IAS 11- CONSTRUCTION CONTRACT

IAS 11- CONSTRUCTION CONTRACT Imagine a construction company that has various shareholders, enters into a contract for the construction of a gigantic building. The contract period is for three years and this is the only contract to be undertaken by the company during the three years, due to the amount of resources (human, capital, financial, etc.) required by the construction which is approximately equal to the full capacity of the contractor (construction company).  How will the construction company recognise the Cost and Revenue associated with this contract? Will the contractor wait until the contract is completed before reporting the outcome of the contract (Revenue and cost) to the shareholders through the financial statements? Will there be no financial information reported in the first and second year? What will be the reaction of the shareholders and will they be willing to wait this long before being apprised of the financial performance of the company? Will the employees wait until after three years when the contract is completed before being paid? Will income tax expense be delayed until when the contract is completed? Will the contractor delay the recognition of the amount paid for building materials, wages of workers on the building, architects' fees and so on, as well as, periodic payments received from the customer?  This is the problem tackled by IAS 11 Construction contracts, and will be understood as we unfold the standard. This Standard shall be applied in accounting for construction contracts in the financial statements of contractors. CONSTRUCTION CONTRACT 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.       CORE PARTIES TO A CONSTRUCTION CONTRACT        a.       The Contractor (Construction company) and        b.      The Customer         TYPES OF CONSTRUCTION CONTRACT This is based on the contract revenue         a.       fixed price contract: This 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. {i.e, Total contract revenue (price): Agreed Fixed contract price Plus Reimbursable Cost escalation (if any OR Fixed rate per output X Total units of output }        b.      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.         Allowable/defined cost                            A plus Agreed % of A (or plus fixed fee)             B Total contract Revenue(price)                         C       DOES A CONSTRUCTION CONTRACT NEEDS TO EXCEED ONE YEAR? There is always this preconceived notion when we hear about construction contract it must exceed one year, but in the real sense, construction contract dealt with under this standard doesn’t have to exceed one year. The main point is that the contract activity starts in one financial period and ends in another, thus creating the problem: To which of two or more periods should contract income and costs be allocated? WHAT DOES CONSTRUCTION CONTRACT ENTAILS? Construction contracts may involve:   The building of one asset, eg a bridge, or a series of interrelated assets e.g. an oil refinery.     Rendering of services (eg architects) or      Restoring or demolishing an asset. CONTRACT REVENUE Recall from IAS 18, Revenue is the gross inflow of economic benefits during the period arising in thecourse of the ordinary activities of an entity…   Contract Revenue refers to the amount specified in the contract, subject to variations in the contract work, incentive payments and claims if these will probably give rise to revenue and if they can be reliably measured. Contract revenue is measured at the fair value of the consideration received or receivable. It is also pertinent to know that,  the amount of contract revenue may increase or decrease from one period to the next as a result of: i. An agreed variation (increase/decrease) ii. Cost escalation clauses in a fixed price contract (increase) iii. Penalties imposed due to delays by the contractor (decrease) iv. Number of units varies in a contract for fixed prices per unit (increase/decrease)   Therefore, Total Contract Revenue= Initial amount agreed +Subsequent increase – Subsequent decrease.                                                                                                           CU a. Initial amount                                                                                 A b. Subsequent Increase i. Variation (+)                                                                            x ii. Claims                                                                                    x iii. Incentive payments                                                                  x iv. Recoverable (Reimbursable) escalation cost                             x v. Other clauses (+)                                                                    x       B c. Subsequent decrease i. Variations ( - )                                                                         x ii. Penalties                                                                              x        (C) Total contract revenue                                                                         D__ CONTRACT COST Contract costs consist of:         a.      Directly attributable cost. E.g. Site labour costs, Costs of materials used in construction,etc.        b.     Generally Allocatable cost. E.g. insurance, cost of design and technical assistance not directly related to a specific contract.        c.      Other specifically chargeable cost. E.g. development costs for which reimbursement is specified in the terms of the contract. NOTE Costs that cannot be attributed to contract activity or cannot be allocated to a contract are excluded from the costs of a construction contract. Such costs include:  (a) general administration costs for which reimbursement is not specified in the contract; (b) selling costs; (c) research and development costs for which reimbursement is not specified in the contract; and (d) depreciation of idle plant and equipment that is not used on a particular contract. RECOGNITION RECOGNITION OF CONTRACT REVENUE and COST The standard set out the recognition criteria for the contact revenue and cost, depending on whether it is a fixed price contract or a cost plus contract. The recognition criteria depicts whether the outcome of the contract can be estimated reliably. This means the recognition criteria set in this standard focus on the reliable measurement of the outcome of the contract.  FOR A FIXED PRICE CONTRACT 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:  (a) Reliability of measurement of  total contract revenue; (b) Probability of inflow of economic benefits associated with the contract; (c) Reliability of measurement of  both the contract costs to complete the contract and the stage of contract completion at the end of the reporting period; and (d) Identifiability & reliability of measurement of the contract costs.  FOR COST PLUS CONTRACT 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:  (a) Probability of inflow of economic benefits associated with the contract; and  (b) Identifiability & reliability of measurement of the contract costs. METHODS OF RECOGNISING REVENUE AND EXPENSES METHOD                                                                               WHEN USED (PERMITTED) 1. Percentage of completion             When the outcome of the contract can be measured reliably.      method 2. Recoverable cost cap                      When the outcome of the contract cannot be estimated reliably   method 3. Completed contract                       Not permitted by the standard. method METHOD 1 Percentage of completion method is the recognition of revenue and expenses by reference to the stage of  completion of a contract. ·         Under this method, contract revenue is matched with the contract costs incurred in reaching the stage of completion. ·         The contract revenue and expense in relation to the stage of completion are reported in the Statement of profit or loss in the reporting period Methods of determining stage of completion There are three ways of determining the stage of completion of a contract as appropriate, they are: ·         Cost method: this the proportion that contract costs incurred for work performed to date bear to the estimated total contract costs; FORMULA                                                        Cost incurred to date reflective of work performed       _______________________________________________________________________         Cost incurred to date whether or not reflective of work performed + latest estimated      .                                                                                                                    cost to complete              OR                                             Cost incurred to date reflective of work performed                             __________________________________________________________                                Initial estimated contact cost ± subsequent adjustments to contract cost NOTE Exclude from the numerator, costs relating to future activity, e.g. cost of materials delivered but not yet used, the remaining balance of the cost of an asset not yet depreciated, i.e. carrying amount. ·         Revenue method: This reflect the proportion of the contract price that a qualified person has certified to have been met in proportion to the total contract price FORMULA:                          Value of work certified                    Latest estimated total contract price ·         Physical unit method:  This method reflects the completion of a physical proportion of the contract work. Formula:                         cumulative unit produced                                             Estimated total production KEY NOTE: The percentage of completion will be calculated at each reporting date REVENUE AND EXPENSE TO BE RECOGNISED IN EACH REPORTING PERIOD  REVENUE: Incremental revenue  EXPENSES: Incremental expenses The Incremental Revenue                                                                                                                                      CU Cumulative revenue to date (current period)                                                               A Cumulative revenue recognised in prior periods                                                        (B) Incremental revenue (Revenue to be recognised in the current year)                       C      Where: Cumulative revenue to date = current percentage (%) of completion X latest total contract revenue. Cumulative revenue recognised in prior periods is the cumulative amount using the above formula calculated in the last period; or the sum of all revenue recognised in the profit or loss in the previous years. The Incremental Expenses                                                                                                                                     CU Cumulative Expenses to date (current period)                                                            A Cumulative Expenses recognised in prior periods                                                     (B) Incremental Expenses (Expenses to be recognised in the current year)                    C      Where: Cumulative expenses to date= current percentage (%) of completion X latest total contract cost. Latest total contract cost: Cost incurred to date whether or not reflective of work performed + latest estimated cost to complete.      Cumulative expenses recognised in prior periods is the cumulative amount using the above formula calculated in the last period; or the sum of all expenses recognised in the profit or loss in the previous years. METHOD II:             RECOVERABLE CONTRACT COST LIMIT METHOD When the outcome of a construction contract cannot be estimated reliably:   a. revenue shall be recognised only to the extent of contract costs incurred that it is probable will be recoverable; and  b. contract costs shall be recognised as an expense in the period in which they are incurred. An expected loss on the construction contract shall be recognised as an expense immediately. NOTE: When the uncertainties that prevented the outcome of the contract being estimated reliably no longer exist, revenue and expenses associated with the construction contract shall be recognised in accordance with Percentage of completion method rather than in accordance with recoverable contract cost limit method.