IAS 11 - Construction Contracts (study material)

(b)  Contracts involving destruction or restoration of old assets.

2. Types of Contract:

a) Fixed Price Contract

A contract in which the contractor & customer decides a fixed sum/price per unit of output.

b) Cost Plus Contract
A contract in which the contractor agrees to receive all the allowable cost of the contract plus a certain decided percentage of the allowable cost as profit.

Combining and Segmenting Construction Contracts

This standard applies to each contract on individual basis. However, sometimes, entity needs to ascertain that whether a contract for the construction of group of assets will be treated as a single contract or each asset in group of assets will be treated as a separate contract; in such circumstances the entity should apply the following:

• Segmenting:

For the contract involving group of assets, the each asset shall be treated as a separate contract if:
(a) Each asset was subject to a separate proposals by contractor and
(b) The terms of each asset was negotiated separately and both the contractor    and customer have option to accept or reject the contract relating  to each asset in the group of assets
(c) Each asset has identifiable revenue and cost on individual basis.

• Combining:

For the contract involving group of assets, the contract as whole will be treated as a single contract if:
(a) The contractor and customer both have a single contract for the construction of group of asset
(b) The assets in the group of assets are interdependent in terms of their design or use, and seems to be the components of a single contract in commercial substance
(c) The parts of the whole contract will be completed in a continuous manner.

• Amendment into Contract:

Normally the construction contract includes an amendment clause for both contractor and customer. If the customer chooses to amend the original contract in order to include the construction of an additional asset. In such situation the additional asset will be taken as a separate contract if:
(a) The additional asset is materially different in terms of its design or function from the asset or group of assets under the original contract;
(b) The contract price for the additional asset is subject to separate negotiation irrespective of the original contract.

Contract Revenue

Contract Revenue may include the following components:

(1) Contract price decided as per the terms of the contract and
(2) Any revenue in respect of variations in the original contract work required by customer, if it is probable:                                                                    

(a) That variation and related amount of revenue will be approved by the customer; and
(b) Revenue related to variation is reliably measurable.

(3) Any revenue in the form of Incentive or efficiency payments if it is probable:

(a) That the contractor will meet the specified performance standards; and
(b) Revenue in respect of the incentive payment is reliably measurable.

Contract Costs

The cost of the contract includes the following:

(1) The cost directly related to the contract which includes:

(a) Direct material and labor cost
(b) Supervision charges
(c) Depreciation expense in respect of plant and equipment used in construction;
(d) Mobilization and demobilization costs
(e) Hiring charges for temporary plant and equipment;
(f) Designing and technical assistance charges related to contract;
(g) Third party claims

(2) Common cost attributable to contract on reasonable and consistent basis which    includes:

(a) Insurance Cost;
(b) General and administrative overheads
(c) Salary Expense of employees working on multiple contracts

(3) Other costs which is specifically related to the contract as per the contractual terms.

Note:
The costs that are incurred in securing the contract are also the part of the cost of the contract if:
(a) It is identifiable, and reliably measurable;
(b) the contract is obtained.

Recognition of Contract Revenue and Cost

The recognition of contract revenue and cost depends upon the outcome of the contract. Therefore, the entity shall apply the guidance as follows if:

1) Outcome of the contract is reliably measurable:

The contract revenue and costs shall be recognized in statement of profit & loss, on the basis of “stage of completion” of the contract, measured at the end of the accounting period.

i) Determination of the outcome of the contract

The outcome of the contract will deemed to be reliably measurable if:

• For a Fixed Price Contract:

For a fixed price contract, the outcome will deemed to be reliably measurable
 If it satisfies the following criteria:
(a) Revenue of the contract is reliably measurable;
(b) Economic benefits related to the contract are probable to flow to the entity;
(c) Costs incurred and to be incurred is reliably measurable;
(d) The stage of completion of the contract is measured reliably at the end of accounting period

• For a Cost Plus Contract:

For a cost plus contract, the outcome will deemed to be reliably measurable
If it satisfies the following criteria:
(a) Economic benefits related to the contract are probable to flow to the entity;
(b) Costs incurred and to be incurred is reliably measurable

ii) Stage of Completion:

The entity will measure the stage of completion of a contract, at the end of reporting period using one of the following methods:

• Cost to Cost Basis:

Cost to date / (Cost to date + Future Cost) *100

• Physical Proportion or Work Certified Method:

Work Certified to date / Total Contract Price * 100

• Survey Method:

Stage of Completion will be assessed by qualified professional

2) Outcome of the contract is not reliably measurable:

The entity shall apply the following:
(a) The contract revenue will be recognized only upto  the extent of costs incurred on the contract to date, if it is recoverable. Hence there will be no profit no loss.
(b) Contract costs will be recorded as expense in the related reporting period.

Note:

a) If there is uncertainty for the recovery of the amount which has previously been recorded as contract revenue in statement of profit or loss, then the such irrecoverable amount will be recorded as an expense in statement of profit or loss, instead of adjustment to recognized contract revenue

b) If in a particular situation, it is probable that entity will not be able, even to recover its allowable cost incurred on the contract, then such cost should be recognized in statement of profit or loss in the relevant period

  This may be the case in the following situations:

• Contracts which are subject to legal proceedings
• Inability of the contractor to meet its performance obligation;
• where the customer is in financial crises

Recognition of Expected Losses for Onerous Contract

If for a particular construction contract, the cost of performance of the contract exceeds the contract revenue, it will be treated as onerous contract. In such circumstance entity is required to recognize the expected loss in statement of profit or loss, in the period in which contract becomes onerous.

Disclosure

1) This Standard requires the following disclosures in respect of construction contract:
(a) Contract revenue recognized in the current period;
(b) the approach used by the entity in determination of revenue recorded in the current period;
(c) the approach used by the entity in determination of the stage of completion of contracts at the end of reporting period

2)  The disclosures shall also include the following:
(a) Cost incurred to date and profits recognized to date;
(b) Any advances received from customer to date

 3) The entity will present the following in the statement of financial position:
(a) Amount due from customer related to contract as an asset; and
(b) Amount due to customers related to contract as a liability.

4)  The disclosure shall also include any contingent liabilities or assets as per requirements of IAS 37 in respect of any contingent liabilities or asset which may arise from events as penalties or expected losses. 

IAS 11 Workings for Financial Statement

(W2)  Estimated Total Profit/ (Loss) on the Contract:

Total Contract Revenue	x
Total Contract Cost	(x)
Estimated Total Profit	x/(x)

(W3) Profit to date:

Revenue to date (Total Revenue* Stage of Comp.)	x
Cost to date        (Balancing Fig)	(x)
Profit to date (Total Profit * Stage of Comp,)	x
- Profit already recognize in previous year	(x)
Profit for the year	x

(W4) Statement of Profit or Loss:

Revenue	x
Cost	(x)
Profit	x
- Rectification Cost of Error by Contractor	(x)
- Provision for Onerous Contract	(x)
Profit for the year	x

(W5) Statement of financial position:

Cost to date (As given in quest.)	x
Profit / (loss) to date	x/(x)
- Progress Billings	(x)
Due from / (to)	x/(x)

 

Worked Examples

Example 1:   (Contracts for which outcome is reliably measurable)

AB LTD is an entity engages in construction business & prepares its financial records to 31 December every year. In the current year ended 31December 2013 the company started two contracts expected to take more than one year. Following are the extracts relating to each contract at 31 December 2013:

Contract	1	2
	$'000	$'000
Total contract price	11,000	2,400
Estimated total cost of contract at 01Jan-2013	8,000	1,800
Estimated total cost at 31 Dec 2013	8,000	2,500
Agreed work completed at 31 Dec 2013	6,600	1,680
Progress billings invoiced 31 Dec 2013	6,000	1,760
Costs incurred to 31 December 2013	7,800	1,440

The entity calculates the percentage of completion as the agreed value of work completed to date, to the total contract price.

Required:
Prepare extracts of financial statements for the year ended 31 December 2013

Solution:

Step 1:  Determination of Outcome of the Contract
As the outcome of the contract is reliably measurable therefore, the contract revenue & cost will be recognized on the basis of stage of completion

Step 2:  Calculation of Stage of Completion (Using Work Certified Method)

Contract	1	2
	$’000	$’000
Total Contract Revenue	11,000	2,400
Work Certified at 31 Dec 2013	6,600	1,680
Percentage of Completion *100	(6,600 / 11,000)*100 = 60%	(1,680 / 2,400)*100 = 70%

Step 3:  Estimated Total Profit/Loss on the Contract

	$’000	$’000
Total Contract Revenue	11,000	2,400
Total Contract Cost	(8,000)	(2,500)
Estimated Total Profit	3,000	(100)

Step 4: Profit to date

	$’000	$’000
Revenue to date (11,000*60) / (2,400*70%)	6,600	1,680
Cost to date         (Balancing Fig)	(4,800)	(1,750)
Profit to date (3000*60%) / (100*70%)	1,800	(70)
- Profit already recognize in previous year	-	-
Profit/ (Loss) for the year	1,800	(70)

Step 5:  Statement of Profit or Loss

	$’000	$’000
Revenue	6,600	1,680
Cost	(4,800)	(1,750)
Profit/ (Loss)	1,800	(70)
- Rectification Cost of Error by Contractor	-	-
- Provision for Onerous Cont. (100-30) Remaining loss	-	(30)
Profit/ (Loss) for the year	1,800	(100)

Step 6: Statement of Financial Position

	$’000	$’000
Cost to date	7,800	1,440
Profit / (loss) to date	1,800	(100)
- Progress Billings	(6,000)	(1,760)
Due from / (to)	3,600	(420)

 

Example 2: (Contracts for which outcome is not reliably measurable)

AB LTD is an entity engages in construction business. It started a contract for the construction of a school building for one of its client, spanning 2 years. The price of the contract was agreed to be $4 million.
The contract was started on 01, January 2013 but unfortunately construction material prices started increasing materially from last few months after the start of the contract, due to unforeseen reason.
AB LTD has intimated the customer for the increase in material price and requested for compensation of additional costs, but yet, the entity is unsure about the compensation of the additional costs.
 Therefore, outcome of the contract is not reliably measurable at the end of the first accounting period 31-12-2013, as to whether the contract will be profitable or not.

Following extracts are available from the records of AB LTD related to this contract at the first year ended 31-12-2013:

	$’000
Contract Price	4,000
Cost incurred to Date	2,400
Cost likely to be recoverable	2,000
Progress billings to customer	1,800

 

Required:
Prepare extracts of financial statements for the year ended 31-12-2013.

Solution:

Step 1: Determination of Outcome of the Contract

As the outcome of the contract is not reliably measurable therefore, the contract revenue will be recognized only upto the extent of costs incurred on the contract to date, to the extent it is recoverable.

Step 2: Statement of Profit or Loss

	$’000
Revenue to date (up to extent, which is recoverable)	2,000
Cost to date	(2,400)
Loss to date	(400)

Step 3: Statement of Financial Position

Cost to date	2,400
-Loss to date	(400)
- Progress Billings	(1,800)
Due from	200