1. Connolly – International Financial Accounting and Reporting – 4 th Edition CHAPTER 12 CONSTRUCTION CONTRACTS

2. Connolly – International Financial Accounting and Reporting – 4 th Edition 12.1 INTRODUCTION Contracts that span more than one accounting period Potential difficulties allocating and recognising revenue and expenses Potential conflict between prudence and accruals/matching

3. Connolly – International Financial Accounting and Reporting – 4 th Edition 12.2 IAS 11 CONSTRUCTION CONTRACTS Objective is to prescribe the accounting treatment of revenue and costs associated with construction contracts Primary issue is the allocation of contract revenue and costs to the period in which construction work is performed

4. Connolly – International Financial Accounting and Reporting – 4 th Edition Contract revenues and costs Revenues  the initial amount of revenue agreed in the contract, and  variations in contract work, claims and incentive payments Costs  those that relate directly to a specific contract  costs that are attributable to general contract activity but can be allocated to specific contracts  any other costs that can be charged to the customer under the terms of the contract

5. Connolly – International Financial Accounting and Reporting – 4 th Edition

11. 12.2 IAS 11 CONSTRUCTION CONTRACTS Three categories of construction contract 1.When the outcome can be estimated reliably 2.When the outcome cannot be estimated reliably 3.When it is probable that total contract costs will exceed total contract revenue and therefore that the contract will incur losses

12. Connolly – International Financial Accounting and Reporting – 4 th Edition When the outcome can be estimated reliably Category 1 If the outcome of a profitable contract can be estimated reliably, contract revenue and costs should be recognised by reference to the stage of completion at the end of each reporting period.

13. Connolly – International Financial Accounting and Reporting – 4 th Edition Options for measuring stage of completion  Costs incurred as a proportion of total estimated costs  Value certified as a proportion of total contract revenue  Completion of physical proportion of contract work Stage of completion

14. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 12.1: Contract outcome estimated reliably Contract X at 31 December 2012: Commencement date1 January 2012 Completion date31 December 2013 Contract price€3,000,000 Cost to date€1,000,000 Cost to complete€1,000,000 Stage of completion to be determined by reference to costs to date and total costs rather than duration.

15. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 12.1: Contract outcome estimated reliably Step 1 Calculate the outcome for the contract € Price 3,000,000 Costs to date (1,000,000) Costs to complete (1,000,000) Profit 1,000,000 Step 2 Determine the stage of completion Cost to date/Total cost€1,000,000/€2,000,000 = 50% Step 3 Statement of profit or loss and other comprehensive income € Revenue (€3m x 50%) 1,500,000 Cost of sales (€2m x 50%) (1,000,000) Profit 500,000

16. Connolly – International Financial Accounting and Reporting – 4 th Edition When the outcome cannot be estimated reliably Category 2 When a contract’s outcome cannot be estimated reliably:  recognise revenue to the extent of the costs incurred which are expected to be recoverable; and  recognise contract costs as an expense in the period in which incurred. This arises during the early stages of a contract when it is difficult to reliably estimate outcome, but likely that costs will be recovered.

17. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 12.2: Outcome cannot be estimated reliably Contract Y at 31 December 2012: Commencement date1 November 2012 Completion date 31 March 2014 Contract price€5,000,000 Cost to date€400,000 Cost to complete€3,600,000 Stage of completion to be determined by reference to costs to date and total costs rather than duration.

18. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 12.2: Outcome cannot be estimated reliably Step 1 Calculate the outcome for the contract € Price 5,000,000 Costs to date (400,000) Costs to complete (3,600,000) Profit 1,000,000 Step 2 Determine the stage of completion Cost to date/Total cost€400,000/€4,000,000 = 10%  Too early to recognise any profit. Step 3 Statement of profit or loss and other comprehensive income € Revenue 400,000 Cost of Sales (€4m x 10%)(400,000) Profit 0Revenue = CoS

19. Connolly – International Financial Accounting and Reporting – 4 th Edition When it is probable that total contract costs will exceed total contract revenue and therefore that the contract will incur losses Category 3 When it is probable that costs > revenue, the expected total loss should be recognised immediately irrespective of whether work has commenced and the stage of completion.

20. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 12.3: Contract loss expected Contract Z at 31 December 2012: Commencement date1 September 2012 Completion date30 April 2014 Cost to date€440,000 Cost to complete€1,760,000 Contract price€2,000,000 % completion20% Stage of completion to be determined by reference to costs to date and total costs rather than duration.

21. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 12.3: Contract loss expected Step 1 Calculate the outcome for the contract € Price 2,000,000 Costs to date (440,000) Costs to complete (1,760,000) Loss (200,000) Step 2 Determine the stage of completion Cost to Date/Total Cost €440,000/€2,200,000 = 20% Step 3 Statement of profit or loss and other comprehensive income € Revenue (€2m x 20%) 400,000 Cost of Sales (€2.2m x 20%) (440,000) Provision for foreseeable loss (160,000) (200,000)

22. Connolly – International Financial Accounting and Reporting – 4 th Edition FURTHER EXAMPLES

23. Connolly – International Financial Accounting and Reporting – 4 th Edition

28. Example 12.6: Recognising contract revenue, expenses and profit A contractor had a fixed price contract for €9,000,000 to build a bridge. The initial amount of revenue agreed in the contract is €9,000,000. The contractors initial estimate of contract costs is €8,000,000. It will take three years to build the bridge. By the end of Year 1, contractor’s estimate of contract costs has increased to €8,050,000, In Year 2, the customer approves a variation resulting in an increase in contract revenue of €200,000 and estimated additional contract costs of €150,000. At the end of Year 2, costs incurred include €100,000 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 comparing the proportion of contract costs incurred for work performed to date with the latest estimated total contract costs incurred for work performed to date with the latest estimated total contract costs. In accordance with IAS 11, the company recognises profit in construction contracts when completion is more than 20%.

29. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 12.6: Recognising contract revenue, expenses and profit Cont’d. A summary of the financial data during the construction period is as follows: Prepare the figures for the SPLOCI – P/L for years 1–3. Year1 €’000 2 €’000 3 €’000 Initial amount of revenue agreed in contract 9,000 VariationNil200 Total contract revenue9,0009,200 Contract costs incurred to date2,0936,1708,200 Contract costs to complete5,9572,030Nil Total estimated contract cost8,0508,200

30. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 12.6: Recognising contract revenue, expenses and profit Solution – Year 1 Step 1 Calculate the overall profit or loss on the contract € Contract price 9,000 Total cost (8,050) Profit 950 Step 2 Stage of Completion Cost incurred to date / Total cost = €2,093 / €8,050 = 26% Step 3 SPLOCI – P/L € Revenue (€9,000 X 26%) 2,340 Cost of sales (€8,050 X 26%) (2,093) Gross profit 247

31. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 12.6: Recognising contract revenue, expenses and profit Solution – Year 2 Step 1 Calculate the overall profit or loss on the contract € Contract price 9,200 Total cost (8,200) Profit 1,000 Step 2 Stage of Completion Cost incurred to date / Total cost = €6,070 / €8,200 = 74% Step 3 SPLOCI – P/L Cumulative € Year 1 € Year 2 € Revenue (€9,000 X 74%)6,808(2,340)4,468 Cost of goods sold (€8,200 X 74%)(6,070)2,093(3,975) Gross profit738493

32. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 12.6: Recognising contract revenue, expenses and profit Solution – Year 3 Step 1 Calculate the overall profit or loss on the contract € Contract price 9,200 Total cost (8,200) Profit 1,000 Step 2 Stage of Completion Cost incurred to date / Total cost = €8,200 / €8,200 = 100% Step 3 SPLOCI – P/L Cumulative € Years 1 & 2 € Year 3 € Revenue9,200(6,808)2,392 Cost of goods sold(8,200)6,070(2,130) Gross profit1,000 262

33. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 12.7: Contract outcome uncertain ABC Limited commenced Contract C in 2012 and has the following details for the year ended 31 December 2012: Requirement Calculate the profit / loss to be recognised in the Statement of profit or loss and other comprehensive income for the year ended 31 December 2012 in respect of Contract C, assuming that costs incurred to date are recoverable €m Total contract value40 Costs incurred to date3 Estimated total costs30 Completion10%

34. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 12.7: Contract outcome uncertain Solution Step 1 Calculate the overall profit or loss on the contract € Contract price 40 Total cost (30) Profit 10 Step 2 Stage of Completion Cost incurred to date / Total cost = €3 / €30 = 10% The contract is at too early a stage to recognise any profit. 10% of the contract revenue is €4, but the revenue in the SPLOCI – P/L is limited to the amount of the costs incurred to date.

35. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 12.7: Contract outcome uncertain Solution SPLOCI – P/L € Revenue 3 Cost of goods sold (3) Gross profit Nil

36. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 12.8: Recognising contract losses ABC Limited commenced Contract B during 2013 and will complete it in 2013. It has the following details for the year ended 31 December 2012: Requirement Calculate the profit or loss to be recognised in the statement of profit or loss and other comprehensive income for the year ended 31 December 2012 and 2013 in respect of Contract B. Total Contract Value€70m Costs incurred to date€40m Estimated costs to complete€39m Completion50%

37. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 12.8: Recognising contract losses Solution Step 1 Calculate the overall profit or loss on the contract € Contract price 70 Total cost (79) Profit / (Loss) (9) Step 2 Stage of Completion 50% (per question) Step 3 SPLOCI – P/L Cumulative € Revenue (€70 X 50%)35 Cost of goods sold (€39.5 + €4.5)(44) Gross profit(9)

38. Connolly – International Financial Accounting and Reporting – 4 th Edition Gross amount due from / to customers Present ‘gross amount due from/to customers for contract work’ as asset/liability Gross amount due is calculated as: Costs incurred to date Plus recognised profit Minus recognised loss Minus invoiced progress billings Progress billings invoiced and still receivable at reporting date are presented as trade receivables See Chapter 12, Examples 12.9 – 12.11

39. Connolly – International Financial Accounting and Reporting – 4 th Edition 12.4 DISCLOSURES 1.Amount recognised as revenue in the period 2.Method used to determine the revenue recognised 3.Method used to determine stage of completion 4.For each contract in progress a)cost incurred to date and recognised profits (less losses) b)amount of advances received c)amount of retentions 5.Gross amount due from customers for contract work where 5 (a) > (b). This is shown as follows: a)cost incurred plus recognised profits, less b)the total of recognised losses and progress billings 6.The gross amount due to customers, i.e. where 5 (a) < 5 (b)

40. Connolly – International Financial Accounting and Reporting – 4 th Edition IFRS 15 REVENUE FROM CONTRACTS WITH CUSTOMERS IFRS 15 was issued in May 2014 and is effective for an entity's first annual IFRS financial statements for periods beginning on or after 1 January 2017. Earlier application is permitted. IFRS 15 replaces IAS 11 Construction contracts, IAS 18 Revenue and IFRIC 13 Customer Loyalty Programmes IFRS 15 moves away from a revenue recognition model based on an ‘earnings process’ to an ‘asset-liability’ approach based on transfer of control The core principle of IFRS 15 is that an entity will recognise revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration (payment) to which the entity expects to be entitled in exchange for those goods or services.

41. Connolly – International Financial Accounting and Reporting – 4 th Edition IFRS 15 REVENUE FROM CONTRACTS WITH CUSTOMERS To apply this principle, a five-step model framework must be followed: Step 1: Identify the contract(s) with a customer. Step 2: Identify the performance obligations in the contract. Step 3: Determine the transaction price. Step 4: Allocate the transaction price to the performance obligations in the contract. Step 5: Recognise revenue when (or as) the entity satisfies a performance obligation. The industries most impacted by IFRS 15 are likely to be telecom, software development, real estate and other industries with long-term contracts. This includes an industry where bundled contracts of ‘product + service’ are quite common.

42. Connolly – International Financial Accounting and Reporting – 4 th Edition ADDITIONAL QUESTIONS

43. Connolly – International Financial Accounting and Reporting – 4 th Edition NECTAR Limited (NECTAR) entered into a €15,000,000 contract to build a multi-storey car park, with a completion date of 30 June 2013, on 1 February 2012. NECTAR has not yet accounted for the contract in its financial statements for the year ended 31 st December 2012. It is company policy to adjust cost of sales by the amount of attributable profit or loss to be recognised in the period to arrive at contract revenue. Further details in relation to the contract at 31 December 2012 are as follows: €’000€’000 Amount invoiced9,500Costs incurred9,250 Amount received9,000Costs certified8,500 Costs to complete4,000 Requirement How should NECTAR reflect the contract in its financial statements for the year ended 31 December 2012? Question 1

44. Connolly – International Financial Accounting and Reporting – 4 th Edition NECTAR€’000 (a)Total profit/loss Contract price15,000 Costs to date(9,250) Estimated to complete(4,000) Estimated contract profit/loss1,750 (b)Attributable profit/loss Stage of completion11/17 = 64.7% Costs cert. / Est. total costs9,250/13,250 = 69.8% Turnover9,500/15,000 = 63.3% Cash received9,000/15,000 = 60% Therefore attrib. profit/lossTake say (65.7%)€1,150 Question 1

45. Connolly – International Financial Accounting and Reporting – 4 th Edition NECTAR (cont’d)€’000 (c)Revenue Costs cert. to date8,500 Attributable profit1,150 9,650 (d)Gross Amount Due From Customer Costs to date9,250 Recognised profit1,150 Progress billings(9,500) 900 (e)Trade Receivable(€9,500 - €9,000)500 Question 1

46. Connolly – International Financial Accounting and Reporting – 4 th Edition PINBALL began work on a long-term construction contract during the year ended 31 December 2013 to construct a by-pass around two towns. Details of the contract are as follows: €’000 Contract price16,000 Costs incurred to date5,800 Estimated costs to completion10,400 Value of work certified to date6,000 Amounts invoiced and received6,800 PINBALL recognises revenue and profit on long-term contracts on the basis of work certified to date. Requirement Calculate the figures to be included in PINBALL’s SPLOCI for the year ended 31 December 2013 and SFP as at that date. Question 2

47. Connolly – International Financial Accounting and Reporting – 4 th Edition PINBALL SPLOCI – P/L (extract):€’000 Revenue6,000 Cost of sales(6,200) Loss (W1)(200) Statement of Financial Position (extract):€’000 Gross amounts due to customers [CL and/or NCL] Costs incurred5,800 - losses to date (w1)(200) - progress billing(6,800) 1,200 W1: Contract price16,000 Costs incurred(5,800) Estimated costs to completion(10,400) (200)