lOMoARcPSD|12946476 Lecture 8 Construction Contracts IAS 11 Revision Notes Financial Reporting and Accounting (University of Bath) StuDocu is not sponsored or endorsed by any college or university Downloaded by Taehyung Kim (taetangjinjaem@gmail.com) lOMoARcPSD|12946476 Lecture 8 – CONSTRUCTION CONTRACTS IAS 11 REVISION NOTES Definition as per IAS 11 • “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 and their ultimate purpose or use” • This includes: • Rendering services directly related to construction of assets – services of project managers/architects • Destruction of restoration of assets and restoration of environment after demolition of assets Construction Contracts • Long-term contracts • Can span more than one accounting period • Accounting treatment implications? • How much revenue to include in income statement? • How much should be charged for related costs? • How much profit should be recognised in an accounting period? Issues with Construction Contracts • Revenue recognition Problem • When to recognise the revenues and the associated expenses • Timing of revenue recognition and expenses • Fair presentation issue • As an investor, what do you want to know? • Tension between IASB qualitative characteristics and other conventions • Accruals/matching • When you recognise it • How certain are you that we will get the revenue? • Prudence/Realisation • Relevance (fair presentation) • Timeliness of info • Better for investor to recognise % each year • But is this prudent? Issues with Construction Contracts Two alternative approaches: 1. Completed-contract method If contract extends over a few years Profit will not be allocated over a number of years Contribution to profits will be zero until contract is complete Prudence o Don’t recognise until certain 2. Percentage-of-completion (POC) method – IAS 11 REQUIRES POC METHOD Allocate total profit on contract over accounting periods How should profit, and resulting contract work in progress be shown in the accounts? Accruals/matching Types of construction contracts IAS 11 makes two distinctions: • Fixed price contract • Customer agrees to fixed contract price/ fixed rate per unit of output and sometimes cost escalation clauses • Room for constructor to declare extra costs • Cost plus contract • Contractor is reimbursed for agreed costs plus a percentage of these costs or a fixed fee • More common type • Lump sum fee • Normally, no built in cost escalations • Higher risk of making a loss • Agree this at start before you build RISK Total revenue and expected total costs of contract • Total Revenue comprises: • Initial amount or revenue agreed in the contract • Plus or minus revenue associated with agreed variations in the contract work 1 Downloaded by Taehyung Kim (taetangjinjaem@gmail.com) lOMoARcPSD|12946476 • • • Plus amounts claimed by the contractor for reimbursements for costs Plus incentive payments to which the contractor is entitled for meeting agreed specified performance targets Minus penalties arising from delays caused by the contractor Expected Total Contract Costs • Costs that relate directly to the specific contract, e.g. • Site labour costs • Materials • Depreciation of plant and equipment (being used on the site) • Hire of plant and equipment • Design and technical costs attributable to contract • Plus indirect costs – to the extent that they are attributable to the contractor's general contracting activity and can be reasonably allocated to the contract • Never selling costs or depreciation of idle plant, but can include insurance and overhead contract costs, Plus such other costs that can be specifically chargeable to the customer under the terms of the contract Recognition of contract revenue and expenses in SPLOCI (Income statement) Different treatment depending on • When outcome of contract can be estimated reliably • Can recognise P or L • Over 30% • When a contract’s outcome cannot be estimated reliably • Under 30% completed • When it is probable that a contract will incur losses • Recognise loss in F/S immediately In question: 1. Can we estimate contract outcome reliably? 2. Look at % complete (>30% = certain) 3. Calculate profit and expense in contract a. Profit – can it measured reliably? >30%? b. Loss – recognise straight away NO to any of these = not recognise Recognition of contract revenue and expenses • When can outcome of contract can be estimated reliably? • When contract revenue, contract costs to date and to completion and stage of completion can be measured reliably • Contract revenue and costs should be recognised as revenue and expenses by reference to stage of completion of contract activity • E.g. 35% complete = recognise 35% revenue and costs for the year Estimation of stage of completion • Determination of stage of completion • By comparing costs incurred for the work performed to date with the estimated total contract costs • By carrying out a survey of the work performed to date • By considering the physical proportion of the contract work completed MAIN FORMULA: COSTS INCURRED TO DATE / ESTIMATED TOTAL COSTS ALTERNATIVE FORMULA: VALUE OF WORK CERTIFIED / CONTRACT PRICE No reliable estimate of contract outcome/or it is probable loss will be incurred • In early stages of contract… • No reliable estimate • Particularly hard to make a reliable estimate of contract outcome – DO NOT RECOGNISE PROFIT • But recognise sufficient contract revenue to cover costs incurred to date, however… • Probable loss • If it is probable that total costs of contract will exceed revenue, expected loss should be recognised as expense immediately • Unlike profits which are spread over the accounting periods of the contract, expected losses are accounted for as soon as they become probable Summary of IAS 11 requirements 2 Downloaded by Taehyung Kim (taetangjinjaem@gmail.com) lOMoARcPSD|12946476 • • • • • Compare contract revenue and expected total costs • If loss recognise immediately Using % of completion calculate revenue for period Calculate total cost of sales = % of completion x total costs – costs previously recognised – losses not previously charged Deduct cost of sales from revenue (excess = provision or accrual) Compare cumulative revenue with progress payments to date: calculate receivables/payables LOSS – DOESN’T MATTER ABOUT STAGE OF COMPLETION RECOGNISE STRAIGHT AWAY IN P&L ABC Example Two contracts A and B: information relating to two years to 30.06.X0 Other information In Year w9 ABC recognised revenue £7m and costs £5.5m on Contract A. Contract B had incurred costs £2m It was at an early stage with no indication at that date of possible loss Step 1: Overall anticipated result Step 2: Revenue In Year w9 ABC recognised revenue £7m on Contract A. Contract B had incurred costs of £2m but was at an early stage with no indication at that date of possible loss 3 Downloaded by Taehyung Kim (taetangjinjaem@gmail.com) lOMoARcPSD|12946476 Step 3 – Costs Summarising the SPLOCI position What about our double entry • If we recognise revenue (a credit to the income statement) there must be a debit somewhere else. • Normally it would be receivables • Credit revenue Debit receivables • BUT with long term contracts two other things are going on. • We are already invoicing our client with progress billings • We are already receiving payments against these invoices Have two receivables accounts in SFP (Statement of Financial Position)! Trade receivables and contract account 4 Downloaded by Taehyung Kim (taetangjinjaem@gmail.com) lOMoARcPSD|12946476 • • • • Credit revenue debit contract account • When recognise revenue Credit contract account debit trade receivables • When progress billing (invoice) raised Credit TR’s debit bank • When customer pays invoice The result is an outstanding balance on the contract account which represents unbilled revenue that has been recognised SFP Contract account Recognise revenue = increase contract account Bill customer = decrease contract account Leftover = what left to bill customer Contract [receivables] account in SFP • IAS 11 requires entity to present gross amount due from/to customers for construction contract work as an asset/liability in SFP • Balance on Contract receivables account – if debit • Gross amount due from customers (Asset) • If credit – gross amt due to customers (Liability) • Comprises • Total costs incurred to date – customer owes contractor for costs incurred on their behalf • Plus attributable profits (Mark-up charged to customer) • Less foreseeable losses (contractor cannot recover) • Less progress billings invoiced Step 4 Entries for Statement of Financial Position Disclosures • Given wide variety of policies and practices allowed under IAS 11, much disclosures are needed in order to enable users to understand the financial statements and make informed comparisons with other organisations • Amt recognised as revenue in the period • The method used to determine revenue recognised • The method used to determine stage of completion • Gross amount due to/from customers The future New IFRS 15 Standard will supersede IAS 11 by 2018 • Changes in accounting for construction contracts: • IFRS 15 • Revenue recognised when performance obligation specified in contract is satisfied • Key driver for recognition or profits Summary • You should now be able to: • Define a construction contract • Discuss issues and problems associated with accounting for construction contracts, particular revenue recognition – prudence/realisation versus matching/accrual tension • Account for profits and losses on construction contracts • Calculate and present contract entries in the financial statements in accordance with the requirements of IAS 11 • Outline the main disclosure requirements 5 Downloaded by Taehyung Kim (taetangjinjaem@gmail.com)
