19.0 ACCOUNTING FOR CONSTRUCTION CONTRACTS 19.1 Introduction This chapter covers the following: a. Applicable Terms b. Applicable Standard c. Key IPSAS Provisions d. Accounting Documentation e. Accounting Procedures f. Applicable Codes g. Accounting Treatment h. Illustration 19.2 Applicable Terms Construction Contract is a contract, or a similar binding arrangement 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. Examples of Construction Contracts include, but not limited to the contracts for construction of: a. Refineries; b. Airports; c. Dams; d. Railway tracks; e. Roads; f. Bridges; g. Pipelines; h. Tunnels; i. Reticulated water supply systems; j. Ships; k. Dockyards; and l. Power plants. A Contractor is an entity (private or public) that performs construction work pursuant to a Construction Contract. FAAC Sub-Committee on IPSAS Implementation Page 180
Types of Construction Contracts a. Fixed Price Contract b. Cost Plus Contract (i.e. Cost-Based Contracts) c. Unit Price Contracts; and d. Time and Material Contracts. 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 or Cost-Based Contract is a Construction Contract in which the contractor is reimbursed for allowable or otherwise defined costs and, in the case of a commercially based contract, an additional percentage (surplus) of these costs or a fixed fee, if any. Unit Price Contracts are based on anticipated quantities of items which are counted in the project in addition to their unit prices. The final price of the project depends upon the quantities required to carry out the work. Generally, these types of contracts are suitable only for construction and supplier projects which involve accurate identification of different types of items, but not their numbers, in the contract documents. These types of contracts are oftentimes used on excavation projects. Time and Material Contracts are usually preferred if the project scope is not clear, or has not been defined. The owner and the contractor must establish an agreed hourly or daily rate, including additional expenses that could arise in the construction process. The costs must be classified as direct, indirect, mark-up, and overhead. Sometimes the owner might want to establish a cap or specific project duration to the contractor that must be met, in order to have the owner s risk minimized. In many instances, Construction Contracts entered into by public sector entities will not specify an amount of contract revenue. Rather, funding to support the construction activity will be provided by an appropriation or similar allocation of general government revenue, or by aid or grant funds. FAAC Sub-Committee on IPSAS Implementation Page 181
In these cases, the primary issue in accounting for Construction Contracts is the: a. Allocation of construction costs to the reporting period in which the construction work is performed, and b. The recognition of related expenses. However, Public Sector Entities (PSEs) may enter into commercial contracts with third parties (private or other PSEs) to generate a profit margin or enter into a non-commercial contracts for full, partial or even no recoveries from other parties (normally other PSEs) to the contract. In this case the PSE becomes the contractor rather than the contracting entity and this is the main focus of this accounting topic. Construction Contracts comprises of two basic elements: a. Contract Revenue; and b. Contract Costs. Contracts Revenues comprise of: a. The initial amount of revenue agreed in the contract; and b. Variations in contract work, claims, and incentive payments to the extent that: i. It is probable that they will result in revenue; and ii. They are capable of being reliably measured. Contract Costs 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 on a systematic and rational basis (indirect costs); and c. Such other costs as are specifically chargeable to the customer/entity under the terms 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: i. General administration costs for which reimbursement is not specified in the contract; FAAC Sub-Committee on IPSAS Implementation Page 182
ii. iii. iv. Selling costs; R&D costs for which reimbursement is not specified in the contract; and Depreciation of idle plant and equipment that is not used on a particular contract. Segmentation and Combination of Construction Contract Construction Contract may need to be combined or segmented for accounting purposes to reflect the substance of the arrangements. 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: a. Separate proposals have been submitted for each asset; b. Each asset has been the subject of separate negotiations, and the contractor and customer have each been able to accept or reject that part of the contract relating to each asset; c. The costs and revenues of each asset can be identified. A group of contracts, whether with a single customer or with several customers, should be combined where: i. The contracts have been negotiated as a single package; ii. The contracts are so closely interrelated that they are, in effect, part of a single project with an overall margin, if any; iii. The contracts are performed concurrently or in a continuous sequence Retentions are amounts of progress billings that are not paid until the satisfaction of conditions specified in the contract for the payment of such amounts, or until defects have been rectified. Progress Billings (Valuation Certificate) are amounts of contract revenue billed for work performed on a contract, whether or not they have been paid by the customer. It is a series of invoices prepared at different stages in the process of a major project, in order to seek payment for the percentage of work that has been completed so far. Progress billing will show the original contract amount, any changes to that amount, how much has been paid to date, what percentage of the job has been completed to date, what payment is currently due and the total FAAC Sub-Committee on IPSAS Implementation Page 183
amount remaining to be paid by the project's completion. Progress billing is common in the construction industry. Advances from Customers Advance received from customers in respect of contract work that is yet to be performed must be recognized as a liability until the work in respect of which the advance was given has been performed. Recognition of Expected Deficits/Losses Contract costs are usually intended at inception to be fully recoverable; however, where it is probable that total contract costs will exceed total contract revenue, the expected deficit shall be recognized and expensed immediately. Trade Receivables (Contract) Trade Receivables are calculated by finding the difference between amount billed to the customer as progress billings and the amount of progress payments received from the customer. Trade Receivables are therefore calculated as follows: Trade Receivables = Amount billed to Customer as progress billings less Progress Payments Received (If any). Note in accordance with accrual concept, any amount outstanding from customer in respect of contractual work yet to be performed shall not be included as trade receivables. Amount Due from Customer (Account Receivable) is the net amount of: a. Cost incurred plus recognized surplus; less b. The sum of recognized deficits and progress billings for all contracts in progress for which costs incurred plus recognized surpluses to be recovered by way of contract revenue (less recognized deficits) exceed progress billings. Amount Due from Customer is tabulated as follows: Description Contract Costs Incurred X1 Add: Surplus (Profit) Recognized X1 Less: Losses Recognized (if any) X Progress Billings X (X) Gross amount due from Customer X FAAC Sub-Committee on IPSAS Implementation Page 184
Conversely, Amount Due to Customer (Account Payable) is the net amount of: a. Cost incurred plus recognized surplus; less b. The sum of recognized deficits and progress billings for all contracts in progress for which progress billings exceed costs incurred plus recognized surpluses to be recovered by way of contract revenue (less recognized deficits). Amount Due to Customer is tabulated as follows: Description Contract Costs Incurred X1 Add: Surplus (Profit) Recognized X1 Less: Deficit (Losses) Recognized X Progress Billings X (X) Gross amount due to Customer (X) Where, a. Costs incurred is amount expensed on the contract to date based on the bills submitted b. Recognised surplus is the profit element/excess of amount billed less cost incurred to date c. Deficit recognised is excess of recognised contract costs over the expected contract revenue to date d. Progress billings are amounts of contract revenue billed for work performed on a contract to date, whether or not they have been paid by the customer. 19.3 Applicable Standard The applicable standard is IPSAS 11 (Construction Contracts). 19.4 Key IPSAS Provisions Recognition When the outcome of a Construction Contract can be estimated reliably, contract costs and revenues associated with the Construction Contract shall be recognized as expenses and revenues respectively by reference to the stage of completion of the contract activity at the reporting date. An expected deficit on a Construction Contract shall be recognized as an expense immediately. FAAC Sub-Committee on IPSAS Implementation Page 185
Fixed Price or Lump Sum Contract In the case of a fixed price contract, the outcome of a Construction Contract can be estimated reliably when all the following conditions are satisfied: a. Total contract revenue, if any, can be measured reliably; b. It is probable that the economic benefits or service potential 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 reporting 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. Cost Plus In the case of a cost plus or cost-based contract, the outcome of a Construction Contract can be estimated reliably when all the following conditions are satisfied: a. It is probable that the economic benefits or service potential associated with the contract will flow to the entity; and b. The contract costs attributable to the contract, whether or not specifically reimbursable, can be clearly identified and measured reliably. The Percentage of Completion Method This method recognizes revenues and expenses by reference to the stage of completion of a contract. Under this method, contract revenue is matched with the contract costs incurred in reaching the stage of completion, resulting in the reporting of revenue, expenses and surplus/deficit that can be attributed to the proportion of work completed. FAAC Sub-Committee on IPSAS Implementation Page 186
Unreliability of Estimates During the early stages of a contract, it is often the case that the outcome of the contract cannot be estimated reliably. Nevertheless, it may be probable that the entity will recover the contract costs incurred. Therefore, contract revenue is recognized only to the extent of costs incurred that are expected to be recoverable. As the outcome of the contract cannot be estimated reliably, no surplus or deficit is recognized. However, even though the outcome of the contract cannot be estimated reliably, it may be probable that total contract costs will exceed total contract revenues. In such cases, any expected excess of total contract costs over total contract revenues for the contract is recognized as an expense immediately. Expected deficits In respect of Construction Contracts in which it is intended at inception of the contract that contract costs are to be fully recovered from the parties to the Construction Contract, when it is probable that total contract costs will exceed total contract revenue, the expected deficit shall be recognized as an expense immediately. Measurement Contract revenue is measured at the fair value of the consideration received or receivable. Both the initial and ongoing measurement of contract revenue is affected 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. Where a contract is a cost plus or cost-based contract, the initial amount of revenue may not be stated in the contract. Instead, it may need to be estimated on a basis consistent with the terms and provisions of the contract, such as by reference to expected costs over the life of the contract. FAAC Sub-Committee on IPSAS Implementation Page 187
Disclosure An entity shall disclose by way of notes to the GPFS the followings: 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 reporting date: a. The aggregate amount of costs incurred and recognized surpluses (less recognized deficits) to date; b. The amount of advances received; and c. The amount of retentions. An entity shall also present by way of disclosures: a. The gross amount due from customers for contract work as an asset; and/or b. The gross amount due to customers for contract work as a liability. 19.5 Accounting Documentation a. Approved Budget Provisions; b. Cashbook; c. Debtors Ledger; d. Creditors Ledger; e. Purchase Order; f. General Ledger; g. Invoice/Waybill Register; h. Assets Register; i. Assets Maintenance Register; j. Relevant Accounting Journals; k. Contract Award Letters; l. Purchase Orders; m. Store Issue Vouchers (SIV). FAAC Sub-Committee on IPSAS Implementation Page 188
19.6 Accounting Procedure a. Obtain relevant approvals for the Construction Contract b. Recognize relevant cost of the Contract in the Books/Ledgers c. Recognize Revenue accruable from the Contract 19.7 Applicable Codes NCOA Description Code 410101 Contract Retention Fees Other relevant codes as in the NCOA 19.8 Accounting Treatment S/No Details Remark 1 i To Recognize Revenue Accruable: DR Account Receivable CR Contract Revenue DR Cash/Bank CR Account Receivable To recognize the revenue accrued to the entity to date (using progress billing) On receipt of the revenue ii 2 To Recognize Cost of the Contract DR Contract expenses CR Account Payables Dr Accounts Payable Cr Cash/Bank To recognize the expenses incurred by the entity to date Upon payments of contract expenses FAAC Sub-Committee on IPSAS Implementation Page 189
iii 3 Recognition of Advance Received Dr Cash/Bank Cr Accounts payable (Customer) Dr Accounts Payable Cr Contract Revenue To recognize advance received in respect of construction contract To recognize utilization of the advance payment received 19.9 Illustration Entity XYZ (Contractor) entered into a contract agreement with Agency MNO to construct 30 units of houses for its staff at the cost of 100,000 per unit. The duration for the completion of the contract is 2 years with no variation clause. At the end of year one, the valuation certificate submitted by entity XYZ indicates that over 60% of the contract has been executed. The amount spent so far by Entity XYZ was estimated at 1,200,000. At the end of year the records show that XYZ has received a total sum of 1,000,000 from Agency MNO Accounting Entries S/No Details Code Dr ( ) Cr ( ) Remark 1 Accounts Receivable 1,800,000 To recognize Contract Revenue 1,800,000 revenue based on valuation certificate submitted Cash/Bank 1,000,000 Upon receipt of Accounts Receivable 1,000,000 cash from Agency MNO Contract expenses 1,200,000 To recognize Accounts Payable 1,200,000 contract expenses to date Accounts Payable 1,200,000 Upon Cash payment to Cash/Bank 1,200,000 suppliers FAAC Sub-Committee on IPSAS Implementation Page 190