IFRSs by KA

IAS 11
Construction Contracts SCOPE

Chapter

00
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This Standard shall be applied in accounting for construction contracts in the financial statements of the 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 term of their design, technology and function or their ultimate purpose or use. A Fixed Price Contract is a construction contract in which the contractor agrees to a fixed contract price, or a fixed rate per unit of output, which in some cases is 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.

COMBINING AND SEGMENTING CONSTRUCTION CONTRACTS

When a contract covers a number of assets, the construction of each asset shall be treated as a separate construction contract when: (a) separate proposals have been submitted for each asset; (b) each asset has been subject to separate negotiation and the contractor and customer have been able to accept or reject that part of the contract relating to each asset; and (c) the costs and revenues of each asset can be identified. A group of contracts, whether with a single customer or with several customers, shall be treated as a single construction contract when: (a) the group of contracts is negotiated as a single package; (b) the contracts are so closely interrelated that they are, in effect, part of a single project with an overall profit margin; and (c) the contracts are performed concurrently or in a continuous sequence.

CONTRACT REVENUE
Contract revenue shall comprise: (a) the initial amount of revenue agreed in the contract; and (b) variations in contract work, claims and incentive payments: (i) to the extent that it is probable that they will result in revenue; and (ii) they are capable of being reliably measured. Contract revenue is measured at the fair value of the consideration received or receivable. The measurement of contract revenue is effected by a variety of uncertainties that depend on the outcome of future events. The estimates often need to be revised as events occur and uncertainties are resolved. Therefore, the amount of contract revenue may increase or decrease from one period to the next. For example: (a) a contractor and a customer may agree variations or claims that increase or decrease contract revenue in a period subsequent to that in which the contract was initially agreed; www.financedoctors.net

IAS 8 (b) the amount of revenue agreed in a fixed price contract may increase as a result of cost escalation clauses; (c) the amount of contract revenue may decrease as a result of penalties arising from delays caused by the contractor in the completion of the contract; or (d) when a fixed price contract involves a fixed price per unit of output, contract revenue increases as the number of units is increased.

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CONTRACT COSTS
Contract costs shall comprise: (a) costs that relate directly to the specific contract; (b) costs that are attributable to contract activity in general and can be allocated to the contract; and (c) such other costs as are specifically chargeable to the customer under the terms of the contract. Costs that relate directly to a specific contract include: (a) site labour costs, including site supervision; (b) costs of material used in construction; (c) depreciation of plant and equipment used on the contract; (d) costs of moving plant, equipment and materials to and from the contract site; (e) cost of hiring plant and equipment; (f) costs of design and technical assistance that is directly related to the contract; (g) the estimated costs of rectification and guarantee work, included expected warranty costs; and (h) claims from third parties. These costs may be reduced by any incidental income that is not included in contract revenue, for example income from the sale of surplus materials and the disposal of plant and equipment at the end of the contract. Costs that may be attributable to contract activity in general and can be allocated to specific contracts include: (a) insurance; (b) costs of design and technical assistance that are not directly related to a specific contract; and (c) construction overheads. Such costs are allocated using methods that are systematic and rational and are applied consistently to all costs having similar characteristics. The allocation is based on the normal level of construction activity. Construction overheads include costs such as the preparation and processing of construction personnel payroll. Costs that may be attributable to contract activity in general and can be allocated to specific contract also include borrowing costs when the contractor adopts the alternative treatment in IAS 23 Borrowing Costs. Costs that are specifically chargeable to the customer under the term of the contract may include some general administration costs and development costs for which reimbursement is specified in the term of the contract. Costs that cannot be attributed to contract activity or cannot be allocated to a contract are excluded from the costs of a construction contract. Such costs include: (a) general administration costs for which reimbursement is not specified in the contract; (b) selling costs; (c) research and development costs for which reimbursement is not specified in the contract; and (d) depreciation of idle plant and equipment that is not used on a particular contract. financedoctors@gmail.com

IFRSs by KA

RECOGNITION OF CONTRACT REVENUE AND EXPENSE

When the outcome of a construction contract can be estimated reliably, contract revenue and contract costs associated with the construction contract shall be recognized as revenue and expenses respectively by reference to the stage of completion of the contract activity at the balance sheet date. An expected loss on the construction contract shall be recognized as an expense immediately. In the case of fixed price contracts, the outcome of a construction contract can be estimated reliably when all the following conditions are satisfied: (a) total contract revenue can be measured reliably; (b) it is probable that the economic benefits associated with the contract will flow to the entity; (c) both the contract costs to complete the contract and the stage of contract completion at the balance sheet date can be measured reliably; and (d) the contract costs attributable to the contract can be clearly identified and measured reliably so that actual contract costs incurred can be compared with prior estimates. In the case of cost plus contracts, the outcome of construction contract can be estimated reliably when all the following conditions are satisfied: (a) it is probable that the economic benefits associated with the contract will flow to the entity; and (b) the contract costs attributable to the contract, whenever or not specifically reimbursable, can be clearly identified and measured reliably. When the outcome of a construction contract cannot be estimated reliably: (a) revenue shall be recognized only to the extent of contract costs incurred that it is probable will be recoverable; and (b) contact costs shall be recognized as an expense in the period in which they are incurred. An expected loss on the construction contract shall be recognized as an expense immediately. When it is probable that total contract costs will exceed total contract revenue, the expected loss shall be recognized as an expense immediately by creating a provision for estimated loss.

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DISCLOSURE
An entity shall disclose: (a) the amount of contract revenue recognized as revenue in the period; (b) the methods used to determine the contract revenue recognized in the period; and (c) the methods used to determine the stage of completion of contracts in progress. An entity shall disclose each of the following for contracts in progress at the balance sheet date: (a) the aggregate amount of costs incurred and recognized profits (less recognized losses) to date; (b) the amount of advances received; and (c) the amount of retentions. An entity shall present: (a) the gross amount due from customers for contract work as an asset; and (b) the gross amount due to customers for contract work as liability.

ACCOUNTING ENTRIES
a) To record costs incurred during the year www.financedoctors.net

IAS 8 Costs incurred on a contract should preferably be charged to an account work-in progress, an asset account (and not to construction costs, an expense account). The corresponding credit is given to cash or account payable. Dr. Workinprogress Cr. Cash or Account payable Page | 4 b) To record progress billings Progress billings should preferably be credited to progress billings, a liability account, (rather than to turnover, a revenue account), and debited to accounts receivable. Dr. Retentions receivables Dr. Accounts receivable Cr. Progress billings c) To record collections from customers Collections against progress billing are recorded by debiting cash and crediting accounts receivable. Dr. Cash Cr. Accounts receivable / retentions receivable d) To recognize contract revenues and costs At each balance sheet date, contract revenues, costs and gross profits will be recognized on the basis of stage completion. Dr. Contract costs Dr. Work in progress (profit recognized) Cr. Contract revenues The account contract costs is equivalent of cost of goods sold in a manufacturing concern. e) To close the contract At the completion of contract, the account progress billing is debited and work in progress is credited. Dr. Progress billings Cr. Work in progress The work in progress is charged with costs incurred plus profit recognized. After the above entry, is recorded, both the progress billing and work in progress accounts are closed.

Q&A
QUESTION 1 Quality Construction Limited signed a contract in 2001 for construction of a building. Contract price was agreed at PKR 3,800 million. Relevant data for the contract is as follows: PKR in million 2001 2002 2003 Cost for the year Estimate of further costs at end of year Progress billing for year Collections from customer during year Required: (a) work out stage of completion (b) Prepare P&L extracts (c) Prepare Balance sheet extracts SOLUTION 1 PKR in million Stage of completion financedoctors@gmail.com 1,200 1,800 1,000 900 1,500 300 1,300 1,000 200 0 1,500 1,400

IFRSs by KA 2001 1,200 0 1,200 1,800 3,000 40% 2002 1,500 1,200 2,700 300 3,000 90% 2003 200 2,700 2,900 0 2,900 Page | 5 100%

Cost for the year Cost incurred upto last year Cost to date Estimated further costs Total estimated cost Percentage completion

Profit and loss account (extracts) Contract revenue Contract costs Gross Profit Balance sheet (extracts) Assets Accounts receivable against progress billings Due from customers Contract costs incurred Recognised profit Contract WIP Progress billings

1,520 1,200 320

1,900 1,500 400

380 200 180

100 1,200 320 1,520 1,000 520

400 2,700 720 3,420 2,300 1,120

500

QUESTION 2 Capital Contracts Limited have extracted the following date from their records at December 31, 2007. Contract A 6,000 4,850 0 5,940 100% All figure in PKR million Contract B Contract C 5,000 9,000 3,200 2,880 865 2,880 4,455 6,675 95% 75%

Price Cost incurred to December 31, 2006 Cost incurred during 2007 Progress receipts to date Percentage completion

One percent of approved bill is retained until twelve months after completion of contract. Upto December 31, 2006 proportionate profits upto 1,900 have been taken in accounts. Required: (a) Compute further costs at December 31, 2007 (b) Determine the amount of profit to be recognised for the year ended December 31, 2007 (c) Set out disclosures to be made in the balance sheet under the headings due from/to customers and retention receivable.

SOLUTION 2 Basic data Contract value Contract A 6,000 All figure in PKR million Contract B Contract C 5,000 9,000 www.financedoctors.net

IAS 8 Cost incurred during 2007 Cost upto last year Cost to date Estimated further costs Estimated costs at completion Page | 6 Stage of completion Total estimated profit at completion Estimated further costs Cost to date Percentage completion Estimated total costs Estimated further costs Profit to be recognised Total estimated profit Stage of completion Profits to be recognised Less: Recognised upto last year Profit to be recognised in current year Balance sheet 2007 (Current Assets) Retentions receivables** Due from Customers Costs incurred to date (note 1) Profit recognised (note 1) Progress billings (note 1) 0 4,850 4,850 0 4,850 100% 1,150 Contract A 4,850 100% 4,850 0 A 1,150 100% 1,150 865 3,200 4,065 214 4,279 95% 721 Contract B 4,065 95% 4,279 214 B 721 95% 685 C 1,320 75% 990 2,880 2,880 5,760 1,920 7,680 75% 1,320 Contract C 5,760 75% 7,680 1,920 Total 3,191 2,825 1,900 925 172 9,825 1,675 11,500 11,242 258

Note 1: The contract A has not been included because it has been completed and there is no more work in progress. Note 2: 6,000 + 4,500 + 6,742 = 17,242 x 1% =172

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