recovered, so therefore revenue will equal costs and no profit recognised as shown in the following illustration: The Facts A company enters into a two-year contract. The project manager is unsure whether the contract will be profitable or loss-making. Costs incurred to date amount to $10,000. Solution As the outcome of the contract cannot be estimated then the amount of revenue to be recognised in the company’s financial statements is the same as the costs incurred resulting in no profit being taken, so: Dr receivables $10,000 Cr revenue $10,000 The outcome of the contract is profitable Where the contract is profitable, revenue should be recognised by reference to the stage of completion. Costs incurred in reaching the stage of completion are taken to the statement of comprehensive income as cost of sales. This is achieved by the percentage of completion to the total costs that are expected to occur over the life of the contract. An illustration of how this works is shown at the end of this article. The outcome of the contract is loss-making Where contracts are loss-making, revenue is recognised by reference to the stage of completion and cost of sales is the balancing figure which generates the required loss. See the following illustration: The Facts Lucas Inc has a contract that is expected to make a loss of $1,000. The finance director at Lucas Inc has calculated that the amount of contract revenue to be recognised is $800. Solution The statement of comprehensive income will include $800 worth of contract revenue. The loss is estimated to be $1,000 so cost of sales will be $1,800 to generate the required loss (i.e. a ‘balancing figure’). This method is used because IAS 11 says that losses must be recognised in the statement of comprehensive income as soon as they are foreseen. Worked Example We shall look at a worked example of how IAS 11 works as follows: Leah Inc reports under IFRS and is preparing their financial statements for the year ended 31 March 2009. On 1 October 2008 Leah Inc commenced work on a contract. The price agreed for the contract was a fixed price of $50 million. Leah purchased plant at a cost of $15 million exclusively for use on the contract. The directors of Leah Inc have estimated that the plant will have no residual value at the end of the contract which is due to finish on 30 September 2009. Costs incurred on the contract plus estimated costs to complete are as follows:

All the costs which have been incurred to date have all been debited to the Contract Account in the general ledger. Leah Inc have appointed an agent who has confirmed that at the reporting date (31 March 2009), the contract was 40% complete at which point the customer made a progress payment amounting to $15 million. The finance department have credited this progress payment to the contract account. There have been no other entries made in respect of this contract. Required Show how the contract should be accounted for under the provisions of IAS 11 ‘Construction Contracts’ in the financial statements of Leah Inc for the year ended 31 March 2009. Solution Step 1 The overall revenue for the contract amounts to $50 million (the fixed price agreed). Step 2 We know that Leah has incurred the following costs and has made estimates of costs to complete as follows: purchase of machine 15000 purchase of material 9000 labour & other overheads 7000 estimated cost to complete 13000 _______ 44000 As costs are less than total revenue we know the contract is going to make a profit of ($50 million less $44 million) = $6 million. Step 3 The agent has confirmed the contract is 40% complete so we take 40% of the total costs to ‘cost of sales’ in the income statement. We then add 40% of the expected revenue to revenue in the statement of comprehensive income. Financial Statements (extracts) Revenue (40% x $50 million) $20,000 Cost of Sales Construction contract (40% x $44 million) ($17,600) Step 4 We then need to work out how much should be shown in the statement of financial position as ‘Gross Amounts due from Customer’. We need a working for this: Working – Gross Amounts Due from Customer cost to date purchase of material 9000 labour and overhead 7000 plant depreciation 7500 total cost to date 23500 contract profit(50000-44000) 6000 ______ 29500 less:progress billings (15000) ---------- gross amount due from customer 14500 The gross amount due from customer can be shown as an ‘other current asset’ in the statement of financial position. Conclusion It is important that when you are dealing with construction contracts questions that you adopt a logical method of dealing with the numbers and are familiar with how to recognise revenue and profits depending on whether a contract is profitable, loss-making or uncertain. Once you have mastered the approach and understand how IAS 11 works, questions on construction contracts become a favourite topic!