© 2011 nelson lam and peter lau intermediate financial reporting: an ifrs perspective, 2e (chapter...

© 2011 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective, 2E (Chapter 10) - 1

Chapter 10

Construction Contracts


Agenda

1. Applicable Standard and Scope

2. Combining and Segmenting Construction Contracts

3. What Are Contract Revenue?

4. What Are Contract Costs?

5. Recognition of Contract Revenue and Expenses

6. Recognition of Expected Losses

7. Changes in Estimates

8. Disclosure


1. Applicable Standard and Scope

• IAS 11 Construction Contracts prescribes the accounting treatment of revenue and costs associated with construction contracts.

• Contractors are required to account for their construction contracts in the financial statements in accordance with IAS 11.

• Because the dates of commencement and completion of the contract activity usually fall into different accounting periods,

– the primary issue is how to allocate contract revenue and contract costs to the accounting periods in which the construction work is performed.

• IAS 11 uses the recognition criteria established in the Framework for the Preparation and Presentation of Financial Statements.



• An entity is required to apply IAS 11 to– the separately identifiable components of a single

contract or– a group of contracts together in order to reflect the

substance of a contract or a group of contracts



• When a contract covers a number of assets,

an entity will treat the construction of each asset as a separate construction contract if all the following three conditions are satisfied:1. separate proposals have been submitted for each asset;

2. each asset has been subject to separate negotiation and the contractor and customer have been able to accept or reject that part of the contract relating to each asset; and

3. the costs and revenues of each asset can be identified.



• An entity treats a group of contracts, whether with a single customer or with several customers, as a single construction contract when all the following three conditions are satisfied:1. the group of contracts is negotiated as a single package;

2. the contracts are so closely interrelated that they are, in effect, part of a single project with an overall profit margin; and

3. the contracts are performed concurrently or in a continuous sequence.



• Construction of the additional asset is treated as a separate construction contract when:

– the asset differs significantly in design, technology or function from the asset or assets covered by the original contract; or

– the price of the asset is negotiated without regard to the original contract price.



• Contract revenue comprises:– the initial amount of revenue agreed in the contract;

and– variations in contract work, claims and incentive

payments• to the extent that it is probable that they will result in

revenue; and

• they are capable of being reliably measured.



• An entity includes a variation in contract revenue when:

– it is probable that the customer will approve the variation as well as the amount of revenue arising from the variation

and – the amount of revenue can be reliably measured



• The contract has a cost escalation clause for adjusting the fixed contract price of $20 million to general inflation rate announced by the government.

• The government has announced the general inflation for the current period is 3%.

• Determine the amount of contract revenue to be increased or decreased for the current period.

Answers• The amount of contract revenue to be increased for the

current period is:

$20 million X 3% = $600,000

Example 10.4Example 10.4



• An entity includes a claim in contract revenue only when:

– negotiations have reached an advanced stage such that it is probable that the customer will accept the claim

and – the amount of the claim can be measured reliably



• The contract has a penalty clause for delays caused by the contractor in the completion of the contract.

• The initial amount of revenue agreed in the contract is $30 million.

• The penalty is agreed to be $20,000 per day of delay. • Due to the contractor’s problem, the completion date of the

contract was 10 days after the agreed deadline.• Determine the amount of contract revenue to be increased

or decreased.

Answers• The amount of contract revenue to be decreased is

$20,000 X 10 = $200,000




• An entity includes an incentive payment in contract revenue when:

– the contract is sufficiently advanced that it is probable that the specified performance standards will be met or exceeded

and

– the amount of the incentive payment can be measured reliably.



• Power has won a contract to construct a building for $50 million.

• The contract allows for an incentive payment of $20,000 per day up to a maximum of $500,000 to Power for early completion of the contract.

• The construction of the building is at the completion stage and it is probable that the contract will be completed eight days before the agreed completion date.

• Determine the amount of incentive payment to be included in Power’s contract revenue.




Answers• The construction of the building is at the completion stage

and it is probable that the specified performance standards (early completion) will be met.

• The amount of the incentive payment can also be measured reliably to be $20,000 per day up to a maximum of $500,000.

• The amount of incentive payment to be included in Power’s contract revenue is $160,000 ($20,000 per day X 8 days)




Figure 10.2 Elements of Contract Costs

Contract Costs

Costs directly related to the

specific contract

Attributable costs allocated to the specific contract

Costs specifically chargeable to the

customer



• Costs that relate directly to the specific contract may be reduced by any incidental income that is not included in contract revenue.

• Costs that may be attributable to contract activity in general and can be allocated to specific contracts include:

– insurance;– costs of design and technical assistance that is not

directly related to a specific contract; and– construction overheads.



• Costs that are specifically chargeable to the customer under the terms of the contract may include some general administration costs and development costs for which reimbursement is specified in the terms of the contract.

• Contract costs include the costs attributable to a contract for the period from the date of securing the contract to the final completion of the contract.



Outcome of contract estimated reliably?( Section 10.5.1 )

Percentage of completion method( Section 10.5.2 )

Match revenue and cost up to stage of

completion( Section 10.5.2 )

Recognise expected loss immediately( Section 10.6 )

Recogniserevenue to the extent contract

cost incurred are probably

recoverable( Section 10.5.3 )

Recognisecontract costs

as an expense when

incurred( Section 10.5.3 )

yesno



When Outcome of Contract Can Be Estimated Reliably• recognises contract revenue and contract costs associated

with the construction contract as revenue and expenses respectively by reference to

– the stage of completion of the contract activity

– at the balance sheet date

• IFRIC Interpretation 15: When an agreement for the construction of real estate is

– within the scope of IAS 11 and

– its outcome can be estimated reliably,

recognises revenue by reference to the stage of completion of the contract activity in accordance with IAS 11



When Outcome of Contract Can Be Estimated Reliably

• In the case of a fixed price contract, the outcome of a construction contract can be estimated reliably when all the following conditions are satisfied:

– total contract revenue can be measured reliably; – it is probable that the economic benefits associated with the

contract will flow to the entity; – both the contract costs to complete the contract and the stage of

contract completion at the balance sheet date can be measured reliably; and

– the contract costs attributable to the contract can be clearly identified and measured reliably so that actual contract costs incurred can be compared with prior estimates.



When Outcome of Contract Can Be Estimated Reliably

• In the case of a cost plus contract, the outcome of a construction contract can be estimated reliably when all the following conditions are satisfied:

– it is probable that the economic benefits associated with the contract will flow to the entity; and

– the contract costs attributable to the contract, whether or not specifically reimbursable, can be clearly identified and measured reliably.



Percentage of Completion Method • contract revenue is matched with the contract costs incurred

in reaching the stage of completion, – resulting in the reporting of revenue, expenses and profit

which can be attributed to the proportion of work completed

• The stage of completion of a contract may be determined in a variety of ways:

– the proportion of contract costs incurred for work performed to date to the estimated total contract costs (see Example 10.9);

– surveys of work performed; or

– completion of a physical proportion of the contract work.



The percentage of completion method • A construction contractor has obtained a fixed price contract

from the Hong Kong Government for $9,000 million to build a bridge between Hong Kong and City A on Mainland China.

• The initial amount of revenue agreed in the contract is $9,000 million. The contractor's initial estimate of contract costs is $8,000 million. It will take 3 years to build the bridge.

• By the end of Year 1, the contractor's estimate of contract costs has increased to $8,050 million.




• In Year 2, the Hong Kong Government approves a variation resulting in an increase in contract revenue of $200 million and estimated additional contract costs of $150 million.

• At the end of Year 2, costs incurred include $100 million for standard materials stored at the site to be used in Year 3 to complete the project.

• The contractor determines the stage of completion of the contract by calculating the proportion that contract costs incurred for work performed to date bear to the latest estimated total contract costs.




A summary of the financial data during the construction period is as follows:


•　•　•　•　•　•　•　•　

　 Year 1 $'m Year 2 $'m Year 3 $'m

Initial amount of revenue agreed in contract 9,000 9,000 9,000

Variation - 200 200

Total contract revenue 9,000 9,200 9,200

Contract costs incurred to date 2,093 6,168 8,200

Contract costs to complete 5,957 2,032 -

Total estimated contract costs 8,050 8,200 8,200

Estimated profit 950 1,000 1,000

Stage of completion 26% 74% 100%



• The stage of completion for Year 2 (74%) is determined by excluding from contract costs incurred for work performed to date the $100 million of standard materials stored at the site for use in Year 3.

Required:• Calculate the amounts of revenue, expenses and profit

recognized in the statement of comprehensive income for each of Year 1, 2 and 3 using the percentage of completion method.

• Prepare journal entries to account for the contract revenues and expenses for Year 1.




Answers


　 To Date $'m Recognised in prior years $'m

Recognised in current year $'m

Year 1 　　　

Revenue (9,000 x 0.26) 2,340 - 2,340

Expenses (8,050 x 0.26) 2,093 - 2,093

Profit 247 - 247

Year 2 　　　

Revenue (9,200 x 0.74) 6,808 2,340 4,468

Expenses (8,200 x 0.74) 6,068 2,093 3,975

Profit 740 247 493

Year 3 　　　

Revenue (9,200 x 1.00) 9,200 6,808 2,392

Expenses 8,200 6,068 2,132

Profit 1,000 740 260



Answers• For Year 1, the following journal entries should be recorded

by the contractor:

Dr Contract expenses $2,093

Cr Cash or Accounts payable $2,093

To recognise the contract expenses for Year 1.

Dr Cash or Due from customers $2,340

Cr Contract revenue $2,340

To recognise the contract revenue for Year 1.




When Outcome of Contract Cannot Be Estimated Reliably – revenue shall be recognized only to the extent of

contract costs incurred that it is probable will be recoverable

– contract costs shall be recognized as an expense in the period in which they are incurred

– contract costs that are not probable of being recovered are recognized as an expense immediately



• Contract costs that are not probable of being recovered include contracts:

– which are not fully enforceable– the completion of which is subject to the outcome of

pending litigation or legislation– relating to properties that are likely to be condemned or

expropriated– where the customer is unable to meet its obligations– where the contractor is unable to complete the contract

or otherwise meet its obligations under the contract



6. Recognition of Expected Losses

• When it is probable that total contract costs will exceed total contract revenue,

– an entity recognizes the expected loss as an expense immediately.

• The amount of expected loss is determined irrespective of:

– whether work has commenced on the contract;– the stage of completion of contract activity; or– the amount of profits expected to arise on other

contracts which are not treated as a single construction contract


7. Changes in Estimates

• An entity accounts for– the effect of a change in the estimate of contract

revenue or contract costs, or – the effect of a change in the estimate on the outcome of

a contract

as a change in accounting estimate


8. Disclosure

• An entity is required to disclose: – the amount of contract revenue recognized as revenue

in the period; – the methods used to determine the contract revenue

recognized in the period; and – the methods used to determine the stage of completion

of contracts in progress.


8. Disclosure

• An entity is also required to disclose each of the following for contracts in progress at the balance sheet date:

– the aggregate amount of costs incurred and recognized profits (less recognized losses) to date;

– the amount of advances received; and – the amount of retentions.


8. Disclosure

• An entity should also present: the gross amount due from customers for contract work

as an asset, which is the net amount of:

• costs incurred plus recognized profits; less

• the sum of recognized losses and progress billings

for all contracts in progress for which costs incurred plus recognized profits (less recognized losses) exceeds progress billings.


8. Disclosure

The gross amount due to customers for contract work as a liability, which is the net amount of:

• costs incurred plus recognized profits; less

• the sum of recognized losses and progress billings

for all contracts in progress for which progress billings exceed costs incurred plus recognized profits (less recognized losses)

© 2011 nelson lam and peter lau intermediate financial reporting: an ifrs perspective, 2e (chapter...

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