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

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 revenue as the balancing figure. In the second year deductions are made for values already
recognised in profit or loss.

2007

Costs CU100,000

Profit CU100,000 x 20% = CU20,000

Revenue Costs + profit = CU100,000 + CU20,000 = CU120,000

2008

Costs CU150,000 to date, less CU100,000 recognised in 2007 = CU50,000

Profit CU50,000 x 20% = CU10,000

Revenue Costs + profit = CU50,000 + CU10,000 = CU60,000

Where the outcome of the project cannot be measured reliably, which may be the case during
the early stages of construction, then revenue should only be recognised to the extent that
costs are recoverable, although the costs should be recognised as an expense as they are
incurred. As the project progresses, the likelihood of being able to assess reliably the
outcome of the project will improve, to the point where the stage of completion method should
be used to assess the revenue and costs that should be recognised. [IAS 11.32, 11.35]

Illustration 3

A business is not able to measure reliably the outcome of a contract, but estimates
that all costs incurred are recoverable from the customer. The following details are
available:

CU000

Estimated contract revenue 100

Costs to date 30

The amounts to be recognised in the statement of comprehensive income are:

CU000

Revenue 30

Cost of sales (costs to date) 30

Profit Nil

5.3 Loss making contracts

Where the revenue and costs in a contract have been assessed and it is expected that a loss
will be incurred, that loss should be recognised as an expense immediately. The loss should
not be deferred until the project is completed or spread over the period of the contract.
[IAS 11.32, 11.36]

This means that when a loss has been identified, there is no need to estimate the contract’s
stage of completion.

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 Illustration 4

The following details relate to a contract expected to be loss making:

CU000

Estimated contract revenue 100

Costs to date 72

Costs to complete 48

Total estimated costs 120

Stage of completion 60%

(costs incurred method)

Estimated overall loss 20 (CU120,000 – CU100,000)

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) 72

Loss 12

Provision for full contract loss 8 (CU20,000 – CU12,000)

Expected contract loss 20

6 Disclosure
A breakdown of amounts recognised in respect of construction contracts should be disclosed.
Such amounts include the amount of contract revenue recognised in the period, the total
costs incurred to date (i.e. on a cumulative basis rather than for the period) and the aggregate
profits recognised to date. [IAS 11.39, 11.40]

The entity should clearly explain the methods used to determine both contract revenues and
the stage of completion. [IAS 11.39]

Amounts recognised in the statement of financial position in relation to the contract should
also be disclosed, including the gross amounts due from customers and recognised as an
asset and any amounts that are due to the customer that have been recognised as a liability
at the end of the reporting period. [IAS 11.42]

Other disclosable amounts which may arise under a contract are any advances received from
customers and any retentions, being amounts held back by the customer as security for any
rectification work required, under the contract. [IAS 11.40]

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7 Chapter Review
This chapter has been concerned with the key issues relating to construction contracts,
including how profits are accounted for over the accounting periods in which construction
work is performed.

This chapter has covered:

 the objectives, scope, definitions and disclosure requirements of IAS 11;

 what can and cannot be treated as contract costs under IAS 11;

 the requirement that contract revenues and contract costs (and therefore contract
profit) should be recognised once the outcome of the contract can be estimated
reliably;

 the application of the recognition criteria to fixed price and cost plus contracts;

 how to deal with contract revenues and costs under the stage of completion method
when the outcome can be measured reliably; and

 the requirement to recognise contract losses immediately.

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8 Self Test Questions
Chapter 26

1. According to IAS11 Construction contracts, an entity should disclose which

TWO of the following?

A For each material contract, the aggregate costs incurred

B The methods used to determine the contract revenue recognised in
the period
C Advances received in cash, analysed according to each material
contract
D Total amount of contract revenue recognised in the period

2. Under IAS11 Construction contracts, when it is probable that total contract

costs on a fixed price contract will exceed total contract revenue, the
expected loss should be

(select one answer)

A set off against profits on other contracts where available

B recognised as an expense immediately, unless revenue to date
exceeds costs to date
C apportioned to the years of the contract according to the stage of
completion method
D recognised as an expense immediately

3. The Hogbean Company is a construction company that has the following

costs on its contracts:

(1) Project managers' costs

(2) Destruction of an existing building
(3) Restoration of an old factory.

According to IAS11 Construction contracts, which costs may be included

within contract costs?

A Cost (1) and cost (2) only

B Cost (1) and cost (3) only
C Cost (2) and cost (3) only
D Costs (1), (2) and (3)

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4. The Donovan Company is nearing completion of a construction contract. The
work has not gone to plan due to the issues outlined below.

(1) The client has requested a variation in the contract by requiring new security devices to be
fitted, at an additional cost to Donovan of CU1.0 million. The client has accepted
responsibility for these additional costs even though they were not originally agreed.

(2) Donovan has carried out additional work on the contract as there had been building errors.
This cost CU2.5 million and the client refuses to accept responsibility.

Which, if either, of the above issues should be included in contract revenue,

according to IAS11 Construction contracts?

A Neither issue
B Issue (1) only
C Issue (2) only
D Both issue (1) and issue (2)

5. According to IAS11 Construction contracts, which ONE of the following

projects undertaken by an entity should be accounted for as a construction
contract?

A An item of plant and machinery being constructed to be sold as

inventory
B An office block being constructed as an investment property
C A warehouse being constructed for the entity's own use
D A large boat being constructed for a third party under a specifically
negotiated contract

6. The Phalangium Company, a construction company, has a 31 December year

end. It is to build a factory for a client and has scheduled its work as follows:

Date Description
20 March 20X8 Contract to be awarded and signed
25 April 20X8 Construction work to commence
27 November 20X8 Principal construction work to be completed
30 December 20X8 Final completion of contract

In accordance with IAS11 Construction contracts, the maximum expected

period over which the costs attributable to the contract should accumulate is

A 20 March 20X8 to 30 December 20X8

B 25 April 20X8 to 27 November 20X8
C 25 April 20X8 to 30 December 20X8
D 20 March 20X8 to 27 November 20X8

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7. According to IAS11 Construction contracts, which TWO of the following could
be valid reasons why the expected revenue from a fixed price construction
contract has increased from the original contract value?

A The costs in the contract have increased and the contract includes
cost escalation clauses
B The contractor has incurred additional costs due to errors made by its
employees
C The contractor has agreed variations to the contract with the client
D The contractor would receive an incentive payment if work continues
at the present rate for the next two years

8. The Tigridia Company has entered into a 5 year fixed price construction
contract to build a factory. The contract value is CU20.0 million and the
estimated costs are CU16.0 million.

At the end of the first year, Tigridia can estimate the outcome of the contract
reliably. It has received cash payments to the value of CU8.6 million and
incurred costs of CU6.0 million.

At the end of the first year, what amount should be recognised as revenue in
the financial statements, according to IAS11 Construction contracts?

A CU3.20 million
B CU7.50 million
C CU6.00 million
D CU8.60 million

9. The Toucan Company has just completed a 4 year contract to which the
following relate:

CU'000
Labour and materials costs 1,800
Machinery cost 600
Initial design costs 100
Disposal proceeds of machinery 50

What are the total contract costs, according to IAS11 Construction contracts?

A CU2,350,000
B CU1,900,000
C CU2,450,000
D CU2,500,000

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10. The Pine Company is attempting to determine the total revenue on a contract
to build a factory for The Aster Company. All calculations are in accordance
with IAS11 Construction contracts, and Pine has identified the following:

Initially agreed fixed contract CU800,000

price
Variation in the contract (see CU100,000
Note 1)
Penalty (see Note 2) CU30,000

Note 1 – During the contract Aster changed the specification of the air
conditioning systems. The changed specification has been agreed but a new
contract with the new price has not yet been signed, although an increase in
the contract price of around CU100,000 is highly probable.

Note 2 – A strike at Pine caused a delay for which the penalty in the original
contract was CU30,000. This was agreed by both parties.

At what amount should the total contract revenue be stated?

A CU770,000
B CU900,000
C CU800,000
D CU870,000

11. The Otsembor Company has the following amounts relating to construction
contracts:

Item CU
Costs incurred 670,000
Recognised profits 60,000
Progress billings 250,000

Under IAS11 Construction contracts, what is the gross amount due from
customers for contract work?

A CU480,000
B CU360,000
C CU730,000
D CU980,000

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