Construction contracts

Construction Contracts

IAS 11

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

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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.


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


Type of Construction Contracts

Fixed price
contracts

Cost plus
contracts


Fixed price contracts

K Ltd gets a contract to construct a bridge for a tender amount
of $5 million. This $5 million is given by the local authority to
K Ltd over a period of the construction. If the minimum labour
wages increase during the construction period, a
reimbursement to that extent is given to K Ltd.


Cost plus contracts

K Ltd gets a contract from the government to construct a
missile. 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 this
construction.


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 continuous
sequence.


Contract Revenue

(a) The initial amount of revenue agreed in the contract; and

(b) Variations in contract work, claims and incentive
payments:
(i) To the extent that it is probable that they will result in
revenue; and
(ii) They are capable of being reliably measured.


Variations

K Ltd enters into a contract of constructing metro station for
the local transport authority. The structure is finalised and the
work is going on smoothly. During the construction period, the
authority wants to add a space for commercial shops within the
metro station premises. This is a variation from the original
construction contract, and will be considered as a part of
revenue.


Claims

Customer caused delays, errors in specifications or design, and
disputed variations in contract work.


Incentives

An incentive payment to the contractor for early completion of
the contract


Construction Costs

(a) costs that relate directly to the specific contract;

(b) costs that are attributable to contract activity in general and
can be allocated to the contract; and

(c) such other costs as are specifically chargeable to the
customer under the terms of the contract.


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 the
contract site;
(e) costs of hiring plant and equipment;
(f) costs of design and technical assistance that is directly related to
the contract;
(g) the estimated costs of rectification and guarantee work, including
expected warranty costs; and
(h) claims from third parties.


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.


Costs specifically chargeable to construction
contract

General administration costs and development costs for which
reimbursement is specified in the terms of the contract.


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


Recognition of profit

When
When
outcome
outcome 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


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.


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.


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 completed
Construction

• K Ltd is constructing a bridge. The government appoints a
surveyor to identify the total construction completed. The
Surveyor’s
report surveyor certifies that the construction is 35% complete.


Loss making contracts

If the result of the contract is a loss, that loss has to be
recognised immediately.


Loss making contract

K Ltd enters into a contract to construct a dam. The contract
price is $50 million. 3 months from the date of beginning of
the contract, K Ltd estimated that total costs would be $60
million. So far, K Ltd has incurred costs of $8 million. The
contract is 20% complete.


Terms associated with construction contracts

Progress Billing: Amount billed by the contractor for work
performed

Retention money: Amount held back by the customer
according to the terms of contract

Advance: Amount received from the customer before
commencement of the contract.


Case study (Dec 2007)
On 1 October 2006 Epsilon signed a contract to construct a dam at a fixed price of $50 million. The
contract has a scheduled completion date of 30 September 2008. However, if the contract is
completed satisfactorily on or before 30 June 2008 Epsilon becomes entitled to a bonus of $5
million. If the contract is completed later than 31 December 2008, then Epsilon will forfeit $15
million of the fixed price and only receive $35 million. Latest estimates regarding completion dates
are 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 incur
further costs of $12 million to complete the contract. Your assistant has shown a net balance of $13
million 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 on
the contract if it was completed after 31 December 2008, and a progress payment of $10 million
made by the customer before 30 September 2007. The loss of $5 million has been charged to the
income statement and justified by the assistant on the grounds of prudence. An independent expert
has recently certified that at 30 September 2007 the construction of the dam was 45% complete. The
assistant proposes deferring recognition of any revenue until the contract is completed.


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


Thanks

KAPP Edge Solutions Pvt. Ltd
Greater Kailash 1, New Delhi

Construction contracts

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