International Financial Reporting. Construction Contracts IAS 11

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1 Construction Contracts IAS 11

2 2 Construction contract definition Construction Contract is a contract specifically negotiated for the construction of an asset (a building, a bridge) or a combination of assets (a complex of plant) that are closely interrelated o interdependent in terms of - design, - technology and function or - their ultimate purpose or use.

3 3 Construction contracts include: 1) Contracts for the rendering of services that are directly related to the construction of assets (e.g. contracts for the services of project manager and architects); 2) Contracts for the destruction or restoration of assets and for the restoration of the environment after the demolition of assets.

4 4 Construction contracts are not included in IAS 2 (inventory) for two reasons: 1) They are often long-term, so they don t end in one accounting period; 2) The profit arising on a CC would not be recognized every accounting period, but only at the end of the contract (it could be after several years).

5 5 Project Phases Pre-Project Planning Business Plan Product Technical Plan Facility Scope Plan Project Execution Plan Contract Strategy Design - Finalize Scope - Detailed Cost Estimate - Detailed Schedule - Detailed Design - Prepare Work Packages

6 6 Project Phases Materials Management Bulk Commodities Fabricated Items Standard Engineered Equipment Specialized Engineered Equipment Field Management Services (GC/Subcontractors) Documentation Field Equipment Management Start-Up - Start-Up Plan - Commissioning - Project Close-Out Construction - Prework - Execution - Demobilization

7 7 Industry Segments Residential Commercial Highway/ Heavy Industrial Private Personal Homes Private Estates Subdivision Developments Office Building Industrial Park Hotel/Motel Hospital & Institutional Railroad Private Utilities/Communications Power Plants Refineries Paper Processing Plants Chemical Processing Plants Other Manufacturing Facilities Public Subsidized housing Public Schools Military Facilities Water Works Bridges and Roads Conservation & Development Publicly Funded Manufacturing (Military)

8 8 Combining and segmenting Construction Contracts 1) a group of contracts should be treated as a single contract when: a) the group of contracts is negotiated as a single package; b) the contracts are so closely related that they are, in effect, a single project; c) the contracts are performed concurrently or in a continuous sequence. 2) a single contract which covers the construction of a number of assets should be treated as several separate contracts (one for each asset) when: a) separate proposals have been submitted for each asset; b) each asset has been subject to separate negotiation; c) the costs and revenues for each asset can be separately identified.

9 9 Contract revenues and costs The total revenues and costs should be estimated, and these estimates may need to be revised periodically. Contract revenue comprises: 1) the initial amount of revenue agreed in the contract; 2) plus or minus the revenue associated with agreed variations in the contract work; 3) plus amounts claimed by the contractor as reimbursement for costs not included in the contract price; 4) plus incentive payments to which the contractor is entitled for meeting or exceeding specified performance targets; 5) minus penalties arising from delays or other problems caused by the contractor. Amounts should be included in contract revenue only if is probable that the revenue will arise and if the amount concerned can be measured reliably.

10 Fixed price contracts Types of contracts agreed fixed contract price, or a fixed rate per unit of output (plus escalation clauses) Cost plus contracts contractor reimbursed for defined costs, plus a percentage of these costs or a fixed fee Combination e.g. cost plus contract with maximum price 10

11 11 Contract costs comprise: Contract revenues and costs 1) costs that relate directly to the specific contract (e.g. materials, labour, plant used in the construction work); 2) costs that relate to contract activity in general and can be allocated to the contract (e.g. insurance); 3) other costs which are specifically chargeable to the customer under the terms of the contract (e.g. general administration costs or R&D costs for which reimbursement is specified in the term of the contract). Costs that relate to contract activity in general should be allocated using methods which are systematic, rational and consistent.

12 Contract costs include Direct costs labor & materials PP&E depreciation moving & hiring plant design rectification and warranty claims Indirect costs insurance indirect design construction overheads [borrowing costs] Costs specifically chargeable reimbursed design, general administration cost 12

13 Contract costs... Following costs are excluded general administration (unless reimbursed) selling costs research & development (unless reimbursed) depreciation of idle plant & equipment Cost cut-off from date of securing contract to completion of contract pre-contract costs? 13

14 14 Recognition of contract revenue and expenses IAS 11, par. 22 requires that: When the outcome of a CC can be estimated reliably, contract revenue and contract costs associated with the CC shall be recognized as revenue and expenses respectively by reference to the stage of completion of the contract activity at the end of the reporting period. The stage of completion may be determined in a number of ways. For example: 1) by comparing the costs incurred for the work performed to date with the estimated total contract costs; 2) by carrying out a survey of the work performed to date; 3) by considering the physical proportion of the contract work completed

15 15 IAS 11 Example A company which prepares accounts to 31 December each year began work on a construction on 17 february The contract price was originally agreed to be 19 million but during 2010 the costumer requested a substantial variation to the contract work and this increased the prices to 25 million. The contract was completed on 2 may Cost information is as follows: 31/12/09 31/12/10 31/12/11 Expected total costs Total costs incurred to date Costs relating to future activity 1 - -

16 16 IAS 11 Example The costs incurred to date of 5 million at 31 December 2009 included 1 million spent on acquiring materials for use during future work on the contract. The company s accounting policy in relation to construction contracts is to determine the stage of completion by comparing the costs incurred to date with the estimated total contract costs. Calculate the revenue and expenses arising from this contract which should be recognized in the statement of comprehensive income for each of the years to 31 December 2009, 2010, 2011.

17 17 IAS 11 example (solution) a) At December 2009 Contract revenue (25% x 19m) Cumulative total Recognized in prior years Recognized this year 4,75-4,75 Contract expenses 4,00-4,00 Contract profit 0,75-0,75

18 18 IAS 11 example (solution) b) At December 2010 Contract revenue (70% x 25m) Cumulative total Recognized in prior years Recognized this year 17,50 4,75 12,75 Contract expenses 14,00 4,00 10,00 Contract profit 3,50 0,75 2,75

19 19 IAS 11 example (solution) c) At December 2011 Contract revenue (100% x 25m) Cumulative total Recognized in prior years Recognized this year 25,00 17,50 7,50 Contract expenses 21,00 14,00 7,00 Contract profit 4,00 3,50 0,50

20 20 Recognition of contract revenue and expenses IAS 11, par. 32 requires that: When the outcome of a CC cannot be estimated reliably: 1) revenue shall be recognized only to the extent of contract costs incurred that it is probable will be recoverable; 2) Contract costs shall be recognized as an expense in the period in which they are incurred.

21 Recognition of revenue total contract revenue costs to complete stage of completion Can be measured reliably AND Flow of economic benefits is probable? YES OUTCOME RELIABLE OUTCOME NOT RELIABLE Percentage of Completion method Costs charged to income to be applied Revenue = recoverable costs 21 NO

22 22 Recognition of expected losses IAS 11, par. 36 requires that: When it probable that total contract costs will exceed total contract revenue, the expected loss shall be recognized as an expense immediately. The amount of such a loss is determined irrespective of: whether work has commenced on the contract; the stage of completion of contract activity; the account of profit expected to arise on other contracts which are not treated as a single construction contract.

23 Changes in estimates Revenue is based on current estimates of contract revenues and costs Effect recognized in income statement for current and subsequent periods (IAS 8) 23

24 Recognition in balance sheet Costs incurred to date Add: recognized profits Less: recognized losses X Progress billings Amount due from/(to) customer X X X X X (X) 24

25 25 An entity shall disclose: Disclosures (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; (c) the methods used to determine the stage of completion of contracts in progress; (d) For contracts in progress at the end of the reporting period: 1) the total of costs incurred to date and total recognized profit/losses to date; 2) the amount of any advances received; advances are amounts received by the contractor before the related work is performed; 3) the amount of any retentions ; retentions are amounts that have been billed to the customer but which are not payable until certain conditions specified in the contract have been satisfied.

26 26 Disclosures An entity shall present: (a) the gross amount due from customers for contract work as an asset; (b) the gross amount due to customers for contract work as a liability. The gross amount due from customers for contract work is equal to: 1) costs incurred to date plus recognized profits; 2) less amounts billed to date (progress billings) and any recognized losses for all contracts in progress at the end of the reporting period for which costs incurred to date plus recognized profits less recognized losses exceed progress billings.

27 27 Disclosures The gross amount due to customers for contract work is equal to: 1) progress billings plus any recognized losses; 2) less costs incurred to date and recognized profits for all contracts in progress at the end of the reporting period for which progress billings exceed costs incurred to date plus recognized profits less recognized losses.