Construction Contracts Chapter 10 Construction Contracts

Agenda Applicable Standard and Scope Combining and Segmenting Construction Contracts What Are Contract Revenue? What Are Contract Costs? Recognition of Contract Revenue and Expenses Recognition of Expected Losses Changes in Estimates Disclosure

1. Applicable Standard and Scope IAS 11 Construction Contracts prescribes the accounting treatment of revenue and costs associated with construction contracts. Contractors are required to account for their construction contracts in the financial statements in accordance with IAS 11. Because the dates of commencement and completion of the contract activity usually fall into different accounting periods, the primary issue is how to allocate contract revenue and contract costs to the accounting periods in which the construction work is performed. IAS 11 uses the recognition criteria established in the Framework for the Preparation and Presentation of Financial Statements.

2. Combining and Segmenting Construction Contracts An entity is required to apply IAS 11 to the separately identifiable components of a single contract or a group of contracts together in order to reflect the substance of a contract or a group of contracts

Combining and Segmenting Construction Contracts When a contract covers a number of assets, an entity will treat the construction of each asset as a separate construction contract if all the following three conditions are satisfied: separate proposals have been submitted for each asset; 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 the costs and revenues of each asset can be identified.

Combining and Segmenting Construction Contracts An entity treats a group of contracts, whether with a single customer or with several customers, as a single construction contract when all the following three conditions are satisfied: the group of contracts is negotiated as a single package; the contracts are so closely interrelated that they are, in effect, part of a single project with an overall profit margin; and the contracts are performed concurrently or in a continuous sequence.

Combining and Segmenting Construction Contracts Construction of the additional asset is treated as a separate construction contract when: the asset differs significantly in design, technology or function from the asset or assets covered by the original contract; or the price of the asset is negotiated without regard to the original contract price.

3. What Are Contract Revenue? Contract revenue comprises: the initial amount of revenue agreed in the contract; and variations in contract work, claims and incentive payments to the extent that it is probable that they will result in revenue; and they are capable of being reliably measured.

3. What Are Contract Revenue? An entity includes a variation in contract revenue when: it is probable that the customer will approve the variation as well as the amount of revenue arising from the variation and the amount of revenue can be reliably measured

3. What Are Contract Revenue? Example 10.4 The contract has a cost escalation clause for adjusting the fixed contract price of $20 million to general inflation rate announced by the government. The government has announced the general inflation for the current period is 3%. Determine the amount of contract revenue to be increased or decreased for the current period. Answers The amount of contract revenue to be increased for the current period is: $20 million X 3% = $600,000

3. What Are Contract Revenue? An entity includes a claim in contract revenue only when: negotiations have reached an advanced stage such that it is probable that the customer will accept the claim and the amount of the claim can be measured reliably

3. What Are Contract Revenue? Example 10.5 The contract has a penalty clause for delays caused by the contractor in the completion of the contract. The initial amount of revenue agreed in the contract is $30 million. The penalty is agreed to be $20,000 per day of delay. Due to the contractor’s problem, the completion date of the contract was 10 days after the agreed deadline. Determine the amount of contract revenue to be increased or decreased. Answers The amount of contract revenue to be decreased is $20,000 X 10 = $200,000

3. What Are Contract Revenue? An entity includes an incentive payment in contract revenue when: the contract is sufficiently advanced that it is probable that the specified performance standards will be met or exceeded and the amount of the incentive payment can be measured reliably.

3. What Are Contract Revenue? Example 10.6 Power has won a contract to construct a building for $50 million. The contract allows for an incentive payment of $20,000 per day up to a maximum of $500,000 to Power for early completion of the contract. The construction of the building is at the completion stage and it is probable that the contract will be completed eight days before the agreed completion date. Determine the amount of incentive payment to be included in Power’s contract revenue.

3. What Are Contract Revenue? Example 10.6 Answers The construction of the building is at the completion stage and it is probable that the specified performance standards (early completion) will be met. The amount of the incentive payment can also be measured reliably to be $20,000 per day up to a maximum of $500,000. The amount of incentive payment to be included in Power’s contract revenue is $160,000 ($20,000 per day X 8 days)

4. What Are Contract Costs?

4. What Are Contract Costs? Costs that relate directly to the specific contract may be reduced by any incidental income that is not included in contract revenue. Costs that may be attributable to contract activity in general and can be allocated to specific contracts include: insurance; costs of design and technical assistance that is not directly related to a specific contract; and construction overheads.

4. What Are Contract Costs? Costs that are specifically chargeable to the customer under the terms of the contract may include some general administration costs and development costs for which reimbursement is specified in the terms of the contract. Contract costs include the costs attributable to a contract for the period from the date of securing the contract to the final completion of the contract.

Recognition of Contract Revenue and Expenses

Recognition of Contract Revenue and Expenses When Outcome of Contract Can Be Estimated Reliably recognises contract revenue and contract costs associated with the construction contract as revenue and expenses respectively by reference to the stage of completion of the contract activity at the balance sheet date IFRIC Interpretation 15: When an agreement for the construction of real estate is within the scope of IAS 11 and its outcome can be estimated reliably, recognises revenue by reference to the stage of completion of the contract activity in accordance with IAS 11

Recognition of Contract Revenue and Expenses When Outcome of Contract Can Be Estimated Reliably 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: 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 complete the contract and the stage of contract completion at the balance sheet date can be measured reliably; and 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.

Recognition of Contract Revenue and Expenses When Outcome of Contract Can Be Estimated Reliably 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: 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.

5. Recognition of Contract Revenue and Expenses 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 The stage of completion of a contract may be determined in a variety of ways: the proportion of contract costs incurred for work performed to date to the estimated total contract costs (see Example 10.9); surveys of work performed; or completion of a physical proportion of the contract work.

5. Recognition of Contract Revenue and Expenses Example 10.9 The percentage of completion method A construction contractor has obtained a fixed price contract from the Hong Kong Government for $9,000 million to build a bridge between Hong Kong and City A on Mainland China. The initial amount of revenue agreed in the contract is $9,000 million. The contractor's initial estimate of contract costs is $8,000 million. It will take 3 years to build the bridge. By the end of Year 1, the contractor's estimate of contract costs has increased to $8,050 million.

5. Recognition of Contract Revenue and Expenses Example 10.9 In Year 2, the Hong Kong Government approves a variation resulting in an increase in contract revenue of $200 million and estimated additional contract costs of $150 million. At the end of Year 2, costs incurred include $100 million for standard materials stored at the site to be used in Year 3 to complete the project. The contractor determines the stage of completion of the contract by calculating the proportion that contract costs incurred for work performed to date bear to the latest estimated total contract costs.

5. Recognition of Contract Revenue and Expenses Example 10.9 A summary of the financial data during the construction period is as follows: Year 1 $'m Year 2 $'m Year 3 $'m Initial amount of revenue agreed in contract 9,000 Variation - 200 Total contract revenue 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 Estimated profit 950 1,000 Stage of completion 26% 74% 100%

5. Recognition of Contract Revenue and Expenses Example 10.9 The stage of completion for Year 2 (74%) is determined by excluding from contract costs incurred for work performed to date the $100 million of standard materials stored at the site for use in Year 3. Required: Calculate the amounts of revenue, expenses and profit recognized in the statement of comprehensive income for each of Year 1, 2 and 3 using the percentage of completion method. Prepare journal entries to account for the contract revenues and expenses for Year 1.

5. Recognition of Contract Revenue and Expenses Example 10.9 Answers To Date $'m Recognised in prior years $'m Recognised in current year $'m Year 1 Revenue (9,000 x 0.26) 2,340 - Expenses (8,050 x 0.26) 2,093 Profit 247 Year 2 Revenue (9,200 x 0.74) 6,808 4,468 Expenses (8,200 x 0.74) 6,068 3,975 740 493 Year 3 Revenue (9,200 x 1.00) 9,200 2,392 Expenses 8,200 2,132 1,000 260

5. Recognition of Contract Revenue and Expenses Example 10.9 Answers For Year 1, the following journal entries should be recorded by the contractor: Dr Contract expenses $2,093 Cr Cash or Accounts payable $2,093 To recognise the contract expenses for Year 1. Dr Cash or Due from customers $2,340 Cr Contract revenue $2,340 To recognise the contract revenue for Year 1.

5. Recognition of Contract Revenue and Expenses When Outcome of Contract Cannot Be Estimated Reliably revenue shall be recognized only to the extent of contract costs incurred that it is probable will be recoverable contract costs shall be recognized as an expense in the period in which they are incurred contract costs that are not probable of being recovered are recognized as an expense immediately

5. Recognition of Contract Revenue and Expenses Example 10.11 Contract costs that are not probable of being recovered include contracts: which are not fully enforceable the completion of which is subject to the outcome of pending litigation or legislation relating to properties that are likely to be condemned or expropriated where the customer is unable to meet its obligations where the contractor is unable to complete the contract or otherwise meet its obligations under the contract

6. Recognition of Expected Losses When it is probable that total contract costs will exceed total contract revenue, an entity recognizes the expected loss as an expense immediately. The amount of expected loss is determined irrespective of: whether work has commenced on the contract; the stage of completion of contract activity; or the amount of profits expected to arise on other contracts which are not treated as a single construction contract

7. Changes in Estimates An entity accounts for the effect of a change in the estimate of contract revenue or contract costs, or the effect of a change in the estimate on the outcome of a contract as a change in accounting estimate

8. Disclosure An entity is required to disclose: the amount of contract revenue recognized as revenue in the period; the methods used to determine the contract revenue recognized in the period; and the methods used to determine the stage of completion of contracts in progress.

8. Disclosure An entity is also required to disclose each of the following for contracts in progress at the balance sheet date: the aggregate amount of costs incurred and recognized profits (less recognized losses) to date; the amount of advances received; and the amount of retentions.

8. Disclosure An entity should also present: the gross amount due from customers for contract work as an asset, which is the net amount of: costs incurred plus recognized profits; less the sum of recognized losses and progress billings for all contracts in progress for which costs incurred plus recognized profits (less recognized losses) exceeds progress billings.

8. Disclosure The gross amount due to customers for contract work as a liability, which is the net amount of: costs incurred plus recognized profits; less the sum of recognized losses and progress billings for all contracts in progress for which progress billings exceed costs incurred plus recognized profits (less recognized losses)