This document discusses accounting for construction contracts under IAS 11. It explains that construction contracts require revenue and costs to be recognized over time based on the percentage of completion. It provides details on calculating percentage of completion using the cost method or work certified method. It also discusses the treatment of fixed-price versus cost-plus contracts and the recognition of revenue and expenses depending on if the contract outcome is profitable or a loss. An example is provided to demonstrate the accounting entries.
This document discusses accounting for construction contracts under IAS 11. It explains that construction contracts require revenue and costs to be recognized over time based on the percentage of completion. It provides details on calculating percentage of completion using the cost method or work certified method. It also discusses the treatment of fixed-price versus cost-plus contracts and the recognition of revenue and expenses depending on if the contract outcome is profitable or a loss. An example is provided to demonstrate the accounting entries.
Original Description:
this is the summary of the IAS 11 on construction contracts; it is not detailed.
This document discusses accounting for construction contracts under IAS 11. It explains that construction contracts require revenue and costs to be recognized over time based on the percentage of completion. It provides details on calculating percentage of completion using the cost method or work certified method. It also discusses the treatment of fixed-price versus cost-plus contracts and the recognition of revenue and expenses depending on if the contract outcome is profitable or a loss. An example is provided to demonstrate the accounting entries.
This document discusses accounting for construction contracts under IAS 11. It explains that construction contracts require revenue and costs to be recognized over time based on the percentage of completion. It provides details on calculating percentage of completion using the cost method or work certified method. It also discusses the treatment of fixed-price versus cost-plus contracts and the recognition of revenue and expenses depending on if the contract outcome is profitable or a loss. An example is provided to demonstrate the accounting entries.
reporting papers will often come across the concept of accounting for construction contracts. Depending on the cemlexlty ef yeur nanclal reporting studies, accounting for construction contracts can become quite complex but with adequate question practise, they can become very simple. The key to these types of ques- tions is to do them in a method- ical format. Accounting for construction con- tracts is dealt with in IAS 11 Con- struction Contracts. This article will look at the core principles involved in IAS 11 and at the end of the ar- ticle will look at a worked example. 1he rst thng to understund s vhut a construction contract actually is. According to IAS 11, a construction contruct s: u contruct speccuy entered into for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design and function or their end use or purpose. The principal concern of account- ing for long-term construction contracts involves the timing of revenue (und thus prot) recogn- tion. Contracts can last for several years and a standard was therefore required to deal with revenue recognition in relation to long-term construction contracts. To avoid distortions in the presen- tuton o perodc nuncu stute- ments, the percentage of comple- tion method was developed which reports the revenues proportionally to the degree to which the projects are being completed. Percentage of Completion Method The percentage of completion method is a method of account- ing that recognises income on a contract as work progresses by matching contract revenue with contract costs incurred, based on the proportion of work completed. The problem in dealing with the percentage of completion method lies in accurately deciphering the extent to which the projects are be- ng nshed und to ussess the ubty of the entity to actually bill and collect for the work done. The percentage of completion method uses the contract account to accumulate costs and to recog- nise income. Under the provisions of IAS 11, income is not based on advances (cash collections) or progress billings. Any advances and progress billings are based on con- tract terms that do not necessarily measure contract performance. Where costs and estimated earn- ings in excess of billings occur, the excess s cussed us un usset. l billings exceed costs and estimated earnings, the difference is treated as a liability. There are two ways in which the stage of completion can be calcu- lated: Werk Certled Methed Work certi- ed todute / totu contruct prce Cost Method Total costs incurred todate / total contract costs Contract Costs All contract costs are costs that ure dentube vth u specc contract plus those that are directly attributable to contracting activity in general and can be allocated to the contract and those that are contractually chargeable to a customer. Examples of such costs could be: Steve Collings, FMAAT FCCA FCCA is the audit and technical partner at Leavitt Walmsley Associates Ltd and the author of The Interpretation and Application of International Standards on Auditing (Wiley March 2011). Construction Contracts IAS 11 May/June 2011 Technical 22 23 globalaccountantmagazine.com - Costs o muteru used n the construction contract. - \uges und other ubour costs directly attributable to the contract. - Costs o desgn und techncu assistance. - Costs o hrng punt und machinery to complete the contract. - Deprecuton churges n respect of plant and machinery used in the construction contract. IAS 11 recognises two types of construction contract that are distinguished according to their pricing arrangements: - lxed-prce contructs, und - Cost pus contructs. Fixed price contracts are con- tracts for which the price is not usually adjusted due to costs incurred by the contractor. Where u contructor ugrees u xed-prce contract, this essentially means that the contractor agrees to a xed contruct prce or u xed rute per unit of output. These types of contracts are sometimes subject to escalation clauses. Cost plus contracts are where the contractor is reimbursed for costs plus a provision for a fee. The contract price is determined by the total amount of reimbursable expenses and a fee. The fee is the prot murgn vhch s cucuuted as revenue less direct costs to be earned on the contract. Recognition of Contract Revenue and Expenses IAS 11 prohibits the use of the percentage of completion method if this method will not result in the nuncu stutements reportng u reasonable level of accuracy. It fol- lows, therefore, that the percentage of completion method can only be used where the outcome of the contract can be estimated reliably. Where the contract is either a xed prce contruct or u cost pus contract, then the following criteria must be met to determine whether the outcome can be reliably esti- mated: Fixed price contract: - lt meets the recognton crteru laid down in the Conceptual Framework which is that total contract revenue can be mea- sured reliably and it is probable thut economc benets v ov to the entity. - oth the contruct costs to com- plete and the stage of comple- tion can be measured reliably. - Contruct costs uttrbutube to the contruct cun be dented properly and measured reliably so that comparison of actual contract costs with estimates can be done. Cost plus contract: - lt s probube thut economc benets v ov to the entty. - 1he contruct costs uttrbutube to the contract, whether or not rembursube, cun be dented and measured reliably. All the conditions above must be sutsed. Example 1 A company enters into a 2-year contract. The project manager is unsure whether the contract v be protube or oss-mukng. Costs incurred todate amount to $10,000. As the outcome of the contract cannot be estimated, the amount of revenue to be recognised in the compuny's nuncu stute- ments is the same as the costs ncurred resutng n no prot being taken, so: DR receivables $10,000 CR revenue $10,000 Outcome of the Contract is Pretable \here the contruct s protube, revenue should be recognised by reference to the stage of comple- tion. Costs incurred in reaching the stage of completion are taken to the income statement as cost of sales. This is achieved by the percentage of completion to the total costs that are expected to occur over the life of the contract. An illustration of how this works is shown at the end of the article. Worked Example Leah Inc reports under IFRS and is prepurng ther nuncu stutements for the year ended 31 March 2009. On 1 October 2008, Leah Inc com- menced work on a contract. The price agreed for the contract was u xed prce o S50 mon. Leuh purchased plant at a cost of $15 mil- lion exclusively for use on the con- tract. The directors of Leah Inc have estimated that the plant will have no residual value at the end of the contruct vhch s due to nsh on 30 September 2009. Costs incurred on the contract plus estimated costs to complete are as follows: Outcome of the Contract is Loss-Making Where contracts are loss-making, revenue is recognised by reference to the stage of completion and costs o sues s the buuncng gure which generates the required loss. Example 2 Lucas Inc has a contract that is expected to make a loss of Sl,000. 1he nunce drector hus calculated that the amount of the contract revenue to be recognised is $800. The income statement will include $800 worth of contract revenue. The loss is estimated to be $1,000 so cost of sales will be $1,800 to generate the required loss (i.e. a buuncng gure). This method is used because IAS 11 stipulates that losses must be recognised in the income state- ment as soon as they are foreseen. Costs to date Estimate of costs to complete Materials purchased 9,000 5,000 Labour and other overheads 7,000 8,000 Outcome of the Contract Cannot be Estimated Reliably Where the outcome of a contract cannot be estimated reliably, con- tract costs and revenues should be recognised by reference to the stage of completion. Revenue should be recognised only to the extent of the contract costs incurred that are probable of being recovered, so therefore revenue will equu costs und no prot recognsed as shown in the following example: Technical 24 May/June 2011 All the costs which have been in- curred todate have all been debited to the contract account in the gen- eral ledger. Leah Inc have appointed un ugent vho hus conrmed thut ut the reporting date (31 March 2009), the contract was 40% complete at which point the customer made a progress payment amounting to 15 mon. 1he nunce depurtment have credited this progress pay- ment to the contract account. There have been no other entries made in respect of this contract. Required Show how the contract should be accounted for under the provi- sons n lAS ll n the nuncu statements of Leah Inc for the year ended 31 March 2009. Solution The overall revenue for the contract umounts to S50 mon (the xed price agreed). We know that Leah has incurred the following costs and has made estimates of costs to complete as follows: As costs are less than total revenue we know the contruct s gong to muke u prot of ($50 million less $44 million = $6 million). 1he ugent hus conrmed that the contract is 40% Financial Statement Extracts Revenue (40% x $50 million) $20,000 Cost of sales (40% x $44 million) $17,600 Step 1 Working: Gross Amounts Due from Costs to date: $,000 $,000 Purchase of materials 9,000 $17,600 Labour and other overheads 7,000 Plant depreciation ($15,000 x 6/12) 7,500 Total costs to date 23,500 Contract prot ($S0,000 - $44,000) 6,000 29,500 Less progress payment received (15,000) Gross amount due from customer 14,500 Step 2 Purchase of machine $15,000 Purchase of machine $ 9,000 Labour and overheads $ 7,000 Estimated costs to complete $13,000 $44,000 Step 3 complete, so we take 40% of the total costs to cost of sales in the income statement. We then add 40% of the expected revenue to revenue in the income statement: We then need to work out how much should be in the stutement o nuncu pos- tion as gross amounts due from customer. We need a working as follows: The gross amount due from customer can be shown as an other current asset in the stutement o nuncu poston. Step 4 Conclusion It is important that when you are dealing with construc- tion contract questions that you adopt a logical method of dealing with the numbers and are familiar with how to recegnlse revenue and rets depending on whether a con- tract ls retable, less-maklng or uncertain. Once you have mastered the approach and understand how IAS 11 works, questions on construction contracts become a favourite topic. Lots of question prac- tise is the key to this area of nanclal reertlng syllabuses. Technical 24 25 globalaccountantmagazine.com