Construction Contracts: IAS 11

Wiecek and Young

IFRS PrimerChapter 8

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Construction Contracts

Related standards IAS 11 Current GAAP comparisons IFRS financial statement disclosures Looking ahead End-of-chapter practice

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Related Standards

SAB 104 Revenue Recognition SOP 81-1 Accounting for Performance of

Construction-Type and Certain Production-Type Contracts

CON 6 Elements of Financial Statements

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Related Standards

IAS 18 Revenue

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IAS 11 – Overview

Objective and scope Combining and segmenting construction contracts Contract revenue Contract costs Recognition of contract revenue and expenses Disclosure and presentation

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IAS 11 – Objective and Scope Standard deals with revenue recognition for construction contracts

and the special problems embedded in these contracts due to the nature of the arrangement with the customer

Specifically, these types of contracts often have the following unique features:

• Signed up front before work is performed

• Customer billings are stipulated in the contract

• Long term in nature, spanning several reporting periods

• Earnings process is made up of many (often significant) events

IAS 11 builds upon the revenue recognition criteria laid down in the framework and also upon IAS 18 Revenue

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IAS 11 – Objective and Scope

The standard provides the following term definitions:

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

A fixed price contract is a construction contract in which the contractor agrees to a fixed contract price, or a fixed rate per unit of output, which in some cases is subject to cost escalation clauses

A cost plus contract is a construction contract in which the contractor is reimbursed for allowable or otherwise defined costs, plus a percentage of these costs or a fixed fee

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IAS 11 – Combining and Segmenting Construction Contracts

There may be a need to group or subdivide contracts for accounting purposes and this would depend on how the contract was negotiated

Contracts for construction of several assets would be grouped for accounting purposes if the contracts were:

• Negotiated together

• Closely interrelated, and

• Performed concurrently or in continuous sequence

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IAS 11 – Combining and Segmenting Construction Contracts

Contracts covering the construction of several assets would be treated as separate contracts for accounting purposes if:

• Separate proposals were submitted for each individual asset

• Each part of the contract was negotiated as a separate part and

• The revenues and related costs are separable

If the contract includes an option to build an additional asset, the arrangement would be accounted for as a separate contract if the additional asset differs from the rest of the assets or the price is negotiated separately

Grouping or segregating contracts allows the accounting to follow the economic substance of the contract negotiations and ensures that any losses are appropriately recognized

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IAS 11 – Contract Revenue

Contract revenues include the amounts originally agreed to in the contract plus variations, claims, and incentive payments that are measurable and probable

Variations, claims, and incentive payments are separately defined in the standard and reflect the differing nature of the revenues

Each has a different point for recognition of revenue.

Although revenues are measured at the fair value of the consideration received or receivable, they may change from period to period

– Treated as a change in estimate

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IAS 11 – Contract Revenue

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IAS 11 – Contract Costs It is important to identify all costs that are related to the contract in order to

measure profit

Sometimes the method used to estimate revenues is based on the costs incurred to date; therefore, if the costs are incorrectly measured, the amount of revenue recognized will be incorrect as well

Contract costs should include costs that are:

• Directly related to the contract (including materials and labor costs, depreciation, and other costs

• Attributable to the contract activity in general (such as insurance, design costs, construction overhead, payroll processing costs, and borrowing costs) and

• Specifically chargeable under the terms of the contract (such as general and administrative costs, development costs)

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IAS 11 – Contract Costs

Contract costs may be shown net of incidental income such as income from resale of excess material that may have been ordered

Costs that are attributable to the contract activity may be allocated using systematic and rational allocation methods and must be allocated consistently to all costs that have similar characteristics

Selling costs and depreciation of idle plant and equipment should not be included.

However, costs incurred in securing the contract may be included as long as they can be separately identified and reliably measured and as long as it is probable that the contract will be obtained

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IAS 11 – Recognition of Contract Revenue and Expenses

Revenue and costs are recognized when the outcome of the contract can be estimated reliably

Reference is made to the stage of completion of the contract and the calculations are done cumulatively each reporting period

Determining whether the outcome of the contract can be estimated reliably depends on the type of construction contract

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IAS 11 – Recognition of Contract Revenue and Expenses

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IAS 11 – Recognition of Contract Revenue and Expenses

In general, the key terms of the contract must be established before an entity can make reliable estimates

Estimates by definition may require adjustment in subsequent periods

The percentage of completion method is used to determine how much revenue should be recognized for fixed price contracts.

For cost plus contracts, the percentage of completion method is not necessary since the amount of revenue recognized each period is equal to the costs expensed plus an agreed upon profit margin or markup

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IAS 11 – Recognition of Contract Revenue and Expenses

According to IAS 11.30, methods for estimating the stage of completion include the following:• Estimating the costs incurred to date as a percentage of total estimated

costs (based on inputs to the process)

- Exclude costs relating to future activity on the contract from the

numerator (e.g., supplies yet to be used and advance payments

made to subcontractors)

• Surveys of work performed (based on outputs) or

• Estimating the proportion physically complete, e.g., the number of

miles of highway completed (outputs)

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IAS 11 – Recognition of Contract Revenue and Expenses

As a default, when the outcome of the contract cannot be estimated reliably, costs incurred to date are expensed and equal revenue may be recognized as long as collection is probable

This may be the case for instance in the early stages of a contract. If total costs are likely to exceed total revenues, this excess loss must be recognized

Finally, any costs incurred that are not recoverable must be expensed even if no revenue is recognized

Illustration 8-3 (on the next slide) shows how revenue and cost recognition changes depending on the likelihood of the outcome

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IAS 11 – Recognition of Contract Revenue and Expenses

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IAS 11 – Disclosure and Presentation

Various disclosures are required including the following:

• Amount of revenue recognized in the period

• Method used to determine the above, as well as the

stage of completion

• For contracts in process, the amount of costs incurred and

profit recognized to date, advance received, and amount

of retentions (unpaid billings)

• Contingent assets/liabilities

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IAS 11 – Disclosure and Presentation

On the statement of financial position:– The gross amount due from customers is presented

as an asset if it is a debit (costs plus recognized profits less recognized losses and progress billings), or

– The gross amount due to customers is presented as

a liability if it is a credit

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Current GAAP Comparisons

Page 102 of 164 ofhttp://www.kpmg.co.uk/pubs/IFRScomparedtoU.S.GAAPAnOverview(2008).pdf

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IFRS Financial Statement DisclosuresSiemens AGhttp://w1.siemens.com/annual/07/pool/download/pdf/e07_00_gb2007.pdf.

Revenue Recognition

on Construction Contracts page 223 of 336

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Looking Ahead

The IASB is not currently looking at accounting for construction contracts specifically, although the accounting may be affected by the revenues project

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End-of-Chapter Practice

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End-of-Chapter Practice

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End-of-Chapter Practice

8-3 Monday Morning Limited is a construction company. During the year, it had one very large construction project underway. The five-year fixed price contract was signed at the beginning of the year, and the project is on schedule and is 20% complete to date. The following costs were incurred during the year:

•Materials costs (some of which are still on hand)•Labor costs for builders•Salary of site supervisor•Salary of head office project manager•Depreciation on construction machinery•Insurance•Head office secretarial (for typing up the contracts and doing the accounting for the contract)

Instructions

Discuss whether the costs are contract costs.

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End-of-Chapter Practice

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