| International Accounting Standard 11 Construction Contract

| Terms used A construction contract: Refers to a contract 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.

| Terms used 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.

| Terms cont’d… A cost plus contract Refers to 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.

| Terms cont’d… A construction contract may be negotiated for the construction of a single asset such as a bridge, building, dam, pipeline, road, ship or tunnel or a number of assets.

| Contract revenue Contract revenue 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 Contract revenue is measured at the fair value of the consideration received or receivable.

| Contract revenue The value of contract revenue may increase or decrease from one period to another, for example: – (a) a contractor and a customer may agree variations or claims that increase or decrease contract revenue, – (b) cost escalation clauses, – (c) penalties imposed due to delays, – (d) for a fixed price contract, when the fixed price per unit of output increases.

| Contract costs 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; and – (c) such other costs as are specifically chargeable to the customer under the terms of the contract.

| Direct contract costs Costs that relate directly to a specific contract include: – (a) site labour costs, including site supervision; – (b) costs of materials 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;

| Direct contract costs – (e) costs 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, including expected warranty costs; and – (h) claims from third parties.

| Costs attributable to contract activity 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.

| Recognition of contract revenue and expenses 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 end of the reporting period. – An expected loss on the construction contract shall be recognized as an expense immediately.

| Fixed price 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 can be measured reliably; – (b) it is probable that the economic benefits associated with the contract will flow to the entity;

| Fixed price contract – (c) both the contract costs to complete the contract and the stage of contract completion at the end of the reporting period 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 contract In the case of a cost plus 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 associated with the contract will flow to the entity; and

| Cost-plus contract – (b) the contract costs attributable to the contract, whether or not specifically reimbursable, can be clearly identified and measured reliably.

| Percentage-of-completion method 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. 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 profit which can be attributed to the proportion of work completed.

| Recognition of contract revenue and expenses Under the percentage of completion method, contract revenue is recognized as revenue in profit or loss in the accounting periods in which the work is performed. Contract costs are usually recognized as an expense in profit or loss in the accounting periods in which the work to which they relate is performed.

| Recognition of contract revenue and expenses However, any expected excess of total contract costs over total contract revenue for the contract is recognized as an expense immediately.

| Recognition of assets on contracts A contractor may have incurred contract costs that relate to future activity on the contract. Such contract costs are recognized as an asset provided it is probable that they will be recovered. Such costs represent an amount due from the customer and are often classified as contract work in progress.

| Stage of completion The stage of completion of a contract may be determined in a variety of ways. – (a) the proportion that contract costs incurred for work performed to date bear to the estimated total contract costs; – (b) surveys of work performed; or – (c) completion of a physical proportion of the contract work. Progress payments and advances received from customers often do not reflect the work performed.

| Stage of completion Commonly used methods are :

| Example 1 Mice Technologies has a contract to build a network for a customer at a contract price of Sh. 10 million. The network will take an estimated 3 years to build. The total costs are estimated to be Sh. 6 million. The company recognizes long term contract revenue using percentage-of-completion method. The stage of completion is based on the cost incurred as a percentage of total costs. The following table shows the costs incurred in each year:

| Example 1 – Required: Compute the revenue to be recognized in each year. Year 1Year 2Year 3 Sh. 'million' Costs incurred to date35.46

| Example 2 - Profit-making contract Lily is a construction company that prepares its financial statements to 31 December each year. During the year ended 31 December 2018, the company commenced a contract that is expected to take more than one year to complete. The contract summary at 31 December 2018 is as follows:

| Example 2 - Profit-making contract The agreed value of the work completed at 31 December 2018 is considered to be equal to the revenue earned in the year ended 31 December The percentage of completion is calculated as the value of the work invoiced to date compared to the contract price. Required: Calculate the effect of the above contract on the financial statements at 31 December Sh. 'million' Progress payments 1,400 Contract price 2,736 Work certified complete 1,824 Contract costs incurred to 31Dec ,160 Estimated total cost at 31 December 2018** 2,520 **‘estimated total cost’ means costs incurred plus costs to complete.

| Example 3: Loss-making contract Gladioli is a construction company that prepares its financial statements to 31 March each year. During the year ended 31 March 2018, the company commenced a contract that is expected to take more than one year to complete. The contract summary at 31 March 2018 is as follows:

| Example 3: Loss-making contract The percentage completion of this contract is to be based on the costs to date compared to the estimated total contract costs. – Required: Calculate the effect of the above contract in the financial statements at 31 March Sh. 'million' Progress payments 3,780 Contract price 4,500 Contract costs incurred to 31 March ,600 Estimated cost to complete at 31 March ,200

| Example 4: Take no profit on contract A welding company negotiated a two-year project that commenced in the latter half of the year. The project manager has been reviewing the contract and, at the year end, is unsure whether the contract will make a profit or a loss as there are uncertainties surrounding the project’s completion. The project manager’s records show that costs during the year amount to Sh. 7,000,000 and no cash had yet been received. What should the accounting entries be regarding the contract at the year end?

| Example 5: Detailed Ling Wu construction co. ltd has been contracted to construct a road stretch. The contract cost is Sh. 9 billion and is expected to take 3 years. The details of the contract are provided below: Year 1Year 2Year 3 Shs ‘m' Initial amount of revenue agreed in contract 9,000 Variation Total contract revenue 9,000 9,200 Contract costs incurred to date 2,093 6,168 8,200 Contract costs to complete 5,957 2,032 - Total estimated contract costs 8,050 8,200 Estimated profit 950 1,000 Stage of completion26%74%100%

| Example 5: Detailed Required: Show Financial statements extracts for the 3 years.

| Summary What is included in contract revenue and costs? – Contract revenue will be the amount agreed in the initial contract, plus revenue from variations in the original contract work, plus incentive payments and claims that can be reliably measured, such as contract revenue which can be valued at the fair value of received or receivable revenue.

| Summary – Contract costs are to include costs relating directly to the initial contract plus costs attributable to general contract activity, plus costs that can be specifically charged to the customer under the terms of the contract.

| Assignment Lax limited, a construction company won a contract to build a student centre at Lang’ata University. Lax estimated the cost of construction as Sh 90 million hence priced the job at Sh 130 million. Due to high inflation rate, an escalation clause was inserted in the contract. Construction began on 1 st January 2016 and was expected to last for three years. Lax financial year end on 31 December. Details of constructions are provided below: The price was revised on 1 st January 2017 to Sh 145 millions and assume the company uses Percentage of Completion Method (PCM) based on the cost incurred to date. Required. Show the extract of the financial statements for the three years in accordance with IAS 11 “Construction contracts”. 31 st Dec st Dec st Dec 2018 Cost incurred to date Direct material cost Sh 11 millionSh 26 millionSh 40 million Direct labour cost Sh 5 millionSh 25 millionSh 30 million Production overhead Sh 5.6 millionSh millionSh 30 million General expenses Sh 8 millionSh 9 millionSh 7 million Additional cost to be incurred to completion date Sh 68.4 millionSh million0 Billing done per year Sh 30 millionSh 50 millionSh 65 million Cash received per year Sh 20 millionSh 40 millionSh 85 million

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