topic 6 - construction contracts

8/10/2019 Topic 6 - Construction Contracts

1/28

TOPIC 6CONSTRUCTION CONTRACTS

(MFRS111)

1

Semester 22013/2014


2/28

COURSE OUTCOME (CO5)

At the end of this course, students should be

able to;

Describe and demonstrate the account for

construction contracts

2


3/28

Introduction

Imagine that you are an accountant at a construction company.Your company is building a large tower block that will houseoffices, under a contract with a client company. It will take threeyears to build the block and over that time you will obviouslyhave to pay for building materials, wages of workers on the

building, architects' fees and so on. You will receive periodicpayments from the client at various predetermined stages of theconstruction.

How do you decide, in each of the three years, what toinclude as income and expenditure for the contract in theincome statement?

How to allocate contract revenue and contract costs to theaccounting periods in which construction work is performed?

3


4/28

The Main Issues

A construction contract often takes a number of years to complete.

The date at which the contract activity commences and the date when the

contract activity is completed falls into different accounting periods.

Question arises as to when the revenue and gross profit arising there from

should be recognised.

Should all the revenue and gross profit be recognised only at the point of

completion (completed contract method)?

Or should the revenue and gross profit be recognised over each and every

accounting period during which the contract activity is performed (percentage

of completion method)?

How do we measurethe amount of contract revenue and contract costs

attributable to a construction contract?

What information do we need to disclosein the financial statements?

This area of accounting is complicated by the need to rely on estimates of

revenues, costs, and progress towards completion, and by the principle of

recognition of losses when apparent.

4


5/28

: ummary o eStandard

Construction Contract DefinedA construction contract is a contractspecifically negotiated for the construction of

an asset or a combination of assets that are

closely interrelated or interdependent in termsof their design, technology and function or their

ultimate purpose or use.

Includes contracts for the rendering of services

(e.g. the services provided by architects) and

contracts for the destruction or restoration of

assets.

5


6/28

Two Types of Contracts

A fixed price contract where the contractor agrees to

a fixed price.

A cost plus contract where the contractor is

reimbursed for allowable costs plus a percentage of

these costs or a fixed fee.

6


7/28

To Combine or Separate?

For internal control as well as for financial accounting

purposes, construction contracts shall be accounted

separately. However

When a contract covers a number of assets, the

construction of each asset should be treated as a

separate construction contract when:

separate proposals have been submitted for each

asset;

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

the costs and revenues of each asset can be

7


8/28


A group of contracts, whether with a single

customer or with several customers, should be

treated as a single construction contract when:

The group of contract is negotiated as a singlepackage;

The contract are so closely interrelated that they

are, in effect, part of a single project with an

overall profit margin; and

The contracts are performed concurrently or in a

continuous sequence.

8


9/28


The construction of an additional asset should

be treated as a separate construction contract

from the original 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.

9


10/28

Measurement of Contract

Revenues

Components of contract revenue in a constructioncontract:1. The initial contract price; plus

2. Variations (instruction by customer for a change in

the scope of work to be performed); plus3. Claims (amounts in excess of the agreed-on

contract price that a contractor seeks to collect froma customer for customer-caused delays, etc); plus

4. Incentive payments (additional amounts paid to

contractor for meeting targets, for e.g., earlycompletion of contract).

5. But ... only include (2), (3), and (4) above if they areprobable and capable of being reliably measured.

10


11/28

Measurement of Contract

Costs

Components of contract costs in a construction

contract:

a) Costs directly related to the contract (e.g., site

labour costs, construction materials used,depreciation of plant & machinery used on the

contract);

b) Costs attributable to contract activity in general and

can be allocated to the contract (e.g., insurance,

construction overheads);

c) Such other costs as are specifically chargeable to

the customer under the terms of the contract (e.g.,

some general admin costs for which reimbursement

is specified in the terms of the contract).

11


12/28

What items to include in

Contract Costs?

Costs incurred in securing a contract (for e.g., at tenderingstage) -a) include as part of contract costs only if it is probable that

contract will be obtained;

b) otherwise, expense-off to the income statement in the period

they were incurred without including them as part of contractcosts.

Construction materials, supplies, etc. which remained unusedat the end of the period should not be included as part ofcontract costs. They should be carried forward as assets inthe balance sheet.

Payments made to subcontractors in advance of workperformed under the subcontract should not be included aspart of contract costs.

12


13/28

Example 1: Amounts to be included

in contract costs

XYZ Sdn Bhd secured a contract to construct a bridge in early 2009.

Construction work commenced on 1 April 2009. As at 31 December 2009, the

following costs have been incurred or allocated to the contract:

RM'000

Materials issued to the construction site 3,500

Site labour & supervision 2,000

Plant & equipment purchased for the contract 2,600

Allocated construction overheads 400

In 2008, the co. incurred RM200,000 for tendering & lobbying for the contract.

The mgmt of the co. estimated at the end of 2008 that the likelihood ofsecuring the contract was possible. A further RM500,000 was incurred in

January 2009 to secure the contract.

As at 31 December 2009, estimates of unused materials at the construction

site totaled RM500,000. Expenses for sub-contracting work incurred but not

paid at year-end totaled RM200,000. The plant & equipment are depreciated

on a straight-line basis over five years.

13


14/28

Example 1

Required:

Calculate the amount of contract costs incurred for the

above contract as at 31 December 2009.

Answer:


15/28

Recognition of Contact Revenue

and Expenses

Let say that we have a three-year construction

contract, currently in progress.

Question: At which stage of the construction

project can we safely take (i.e., recognise)revenue and costs relating to the project in the

income statement?

15


16/28

Methods to recognise contract

revenue and costs

Completed contract method- revenue and

costs are not recognised in the income

statement until the contract ends.

Advantage- based on actual results not onestimates.

Disadvantage- income reported does not

reflect general contract activity level for thecompany.

16


17/28


revenue and costs

Percentage of completion method- revenue

and costs are recognised in the income statement

as the contract activity progresses, by reference

to the stage of completion of the contract (that is,based on the proportion of work completed).

Advantage- income reported reflect general

contract activity level for the company; results in

fairer reporting; in accordance with accrualsconcept.

Disadvantage- based on estimates, which may

result in error.

17


18/28


revenue and costs

When the outcome of a construction contract can beestimated reliably, contract revenue and contractcosts associated with the construction contract shallbe recognised as revenue and expenses respectivelyby reference to the stage of completion of the contract

activity at the end of the reporting period. The Standard mentions the following methods to

determine the stage of completion of a contract:1. Contract costs incurred to date as a proportion of the

estimated total contract costs;

2. Surveys of work performed, for e.g., value of workcertified to date as a proportion of the total contractrevenue; or

3. Completion of a physical proportion of the contract work.

18


19/28

Disclosure Requirements

The Standard requires the following to be

disclosed:

The amount of contract revenue recognised as

revenue in the period; The amount of contract costs recognised as

expense in the period;

The methods use to determine the contract

revenue recognised in the period; and

The methods used to determine the stage of

completion of contracts in progress.

19


20/28

Disclosure Requirements

An entity should disclose each of the following forcontracts in progress at the end of the reportingperiod:

The aggregate amount of costs incurred and

recognised profits (less recognised loses) to date;

The amount of advances received; and

The amount of retentions.

An entity should present:

The gross amount due from customers for contractwork as an asset; and

The gross amount due to customers for contract workas a liability.

20


21/28

Example 2: Extracts of Disclosure

in the Financial StatementsStatement of Comprehensive Income (extract) RM000 RM000

Contract revenue XX

Contract costs (XX)

Profit for the year XX

Statement of Financial Position (extract)

Current assets:Construction materials XX

Gross amount due from customers (1) XX

Current liabilities:

Gross amount due to customers (2) XX

Notes on Accounting Policies and Explanatory

Materials

RM000

Costs incurred to date XX

Add: Attributable profits XX

Less: Recognised losses (XX)

XX

Less: Progress billings (XX)

Gross amount due from customer (1) XX

Gross amount due to customer (2) (XX)

21

xamp e : easur ng s age o


22/28

xamp e : easur ng s age ocompletion of contract, revenue and

cost

Refer to Example 1- Tan Liong Tong (page

281)

22


23/28

Contract Uncertainties

When uncertainties surround the contract, the

outcome of the construction contract cannot be

estimated reliably. Under such circumstances:

use of the stage of completion method is notappropriate;

recognise revenue only to the extent of contract

costs incurred that are recoverable; and

contract costs should be recognised as an

expense in the period in which they are incurred.

23

E l 4 R d t iti


24/28

Example 4: Revenue and cost recognition

when outcome of contract cannot be

estimated reliably

Refer to Example 3 Tan Liong Tong (page

284)

When the uncertainties that prevented the

outcome of the contract being estimated

reliably no longer exist in a subsequent periodand the outcome can be estimated reliably, the

enterprise should revert (i.e., go back) to the

recognition of revenue and expenses based

on the stage of completion.

24

f


25/28

Recognition of Expected

Losses When it is probable that total contract costs will

exceed total contract revenue, the expected lossshould be recognised as an expense immediately.

In other words, a foreseeable loss should be

recognised in full, both: for the stage of completion reached; and

for the future loss on the contract.

The amount of loss is determined irrespective ofwhether work has started on the contract, thestage of completion of the work, or profits madeon other contracts.

Refer to Example 5 Tan Liong Tong (page 286)

25

A di 1


26/28

ActivityPercentage of Completion

Method

When contract costs are incurred Dr. Contract costs

Cr. Cash/Creditors/etc

At each year end, carry forward

unused contract costs as an asset

Dr. Construction materials etc

Cr. Contract costs

At year end, close off contract

costs a/c to Income Statement

Dr. Contract costs (in I/S)

Cr. Contract costs

When customers are billed Dr. Accounts Receivables

Cr. Progress billingsWhen customers pay up Dr. Cash/Bank

Cr. Accounts receivables

At each year end, recognise

contract revenue based on stage of

completion method

Dr. Progress billings

Cr. Contract revenue (in I/S)

Appendix 1:

Main Journal Entries to record Construction

Contracts26


27/28

Appendix 2:

Summary of the Main Points

A construction contract may take many years to complete, such that

contract activity spans across different accounting periods.

Revenues and costs should be taken to the income statement as the

contract activity progresses (percentage of completion method) and

not when the contract is fully completed or substantially completed

(completed contract method)

If contract outcome is uncertain & cannot be reliably estimated

recognise revenues and costs by reference to the stage of completion

(cost-to-cost basis/value of work certified basis/other bases)

If contract outcome is uncertain & cannot be reliably estimatedrecognise revenues up to the amount of costs incurred that are

recoverable and recognise contract costs as expense in the period

incurred.

27


28/28

Appendix 2:

Summary of the Main Points28

Recognise losses immediately in full in the period the losses were

identified.

Generally the contract revenue = contract price. But in later years,

as the contract progresses, it may also include variations, claims

and incentive payments. However only include them if they are

probable and capable of being reliably measured.

Include under contract costs only those costs which reflect the

actual work doneexclude:

depreciation on idle plant & machinery

costs of unusual materials, advance payments to sub-contractors.

topic 6 - construction contracts

Documents