IFRS

7 Key Points to Study for IAS 11 Construction Contracts

When studying IAS 11 Construction Contracts, you can split the topic into seven key areas:

1.  Definition of a construction contract

A construction contract is a contract specifically negotiated for the design, manufacture or construction of:

  • a single asset such as a bridge, building or road, or
  • a number of related assets. For example, a large factory may have different components

2. How to account for revenue and profit in construction contracts

The work on a construction contract often takes more than one accounting period, and rules are needed to determine how and when to recognise revenue and profit.

One method that could be used is to only recognise the profit at the end of the contract, which would be in accordance with IAS 18 – Revenue, but does not reflect the fact that profit is accrued over the life of the project.

It also creates a spike in profit at the end of the project, which is not in line with the accruals concept.

Construction Contracts governs how an entity that is an asset under a construction contract should deal with the revenue and costs associated with the construction contract in its financial statements.

Under IAS 11, revenue and costs are matched to accounting period. This results in a proportion of the overall estimated profits being recorded in profit or loss each financial period.

The following rules must apply under IAS 11 Construction Contracts:

  • Revenue and costs should only be recognised when the outcome of a contract can be estimated reliably.
  • If a loss is expected for the contract, the entire loss must be recognised immediately.

3. Two types of construction contract

The two types of construction contracts are:

  • Fixed price contract: the contractor agrees to a fixed contract price, which is in some cases subject to cost escalation clauses.
  • Cost plus contract: the contractor is reimbursed for allowable or defined costs, plus a percentage of these costs or a fixed fee for profit.

4. What is Contract Revenue?

Contract revenue is the amount payable by the customer to the entity as contractor. Under IAS 11, contract revenue is:

  • the initial amount of revenue agreed in the contract; plus
  • variations in contract work, claims and incentive payments (so long as they’ll result in revenue and can be reliable measured)

Often a contract will be negotiated as a fixed amount. So long as the outcome of the contract can be measured reliably, the entity may record revenue as a percentage of the completed contract.

This known as the ‘stage of completion’ or ‘percentage of completion’ method of accounting for construction contracts.

5. How to calculate the stage of completion of contract

There are a number of methods available in calculating the stage of completion of a contract, including:

  • Costs basis – Using a percentage of the total contract costs incurred to date.
  • Sales basis – Using a survey of works performed. This is where an independent expert such as a surveyor inspects the work and issues a certificate stating the value of work carried out so far. The most recent certificate issued may be used to calculate the proportion of work carried out.
  • Physical proportions – This will involve an assessment of how much actual work has been carried out. (e.g. 2 out of 3 buildings complete)

Don’t mix up progress payments or advances by the customer with the stage of completion. Sometimes a customer will pay money upfront which is not related to how much work is complete.

If a progress payment is made for work not yet complete it should be recognised as a current liability, owing to the customer, not as revenue.

If a contract is not a fixed price contract, it may be a cost-plus contract. This is where the contractor will negotiate an amount which covers their own costs and adds an extra amount, usually a percentage for profit.

6. What are contract costs?

Contract costs are:

  • direct costs of the contract (such as site labour costs, costs of materials, depreciation of plant used in the construction work, design and technical work), and
  • indirect costs that are attributable to contract activity in general and can be charged to the customer (e.g. insurance, overheads)
  • other costs that are specifically chargeable to the customer under the terms of the contract.

7. What is recognition and how is it estimated?

Contract revenue and costs should only be recognised when the outcome of the contract can be estimated reliably. What does this mean?

Fixed Price contract – This can be reliably measured when:

  • The total contract revenue can be measured reliably
  • It is probable that economic benefits will flow to the entity
  • The costs to complete and the stage of completion can be measured reliably at the end of the reporting period
  • The costs attributable to the contract can be clearly identified and measured reliably so the actual contract costs can be compared with prior estimates.

Cost Plus contract – This can be measured reliably when:

  • It is probable that economic benefits will flow to the entity
  • The costs can be identified and measured reliably
  • What is the outcome if the contract cannot be estimated reliably?
  • Revenue should be recognised only to the extent of contract costs incurred that are expected to be recoverable.
  • Contract costs should be recognised as an expense in the period incurred.

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