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Construction contracts
Extract from FRS 102 – Sections 23.17-23.27
23.17 When the outcome of a construction contract can be estimated reliably, an entity shall recognise 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 end of the reporting period (often referred to as the percentage of completion method). Reliable estimation of the outcome requires reliable estimates of the stage of completion, future costs and collectability of billings. Paragraphs 23.21 to 23.27 provide guidance for applying the percentage of completion method.
23.18 The requirements of this section are usually applied separately to each construction contract. However, in some circumstances, it is necessary to apply this section to the separately identifiable components of a single contract or to a group of contracts together in order to reflect the substance of a contract or a group of contracts.
23.19 When a contract covers a number of assets, the construction of each asset shall be treated as a separate construction contract when:
(a) separate proposals have been submitted for each asset;
(b) each asset has been subject to separate negotiation, and the contractor andcustomer are able to accept or reject that part of the contract relating to eachasset; and
(c) the costs and revenues of each asset can be identified.
23.20 A group of contracts, whether with a single customer or with several customers, shall be treated as a single construction contract when:
(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.
Percentage of completion method
23.21 This method is used to recognise revenue from rendering services (see paragraphs 23.14 to 23.16) and from construction contracts (see paragraphs 23.17 to 23.20). An entity shall review and, when necessary, revise the estimates of revenue and costs as the service transaction or construction contract progresses.
23.22 An entity shall determine the stage of completion of a transaction or contract using the method that measures most reliably the work performed. Possible methods include:
(a) the proportion that costs incurred for work performed to date bear to the estimated total costs. Costs incurred for work performed to date do not include costs relating to future activity, such as for materials or prepayments;
(b) surveys of work performed; and
(c) completion of a physical proportion of the contract work or the completion of a proportion of the service contract.
Progress payments and advances received from customers often do not reflect the work performed.
23.23 An entity shall recognise costs that relate to future activity on the transaction or contract, such as for materials or prepayments, as an asset if it is probable that the costs will be recovered.
23.24 An entity shall recognise as an expense immediately any costs whose recovery is not probable.
23.25 When the outcome of a construction contract cannot be estimated reliably:
(a) an entity shall recognise revenue only to the extent of contract costs incurred that it is probable will be recoverable; and
(b) the entity shall recognise contract costs as an expense in the period in which they are incurred.
23.26 When it is probable that total contract costs will exceed total contract revenue on a construction contract, the expected loss shall be recognised as an expense immediately, with a corresponding provision for an onerous contract (see Section 21).
23.27 If the collectability of an amount already recognised as contract revenue is no longer probable, the entity shall recognise the uncollectible amount as an expense rather than as an adjustment of the amount of contract revenue.
OmniPro comment
Definition of construction contract
A construction contract is defined in Appendix I of FRS 102 as ‘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’.
Determining whether a construction contract exists is critical as this determines whether revenue is recognised under the percentage of completion method or the revenue is not recognised until the risk and rewards of ownership and control have passed.
In relation to a single construction contract, examples include:
- Building a single property/building whether for residential or commercial purposes
- Building a bridge
In relation to a combination of assets included in the definition of a construction contract would mean:
- Construction of complex plant and machinery
- Housing estate
The section does not define any length for a construction contract however it is usually for more than one year but it can be shorter. Where a construction contract straddles two accounting periods, a contract for less than one year would be relevant.
Combination and segmentation of contracts
Determining whether a contract is a series of separate individual contracts or one single contract for the construction of assets is very important and this will drive the allocation of revenue and profits.
Section 23.19 and 23.20 above provides an entity with details of whether the contract should be broken down or not. In assessing this for where a single contract covers the construction of a number of assets, each of which is a separate asset then consideration would need to be had as to whether there were separate proposals submitted, or if each asset is subject to separate negotiation and if the costs of revenues for each can be determined.
Recognition of Contract revenue and contract costs
When an outcome of a construction contract can be reliably measured an entity must recognise the costs and revenue based on the stage of completion for each year end. Changes in the measurement estimates are corrected prospectively, no prior year adjustment is required. Therefore the amount recognised in revenue can increase or decrease.
As can be seen from the definition of contract revenue and costs below, the key items when measuring the profit to be shown is the costs and the revenue. The contract may not therefore have the same profit margin over its life time. As costs drive the revenue figure.
Contract revenue
The total contract revenue for a contract is usually specified in a contract at a fixed price or a cost plus margin basis. However there may be instances even in a fixed price contract where adjustments are made.
Section 23 does not define what should be included in contract revenue, therefore it is necessary to look to IAS 11 in IFRS which deals with construction contracts for further guidance based on the hierarchy stated in Section 10.
IAS 11 states that contract revenue is the amount of revenue initially agreed by the parties together with any variations, claims and incentive payments as long as it is probable that they will result in revenue and can be reliably measured.
The amount of revenue to recognise is the fair value received or receivable. Fair value may change as events occur as the consideration is to be revised as events occur or uncertainties are resolved. These may include:
- contractual matters such as increases in revenue in fixed price contract as a result of cost escalation clauses; or,
- a contract involves a fixed price per unit of output,
- contract revenue may increase as the number of units is increased.
Penalties for delays may reduce revenue. In addition, variations must be taken into account. Variations are instructions by the customer to change the scope of the work to be performed under the contract, including changes to the specification or design of the asset or to the duration of the contract.
Variations are only included in the contract when:
- it is probable the customers will approve the variation; and
- it is probable the customers will approve the amount to be charged for it; and
- the amount can be reliably measured.
For claims made for costs not included in the original contract or arising as an indirect consequence of approved variations, such as customer delays, errors in design and specification or disputed variation the settlement of final amounts is likely determined through negotiation that are subject to uncertainty, such additional amounts being claimed should not be recognised as revenue unless:
- it is probable that the customer will accept the claim; and
- the amount can be measured reliably (IAS 11.14)
Therefore at a minimum the claims must have been agreed in principle and an amount must be very well estimated.
For incentive payments, these should only be recognised if it is probable the milestone will be achieved. For penalties the same position would be held.
Contract costs
Section 23 does not define what should be included in contract costs. However the costs allowed under Section 13 Inventories would be indicative of what should be included in costs. In addition, guidance can be got from IAS 11 in IFRS.
IAS 11.16-11.17 states that contract costs are those costs that relate directly to the specific contract and to those that are attributable to contract activity in general that can be allocated to the contract. In addition, they include costs that are specifically chargeable to the customer under the terms of the contract. Directly related costs include:
- direct labour costs, including site supervision
- cost of materials used in construction
- depreciation of plant and equipment used in the contract
- cost of moving plant, equipment and materials to and from the contract site
- cost of hiring plant and equipment
- cost of design and technical assistance that is directly related to the contract
- the estimated costs of rectification and guarantee work, including expected warranty costs; and
- claims from third parties
- any administration costs or research and development costs which are specifically reimbursable under the terms of the contract.
- Cost relating directly to the contract, which were incurred in gaining the business may be included if they have been incurred and at the time it is probable the contract will be obtained. However costs which were specifically written off due to the chance of success not being probable cannot be reinstated at a later date.
If the contractor generates incidental income from any directly related cost, e.g. by selling surplus materials and disposing of equipment at the end of the contract, this is treated as a reduction on contract costs.
A second category of costs as identified in IAS 11.18, which are to be included in contract costs are those costs that are attributable to contract activity in general that cannot be allocated to a particular contract. These costs should be allocated using a systematic and rational method and should be allocated over the normal level of activity. Example of such costs would include:
- design and technical assistance not related to an individual contract
- insurance
- construction overheads such as the costs of preparing and processing payroll for the personnel actually working on the contract
- borrowing costs specifically related to the construction contract
Examples of costs that would be excluded are:
- general administration expenses
- selling expenses
- depreciation on idle plant and machinery not used for a particular contract
- research and development costs
- Any abnormal costs due to inefficiencies such as wasted material or labour costs etc. Although this is not dealt with in Section 23, IAS 11.16 would support this view and states that such costs should be expensed immediately.
Where the percent of completion is used (i.e. total cost incurred to date less expected costs to complete), only work performed up to that date should be included. Therefore costs which should be excluded are detailed below:
Payments made to sub-contractors in advance of work performed under the subcontract (this should be set against the net receivable from customers for contract work on the balance sheet)
Contract costs that relate to future activity on the contract e.g. materials delivered to the site which will be used and installed in the future and have not been used/installed (this should be included within inventories on the balance sheet). The exception is material which has specifically been made for the contract, if this is the case it should be included
Percentage of completion
Section 23 requires the percent of completion method to be used for construction contracts in determining the amount of revenue to recognise. Estimates of revenue are reviewed regularly and changes in estimates recognised in revenue prospectively.
The percent completion is applied on a cumulative basis in each accounting period to the current estimate of revenue and costs. Although not stated in Section 23, IAS 11 states that the revised estimates should be used in determining the amount of revenue and expenses recognised in the profit and loss in the period of the change.
As stated above there are three methods given in Section 23 in relation to determing the method of completion.
Proportion of costs incurred to date excluding inefficiencies, payments on account and cost for future work.
Example 25: – Proportion of cost basis
Company A entered into a fixed contract during year 1 to construct a building for CU50,000. The expected cost of construction was CU40,000. At the end of year 1 the financial statements are being prepared. At that point total costs incurred to date was CU20,000. The expected future costs are CU22,000. Included in the CU20,000 cost, is construction materials which will be used on the second floor which has not been started by the year end. The total cost of this material was CU2,000. The Company paid a subcontractor CU1,000 for work to be done in the future. The costs to date also include labour costs incurred during two weeks of strike for CU500. Also included in cost to date is CU200 in relation to a specific part produced specifically for the property to be installed in the future.
The cost which should be included in the calculation as costs incurred to date is:
Total Costs Incurred to date as per above CU20,000
Less Materials to be used in the future (CU2,000)
Less Payment to Subcontractor in advance (CU1,000)
Less Wasted Cost Inefficiencies during strike (CU500)
Total Costs to date for calculation CU16,500
The total expected cost to complete of CU22,000 needs to be increased by the CU3,000 (excluding CU500 for the cost of the strike) taken away above = CU25,000
Therefore total revenue to be recognised =
CU50,000 * 16,500 = CU19,880
CU25,000 + CU16,500
The journals required assuming all costs to date have been posted to the P&L are:
|
|
CU |
CU |
|
Dr Accrued Income/Gross Amounts Due from Customers for Contract Work* |
19,880 |
|
|
Cr Revenue |
|
19,880 |
Being journal to recognise revenue for the period
*note this would be netted against the amounts due to customers if there was a payment in advance.
|
|
CU |
CU |
|
Dr Inventory |
2,000 |
|
|
Dr Other Debtors |
1,000 |
|
|
Cr Cost of Sales |
|
3,000 |
Being journal to show the future material cost in work in progress and the payment in advance to supplier as a receivable balance.
Note the specific part for future work should be included in the costs incurred to date.
Stage of completion method through surveys of work performed
If we take example 25 in (1) above and assume a quantity surveyor valued the progress of work done at 55% and therefore the Company is entitled to a payment of CU27,500 (CU50,000*55%) which includes retention of 5%. When recognising income here the CU27,500 would have to be recognised including the retention assuming that it is highly probable it will be received as there are no snags. However depending on materiality the retention amount would have to be present valued.
Stage of completion method measured by completion of a physical proportion of the contract work
The Company’s best estimate of the physical proportion of work done is 40% complete. The value of the work done is therefore CU20,000 (CU50,000*40%).
As can be seen from the above, the method used has a big impact on the revenue to be recognised so careful consideration needs to be given as to which method more correctly reflects the progress of the contract.
Where methods 2 or 3 above are used, it may mean that the profit margin is not in line with expectation due to timing of recognition of costs. FRS 102 does not say whether the costs should be deferred or accrued and therefore it would appear that they cannot be. Instead an entity should assess whether this method used is appropriate as Section 23 does not look to achieve a set profit margin.
Reliable measurement
Section 23.25 makes it clear that where the stage of completion or the stage or costs to complete cannot be reliably measured then the company must recognise revenue equal to the cost incurred to date but only to the extent that it is probable that the costs will be reimbursed.
Example 26: Inability to reliably measure the contract
Company A entered into a fixed value contract during year 1 to construct a building for CU50,000. At the end of year 1 the financial statements are being prepared. The cost incurred to date was CU15,000 At this date given the complexities in the contract Company A could not reliably measure the costs to complete. The Company believes that it is probable if not certain that all costs incurred to date will be recovered.
As a result of the inability to measure the costs to complete revenue of CU15,000 should recognised.
Loss expected on contract
Where a loss on a contract becomes probable Section 23.26 requires a provision for an onerous contract be included for future losses in line with Section 23. The provision should be set against any amounts due from customers in the balance sheet. Note where it is not probable that costs will be recovered due a change of law or customer going into liquidation, the costs should be expensed
Example 27: loss on contract
Company A entered into a fixed value contract during year 1 to construct a building for CU50,000. The initial expected costs were CU40,000. At the end of year 1 the total costs incurred were CU15,000 and the expected costs to complete were CU30,000.
At the end of year 2, the total costs incurred was CU45,000 and the company now believe that the total cost to complete will be CU15,000 thereby resulting in an expected loss on the contract of CU10,000.
The accounting for same would be as follows:
At the end of year 1 the amount to be included in revenue is CU16,667 (CU50,000 * (CU15,000/(45,000)).
At the end of year 2 the Company now have an onerous contract.
The total revenue to be recognised at year end is CU20,883 as per below.
|
|
To date (year 2) |
Prior year (year 1) |
To be recognised in year 2 |
|
Revenue recognised |
37,500* |
16,667 |
20,883 |
|
Costs |
45,000 |
15,000 |
30,000 |
|
(Loss)/Profit |
(7,500) |
1,667 |
(9,117) |
|
Provision for future loss |
(2,500) |
– |
(2,500) |
|
Total |
(10,000) |
1,667 |
(11,617) |
The provision for future loss of CU10,000 has now been recognised in full. There is a loss of 11,617 recognised in year 2 as CU1,667 is reversing the previous profit recognised. For the remainder of the contract if the estimates are correct the revenue will equal the costs.
* (CU50,000 * (CU45,000/(60,000))
The journals required at the end of year 2 are:
|
|
CU |
CU |
|
Dr Accrued Income/Gross Amounts Due from Customers for Contract Work |
20,883 |
|
|
Cr Revenue |
|
20,883 |
Being journal to recognise required revenue
|
|
CU |
CU |
|
Dr Cost of Sales |
CU2,500 |
|
|
Cr Provision |
|
CU2,500 |
Being journal to recognise loss on onerous contract
Example 28: Application of change in estimate
Company A entered into a fixed value contract during year 1 to construct a building for CU50,000. The contract finishes at the end of year 3. The initial expected costs were CU40,000.
At the end of year 1 the total costs incurred were CU15,000 and the expected costs to complete was CU30,000.
At the end of year 2, the total cost incurred was CU30,000 and the cost to complete will be CU11,000.
At the end of year 3, the total cost incurred was CU46,000.
The accounting for same would be as follows:
At the end of year 1 the amount to be included in revenue is CU16,667 (CU50,000 * (CU15,000/(45,000)).
At the end of year 2 the total revenue to be recognised is CU36,585 (CU50,000 * (CU30,000/(41,000)).
|
|
To date (year 2) |
Prior year (year 1) |
To be recognised in year 2 |
|
Revenue Recognised |
36,585* |
16,667 |
19,918 |
|
Costs |
30,000 |
15,000 |
15,000 |
|
Profit |
6,585 |
1,667 |
4,918 |
*(CU50,000 * (CU30,000/(41,000))=CU36,585
At the end of year 2 the total revenue to be recognised is CU19,918.
|
|
To date (year 3) |
Prior year (year 2) |
To be recognized in year 3 |
|
Revenue Recognised |
50,000* |
36,585 |
13,415 |
|
Costs |
46,000 |
30,000 |
16,000 |
|
Profit/(Loss) |
4,000 |
6,585 |
(2,585) |
*actual revenue as contract complete
We can see the overall profit shown in the P&L over the three years is CU4,000
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