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IAS – 11Construction Contracts
- CA Avineesh Matta26th June 2010
AICAS, New Delhi
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Objective
• Addressing the primary issue of accounting for construction contracts i.e. the allocation of contract revenue and contract costs to the accounting periods in which construction work is performed
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Prevalent Practices
• Project Completion Method of Accounting• Percentage of Contract Completion Method• AS – 7 (Construction Contracts)
• 1983• 2002 revised• Exposure draft (Revised 20XX)
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Revenue recognition
HDIL - Housing Development and Infrastructure LimitedProject Completion Method of AccountingThe Group follows completed project method of accounting (“Project Completion Method of Accounting”). Allocable expenses incurred during the year are debited to work-in-progress account. The income is accounted for as and when the projects get completed or substantially completed and then revenue is recognized to the extent that it is probable that the economic benefits will flow to the Company and the revenue can be reliably measured.
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Revenue recognition
NCC - Nagarjuna Construction Company Ltd. Percentage of CompletionRevenue from construction contracts is recognised by reference to the percentage of completion of the contract activity. The stage of completion is determined by survey of work performed and / or on completion of a physical proportion of the contract work, as the case may be, and acknowledged by the contractee. Future expected loss, if any, is recognised as expenditure.
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Scope of IAS - 11
• Shall be applied in accounting for construction contracts in the financial statements of contractors– Real estate Developers– IFRIC 15
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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.– Fixed Price Contracts, may be with escalation clause– Cost Plus Contracts – may be with fixed fee too– May have both the features – cost plus with agreed
maximum price
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Related servicesAre these construction contracts?
• Architects, Project Managers• Contracts for destruction/ restoration of environment
Para 5 For the purposes of this Standard, construction contracts include:
(a) contracts for the rendering of services which are directly related to the construction of the asset, for example, those for the services of project managers and architects; and
(b) contracts for the destruction or restoration of assets, and the restoration of the environment following the demolition of assets
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Combining and segmenting construction contracts
• Requirements of this standard are usually applied separately to each contract– Circumstantially may be applied to the separately
identifiable components of • a single contract, or• to a group of contracts
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More than a single asset but separate contracts (para – 8)
• 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 and customer have been able to accept or reject that part of the contract relating to each asset; and(c) the costs and revenues of each asset can be identified
National Highway with Rail over bridge
LMN Limited has a master contract to build 800 houses for a developer over a two year period, in different locations throughout the Country. The cost for each group of houses is negotiated separately and it received a 10% profit, based on the agreed cost. Each group should be treated as a separate contract.
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Group of Contractsbut single contract (para – 9)
• 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 sequenceRedevelopment of airport with metro link under single tenderABC Limited has contracts to build 12 standard hotels. Land preparation is done by the client. Building costs are similar for each hotel. This should be treated as a single contract.
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Additional Assetat the option of customer (para 10)
• As part of initial contract agreed or as part of probable amendments
• Treat separate contract, only if,(a) the asset differs significantly in design, technology or function from the asset or assets covered by the original contract; or(b) the price of the asset is negotiated without regard to the original contract price
ABC Limited is building an apartment building and its client asks it to build a swimming pool in the grounds, at a price to be negotiated. This will be treated as an additional contract.
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Contract revenuepara 11
• Contract revenue shall comprise: (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.
• Contract revenue may change from one period to the next• Contract revenue is measured at the fair value of the
consideration received or receivable
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Examples
• Variations – due to change in design, specification or scope– ABC Limited is building a bridge road. The original plan called
for a bridge over a railway, but the authorities now insist on a tunnel under the railway instead
• Claims – cost not included in agreed contract price– XYZ Limited has been contracted to demolish some houses and build
new ones. It was promised a vacant possession. When its staff arrived, they found that the tenants still occupy the old houses. It takes a month to re-house them and delaying the start of work
• Incentives – early completion in full or part• Only to be recognized if acceptance or its probability by
customer and is reliably measurable
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Contract Costpara 16
Contract costs shall comprise: (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
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(a) Directly Relatable Costs• site labour costs, including site supervision• costs of materials used in construction• depreciation of plant and equipment used on the contract• costs of moving plant, equipment and materials to and from
the contract site• costs of hiring plant and equipment• costs of design and technical assistance that is directly
related to the contract• the estimated costs of rectification and guarantee work,
including expected warranty costs• claims from third parties
These costs may be reduced by any incidental income, Dismantled material disposed of
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(b) Attributable Costsin general
• Allocation – Systematic and rational method– Allocation to be applied consistently to all costs with similar characteristics– Should be based on normal level of activity
• Insurance• Costs of design and technical assistance that are not directly related
to a specific contract• Construction overheads
• Construction payroll preparation• Borrowing Costs (para 18 of IAS – 11)
Costs that have been written off cannot be reinstated if the contract is obtained in a subsequent period
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Exclusion from Contract Costs• General administration costs for which reimbursement is
not specified in the contract• Selling costs• Research and development costs for which reimbursement
is not specified in the contract• Depreciation of idle plant and equipment that is not used
on a particular contract• Cost of securing contract cannot form part of contract cost
except where it is directly identifiable• XYZ Limited has a team whose sole job is to write bids for construction
contracts and negotiate them up to the point of signing contracts. All costs can be allocated to separate bids. Their costs should be expensed in each period, except those costs for bids that are likely to be won.
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Recognition of contract revenue and expensesPara 22
• When the outcome of a construction contract can be estimated reliably, contract revenue and contract costs associated with the construction contract shall be recognised as revenue and expenses respectively by reference to the stage of completion of the contract activity at the end of the reporting period.
• An expected loss on the construction contract shall be recognised as an expense immediately.
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example
• XYZ Limited has been notified by a sub-contractor that his costs (to it) for next year will increase by 15%. It cannot bill the client for this increase, and it will cause it to lose money on the contract and it can find no alternative supplier. Therefore, it should recognize the anticipated loss immediately.
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Example-1
Year (at the end of year)
Contract Price (a)
Cost incurred till date (b)
Expected cost to be incurred for completion(c)
Revenue to be recognised=(b*a)/(b+c)(Revenue Till Date )
1 20,00,000 8,00,000 6,00,000 11,42,857(57.14%)
2 20,00,000 12,50,000 2,00,000 17,24,138(86.21%)
3 20,00,000 14,75,000 - 20,00,000(100%)
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Example-2 (Loss Contract)
Year (at the end of year)
Contract Price (a)
Cost incurred till date (b)
Expected cost to be incurred for completion(c)
Revenue to be recognised=(b*a)/(b+c)(Revenue Till Date )
1 20,00,000 12,00,000 7,00,000 12,63,158(63.16%)
2 20,00,000 18,50,000 2,50,000 17,61,905 (88.09%)(100,000)
3 20,00,000 21,75,000 - 20,00,000(100%)
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Reliable Estimation of outcome of a construction contract - conditions
Fixed Price Contract
Total contract revenue can be measured reliably
Probability of flowing of economic benefit to the entity
Cost and stage of contract completion can be measured reliably at reporting date
Attributable costs can be clearly identified and compared with prior estimates
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Percentage of Completion Method
• Provides useful information• On extent of contract activity• Performance during the period
• Revenue is recognized by reference to stage of completion• Matching of contract revenue and costs• Reporting of revenue, expenses and profit that can be
attributed to the proportion of work completed• Contract revenue recognized in the period work is
performed• Expected excess of total contract costs over total revenue
be recognized as expense immediately
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PCM….Para 27 & 28• Contract costs incurred for future activity be recognized as an
assets (WIP) provided it is probable that it shall be recovered• PQR Limited is building a hotel and has imported some insulation material
that will not be needed until next year. This was done to avoid an imminent price rise, announced by the supplier. It has also paid an advance to a sub-contractor. Both items should be booked to work in progress
• When there is uncertainty about the collectability of an amount already recognized as revenue that should be recognized as expense, rather than adjustment to contract revenue
• XYZ Limited is a sub-contractor. The contractor has approved its work and it has recognized the revenue according to the contract. The client is delaying payment, for reasons that are not clear. Accordingly, it should create a doubtful debt provision for the disputed revenue
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Determination of stage of completionpara 30
• Reliability of measurement or work performed is of supreme importance
• Proportion of contract cost incurred for the work performed to the estimated total cost
• Surveys of the work done• Completion of the physical proportion of the
contract work• Progress payments and advances received often
do not reflect the work performed
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When outcome of contract cannot be estimated reliablypara 32
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
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Case studies• Financial difficulties of the contractor or the client
The client of ABC Limited has not paid it for the work on the agreed date. Arguments ensue, but it thinks that the client has serious financial problems and the contract is at risk.
• Pending litigation or legislationABC Limited is rebuilding a chemical plant. The government finds toxic
effluent has been leaking from the site and applies to the court for an order to stop work.
• Lack of clarity in contract or reimbursement of costABC Limited is building a hotel. Government officials demand additional
safety features, which are not covered by the contract. It submits a variation proposal to the client, who refuses it, claiming that the cost is on the part of ABC Limited.
• Anticipated failure to complete the contractABC Limited is building a road 200 Kms long. Part of the route becomes
flooded and it cannot determine whether or not the road will be completed within the contract period.
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Recognition of expected lossespara 36
• When it is probable that total contract costs will exceed total contract revenue, the expected loss shall be recognised as an expense immediately– The amount of such a loss is determined irrespective of:
(a) whether work has commenced on the contract;(b) the stage of completion of contract activity; or(c) the amount of profits expected to arise on
other contracts
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Case studies
• Before start of the work– XYZ Limited is going to build a hotel on a cliff. It hires staff,
machinery and materials. It travels to the cliff and find that it has fallen into the sea. The client offers another site, but for the same contract price. This would reduce its loss, but not eliminate it. Accordingly, it should recognize the loss immediately.
• Profit in other contracts– XYZ Limited has 5 separate construction contracts with the same
client. Its project is “State A” is hit by strikes, which means additional costs, and penalties for late completion. This will create a loss for the project, though the 4 other projects will make enough profits to cover the loss. It must still recognize the loss on the “State A” immediately.
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Illustration• Apsara Ltd. entered into an agreement with the Government for the
construction of a dam and hydel project across River Ganga.• Contract period being 3 years. • The consideration was agreed at Rs.200 Crores• Initial cost estimate of the Company was Rs.190 Crores.• The Company incurred Rs.65 Crores, Rs.90 Crores and Rs.55 Crores
respectively in the three years.• The cost incurred in year 2 includes Rs.15 Crores towards additional
work for which the Government agreed for a price increase of Rs.18 Crores. Also, the Company is entitled to receive a 5% incentive on the original price agreed, for completion of project within 3 years. This incentive was also promptly received by the Company.
• Determine the Contract Revenues, Costs and Profits to be recognised in each of the 3 years in the above situation.
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Working
Particulars Year 1 Year 2 Year 3 Contract Price 200 200 200 Variations --- 18 18 Incentive -- --- (200 * 5%) = 1 A. Total Contract Revenue 200 218 219 Costs till date 65 65 + 90 = 155 155 + 55 = 210 Estimated costs to complete (See Note 1)
75 + 55 = 130 55 ---
B. Total Contract Costs 195 210 210 C. Estimated Total Profit 5 8 9 D. Percentage of Completion = Cost till date/Total Contract Costs
65/195 = 33.33% 155/210 = 73.81% 100%
Note : 1 : Initial estimate of Rs.190 Crores is not relevant since it is made prior to the commencement of contract work. As at the end of Year 1, the variations/additional costs of Year 2 will not be known and hence the revised estimate cost to complete the original contract (excluding additional work) will be taken at Rs.130 Crores
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The Contract Revenues, Costs and Profits recognised in each of the three years
Year Upto Reporting Date Recognised in previous year
Recognised in Current year
First Contract Revenue 200 * 33.33% = 66.66
--- 66.66
Contract Costs 65 -- 65 1. Contract Profits 1.66 --- 1.66 Second Contract Revenue 218 * 73.81 = 161 66.66 94 Contract Costs 155 65 90 2. Contract Profits 6 1.66 4 Third Contract Revenue 219 161 58 Contract Costs 210 155 55 3. Contract Profits 9 6 3
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First time adoption
• Percentage of completion accounting • no change, AS – 7 compliant
• If Project completion accounting• Change in accounting policy• Impact on estimates due to change in accounting policy
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Differences between AS – 7 & IAS - 11
• Appendix F to exposure draft• Existing AS - 7 permits Borrowing Costs in the costs that
may be attributable to contract activity in general and can be allocated to specific contracts; IAS – 11 permits but not in ED
• Existing AS - 7 does not recognise fair value concept as contract revenue is measured at consideration received/receivable
• Existing AS - 7 does not deal with accounting for Service Concession Arrangements
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Real estate transactions IFRIC 15
• An agreement for the construction of real estate is a construction contract within the scope of IAS 11 only when the buyer is able to specify the major structural elements of the design of the real estate before construction begins and/or specify major structural changes once construction is in progress (whether it exercises that ability or not).
• If the buyer has that ability, IAS 11 applies. • If the buyer does not have that ability, IAS 18
applies.
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IFRIC -15…
• An agreement for the construction of real estate in which buyers have only limited ability to influence the design of real estate , for example to select a design from a options specified by the entity , or to specify only minor variations to the basic design, is an agreement for sale of goods and therefore within the scope of IAS-18.
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Land element……IFRIC 15
• If the contract can be segmented into a construction contract and the sale of the land, the delivery of land follows the revenue recognition as per IAS-18.
• Construction cost shall be followed as per IAS-11.
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Disclosurespara 39 & 40
• The amount of contract revenue recognised as revenue in the period;
• the methods used to determine the contract revenue recognised in the period; and
• the methods used to determine the stage of completion of contracts in progress.
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Disclosures
• An entity shall disclose each of the following for contracts in progress at the end of the reporting period:
• the aggregate amount of costs incurred and recognised profits (less recognised losses) to date;
• the amount of advances received; and• the amount of retentions
• An entity discloses any contingent liabilities and contingent assets in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets. Contingent liabilities and contingent assets may arise from such items as warranty costs, claims, penalties or possible losses. (para 45)
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Presentationpara 42
• An entity shall present:(a) the gross amount due from customers for contract work as an asset; and(b) the gross amount due to customers for contract work as a liability
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Accounting Policies….ex..Unitech
• a) Real Estate Projects • Real Estate Projects undertaken up to 31st March, 2004. • (i) Revenue is recognized to estimate the profit @ 20% of actual receipts and installments fallen
due during the year towards booking of plots/constructed properties, subject to final adjustment, on the completion of the respective project.
• (ii) Real Estate Projects undertaken on and after 1st April, 2004. • i. Revenue from real estate projects is recognized on the "Percentage of Completion Method" of
accounting. Revenue comprises the aggregate amounts of sale price in terms of the agreements entered into and is recognized on the basis of percentage of actual costs incurred thereon, including proportionate land cost and total estimated cost of projects under execution, subject to such actual costs being 20 percent or more of the total estimated cost.
• ii. Where aggregate of the payment received provide insufficient evidence of buyers commitment to make the complete payment, revenue is recognized only to the extent of realization.
• iii. The estimates of the saleable areas and costs are reviewed periodically by the management and any effect of changes in estimates is recognized in the period such changes are determined. However, when the total project cost is estimated to exceed total revenues from the project, the loss is recognized immediately.
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Nagarjuna ConstructionReal Estate Project:• Revenue from the sale of properties is recognised on transfer of all significant risks
and rewards of ownership to the buyers, which coincides with the entering into a legally binding agreement and it is not unreasonable to expect ultimate collection and no significant uncertainty exists regarding the amount of consideration.
• However, if at the time of transfer substantial acts are yet to be performed under the contract, revenue is recognised on the basis of percentage completion method, measured on the basis of percentage of actual cost incurred including proportionate land cost bears to the total estimated cost of the project under execution.
• Revenue comprises the aggregate amount of sale price as per the terms of the agreement entered into with the customers. The recognition is subject to reaching 25% of physical progress measured in terms of estimated cost. The estimate of cost and saleable areas is reviewed periodically by the management and any effect of changes in estimates is recognised in the period of changes. Further, on periodical review if any project is expected to incur loss, the entire loss is recognised immediately.
• Cost in relation to the above includes cost of land, development cost, project over heads, borrowing cost and all cost incurred for bringing the property to marketable condition or its intended use.
