Chapter 26 – Construction Page 361
Chapter 26 CONSTRUCTION
1 Business Context
Construction contracts are common in certain industries, such as the building and aerospace industries where entities enter into contracts for the construction of a substantial asset that
takes a considerable amount of time to complete. Such contracts may extend over several years.
Few entities can afford to wait until the end of the contract before being paid by the customer. In practice, stage payments for work completed are agreed within the overall
contract, and partial payment is received from the customer.
Similarly, if profit was only recognised at the end of each contract, then reported profits in the financial statements would not represent the value of work achieved in an accounting period.
It is therefore necessary to divide the overall contract over the total time it takes and to recognise an appropriate part of the contract costs, revenues and profit each period.
2 Chapter Objectives
This chapter deals with the accounting and disclosure requirements in IAS 11 Construction contracts.
On completion of this chapter you should be able to: demonstrate a knowledge of the objectives and scope of IAS 11;
demonstrate a knowledge of the important terminology and definitions which relate to the valuation of construction contracts;
demonstrate an understanding of the key principles relating to the valuation of construction contracts and the allocation of contract costs and revenues to
accounting periods; and apply this knowledge and understanding in particular circumstances through basic
calculations.
3 Objectives, Scope and Definitions of IAS 11
The objective of IAS 11 is to prescribe the accounting treatment of the revenues receivable and costs incurred in a construction contract.
IAS 11 defines a construction contract as one specifically negotiated for the construction of an asset, for example a building, pipeline or ship, or a combination of assets that are closely
related in terms of their design, technology and function or their ultimate purpose or use. Services that are directly related to the construction of an asset, for example project
management, meet the definition of a construction contract, as does a contract for the demolition of an asset. [IAS 11.3]
The dates on which a construction contract starts and ends usually fall in different accounting periods, so the principal concern is how to allocate revenue and costs to the different
accounting periods to reflect the reality of the construction activity as it takes place.
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IAS 11 applies only to the contractor, i.e. the entity carrying out the work; it does not apply to the customer for whom the work is being carried out. The customer will usually account for
the constructed asset in accordance with IAS 16 Property, plant and equipment. [IAS 11.1]
There are two distinct types of construction contract: fixed price contracts: where the revenue arising is fixed, either for the contract as a
whole or per unit of output, at the outset of the contract. Under such contracts there is an element of certainty about the revenue accruing, but not about the costs which will
arise; and
cost plus contracts: where costs will be recoverable plus some agreed element of profit. Under such contracts there is a high degree of certainty about the profit
arising, although there is no certainty about either the revenue or the costs. The distinction between the two types of contract is particularly important when deciding the
stage at which contract revenues and expenses should be recognised. IAS 11 will generally be applied to individual construction contracts; but in order to reflect
economic reality it will occasionally be necessary to aggregate several contracts together or break a large contract down into smaller ones.
If one contract covers the construction of a number of individual assets that have been separately tendered for, it may be appropriate to treat the construction of each asset as a
separate contract. To be treated separately the acceptance of each proposal should not be reliant on the acceptance of the other proposals, and it should be possible to identify the
costs and revenues relating to each asset. [IAS 11.8]
A number of individual contracts should be aggregated if the individual contracts have been negotiated as one, the contracts are closely interrelated with an overall profit margin and
they are performed at the same time or consecutively. [IAS 11.9]
Where a contract entered into for the construction of a single asset contains a clause that provides for the construction of an additional asset at the option of the customer, the second
asset should be treated as a separate contract if its design or function differs significantly from the asset under the original contract or if the price is separately negotiated. [IAS 11.10]
4 Contract Revenue and Contract Costs
4.1 Contract revenue
This section looks at how total contract revenue should be built up over the life of the contract. It does not deal with the timing of recognition through its allocation to
accounting periods, which is discussed later.
Contract revenue is the total amount of consideration receivable under the contract. This will therefore include revenue due from the originally agreed contract and from
any subsequent changes variations in the contract provided that they have been agreed i.e. the amounts are known and are recoverable. [IAS 11.11]
In the early stages of a contract, the contract revenue will often be an estimate of what the final amount will be, as it may be dependent on the outcome of future events.
Contract revenue may alter where it is possible for the contractor to make claims against the customer, or a third party, for costs that were not originally included in the
contract.
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4.2 Contract costs
Contract costs should include the costs that directly relate to a contract, for example costs of materials used in the construction, site labour costs, the cost of hiring equipment and
depreciation of equipment used in the contract. In addition, contract costs will include an allocation of costs incurred to carry out contract activity in general, for example insurance and
construction overheads. It is appropriate to allocate these costs to each contract on a systematic and rational basis. [IAS 11.16]
If other costs are identified as being specifically recoverable under a particular contract, these should also form part of the construction costs of that contract. [IAS 11.16]
5 Recognition of Contract Revenue and Costs
5.1 Stage of completion
The principal objective of IAS 11 is to recognise contract revenue and costs in each accounting period to reflect the stage of completion of the contract. In order for contract
revenue and costs to be recognised, the entity should be able to measure reliably both amounts. [IAS 11.22]
The stage of completion approach avoids the mismatch between costs being recognised as they are incurred and revenue only being recognised when the contract is completed. This
would not reflect commercial substance, since the contractor earns revenues as the project activity progresses. The stage of completion method is often referred to as a percentage of
completion method.
Under this method, contract costs should be expensed in the period in which the work that gives rise to them is completed, and the associated revenue should be recognised to match
the work completed. Costs may also be incurred in relation to work that will be carried out in a future period; these should be deferred in the statement of financial position as an asset,
assuming that they are recoverable under the contract, and are usually referred to as ‘contract work in progress’.
The stage of completion of a contract can be assessed in a number of ways. Examples included in IAS 11 are:
measurement of the costs incurred to date on work performed as a proportion of the total estimated costs under the contract;
surveys of work completed. This may be appropriate where a specialised asset is being constructed or where it is likely that significant costs will be incurred in the
earlier stages of the project although this does not match the level of completion of the asset; and
measurement of the physical completion to date as compared with the total asset. This may be appropriate for the construction of buildings.
5.2 Reliable measurement
As mentioned above, contract revenue and costs should only be recognised where the outcome of the contract can be measured reliably. Where contract revenue has been
recognised but the recovery of the amount subsequently looks unlikely, an expense should be recognised for the amount thought to be uncollectible rather than an adjustment being made
to revenue.
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IAS 11 distinguishes between the two types of contract in terms of the criteria to be met for measurement to be reliable.
For a fixed price contract the contractor should be able to measure reliably the total contract revenues and be able to identify and measure reliably both the costs that
have been incurred and those that will be incurred to complete the project. The contractor should also assess whether it is probable that payment will be received
under the contract. [IAS 11.23]
Under a cost plus contract the outcome of the contract is capable of reliable measurement where it is probable that the contractor will receive payment for the
revenues under the contract and the costs can be both clearly identified and reliably measured. [IAS 11.24]
Illustration 1
The following information relates to a contract. CU000
Estimated contract revenue 100
Costs to date 48
Costs to complete 32
Total estimated costs 80
Using the “costs incurred” method, the stage of completion is 60 CU48,000 as a percentage of CU80,000
The amounts to be recognised in the statement of comprehensive income are: CU000
Revenue 60
60 of CU100,000 Cost of sales costs to date
48 60 of CU80,000
Profit 12
60 of CU100,000 – CU80,000
Illustration 2
The following information relates to a cost plus contract obtained by a business with a 30 June year end:
2007 2008
CU000 CU000
Cumulative costs incurred on work to date 100
150 Agreed profit as a percentage of costs
20 20
The outcome of the contract can be estimated reliably at both year ends. To prepare the statement of comprehensive income for each of the two years, the business
calculates the costs incurred, assesses the profit that should be recognised and inserts
