1 Construction contracts 1.1 Definitions
2.1 The rules
2.1.1 General
Contracts should be considered on a contract by contract basis. Commentary
In certain circumstances:
two or more contracts may be combined to be considered as one; Commentary
When they are negotiated as a package, closely inter-related and performed concurrently or in a continuous sequence.
a contract may be “segmented” into two or more separate contracts. Commentary
When there are separate proposals/negotiations such that segments can be individually accepted/rejected and separately identifiable costs/revenues.
The impact that a contract will have on the financial statements depends on the estimate of the future outcome of the contract.
The rules in IAS 11 provide for three possibilities, arising on contract review. (1) Profits are expected and the outcome is reasonably certain.
Commentary
Revenue and cost will be recognised in comprehensive income (in profit or loss) resulting in some profit being taken.
(2) A loss is expected. Commentary
The exercise of prudence requires that this loss be recognised immediately and in full.
(3) The outcome cannot be assessed with reasonable certainty.
2.1.2 Specific
(1) When the outcome of a construction contract can be estimated reliably, contract revenue and associated contract costs should be recognised as revenue and expenses respectively by reference to the stage of completion of the contract activity at the end of the reporting period. (Profit will be taken.)
(2) When it is probable that total contract costs will exceed total contract revenue, the expected loss must be recognised as an expense immediately. Commentary
A contract does not need to have started for a loss to be recognised. In a recession an entity may undertake contracts at a loss in order to retain a skilled workforce.
(3) When the outcome of a construction contract cannot be estimated reliably:
Revenue should be recognised only to the extent of contract costs incurred that it is probable will be recoverable; and
Contract costs should be recognised as an expense in the period in which they are incurred.
Situation How is revenue measured?
How are costs measured for recognition in profit or loss?
Commentary
(1) Profit By reference to stage of (percentage) completion.
The costs incurred in reaching the stage of completion are included in the determination of profit or loss, as cost of sales. Often this is achieved by applying the percentage
completion to the total costs that are expected to occur over the life of the contract.
Revenue exceeds costs therefore profit is recognised.
If the same % completion is applied to revenue and costs then this will result in that percentage of the total estimated profit being recognised.
(2) Loss By reference to stage of (percentage) completion.
As a balancing figure to interact with the revenue that has been recognised and generate the required loss.
Loss may be recognised at any
stage. For example, a contract
may be signed knowing that it will make a loss. In this case the loss should be recognised when the contract is signed.
(3) Un- certain
To equal the cost figure
The costs incurred in the period should be expensed
Revenue = costs
The usual source of uncertainty is that the contract is still quite “young”. For example, it may be imprudent to take profit on a 10 year contract which has only just started.
The accounting should recognise revenue and costs that have arisen in the period. This is done by calculating the amounts in total that should be recognised by the year end and then adjusting them for what has been recognised in earlier years.
2.1.3
Meaning of “can be estimated reliably”
In the case of a fixed price contract, the outcome can be estimated reliably when all the following conditions are satisfied:
total contract revenue can be measured reliably;
it is probable that the economic benefits associated with the contract will flow to the entity;
both the contract costs to completion and the stage of contract completion at the end of the reporting period can be measured reliably; and
costs attributable to the contract can be clearly identified and measured reliably so that actual costs incurred can be compared with prior estimates.
In the case of a cost plus contract, the outcome can be estimated reliably when both the following conditions are satisfied:
it is probable that the economic benefits associated with the contract will flow to the entity; and
the contract costs attributable to the contract, whether or not specifically reimbursable, can be clearly identified and measured reliably.
2.1.4
Stage of completion
The recognition of revenue and expenses by reference to the stage of completion of a contract is often referred to as the percentage of completion method.
Contract revenue is matched with the contract costs incurred in reaching the stage of completion, resulting in the reporting of revenue, expenses and profit which can be attributed to the proportion of work completed.
This method provides useful information on the extent of contract activity and performance during a period. The standard does not specify a single method for calculating the percentage of completion. Methods include:
the proportion that contract costs incurred for work performed to date bear to the estimated total contract costs;
surveys of work performed; or
completion of a physical proportion of the contract work. An expected loss on the construction contract must be recognised as an expense immediately.
Note that:
amounts billed are irrelevant to determining the amount of revenue to be included in the statement of profit or loss; and
costs incurred by the year end (and therefore appearing in the cost accounts) may be an irrelevant figure in determining cost of sales.
Commentary
IAS 11 applies to construction contracts as defined. IAS 18 Revenue requires a similar approach for contracts for the provision of a service.
Illustration 1
1. ACCOUNTING PRINCIPLES