Construction contracts

Construction Contracts

IAS 11

Learning Outcomes

• Why recognition of profit on construction contracts is

important

• Recognition of contract revenue and contract cost

• Calculation and disclosure of amounts to be shown in the

financial statements for construction contracts

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Definition

• A construction contract is 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.


Recognition of profit before completion

• Construction usually lasts for more than one accounting period

(12 months)

• Usually, costs start getting incurred even before the beginning

of construction

• Usually, the receipts come at a later stage even after

completion

• The time gap between receipts and costs incurred is significant

–matching of revenue and costs is important


Type of Construction Contracts

Fixed price contracts

Cost plus contracts


Fixed price contracts

K Ltd gets a contract to construct a bridge for a tender amount

of $5 million. This $5 million is given by the local authority to

K Ltd over a period of the construction. If the minimum labour

wages increase during the construction period, a

reimbursement to that extent is given to K Ltd.


Cost plus contracts

K Ltd gets a contract from the government to construct a

missile. Since it is a new technology to be used for the missile,

the costs thereof are not identifiable at the initial stage. Hence,

K Ltd has quoted a cost plus 5% pricing to the government.

The government has agreed with K Ltd to execute this

construction.


Construction contract to be identified

separately unless:

(a) the group of contracts is negotiated as a single package;

(b) the contracts are so closely interrelated that they are, in effect,

part of a single project with an overall profit margin; and

(c) the contracts are performed concurrently or in a continuous

sequence.


Contract Revenue

(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.


Variations

K Ltd enters into a contract of constructing metro station for

the local transport authority. The structure is finalised and the

work is going on smoothly. During the construction period, the

authority wants to add a space for commercial shops within the

metro station premises. This is a variation from the original

construction contract, and will be considered as a part of

revenue.


Claims

Customer caused delays, errors in specifications or design, and

disputed variations in contract work.


Incentives

An incentive payment to the contractor for early completion of

the contract


Construction Costs

(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.


Directly related to contract

(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;

(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 construction contracts

(a) insurance;

(b) costs of design and technical assistance that are not directly

related to a specific contract; and

(c) construction overheads.


Costs specifically chargeable to construction

contract

General administration costs and development costs for which

reimbursement is specified in the terms of the contract.


Cost of Construction Contract

• Site labour cost: $320,000

• Materials purchased: $560,000

• Depreciation of plant & equipment: $75,000

• Costs of moving plant equipment & materials to and from the contract site:

$10,000

• Costs of hiring plant and equipment: $15,000

• Costs of design and technical assistance: $25,000 inclusive of $5,000

which is related to another contract

• Costs to fix a mistake made by K Ltd: $50,000

• Claims from local authority for causing environmental pollution: $5,000

• Unused material at the reporting date: $60,000


Recognition of profit

Percentage of completion for revenue

Percentage of completion for costs

When outcome can be reliably measured Revenue to the

extent of costs recoverable

Costs to the extent incurred

When outcome cannot be reliably

measured


Outcome cannot be reliably measured

• K Ltd is a contractor which is constructing flats for Commonwealth games. There has been continuous issues with the construction since it began. A research published in newspapers stated that the land on which the flats are being constructed is lying on a river bed. The government is looking into the possible scams in the award of contracts. There are stay orders issued by the court of law on the construction.

• These factors make K Ltd feel that the flats may not eventually get sold, and is concerned whether the construction will be completed or not. K Ltd has spent $5 million on the construction so far during the year. K Ltd has received $3 million so far from the government and expects to receive further 0.5 million.


Outcome can be reliably measured

• K Ltd has been awarded a contract to construct a bridge. The

bridge is 40% complete on the reporting date. The tender price

of contract is $6 million. Total costs incurred are $3 million so

far. Expected costs to be incurred by K Ltd on construction are

$2 million.

• Calculate the revenue and costs to be charged to the SOCI for

the current year.


Stage of completion

Floor area

• K Ltd enters into a contract to place tiles for 50,000 sq ft. of area. Total area on which tiles have been placed so far is 30,000 sq ft.

Physical Construction

• K Ltd is constructing a building of 10 storeys. On the reporting date, 5 storeys are completed

Surveyor’s report

• K Ltd is constructing a bridge. The government appoints a surveyor to identify the total construction completed. The surveyor certifies that the construction is 35% complete.


Loss making contracts

If the result of the contract is a loss, that loss has to be

recognised immediately.


Loss making contract

K Ltd enters into a contract to construct a dam. The contract

price is $50 million. 3 months from the date of beginning of

the contract, K Ltd estimated that total costs would be $60

million. So far, K Ltd has incurred costs of $8 million. The

contract is 20% complete.


Terms associated with construction contracts

Progress Billing: Amount billed by the contractor for work

performed

Retention money: Amount held back by the customer

according to the terms of contract

Advance: Amount received from the customer before

commencement of the contract.


Case study (Dec 2007)

On 1 October 2006 Epsilon signed a contract to construct a dam at a fixed price of $50 million. The contract has a scheduled completion date of 30 September 2008. However, if the contract is completed satisfactorily on or before 30 June 2008 Epsilon becomes entitled to a bonus of $5 million. If the contract is completed later than 31 December 2008, then Epsilon will forfeit $15 million of the fixed price and only receive $35 million. Latest estimates regarding completion dates are as follows:

Prior to 1 July 2008 – 20% probability.

1 July 2008 to 31 December 2008 – 70% probability.

After 31 December 2008 – 10% probability.

Epsilon incurred costs of $28 million on the contract up to 30 September 2007 and expects to incur further costs of $12 million to complete the contract. Your assistant has shown a net balance of $13 million in inventories on the balance sheet. This is the difference between the costs incurred to date ($28 million), the loss of $5 million ($35 million – ($28 million + $12 million)) that would arise on the contract if it was completed after 31 December 2008, and a progress payment of $10 million made by the customer before 30 September 2007. The loss of $5 million has been charged to the income statement and justified by the assistant on the grounds of prudence. An independent expert has recently certified that at 30 September 2007 the construction of the dam was 45% complete. The assistant proposes deferring recognition of any revenue until the contract is completed.


Summary

What we learnt today:

• Why recognition of profit on construction contracts is

important

• Recognition of contract revenue and contract cost

• Calculation and disclosure of amounts to be shown in the

financial statements for construction contracts


Thanks

KAPP Edge Solutions Pvt. Ltd

Greater Kailash 1, New Delhi


Construction contracts

Education

Transcript of Construction contracts