Transcript IAS-11 Construction Contracts

Submitted By :- Dushyant Chaturvedi
IAS-11
CONSTRUCTION CONTRACTS
AN OVERVIEW OF THE STANDARD.
Flow Of Information
I.
Purpose of Introduction of Standard.
II.
Applicability of Standard
III.
Combining and Segmenting of Contracts
IV.
Major Definitions
V.
Recognition of Revenue and Costs
VI.
Disclosure Requirements
VII.
Detailed Example of one Contract for three years covering each area of Standard
Purpose of Introduction of Standard.

Construction Contracts are generally long term in nature and the activity
usually falls into different accounting periods. Thus the date on which the
contract is entered and the date when the activity is completed fall into
different accounting periods.
 Therefore an approach, different from ‘as earned’ approach as prescribed in
IAS 18 for revenue recognition, was required to account for long term
construction contracts.

Thus the primary purpose of introduction of IAS 11 is


To Prescribe the Accounting Treatment of Revenue & Cost Associated with
Construction Contracts.
and
To provide practical guidance on the application of above mentioned criteria.
Does that mean a contract shall last for more than One Accounting Period ?
 No
e.g.
A company completes a material short term contract just after the year end, but a substantial part of the work is
completed before the year end.
In such a case IAS-11 shall apply because if revenue & cost is not attributed to the current period , this might not
give a fair picture of its results & financial position.
e.g.
Whether IAS 11 would apply to short term contracts, which do not take 3 months to complete?

Assuming that these contracts complete in same accounting period, allocation of contract revenue & cost to
different accounting period does not arise.

However, disclosure requirement of IAS 11 would nevertheless apply to such standards.
CONCLUSION
If a short term contract straddle an accounting period - then both accounting & disclosure requirement IAS 11 applies.
If it doesn't - only disclosure requirement of IAS 11 applies.
 THUS IAS 11 APPLIES TO CONSTROCTION CONTRACTS IRRESPECTIVE OF THE TIME OF EXECUTION OF THE
CONTRACT.
Applicability of the Standard
 Applied in accounting for construction contracts in the financial
statements of contractors.

Where a Construction Contract
•
is a contract specifically negotiated for the
•
•
•
•
construction of an asset or combination of assets
that are closely interrelated or interdependent
in terms of their design, technology and function
or their ultimate purpose or use.
and includes:
1) Contract for rendering of services which are directly related to the
construction of asset(e.g. Architect ).
2) Contract for destruction or restoration of assets, and the restoration
of environment following the demolition if asset.
Further Analysis Of Applicability
Thus IAS 11 applies in case of Construction of asset and not Manufacturing.
“Manufacturing is a process dominated approach where manufacturer tends to
make same product over and over. Whereas construction implies a project
dominated approach, where constructor makes a unique product one at a
time.”
Thus if a company constructs a piece of equipment for :
• A third party in accordance with the specific needs of a customer
- IAS 11 applies
• Future sale
- IAS 2 applies
• Own use
- IAS 16 applies
Standard gives example of construction contracts such as a bridge, a building, a dam, a
road, a ship, a tunnel etc.
Further Analysis Of Applicability
Also a construction contract may be for a number of asset that are closely related or
interdependent.
For e.g.
Construction of a Refinery would entail construction of various types of
complex equipments and machineries. But the ultimate use of construction of
all such individual assets is to assist the process of refining. Hence these could
be said to be closely interrelated and interdependent.
Contracts for rendering of indirect service would not attract the applicability of IAS11 .
For e.g.
Providing of strategic consulting service to an enterprise would not attract
applicability of IAS 11.
Whereas those for the service of project manager can be directly related to the
construction of asset and hence accounted for in accordance with IAS 11.
Combining & Segmenting
A contract is generally negotiated as one package deal

and therefore the margin on the contract as a whole is considered to be the margin of its individual
components too.
Thus usually IAS 11 applies to each construction contract separately.
However ,in certain circumstances, it is necessary to apply IAS 11 to
 Separate identifiable components of a single contract
 Or to a group of contracts together
 In order to reflect the substance of contract or a group of contracts
 And hence the need for combining and segmenting.
Combining & Segmenting Contd….
Segmenting
If a single contract covers no. of assets, each asset should be treated as separate construction
contract if
-
SEPARATE PROPOSAL has been submitted for each asset;
And
-
Each contract is subject to SEPARATE NEGOTIATION**;
And
**
Cost / Revenue of each asset can be IDENTIFIED.
If neither the contractor nor the customer has the power to accept or reject a part of contract - then the contract cannot
be said to subject to separate negotiation.
Combining
Group of contract to be treated as a single construction contract when
Group of contracts is NEGOTIATED as a SINGLE package
And
-
The contracts are closely INTERRELATED.
And
-
Contracts are performed CONCURRENTLY or CONTINUOUSLY.
“Combining / Segmenting are not optional but depends upon the criteria discussed above”.
Illustration (Combining & Segmenting)
Suppose a company has invited tenders for construction of a factory and a township that includes a
residential complex, school, garden, hospital, club, sewage system etc. The tender offer requires
estimates to be made and disclosed in the tender for each of these components separately. However
the contract will be awarded lump-sum.
Following are the noteworthy points in this contract:
1).
The group of contracts in this case is negotiated as a single package;
And
2).
The group of contract are closely interrelated, in effect,
part of a single project with an overall profit margin;
And
3).
The factory & township will be constructed simultaneously and
will be completed almost at the same time.
Since all these conditions are fulfilled, this becomes a perfect example of Combining of Construction
Contracts.
In the above case construction of each asset cannot be treated as separate construction contracts
because:
 Neither a separate proposal for each asset was submitted.
 Nor they has been subject to separate negotiation.
Combining & Segmenting Contd….
When a single contract covers several elements of a transaction“ they are needed to be unbundled and accounted for separately”.
But unbundling could be done only if:1).
2).
These several components are sold separately in ordinary course of business of the entity.
(+)
Fair value of each component could be objectively determined.
For e.g.
Under a single contract an entity may supply customised computer system and also provides
maintenance services for period after the system has been delivered.
In such a situation it may be necessary to unbundle the element of the contract relating to the
supply of the system from the element relating to the maintenance service.
 Presuming that the above mentioned conditions have been duly fulfilled. Here, construction of
customized computer system shall be accounted for as construction contract under IAS 11 &
the maintenance services will be recognised as per IAS 18.
Major Definitions
Contract Revenue
Initial amount + Variations
+
Claims + Incentives
As agreed by customer and
Due to instructions of
Reimbursement for cost
Additional amount
contractor
customer for change in
not included in contract
payable for meeting
scope of work
price
the standards
Major Definitions Contd…..
Contract Revenue –
is measured at the fair value** of the consideration received or receivable.
The measurement of contract revenue is affected by variety of uncertainties
that depend on outcome of future events. Therefore the estimates often
need to be revised when these uncertainties are resolved.
**
Since the IAS follows the fair value concept, then where the payment is
received in arrears to such an extent that the fair value of the consideration
is less than the nominal amount of cash received or receivable
 Than it would be necessary to discount the revenue to fair value.
 Such discount shall be credited to Finance Income.
Major Definitions Contd….
Contract Cost
Directly Related + Attributable Cost + Specifically Chargeable
e.g. Labour cost, Supervision,
Depreciation, Warranty etc.
e.g. Insurance, Construction Overhead,
Borrowing cost as per IAS-23
e.g. Any Reimbursement Specified in
the Contract.
Major Definitions Contd….
Cost of Securing a Contract.
Cost incurred for preparing/presenting the bid including external consultancy fees etc.
Included as a Part of Contract Cost If Such Cost –
 Is Separately Identifiable.
 Could be Measured Reliably
 & it is Probable that the Contract will be Obtained.
“Therefore significant costs are treated as recoverable once the management consider that it is
probable that the contract will be won. This is generally presumed to be when preferred bidder
status is awarded”.
 Generally if a contract is won before the date of signing of balance sheet than all costs
related to securing such contract can be included as a part of contract cost.
 But where costs of obtaining the contract have been written off in a period prior to that in
which contract is obtained than such cost is not capable of any reversal in the subsequent
period.
Major Definitions Contd….
Contract Cost shall be Reduced by Incidental
Income that is Not Included in Contract Revenue.
For e.g. A construction contract for land reclamation involves clearing old
collieries. As a by-product the company is entitled to sell of any coal that it
recovers.

Here incidental income from coal shall be reduced from the contract cost.
As per IAS-2 “ Valuation of Inventories “
- If cost of main & by-product are not separately identifiable, the allocation of the cost may be based
on the value of relative sales.
- But most of the by-products are immaterial. Hence they are measured at NRV & their value is
reduced from the cost of the main product. As a result carrying amount of main product is not
materially different from its cost.
Major Definitions contd….
Following shall be Excluded from Cost of Construction:1)
General Admin Cost for which reimbursement is not specified in the contract.
2)
Selling Costs.
3)
R&D Cost for which reimbursement is not specified in the contract.
4)
Depreciation of Idle Plant & Equipment .
Period for which Cost is Recognised :01.01.2006
01.04.2006
31.03.2007
06.11.2007
31.03.2008
Date of Securing
the Contract
Date of Reporting
Date of completion
Date of Reporting
Cost Incurred in This Period Shall be Recognised as Contract Cost.
* Cost incurred to secure the contract, if separately identified and reliable measured can form part of contract cost.
Recognition of Contract Revenue and Contract Costs
Conditions for
Recognition of
contract cost
and revenue.
Fixed Price Contracts
Contract revenue can be reliably
measured + It is probable that economic
benefit flow to the enterprise + Contract
cost and stage of completion at B/S
date can be reliable measured + actual
cost can be identified and compared
with prior estimates.
Cost Plus
Contracts
It is probable that
economic benefit will
flow to enterprise +
contract cost can be
clearly identified and
reliably measured.
Recognition of Contract Revenue and Contract Costs
Conditions
satisfied?
Yes - “ Then
final outcome
of a contract
can be reliably
estimated”.
Recognize revenue/cost with
respect to stage of
completion*
No
Revenue equal to Recoverable
Cost
incurred
will
be
recognized. Contract cost will
be recognised in the period
they are incurred.*
* If it is probable that contract cost will exceed contract revenue – Expected losses will be recognised
immediately.
Recognition of Contract Revenue and Contract
Costs
 It is usually assumed that during the early stages of the contract the
outcome of contract cannot be reliably estimated.
 These early stages could range between 20-25% of the contract
revenue.
 But these limits are subjective and to an extent a judgment have to
be made.
 Contractor with a high degree of experience may ignore these
thresholds.
Recognition of Contract Revenue and Contract Costs
Variation, Claims, Incentives to be recognised :to the extent that it is probable
that they will result in revenue.
&
they are capable of being
reliably measured.
Other Conditions to be Satisfied


For recognising the claims negotiations shall reach an advanced stage.
For recognising incentives contract should be sufficiently advanced that
it is probable that the specified performance standards will be met or
exceeded.
Recognition of Contract Revenue and Contract Costs
Conditions for Including Cost of Variation in
Contract Cost?
 Where it is appropriate to include the amount in
contract revenue
 To the extent such cost are considered to be
recoverable.
“ A degree of skepticism should be used in assessing the
recoverability of such amount”.
An Extract from Annual Report and Account of
Aker ASA (31 December,2005)
“Revenue related to construction contracts is recognised using the percentage of
completion method, based primarily on contract cost incurred to date, compared to
estimated overall contract cost.
If the final outcome of a contract cannot be estimated reliably, contract revenue is
recognised only to extent cost incurred are expected to be recovered. Any projected
losses on future work done under existing contracts are expensed and classified as
accrued costs/provision in the B/S under short term debt. Losses on contracts are
recognised in full when identified. Recognised contract profit includes profit derived
from change orders and disputed amounts when, in management’s assessment,
realisation is probable and reasonable estimate can be made”.
Some Concepts
Methods used for Measuring the Stage of Completion

Proportionate Cost Incurred

Survey of Work Performed

Completion of Physical Proportion of Contract Work
Concepts of CWIP

Contract Cost that Relates to Future Activity

Recognised as an Asset (since such Amount is Due from the Customer)
Uncollectable Amount

Sometimes Uncertainty Arises about the Recovery of an Amount

Will be Recognised as an Expense (not as an adjustment to cost revenue)
Costs to be Excluded

Cost Relating to Future Activity

Advance Payment to Sub Contractors
Contract Costs – Recovery of Which is Not Probable will be Recognised as an Expenses Immediately

Contracts Which are Not Fully Enforceable

Subject to Litigation

Properties Likely to be Condemned or Expropriated.
Disclosures

The Amount of Contract Revenue Recognised.

Method Used to Determine the Contract Revenue and Stage of Completion.
For Contract in Progress it should also Disclose:





Costs Incurred and Recognised Profits upto the reporting date.
Amount of Advance Received .
Amount of Retentions.
Gross Amount Due to the customer.
Gross Amount Due from the customer.
ILLUSTRATION
YEAR
I
YEAR
II
YEAR
III
Initial amount of revenue
agreed in contract
9000
9000
9000
Variation
-
200
200
Total Contract Revenue
9000
9200
9200
Contract Costs incurred upto
the reporting date
2098
6168
8200
Contract costs to complete
5957
2032
0
Total Estimated costs
8050
8200
8200
Illustration cont……..
YEAR
I
YEAR
II
YEAR
III
Estimated Profit
950
1000
1000
Stage of Completion
26%
74%
100%
…………
Illustration cont
Upto Reporting
date
Recognised in
prior year
Recognised in
current year
Year I
Revenue (9000 x 2340
0.26)
2340
Expenses (8050
x 0.26)
2093
2093
Profit
247
247
…………
Illustration cont
Upto Reporting
date
Recognised in
prior year
Recognised in
current year
Revenue (9200 x 6808
0.74)
2340
4468
Expenses (8200
x 0.74)
6068
2093
3975
Profit
740
247
493
Year II
Illustration cont…
Upto Reporting
date
Recognised in
prior year
Recognised in
current year
Revenue (9200 x 9200
1.00)
6808
2392
Expenses (8200
x 1.00)
8200
6068
2132
Profit
1000
740
260
Year III
ILLUSTRATION - DISCLOSURE WORKING
A
B
C
D
E
TOTAL
A. Contract Revenue
recognised
145
520
380
200
55
1300
B. Contract Expenses
recognized
110
450
350
250
55
1215
40
30
70
C. Expected Losses
recognized
D. Recognized Profits
less losses
35
70
30
(90)
(30)
15
E. Contract Costs
incurred in the period
110
510
450
250
100
1420
F. Contract Costs
incurred recognized as
contract expense in the
period
110
450
350
250
55
1215
ILLUSTRATION - DISCLOSURE WORKING
A
G. Contract Costs that relate
to future activity
B
C
60
100
D
E
TOTAL
45
205
H. Contract Revenue
145
520
380
200
55
1300
I. Progress Billing
100
520
380
180
55
1235
-
-
20
-
65
80
20
-
25
125
J. Unbilled Contract Revenue 45
K. Advances
-
Thank You