Construction Contracts (IAS-11)
A Construction contract is defined in IAS 11 as “ …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”
There are two types of construction contract
§Cost plus contracts
Although the standard notes that construction contracts are usually formulated as fixed price of cost plus contract, some contract have feature of both types.
In such cases, the standard states that, in order to determined when to recognise contract revenue and expenses, the contractor needs to consider all the conditions for both fixed price and cost plus contracts set out.
Normally, the requirements of IAS 11 are applied separately to each construction contract.
However, sometimes it is necessary to break a single contract down into separable elements and apply the standard to each of those elements separately. A single contract may cover the construction of a number of assets
The construction of each asset should be treated as a separate contract where
§Separate proposals have been submitted for each assets
§Each asset has been the subject of separate negotiations and the contractor and customer have been able to accept or reject that part of the contract relating to each asset
§The costs and revenue of each assets can be identified
Where a contract provides for the construction of an additional asset at the customer’s option, or is amended to include construction of an addition asset, the construction of the asset should be accounted for as a separate construction contract where:
§The asset differs significantly in design, technology etc by the original contract
§The price of the asset is negotiated without regard to the original contract price
Costs that incurred prior to the contract being probable and costs that do not relate to future activities should be recognised as expenses.
Costs incurred on a construction contract after the date the contract is probable should be capitalised if they meet the criteria for construction costs.
Where costs of obtaining a contract have been written off in a period prior to that in which the contract is obtained ( because at that point it was not probable that the contract would be obtained) .
It states that the write off of such costs is not reversed and, hence they are not capitalised when the contract is obtained in the subsequent period. Where borrowing costs meet the definition of contract costs, it will be capitalised.
Costs that excluded form contract cost:-
§General administration costs for which reimbursement is not specified in the contract
§Research and development Costs for which reimbursement is not specified in the contract
§Deprecation of idle plant and equipment that is not used on a particular contract
The contracts costs may be reduced by incidental income that is not included in contract revenue.
For example, from sales of surplus material or the disposal of plant and machinery after the contract has been completed.
Revenue is measured at the fair value of the consideration received or receivable. The amount of revenue and estimates should be revised as events occur and an uncertainties are resolved.
The standards notes that contract revenue may increase or decrease from one period to the next.
§A contractor and a customer may agree variations or claims that increase or decrease value.
§Due to Escalation clause
§Penalties arising from delays caused by the contractor in completing the contract.
§Fixed price contract involves a fixed price per unit of output, contract revenue increase if the number of units is increased.
“Incentive payments” are additional amount that the customer pays to the contractor if certain specified performance targets or standards are met. Its included in the contract when:
§The contract is sufficiently advanced that its probable that the specified performance standards will be met or exceeded.
§The amount of the incentive payment can be reliably measured.
Where the outcome of a contract can be reliably estimated, contract costs and revenue are recognised by reference to the stage of completion of the contract activity at the balance sheet date.
Where the outcome of a contract cannot be reliably estimated, contract costs are recognised as an expenses when incurred and revenue is recognised only to the extent of the contract costs incurred and that it is probably the revenue will be recoverable.
In both cases, any expected contract loss is recognised immediately.
Progress payments and advances received usually do not give a reliable basis for measuring the stage of completion. For example :-
§ Contract costs that relate to future activity on the contract, such as costs of materials that have been delivered to a contract site or set aside for use in a contract, but not yet installed, used or applied during contract performance unless the material have been specially for the contract
§ Payment made to sub-contractors in advance of work performed under the sub-contracts.
Such costs are recognised as an assets provided its probable that they can be recovered and included in work in progress, but they are not taken into account for the purpose of determining the costs incurred to date for comparison with total expected contract costs.
Where its not possible to estimate reliably the outcome of a contract, a different percentage of completion method is applied. Revenue is only recognised to the extent of recoverable contract costs. This approach is necessary to avoid recognising profit on a contract before its probable that a profit will be earned on the overall contract.
When its probable that contract costs will exceed total contract revenue the expected loss should be recognised immediately as an expenses.
Provision for losses are set against “due from customers”.
These provisions for losses on construction contracts are specifically excluded from the scope of IAS 37 and so the losses should not be included with in provisions that an entity makes according to with IAS -37.
Where revenue has been validly recognised on a contract, but an uncertainty subsequently arises about the recoverability of the related amount due form the customer, any provision against the amount due is recognised an expenses, rather than as a reduction of contract revenue
Example:- Entity A is constructing a building for its customer. The construction is in its second year of the three year project.
Management had originally assessed the contract to be profitable and recognised a profit of $20,000 in year 1 based on the POC.
Management now believes that the contract will incur a loss of $30,000/
In this case, Management should recognise a loss in respect of the contract of $50,000 in year 2.
This represents a reversal of the $20,000 profit recognised in year 1 and $30,000 loss expected on the contract as a whole.
Change in estimates of contract revenue or contract costs are accounted for as changes in accounting estimates under IAS 8.
Accordingly, the effects of such changes are accounted for in the current and future periods, as appropriate, and not as a prior year adjustment.