Technical 22

5tudents studylng nanclal

reporting papers will often
come across the concept of
accounting for construction
contracts. Depending on the
cemlexlty ef yeur nanclal
reporting studies, accounting
for construction contracts can
become quite complex but with
adequate question practise,
they can become very simple.
The key to these types of ques-
tions is to do them in a method-
ical format.
Accounting for construction con-
tracts is dealt with in IAS 11 Con-
struction Contracts. This article will
look at the core principles involved
in IAS 11 and at the end of the ar-
ticle will look at a worked example.
1he rst thng to understund s vhut
a construction contract actually is.
According to IAS 11, a construction
contruct s: u contruct speccuy
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 account-
ing for long-term construction
contracts involves the timing of
revenue (und thus prot) recogn-
tion. 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 presen-
tuton o perodc nuncu stute-
ments, the percentage of comple-
tion 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 account-
ing 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 be-
ng nshed und to ussess the ubty
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 recog-
nise 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 con-
tract terms that do not necessarily
measure contract performance.
Where costs and estimated earn-
ings in excess of billings occur, the
excess s cussed us un usset. l
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 calcu-
lated:
Werk Certled Methed Work certi-
ed todute / totu contruct prce
Cost Method Total costs incurred
todate / total contract costs
Contract Costs
All contract costs are costs that
ure dentube vth u specc
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:
Steve Collings, FMAAT FCCA
FCCA is the audit and technical partner at
Leavitt Walmsley Associates Ltd and the
author of The Interpretation and Application
of International Standards on Auditing (Wiley
March 2011).
Construction
Contracts
IAS 11
May/June 2011
Technical 22 23 globalaccountantmagazine.com
- Costs o muteru used n the
construction contract.
- \uges und other ubour costs
directly attributable to the
contract.
- Costs o desgn und techncu
assistance.
- Costs o hrng punt und
machinery to complete the
contract.
- Deprecuton churges n respect
of plant and machinery used in
the construction contract.
IAS 11 recognises two types of
construction contract that are
distinguished according to their
pricing arrangements:
- lxed-prce contructs, und
- Cost pus contructs.
Fixed price contracts are con-
tracts for which the price is not
usually adjusted due to costs
incurred by the contractor. Where
u contructor ugrees u xed-prce
contract, this essentially means
that the contractor agrees to a
xed contruct prce or u xed rute
per unit of output. These types of
contracts are sometimes subject to
escalation clauses.
Cost plus 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
prot murgn vhch s cucuuted
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
nuncu stutements reportng u
reasonable level of accuracy. It fol-
lows, therefore, that the percentage
of completion method can only
be used where the outcome of the
contract can be estimated reliably.
Where the contract is either a
xed prce contruct or u cost pus
contract, then the following criteria
must be met to determine whether
the outcome can be reliably esti-
mated:
Fixed price contract:
- lt meets the recognton crteru
laid down in the Conceptual
Framework which is that total
contract revenue can be mea-
sured reliably and it is probable
thut economc benets v ov
to the entity.
- oth the contruct costs to com-
plete and the stage of comple-
tion can be measured reliably.
- Contruct costs uttrbutube to
the contruct cun be dented
properly and measured reliably
so that comparison of actual
contract costs with estimates
can be done.
Cost plus contract:
- lt s probube thut economc
benets v ov to the entty.
- 1he contruct costs uttrbutube
to the contract, whether or not
rembursube, cun be dented
and measured reliably.
All the conditions above must be
sutsed.
Example 1
A company enters into a 2-year
contract. The project manager
is unsure whether the contract
v be protube or oss-mukng.
Costs incurred todate amount to
$10,000.
As the outcome of the contract
cannot be estimated, the amount
of revenue to be recognised in
the compuny's nuncu stute-
ments is the same as the costs
ncurred resutng n no prot
being taken, so:
DR receivables $10,000
CR revenue $10,000
Outcome of the Contract is
Pretable
\here the contruct s protube,
revenue should be recognised by
reference to the stage of comple-
tion. Costs incurred in reaching
the stage of completion are taken
to the income statement 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 the article.
Worked Example
Leah Inc reports under IFRS and is
prepurng ther nuncu stutements
for the year ended 31 March 2009.
On 1 October 2008, Leah Inc com-
menced work on a contract. The
price agreed for the contract was
u xed prce o S50 mon. Leuh
purchased plant at a cost of $15 mil-
lion exclusively for use on the con-
tract. The directors of Leah Inc have
estimated that the plant will have
no residual value at the end of the
contruct vhch s due to nsh on
30 September 2009. Costs incurred
on the contract plus estimated costs
to complete are as follows:
Outcome of the Contract is
Loss-Making
Where contracts are loss-making,
revenue is recognised by reference
to the stage of completion and
costs o sues s the buuncng gure
which generates the required loss.
Example 2
Lucas Inc has a contract that
is expected to make a loss of
Sl,000. 1he nunce drector hus
calculated that the amount of the
contract revenue to be recognised
is $800.
The income statement 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
buuncng gure).
This method is used because IAS
11 stipulates that losses must be
recognised in the income state-
ment as soon as they are foreseen.
Costs
to date
Estimate
of costs
to
complete
Materials
purchased
9,000 5,000
Labour
and other
overheads
7,000 8,000
Outcome of the Contract
Cannot be Estimated Reliably
Where the outcome of a contract
cannot be estimated reliably, con-
tract costs and revenues 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
equu costs und no prot recognsed
as shown in the following example:
Technical 24
May/June 2011
All the costs which have been in-
curred todate have all been debited
to the contract account in the gen-
eral ledger. Leah Inc have appointed
un ugent vho hus conrmed thut ut
the reporting date (31 March 2009),
the contract was 40% complete at
which point the customer made a
progress payment amounting to 15
mon. 1he nunce depurtment
have credited this progress pay-
ment 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 provi-
sons n lAS ll n the nuncu
statements of Leah Inc for the year
ended 31 March 2009.
Solution
The overall revenue for the contract
umounts to S50 mon (the xed
price agreed).
We know that Leah has incurred
the following costs and has made
estimates of costs to complete as
follows:
As costs are less than total
revenue we know the
contruct s gong to muke u prot
of ($50 million less $44 million =
$6 million).
1he ugent hus conrmed
that the contract is 40%
Financial
Statement
Extracts
Revenue
(40%
x $50
million)
$20,000
Cost of
sales
(40%
x $44
million)
$17,600
Step 1
Working: Gross Amounts Due from
Costs to date: $,000 $,000
Purchase of materials 9,000 $17,600
Labour and other overheads 7,000
Plant depreciation ($15,000 x 6/12) 7,500
Total costs to date 23,500
Contract prot ($S0,000 - $44,000) 6,000
29,500
Less progress payment received (15,000)
Gross amount due from customer 14,500
Step 2
Purchase of machine $15,000
Purchase of machine $ 9,000
Labour and
overheads
$ 7,000
Estimated costs to
complete
$13,000
$44,000
Step 3
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 income statement:
We then need to work out
how much should be in
the stutement o nuncu pos-
tion as gross amounts due from
customer. We need a working as
follows:
The gross amount due
from customer can be
shown as an other current asset in
the stutement o nuncu poston.
Step 4
Conclusion
It is important that when you
are dealing with construc-
tion contract questions that
you adopt a logical method
of dealing with the numbers
and are familiar with how to
recegnlse revenue and rets
depending on whether a con-
tract ls retable, less-maklng
or uncertain. Once you have
mastered the approach and
understand how IAS 11 works,
questions on construction
contracts become a favourite
topic. Lots of question prac-
tise is the key to this area of
nanclal reertlng syllabuses.
Technical 24 25 globalaccountantmagazine.com