Construction contracts


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Construction Contracts-IAS11

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Construction contracts

  1. 1. Construction Contracts IAS 11
  2. 2. 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
  3. 3. 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.
  4. 4. 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
  5. 5. Type of Construction Contracts Fixed price contracts Cost plus contracts
  6. 6. Fixed price contractsK Ltd gets a contract to construct a bridge for a tender amountof $5 million. This $5 million is given by the local authority toK Ltd over a period of the construction. If the minimum labourwages increase during the construction period, areimbursement to that extent is given to K Ltd.
  7. 7. Cost plus contractsK Ltd gets a contract from the government to construct amissile. 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 thisconstruction.
  8. 8. 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 continuoussequence.
  9. 9. Contract Revenue(a) The initial amount of revenue agreed in the contract; and(b) Variations in contract work, claims and incentivepayments: (i) To the extent that it is probable that they will result in revenue; and (ii) They are capable of being reliably measured.
  10. 10. VariationsK Ltd enters into a contract of constructing metro station forthe local transport authority. The structure is finalised and thework is going on smoothly. During the construction period, theauthority wants to add a space for commercial shops within themetro station premises. This is a variation from the originalconstruction contract, and will be considered as a part ofrevenue.
  11. 11. ClaimsCustomer caused delays, errors in specifications or design, anddisputed variations in contract work.
  12. 12. IncentivesAn incentive payment to the contractor for early completion ofthe contract
  13. 13. Construction Costs(a) costs that relate directly to the specific contract;(b) costs that are attributable to contract activity in general andcan be allocated to the contract; and(c) such other costs as are specifically chargeable to thecustomer under the terms of the contract.
  14. 14. 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 thecontract site;(e) costs of hiring plant and equipment;(f) costs of design and technical assistance that is directly related tothe contract;(g) the estimated costs of rectification and guarantee work, includingexpected warranty costs; and(h) claims from third parties.
  15. 15. 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.
  16. 16. Costs specifically chargeable to construction contractGeneral administration costs and development costs for whichreimbursement is specified in the terms of the contract.
  17. 17. 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
  18. 18. Recognition of profit When When outcomeoutcome can cannot be be reliably reliably measured Percentage of measured Revenue to the completion for extent of costs revenue recoverable Percentage of Costs to the completion for extent incurred costs
  19. 19. 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.
  20. 20. 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.
  21. 21. Stage of completion • 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 Floor area 30,000 sq ft. • K Ltd is constructing a building of 10 storeys. On the Physical reporting date, 5 storeys are completedConstruction • K Ltd is constructing a bridge. The government appoints a surveyor to identify the total construction completed. TheSurveyor’s report surveyor certifies that the construction is 35% complete.
  22. 22. Loss making contractsIf the result of the contract is a loss, that loss has to berecognised immediately.
  23. 23. Loss making contractK Ltd enters into a contract to construct a dam. The contractprice is $50 million. 3 months from the date of beginning ofthe contract, K Ltd estimated that total costs would be $60million. So far, K Ltd has incurred costs of $8 million. Thecontract is 20% complete.
  24. 24. Terms associated with construction contractsProgress Billing: Amount billed by the contractor for workperformedRetention money: Amount held back by the customeraccording to the terms of contractAdvance: Amount received from the customer beforecommencement of the contract.
  25. 25. Case study (Dec 2007)On 1 October 2006 Epsilon signed a contract to construct a dam at a fixed price of $50 million. Thecontract has a scheduled completion date of 30 September 2008. However, if the contract iscompleted satisfactorily on or before 30 June 2008 Epsilon becomes entitled to a bonus of $5million. If the contract is completed later than 31 December 2008, then Epsilon will forfeit $15million of the fixed price and only receive $35 million. Latest estimates regarding completion datesare 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 incurfurther costs of $12 million to complete the contract. Your assistant has shown a net balance of $13million 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 onthe contract if it was completed after 31 December 2008, and a progress payment of $10 millionmade by the customer before 30 September 2007. The loss of $5 million has been charged to theincome statement and justified by the assistant on the grounds of prudence. An independent experthas recently certified that at 30 September 2007 the construction of the dam was 45% complete. Theassistant proposes deferring recognition of any revenue until the contract is completed.
  26. 26. 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
  27. 27. ThanksKAPP Edge Solutions Pvt. LtdGreater Kailash 1, New