Construction contracts – Part 2

1. Construction contracts – Part 2 Management Level – Paper F2 Advanced Financial Reporting Lecture - 016 Vidya Rajawasam ACMA CGMA MBA

2. Construction contracts We have discussed the subject area related • Introduction to Construction contracts (IAS 11) in our previous lecture.

3. Construction contracts • In this lecture we will discuss the Further aspects of Construction contracts (IAS 11)

4. Construction contracts IAS 11 In the absence of IAS 11, contractors may show years of no profit, or losses, followed by a bonanza year of profits at the completion of the project. The aim of IAS 11 is fairly to match activity and profit over the life of the contract. IAS 11 is focused on the profit and loss figures far more than the statement of financial position figures.

5. Construction contracts IAS 11 IAS 11 does not apply to provision of services, nor is there any minimum length of the contact, as long as it spans an accounting period. The aim of IAS 11 is to strike an appropriate balance between imprudently recognizing profits before they are reasonably certain to be earned and mismatching costs and revenues with unfair recognition of profits.

6. Construction contracts IAS 11 - Example, Imagine that you are the accountant at a construction company. Your company is building a large tower block that will house offices, under a contract with an investment company. It will take three years to build the block and over that time you will obviously have to pay for building materials, wages of workers on the building, architects' fees and so on. You will receive periodic payments from the investment company at various predetermined stages of the construction. How do you decide, in each of the three years, what to include as income and expenditure for the contract in the statement of profit or loss and other comprehensive income?

7. Construction contracts IAS 11 - Example A numerical example might help to illustrate the problem. Suppose that a contract is started on 1 January 20X5, with an estimated completion date of 31 December 20X6. The final contract price is $1,500,000. In the first year, to 31 December 20X5: (a) Costs incurred amounted to $600,000. (b) Half the work on the contract was completed.

8. Construction contracts IAS 11 - Example (c) Certificates of work completed have been issued, to the value of $750,000. (Note. It is usual, in a construction contract, for a qualified person such as an architect or engineer to inspect the work completed, and if it is satisfactory, to issue certificates. This will then be the notification to the customer that progress payments are now due to the contractor. Progress payments are commonly the amount of valuation on the work certificates issued, minus a precautionary retention of 10%). (d) It is estimated with reasonable certainty that further costs to completion in 20X6 will be $600,000.

9. Construction contracts IAS 11 - Example What is the contract profit in 20X5, and what entries would be made for the contract at 31 December 20X5 if: (a) Profits are deferred until the completion of the contract? (b) A proportion of the estimated revenue and profit is credited to the profit or loss in 20X5?

10. Construction contracts IAS 11 - Solution, (a) If profits were deferred until the completion of the contract in 20X6, the revenue and profit recognised on the contract in 20X5 would be nil, and the value of work in progress on 31 December 20X5 would be $600,000. IAS 11 takes the view that this policy is unreasonable, because in 20X6, the total profit of $300,000 would be recorded. Since the contract revenues are earned throughout 20X5 and 20X6, a profit of nil in 20X5 and $300,000 in 20X6 would be contrary to the accruals concept of accounting.

11. Construction contracts IAS 11 - Solution, (b) It is fairer to recognize revenue and profit throughout the duration of the contract. As at 31 December 20X5 revenue of $750,000 should be matched with cost of sales of $600,000 in the statement of profit or loss and other comprehensive income, leaving an attributable profit for 20X5 of $150,000. The only entry in the statement of financial position as at 31 December 20X5 is a receivable of $750,000 recognizing that the company is owed this amount for work done to date. No balance remains for work in progress, the whole $600,000 having been recognised in cost of sales.

12. Construction contracts Example -1, The main business of Santolina Co is construction contracts. At the end of September 20X3 there is an uncompleted contract on the books, details of which are as follows. Date commenced 1.4.X1 Expected completed date 23.12.X3 Santolina Co calculates the stage of completion of contracts using the value of work certified as a proportion of total contract value.

13. Construction contracts Example -1, $ Final contract price 290,000 Costs to 30.9.X3 210,450 Value of work certified to 30.9.X3 230,000 Progress billings to 30.9.X3 210,000 Cash received to 30.9.X3 194,000 Estimated costs to completion at 30.9.X3 20,600

14. Construction contracts Example -1, Required Prepare calculations showing the amounts to be included in the statement of profit or loss and the statement of financial position at 30 September 20X3 in respect of the above contract.

15. Construction contracts Example -1; Answer , Tutorial note: you should first determine whether the contract is profitable or loss making $ Final contract price 290,000 Less: costs to date (210,450) estimated future costs (20,600) Estimated final profit 58,950

16. Construction contracts Example -1; Answer , Stage of completion = Total contract price / Work certified = 290,000 / 230,000 = 79.3% Amounts recognised in the statement of profit or loss to 30 September 20X3: $ Revenue recognised (work certified) 230,000 Costs recognised (balancing figure) (183,253) Recognised profit (79.3% × 58,950) 46,747

17. Construction contracts Example -1; Answer , Amounts recognised in the statement of financial position at 30 September 20X3: $ Costs incurred 210,450 Recognised profits 46,747 257,197 Less: progress billings to date (210,000) Gross amount due from customers (asset) 47,197

18. Construction contracts Example -1; Answer , Amounts recognised in the statement of financial position at 30 September 20X3: Recognize an asset in the statement of financial position under current assets: Gross amounts due from customers $47,197 There will also be a receivable balance for the progress billings not yet received in cash of 210,000 – 194,000 = $16,000.

19. Construction contracts Review MCQs The Accounting standard related to Construction contracts is ? • IFRS 2 • IAS 11 • IAS 39 • Non of the above.

20. Construction contracts Review MCQs The Accounting standard related to Construction contracts is ? • IFRS 2 • IAS 11 • IAS 39 • Non of the above.

21. Construction contracts Review MCQs What statement is true with regard to construction contracts ? • A contract specifically negotiated for the construction of an asset or group of assets. • A contract negotiated through loan financing. • A contract negotiated through franchise agreement. • Non of the above.

22. Construction contracts Review MCQs What statement is true with regard to construction contracts ? • A contract specifically negotiated for the construction of an asset or group of assets. • A contract negotiated through loan financing. • A contract negotiated through franchise agreement. • Non of the above.

23. Construction contracts Example – 2 A construction contractor has a fixed price contract to build a bridge. The initial amount of revenue agreed in the contract is $9,000. The contractor’s initial estimate of contract costs is $8,000. It will take three years to build the bridge. By the end of year 1, the contractor’s estimate of contract costs has increased to $8,050. In year 2, the customer approves a variation resulting in an increase in contract revenue of $200 and estimated additional contract costs of $150. At the end of year 2, costs incurred include $100 for standard materials stored on site to be used in year 3 to complete the project.

24. Construction contracts Example – 2 The contractor determines the stage of completion of the contract by calculating the proportion that contract costs incurred for work performed to date bear to the latest estimated total contract costs. A summary of the financial data during the construction period is as follows: Year 1 Year 2 Year 3 Initial amount of revenue agreed $ $ $ in contract 9,000 9,000 9,000 Variation – 200 200 Total contract revenue 9,000 9,200 9,200

25. Construction contracts Year 1 Year 2 Year 3 $ $ $ Contract costs incurred to date 2,093 6,168 8,200 Contract costs to complete 5,957 2,032 – Total estimated contract costs 8,050 8,200 8,200 Estimated profit 950 1,000 1,000 Stage of completion 26% 74% 100% The stage of completion for year 2 (74%) is determined by excluding from contract costs incurred for work performed to date the $100 of standard materials stored at the site for use in year 3.

26. Construction contracts The amounts of revenue, expenses and profit recognised in the statement of profit or loss and other comprehensive income in the three years are as follows: Recognised in Recognised in To date prior years current year Year 1 $ $ $ Revenue (9,000  26%) 2,340 – 2,340 Expenses (8,050  26%) 2,093 – 2,093 Profit 247 – 247

27. Construction contracts The amounts of revenue, expenses and profit recognised in the statement of profit or loss and other comprehensive income in the three years are as follows: Recognised in Recognised in To date prior years current year Year 2 $ $ $ Revenue (9,200  74%) 6,808 2,340 4,468 Expenses (8,200  74%) 6,068 2,093 3,975 Profit 740 247 493

28. Construction contracts The amounts of revenue, expenses and profit recognised in the statement of profit or loss and other comprehensive income in the three years are as follows: Recognised in Recognised in To date prior years current year Year 3 $ $ $ Revenue (9,200  100%) 9,200 6,808 2,392 Expenses 8,200 6,068 2,132 Profit 1,000 740 260

29. Construction contracts Example – 3 - Construction contracts Noah has a three year contract which commenced on 1 January 20X5. At 31 December 20X5 Noah extracted the following balances from its ledger relating to the contract: $000 $000 Total contract value 140,000 Cost incurred up to 31 December 20X5: Attributable to work completed 52,000 Inventory purchased for use in future years 8,00060,000

30. Construction contracts Example – Construction contracts Noah has a three year contract which commenced on 1 January 20X5. At 31 December 20X5 Noah extracted the following balances from its ledger relating to the contract: $000 $000 Progress billing to date 45,000 Cash received 26,500 Other information: Expected further costs to completion 48,000

31. Construction contracts Example – Construction contracts Noah has a three year contract which commenced on 1 January 20X5. At 31 December 20X5 Noah extracted the following balances from its ledger relating to the contract: At 31 December 20X5, the contract was certified as 40% complete. Prepare extracts from the statement of profit or loss and statement of financial position for the year ended 31 December 20X5, as required by IAS 11 Construction Contracts.

32. Construction contracts Answer – Construction contracts Statement of profit or loss (extract) $000 Revenue (40% x 140,000) 56,000 Cost (β) (43,200) Profit 12,800

33. Construction contracts Answer – Construction contracts Statement of financial position (extract) Current assets $ Costs incurred to date 52,000 Recognised profits 12,800 Recognised losses (-) Progress billings to date (45,000) Gross amount due from/(to) customers 19,800 Receivables (45,000 – 26,500) 18,500

34. Construction contracts Answer – Construction contracts Workings $000s Total revenue 140,000 Total costs (60,000 + 48,000)) (108,000) Profit 32,000 @ 40% 12,800

35. Construction contracts Review MCQs The true statement with regard to accounting treatment related construction contracts ? • Contract revenue is not recognized until the completion of contract. • Contract revenue is recognized from the 2nd year onwards. • Contract revenue is recognized when the work is performed. • Non of the above

36. Construction contracts Review MCQs The true statement with regard to accounting treatment related construction contracts ? • Contract revenue is not recognized until the completion of contract. • Contract revenue is recognized from the 2nd year onwards. • Contract revenue is recognized when the work is performed. • Non of the above

37. Construction contracts Review MCQs As per IAS 11, which methods are used to measure the stage of completion of contract ? • Proportion of contract costs incurred for work carried out to date; • Proportion of contract Revenue incurred for work carried out to date; • Physical proportion of work in progress. • Non of the above

38. Construction contracts Review MCQs As per IAS 11, which methods are used to measure the stage of completion of contract ? • Proportion of contract costs incurred for work carried out to date; • Proportion of contract Revenue incurred for work carried out to date; • Physical proportion of work in progress. • Non of the above

39. Construction contracts Lecture Summary • Further aspects of Construction contracts (IAS 11)

40. Construction contracts – Part 2 Management Level – Paper F2 Advanced Financial Reporting Lecture - 015 Vidya Rajawasam ACMA CGMA MBA