Topic 6 - Construction Contracts
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Transcript of Topic 6 - Construction Contracts
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TOPIC 6CONSTRUCTION CONTRACTS
(MFRS111)
1
Semester 22013/2014
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COURSE OUTCOME (CO5)
At the end of this course, students should be
able to;
Describe and demonstrate the account for
construction contracts
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Introduction
Imagine that you are an accountant at a construction company.Your company is building a large tower block that will houseoffices, under a contract with a client company. It will take threeyears to build the block and over that time you will obviouslyhave to pay for building materials, wages of workers on the
building, architects' fees and so on. You will receive periodicpayments from the client at various predetermined stages of theconstruction.
How do you decide, in each of the three years, what toinclude as income and expenditure for the contract in theincome statement?
How to allocate contract revenue and contract costs to theaccounting periods in which construction work is performed?
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The Main Issues
A construction contract often takes a number of years to complete.
The date at which the contract activity commences and the date when the
contract activity is completed falls into different accounting periods.
Question arises as to when the revenue and gross profit arising there from
should be recognised.
Should all the revenue and gross profit be recognised only at the point of
completion (completed contract method)?
Or should the revenue and gross profit be recognised over each and every
accounting period during which the contract activity is performed (percentage
of completion method)?
How do we measurethe amount of contract revenue and contract costs
attributable to a construction contract?
What information do we need to disclosein the financial statements?
This area of accounting is complicated by the need to rely on estimates of
revenues, costs, and progress towards completion, and by the principle of
recognition of losses when apparent.
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: ummary o eStandard
Construction Contract DefinedA construction contract is a contractspecifically negotiated for the construction of
an asset or a combination of assets that are
closely interrelated or interdependent in termsof their design, technology and function or their
ultimate purpose or use.
Includes contracts for the rendering of services
(e.g. the services provided by architects) and
contracts for the destruction or restoration of
assets.
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Two Types of Contracts
A fixed price contract where the contractor agrees to
a fixed price.
A cost plus contract where the contractor is
reimbursed for allowable costs plus a percentage of
these costs or a fixed fee.
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To Combine or Separate?
For internal control as well as for financial accounting
purposes, construction contracts shall be accounted
separately. However
When a contract covers a number of assets, the
construction of each asset should be treated as a
separate construction contract when:
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
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To Combine or Separate?
A group of contracts, whether with a single
customer or with several customers, should be
treated as a single construction contract when:
The group of contract is negotiated as a singlepackage;
The contract 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.
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To Combine or Separate?
The construction of an additional asset should
be treated as a separate construction contract
from the original 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.
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Measurement of Contract
Revenues
Components of contract revenue in a constructioncontract:1. The initial contract price; plus
2. Variations (instruction by customer for a change in
the scope of work to be performed); plus3. Claims (amounts in excess of the agreed-on
contract price that a contractor seeks to collect froma customer for customer-caused delays, etc); plus
4. Incentive payments (additional amounts paid to
contractor for meeting targets, for e.g., earlycompletion of contract).
5. But ... only include (2), (3), and (4) above if they areprobable and capable of being reliably measured.
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Measurement of Contract
Costs
Components of contract costs in a construction
contract:
a) Costs directly related to the contract (e.g., site
labour costs, construction materials used,depreciation of plant & machinery used on the
contract);
b) Costs attributable to contract activity in general and
can be allocated to the contract (e.g., insurance,
construction overheads);
c) Such other costs as are specifically chargeable to
the customer under the terms of the contract (e.g.,
some general admin costs for which reimbursement
is specified in the terms of the contract).
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What items to include in
Contract Costs?
Costs incurred in securing a contract (for e.g., at tenderingstage) -a) include as part of contract costs only if it is probable that
contract will be obtained;
b) otherwise, expense-off to the income statement in the period
they were incurred without including them as part of contractcosts.
Construction materials, supplies, etc. which remained unusedat the end of the period should not be included as part ofcontract costs. They should be carried forward as assets inthe balance sheet.
Payments made to subcontractors in advance of workperformed under the subcontract should not be included aspart of contract costs.
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Example 1: Amounts to be included
in contract costs
XYZ Sdn Bhd secured a contract to construct a bridge in early 2009.
Construction work commenced on 1 April 2009. As at 31 December 2009, the
following costs have been incurred or allocated to the contract:
RM'000
Materials issued to the construction site 3,500
Site labour & supervision 2,000
Plant & equipment purchased for the contract 2,600
Allocated construction overheads 400
In 2008, the co. incurred RM200,000 for tendering & lobbying for the contract.
The mgmt of the co. estimated at the end of 2008 that the likelihood ofsecuring the contract was possible. A further RM500,000 was incurred in
January 2009 to secure the contract.
As at 31 December 2009, estimates of unused materials at the construction
site totaled RM500,000. Expenses for sub-contracting work incurred but not
paid at year-end totaled RM200,000. The plant & equipment are depreciated
on a straight-line basis over five years.
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Example 1
Required:
Calculate the amount of contract costs incurred for the
above contract as at 31 December 2009.
Answer:
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Recognition of Contact Revenue
and Expenses
Let say that we have a three-year construction
contract, currently in progress.
Question: At which stage of the construction
project can we safely take (i.e., recognise)revenue and costs relating to the project in the
income statement?
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Methods to recognise contract
revenue and costs
Completed contract method- revenue and
costs are not recognised in the income
statement until the contract ends.
Advantage- based on actual results not onestimates.
Disadvantage- income reported does not
reflect general contract activity level for thecompany.
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Methods to recognise contract
revenue and costs
Percentage of completion method- revenue
and costs are recognised in the income statement
as the contract activity progresses, by reference
to the stage of completion of the contract (that is,based on the proportion of work completed).
Advantage- income reported reflect general
contract activity level for the company; results in
fairer reporting; in accordance with accrualsconcept.
Disadvantage- based on estimates, which may
result in error.
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Methods to recognise contract
revenue and costs
When the outcome of a construction contract can beestimated reliably, contract revenue and contractcosts associated with the construction contract shallbe recognised as revenue and expenses respectivelyby reference to the stage of completion of the contract
activity at the end of the reporting period. The Standard mentions the following methods to
determine the stage of completion of a contract:1. Contract costs incurred to date as a proportion of the
estimated total contract costs;
2. Surveys of work performed, for e.g., value of workcertified to date as a proportion of the total contractrevenue; or
3. Completion of a physical proportion of the contract work.
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Disclosure Requirements
The Standard requires the following to be
disclosed:
The amount of contract revenue recognised as
revenue in the period; The amount of contract costs recognised as
expense in the period;
The methods use to determine the contract
revenue recognised in the period; and
The methods used to determine the stage of
completion of contracts in progress.
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Disclosure Requirements
An entity should disclose each of the following forcontracts in progress at the end of the reportingperiod:
The aggregate amount of costs incurred and
recognised profits (less recognised loses) to date;
The amount of advances received; and
The amount of retentions.
An entity should present:
The gross amount due from customers for contractwork as an asset; and
The gross amount due to customers for contract workas a liability.
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Example 2: Extracts of Disclosure
in the Financial StatementsStatement of Comprehensive Income (extract) RM000 RM000
Contract revenue XX
Contract costs (XX)
Profit for the year XX
Statement of Financial Position (extract)
Current assets:Construction materials XX
Gross amount due from customers (1) XX
Current liabilities:
Gross amount due to customers (2) XX
Notes on Accounting Policies and Explanatory
Materials
RM000
Costs incurred to date XX
Add: Attributable profits XX
Less: Recognised losses (XX)
XX
Less: Progress billings (XX)
Gross amount due from customer (1) XX
Gross amount due to customer (2) (XX)
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xamp e : easur ng s age o
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xamp e : easur ng s age ocompletion of contract, revenue and
cost
Refer to Example 1- Tan Liong Tong (page
281)
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Contract Uncertainties
When uncertainties surround the contract, the
outcome of the construction contract cannot be
estimated reliably. Under such circumstances:
use of the stage of completion method is notappropriate;
recognise revenue only to the extent of contract
costs incurred that are recoverable; and
contract costs should be recognised as an
expense in the period in which they are incurred.
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Example 4: Revenue and cost recognition
when outcome of contract cannot be
estimated reliably
Refer to Example 3 Tan Liong Tong (page
284)
When the uncertainties that prevented the
outcome of the contract being estimated
reliably no longer exist in a subsequent periodand the outcome can be estimated reliably, the
enterprise should revert (i.e., go back) to the
recognition of revenue and expenses based
on the stage of completion.
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Recognition of Expected
Losses When it is probable that total contract costs will
exceed total contract revenue, the expected lossshould be recognised as an expense immediately.
In other words, a foreseeable loss should be
recognised in full, both: for the stage of completion reached; and
for the future loss on the contract.
The amount of loss is determined irrespective ofwhether work has started on the contract, thestage of completion of the work, or profits madeon other contracts.
Refer to Example 5 Tan Liong Tong (page 286)
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ActivityPercentage of Completion
Method
When contract costs are incurred Dr. Contract costs
Cr. Cash/Creditors/etc
At each year end, carry forward
unused contract costs as an asset
Dr. Construction materials etc
Cr. Contract costs
At year end, close off contract
costs a/c to Income Statement
Dr. Contract costs (in I/S)
Cr. Contract costs
When customers are billed Dr. Accounts Receivables
Cr. Progress billingsWhen customers pay up Dr. Cash/Bank
Cr. Accounts receivables
At each year end, recognise
contract revenue based on stage of
completion method
Dr. Progress billings
Cr. Contract revenue (in I/S)
Appendix 1:
Main Journal Entries to record Construction
Contracts26
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Appendix 2:
Summary of the Main Points
A construction contract may take many years to complete, such that
contract activity spans across different accounting periods.
Revenues and costs should be taken to the income statement as the
contract activity progresses (percentage of completion method) and
not when the contract is fully completed or substantially completed
(completed contract method)
If contract outcome is uncertain & cannot be reliably estimated
recognise revenues and costs by reference to the stage of completion
(cost-to-cost basis/value of work certified basis/other bases)
If contract outcome is uncertain & cannot be reliably estimatedrecognise revenues up to the amount of costs incurred that are
recoverable and recognise contract costs as expense in the period
incurred.
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Appendix 2:
Summary of the Main Points28
Recognise losses immediately in full in the period the losses were
identified.
Generally the contract revenue = contract price. But in later years,
as the contract progresses, it may also include variations, claims
and incentive payments. However only include them if they are
probable and capable of being reliably measured.
Include under contract costs only those costs which reflect the
actual work doneexclude:
depreciation on idle plant & machinery
costs of unusual materials, advance payments to sub-contractors.