OBJECTIVE
Construction contracts, by their nature, usually are completed over more than one accounting period. Thus, the main issue addressed by IAS 11 is the allocation of the revenue and costs of the contract over this extended time period.
The standard applies to construction contracts in the financial statements of contractors.
DEFINITIONS
A construction contract is a contract specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use.
Essentially the standard is referring to a contract for the construction of a substantial asset like a motorway, a bridge, a ship, etc.
The accounting treatment that is adopted must recognise the common factor that the above examples contain i.e. the assets usually take more than one accounting period to complete. So, how and when is the profit or loss on such items shown in the accounts?
Rather than waiting for the contract to be completed before any profit is recognised (which may lead to misleading financial statements), IAS 11 establishes the principle that such profit can be recognised once the overall profitability of the project can be estimated reliably.
In essence, this means that a portion of the profit is recognised on an annual basis. This is called the “percentage of completion” method, indicating that the amount of profit to be recognised is based on the percentage of the project that has been completed.
CONTRACTS
A fixed-price contract is a construction contract in which the contractor agrees to a fixed contract price. This price may be subject to cost escalation clauses.
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.
If a contract covers a number of assets, the construction of each asset should be accounted for separately if: (a) Separate proposals have been submitted for each asset
- Each asset has been subject to separate negotiation and both the contractor and the customer have the ability to accept or reject the part of the contract relating to each asset
- The costs and revenues of each asset can be identified
On the other hand, a group of contracts should be treated as a single construction contract when:
- The group of contracts is negotiated as a single package
- The contracts are so closely related that they are, in effect, part of a single project with an overall profit margin
- The contracts are performed concurrently or in a continuous sequence.
CONTRACT COSTS
Contract costs comprise:
- Direct costs of contract, for example:
− Site labour
− Materials
− Depreciation of plant and equipment
− Costs of rectification
− Hire of plant and equipment
- Costs attributable to the contract that can be allocated to the contract, for example:
− Overheads
− Insurance
− Borrowing costs are permitted under IAS 23
- Other such costs that are chargeable to the customer under the terms of the contract
Contract costs include costs from the date the contract is secured to the final completion of the contract. Costs incurred in securing the contract may be included if they can be:
- Separately identifiable,
- Measured reliably, and
- It is probable that the contract will be secured
CONTRACT REVENUE
Contract revenue comprises:
- Initial amount of revenue agreed in the contract • Variations in contract work, claims and incentives if:
- It is probable they will result in revenue; and
- They can be measured reliably
Contract revenue is measured at the fair value of consideration received or receivable. The revenue may be uncertain and dependent on future events. Thus the revenue may increase or decrease from period to period.
RECOGNITION OF COSTS AND REVENUES
Revenues and costs of a construction contract can be recognised if the outcome of the contract can be measured reliably.
If the contract is expected to make a profit, then the “percentage of completion” method is used.
If the contract is expected to make a loss, then the total loss must be recognised immediately in the Statement of Comprehensive Income. (If any profit has been recognised prior to the loss becoming apparent, this previous profit must be reversed also).
MEASURING OUTCOME RELIABLY
The point at which the outcome of a contract can be measured reliably depends on whether it is a fixed-price contract or a cost-plus contract.
If it is a fixed-price contract, then its outcome can be measured reliably if:
- Total contract revenue can be measured reliably; and
- The contract will probably lead to economic benefits flowing to the entity; and
- The costs to complete the contract and its stage of completion can be measured reliably; and
- The costs of the contract can be clearly identified so that actual costs can be compared to prior estimates
If it is a cost-plus contract, then its outcome can be measured reliably if:
- It is probable that economic benefits of the contract will flow to the entity; and
- The contract costs can be clearly identified and measured reliably.
PRESENTATION
If no profit is being recognised on the contract for the period (assuming there is no loss either), then the revenue included in the Statement of Comprehensive Income will equal the recoverable costs incurred. The recoverable costs will be shown, as part of cost of sales, thus no profit arises.
If the contract is at a stage when profit can be taken, the revenue and costs relating to that stage are calculated, using the percentage of completion.
Both the revenues and costs will be for the current period only. This means that any previous revenue and costs from prior periods should be deducted.
If a loss is anticipated on completion of the contract, the loss to date is brought in by the inclusion of the revenue and costs to date. The remainder of any loss is then shown as an expense.
In the Statement of Financial Position, it is necessary to show:
- The gross amount due from customers for contract work. This is an asset.
- The gross amount due to customers for contract work. This is a liability.
This figure is calculated as follows:
Costs incurred to date
+ Recognised profits
(– Total recognised losses if applicable)
– Progress billings
If this is a positive figure it represents an asset. If this is a negative figure, it represents a liability.
DISCLOSURES
The following should be disclosed:
- The amount of contract revenue recognised as revenue in the period
- The methods used to determine the contract revenue recognised in the period (c) The methods used to determine the stage of completion of contracts in progress
For contracts in progress at the Statement of Financial Position date, disclose:
- The aggregate amount of costs incurred and recognised profit (less recognised losses) to date
- The amount of advances received
- The amount of retentions
FURTHER DEFINITIONS
Retentions: Retentions are amounts of progress billings that are not paid by the customer to the contractor until a specific stage has been reached or any defects have been rectified.
Progress Billings: Progress billings are amounts billed for work performed on a contract whether or not they have been paid by the customer.
