IAS 11 Construction Contracts

Segun Ilori FCA

INSTITUTE OF CHARTERED ACCOUNTANTS OF NIGERIAIFRS CERTIFICATION TRAINING PROGRAMME

2

Contents

• Scope• Types of Contracts• Contracts classification• Contracts Revenue• Contracts Cost• Revenue and Cost recognition• Provision for expected Losses• Case studies• References

3

Scope • The accounting for long-term construction contracts addresses the issue

of when revenue and associated costs should be recognized and how these must be measured in the books of the contractor. The primary objective of IAS 11 is the allocation of contract revenue and contract cost to the accounting period in which construction work is performed.

• IAS 11 is applicable in accounting for construction contracts in the contractor's financial statements.

• The standard does not apply to the customer.

4

Types of Contracts

Construction contract.–  A contract specifically negotiated for the construction of an asset or

combination of assets that are closely interrelated or interdependent in terms of their design, technology, function, or use. Examples of such construction contracts are contracts for construction of a bridge, building, dam, pipeline, or road. IAS 11.3

– Contracts for the rendering of services that are directly related to the construction of assets, for example, services of an architect, and contracts for destruction or restoration of an asset and for the restoration of the environment following the demolition of an asset, are also included in the construction contract.

5

Types of Contracts• Fixed price contracts. Contracts wherein the contractor agrees on a fixed

price or on a fixed rate per unit. In some cases, however, the contract price is subject to escalation.

• Cost-plus contracts. Contracts in which the contractor is reimbursed the costs as defined in addition to a fixed percentage of the costs or a fixed fee.

6

Contracts classification• More than one Asset (IAS 11.8)

– When the contract relates to the construction of more than one asset, it shall be treated as separate construction contracts if:• separate proposals for the construction of each asset were submitted, • proposals were subject to separate negotiation and finalization, and• revenue and costs related to the construction are separately identifiable. (IAS 11.8)

• Group contracts – A group contract with a single or multiple customers can be treated as

a single construction contract provided:• The group contract has been negotiated and finalized as a single package, • the contracts are interconnected and form part of a single project,• the contracts have to be performed sequentially or concurrently, and the revenue

and costs related to each construction activity cannot be determined. (IAS 11.9)

7

Contracts classification

• Additional Assets– When a contract provides for the construction of an

additional asset at the option of the customer, such construction of the additional asset should be treated as a separate construction contract if:• the nature of the asset differs significantly as compared to that

mentioned in the original contract and • the price of the additional asset is negotiated and finalized independent

of the terms in the original contract. (IAS 11.10)

8

Contract Revenue• Contract revenue shall comprise the amount of revenue initially agreed

upon with the customer and the amount on account of variations from the agreed terms, claims made and incentives claimed, provided that it is probable that they will result in revenue and that they can be reliably measured. (IAS 11.11)

• The Standard provides that contract revenue is measured at the fair value of the consideration that is received or is receivable. This revenue measurement may have to be revised during the execution of the contract on account of uncertainties that may arise and are resolved.

9

Contract RevenueContract revenues also include the following:• Increase or decrease in revenue due to change or variation in scope;• Increase on account of price escalation clauses that are mentioned in the

initial contract;• Increase or decrease in revenue due to increase or shortfall in units of

output when the payment terms relate to a fixed rate per unit of output;• Claims made as reimbursement of costs incurred on account of customer-

caused delays in execution of the project that have been accepted or are likely to be accepted by the customer;

• Incentive payments received or receivable on an early completion of the contract; or

• Decrease in contract revenue due to penalties levied by the customer on account of delay in completion of the contract.

10

Contract cost

• Contract costs shall comprise :– all costs that are directly related to the specific contract, general costs related

to the contract that can be allocated to the contract, and– all other costs that can be specifically charged to the customer on the basis of

the terms of the contract agreement.

• The contract costs must relate to the period from the date of obtaining the contract to the final date of its completion.

• Cost that relates to future activity on the contract such as cost of material delivered to site and the advance payment made to subcontractors must not be considered.

11

Contract CostCosts that can be directly related to the specific contract include:• Identifiable and measurable costs incurred to secure the contract; • Labor cost, including supervision costs incurred at the site; • Cost of material used in the contract; • Depreciation on plant and equipment used on the contract; • Mobilization and demobilization costs, like the cost incurred in moving

materials and equipment to and from the site of the contract; • Cost incurred on hiring of plant and equipment; • Cost of design and technical assistance related to the contract; • Claims from third parties; and • Costs incurred on rectification work or work executed during a warranty

period.

12

Contract Cost

Effect of Incidental Income in the course of execution– In the event that an incidental income that is not related to contract

revenue is generated (such as sale of scrap materials), these costs must be reduced by such income.

General costs for direct allocation – Construction overheads, like payroll preparation charges; – Insurance, like professional indemnity insurance; and – Costs of design and technical assistance that are not directly related to

the contract. Basis of allocation must be systematic and consistently applied

13

Contract Cost

Chargeable costSome of the costs that can be specifically charged to the customer on the basis of the terms of the contract agreement are – General administration cost for which reimbursement is agreed upon; – Development cost agreed upon; and – Reimbursement of any other cost that is agreed upon

14

Revenue and Cost recognitionRecognition of Revenue and Costs  An important factor in the recognition of contract revenue and expenses

is whether the outcome of the construction contract can be estimated reliably. When the outcome of a construction contract can be estimated reliably, the contract revenue and contract costs must be recognized with reference to the stage of completion of the construction activity at the end of the reporting period.

Outcome of Construction Contract Can Be Estimated Reliably • According to paragraph 23 of IAS 11, the outcome of a fixed-price

contract can be estimated reliably when :– The total contract revenue can be measured reliably; – It is probable that the economic benefits associated with the contract will flow

to the entity;

15

Revenue and Cost recognition– 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

– 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.

– Similarly, paragraph 24 of IAS 11 states that the outcome of a cost-plus contract can be estimated reliably when:• 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 specifically

reimbursable, can be clearly identified and measured reliably.

16

Revenue and Cost recognitionStage of Completion  • Recognition of revenue and expenses by reference to the stage of

completion of a contract is often known as the percentage of completion 

method.– The contract revenue and contract costs to the stage of completion are

matched so that only the revenue, expenses, and profit or loss attributable to the proportion of work completed is recognized.

– The contract revenue is recognized as revenue in the reporting period in which the contract work is carried out.

– The contract costs are recognized as an expense in the reporting period to which the work performed relates to.

– Any costs incurred that relate to a future activity must be considered as an asset when the costs are realizable.

17

Revenue and Cost recognition

Methods of determining the stage of completion of a contract. The progress payments and advances received from the

customers is not a measurement of the contract work completed.

Measuring extent of work:– Cost-to-cost method, which is the stage of completion or percentage

of completion that would be estimated by comparing the total cost incurred to the reporting date with the total expected cost of the entire contract;

– By survey of work performed; or – Completion of physical proportion of the contract work.

18

Revenue and Cost recognitionOutcome of Construction contract cannot be estimated reliably • Recognize contract revenue only to the extent of the contract costs

incurred, and the contract costs must be recognized as an expense in the reporting period that they are incurred.

• In the early stages of a contract it might be difficult to reliably estimate the outcome of the contract. However, when there are existing conditions, it may be possible to estimate that the entity will recover in full the contract costs incurred to the reporting date. Therefore, in such circumstances, contract revenue is recognized only to the extent of costs incurred that are expected to be recoverable. That is, no profit is recognized.

19

Provision for Expected Losses • When it is expected that the total contract cost will exceed the total

contract revenue, such excess must be recognized immediately, irrespective of

• Whether the contract work has commenced; • The stage of completion of contract; or • The amount of profits expected on other contracts that are not treated as

a single contract

20

Changes in contract estimatesEffect of Change in Estimate in Construction Contract • As the recognition of revenue and expenses in a construction contract is

based on reliable estimates, they are bound to vary from one reporting period to another. The effect of the change in estimate of contract revenue or contract cost is accounted for as a change in accounting estimate in accordance with IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors. The changed estimates are used to determine the contract revenue and contract expenses in the reporting period in which the change is made and in subsequent re- porting periods.

21

Disclosures In accordance with paragraph 39 of IAS 11, an entity (the contractor) shall disclose in

the financial statements the following: • The amount of contract revenue recognized in the contract period; • The method used to determine the contract revenue recognized in the period; • The method used to determine the stage of completion of contracts in progress; • Total contract costs incurred and recognized profit (less recognized losses) up to the

reporting date; • Total advances received; • Total amount of retentions; • Gross amounts due from the customers for contract work, as an asset [(Cost incurred

+ Recognized profit) - (Recognized losses + Progress billing)]; • Gross amounts due to customers for contract work, as a liability [(Recognized losses

+ Progress billing) - (Cost incurred + Recognized profit)]; or • Contingent liabilities or contingent assets that may arise on warranties, claims, and

so on.

22

Case Studies

CASE STUDY 1Great Wall Construction Company Limited signed a contract to construct a building for N8.5 million. The company incurred contract costs of N5.2 million up to December 31, 2008. It is estimated that the additional cost to complete the project will be N2.5 million.

Required:Determine stage of contract completion, revenue to be recognised based on the project and estimated profit

23

Case Studies

CASE STUDY 2 Abuja City Engineers Plc (ACE) is well known for its expertise in building fly-overs and maintaining these structures. Impressed with ACE’s track record, the local municipal authorities have invited them to submit a tender for a two-year contract to build a super flyover in the heart of the city (the largest in the region) and another tender for maintenance of the flyover for ten years after completion of the construction.

Required Evaluate whether these two contracts should be segmented or combined into one contract for the purposes of IAS 11.

24

References• Understanding IFRS Fundamentals, Nandakumar Ankarath, Kalpesh J. Mehta,Dr. T.P. Ghosh and

Dr. Yass A. Alkafaji, wiley 2010

• Practical Implementation Guide and Workbook for IFRS, Third Edition, Abbas Ali Mirza and Graham J. Holt, Wiley 2011

• International Financial Reporting Standards. A practical guide, 5th Edition, Hennie Van Greuning, International Bank for Reconstruction and Development and the world Bank, 2010