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reporting papers will often come across the concept of accounting for construction contracts. Depending on the

reporting studies, accounting for construction contracts can become quite complex but with adequate question practise, they can become very simple. The key to these types of ques-tions is to do them in a method-ical format.

Accounting for construction con-

tracts is dealt with in IAS 11 Con-

struction Contracts. This article will

look at the core principles involved

in IAS 11 and at the end of the ar-

ticle will look at a worked example.

a construction contract actually is.

According to IAS 11, a construction

entered into for the construction

of an asset or a combination of

assets that are closely interrelated

or interdependent in terms of their

design and function or their end

use or purpose.’

The principal concern of account-

ing for long-term construction

contracts involves the timing of

-

tion. Contracts can last for several

years and a standard was therefore

required to deal with revenue

recognition in relation to long-term

construction contracts.

To avoid distortions in the presen-

-

ments, the percentage of comple-

tion method was developed which

reports the revenues proportionally

to the degree to which the projects

are being completed.

Percentage of Completion MethodThe percentage of completion

method is a method of account-

ing that recognises income on a

contract as work progresses by

matching contract revenue with

contract costs incurred, based on

the proportion of work completed.

The problem in dealing with the

percentage of completion method

lies in accurately deciphering the

extent to which the projects are be-

of the entity to actually bill and

collect for the work done.

The percentage of completion

method uses the contract account

to accumulate costs and to recog-

nise income. Under the provisions

of IAS 11, income is not based

on advances (cash collections) or

progress billings. Any advances and

progress billings are based on con-

tract terms that do not necessarily

measure contract performance.

Where costs and estimated earn-

ings in excess of billings occur, the

billings exceed costs and estimated

earnings, the difference is treated

as a liability.

There are two ways in which the

stage of completion can be calcu-

lated:

Work certi-

Cost Method Total costs incurred

todate / total contract costs

Contract CostsAll contract costs are costs that

contract plus those that are directly

attributable to contracting activity

in general and can be allocated

to the contract and those that

are contractually chargeable to a

customer. Examples of such costs

could be:

Steve Collings, FMAAT FCCAFCCA is the audit and technical partner at Leavitt Walmsley Associates Ltd and the author of ‘The Interpretation and Application of International Standards on Auditing’ (Wiley March 2011).

Construction

Contracts

IAS 11

May/June 2011

Technical22 23globalaccountantmagazine.com

construction contract.

directly attributable to the

contract.

assistance.

machinery to complete the

contract.

of plant and machinery used in

the construction contract.

IAS 11 recognises two types of

construction contract that are

distinguished according to their

pricing arrangements:

Fixed price contracts are con-

tracts for which the price is not

usually adjusted due to costs

incurred by the contractor. Where

contract, this essentially means

that the contractor agrees to a

per unit of output. These types of

contracts are sometimes subject to

escalation clauses.

Cost plus contracts are where the

contractor is reimbursed for costs

plus a provision for a fee. The

contract price is determined by

the total amount of reimbursable

expenses and a fee. The fee is the

as revenue less direct costs to be

earned on the contract.

Recognition of Contract Revenue and ExpensesIAS 11 prohibits the use of the

percentage of completion method

if this method will not result in the

reasonable level of accuracy. It fol-

lows, therefore, that the percentage

of completion method can only

be used where the outcome of the

contract can be estimated reliably.

Where the contract is either a

contract, then the following criteria

must be met to determine whether

the outcome can be reliably esti-

mated:

Fixed price contract:

laid down in the Conceptual

Framework which is that total

contract revenue can be mea-

sured reliably and it is probable

to the entity.

-

plete and the stage of comple-

tion can be measured reliably.

properly and measured reliably

so that comparison of actual

contract costs with estimates

can be done.

Cost plus contract:

to the contract, whether or not

and measured reliably.

All the conditions above must be

Example 1A company enters into a 2-year

contract. The project manager

is unsure whether the contract

Costs incurred todate amount to

$10,000.

As the outcome of the contract

cannot be estimated, the amount

of revenue to be recognised in

-

ments is the same as the costs

being taken, so:

DR receivables $10,000

CR revenue $10,000

Outcome of the Contract is

revenue should be recognised by

reference to the stage of comple-

tion. Costs incurred in reaching

the stage of completion are taken

to the income statement as cost

of sales. This is achieved by the

percentage of completion to the

total costs that are expected to

occur over the life of the contract.

An illustration of how this works is

shown at the end of the article.

Worked ExampleLeah Inc reports under IFRS and is

for the year ended 31 March 2009.

On 1 October 2008, Leah Inc com-

menced work on a contract. The

price agreed for the contract was

purchased plant at a cost of $15 mil-

lion exclusively for use on the con-

tract. The directors of Leah Inc have

estimated that the plant will have

no residual value at the end of the

30 September 2009. Costs incurred

on the contract plus estimated costs

to complete are as follows:

Outcome of the Contract is Loss-MakingWhere contracts are loss-making,

revenue is recognised by reference

to the stage of completion and

which generates the required loss.

Example 2Lucas Inc has a contract that

is expected to make a loss of

calculated that the amount of the

contract revenue to be recognised

is $800.

The income statement will include

$800 worth of contract revenue.

The loss is estimated to be $1,000

so cost of sales will be $1,800 to

generate the required loss (i.e. a

This method is used because IAS

11 stipulates that losses must be

recognised in the income state-

ment as soon as they are foreseen.

Costs to date

Estimate of costs

to complete

Materialspurchased 9,000 5,000

Labourand other overheads

7,000 8,000

Outcome of the Contract Cannot be Estimated ReliablyWhere the outcome of a contract

cannot be estimated reliably, con-

tract costs and revenues should be

recognised by reference to the stage

of completion.

Revenue should be recognised only

to the extent of the contract costs

incurred that are probable of being

recovered, so therefore revenue will

as shown in the following example:

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May/June 2011

All the costs which have been in-

curred todate have all been debited

to the contract account in the gen-

eral ledger. Leah Inc have appointed

the reporting date (31 March 2009),

the contract was 40% complete at

which point the customer made a

progress payment amounting to £15

have credited this progress pay-

ment to the contract account. There

have been no other entries made in

respect of this contract.

RequiredShow how the contract should be

accounted for under the provi-

statements of Leah Inc for the year

ended 31 March 2009.

SolutionThe overall revenue for the contract

price agreed).

We know that Leah has incurred

the following costs and has made

estimates of costs to complete as

follows:

As costs are less than total

revenue we know the

of ($50 million less $44 million =

$6 million).

that the contract is 40%

Financial Statement Extracts

Revenue(40% x $50

million)$20,000

Cost of sales

(40% x $44

million)$17,600

Step 1

Working: Gross Amounts Due from

Costs to date: $,000 $,000

Purchase of materials 9,000 $17,600

Labour and other overheads 7,000

Plant depreciation ($15,000 x 6/12) 7,500

Total costs to date 23,500

6,000

29,500

Less progress payment received (15,000)

Gross amount due from customer 14,500

Step 2

Purchase of machine $15,000

Purchase of machine $ 9,000

Labour and overheads $ 7,000

Estimated costs to complete $13,000

$44,000

Step 3

complete, so we take 40% of the

total costs to ‘cost of sales’ in the

income statement. We then add

40% of the expected revenue to

revenue in the income statement:

We then need to work out

how much should be in

-

tion as ‘gross amounts due from

customer’. We need a working as

follows:

The gross amount due

from customer can be

shown as an ‘other current asset’ in

Step 4

ConclusionIt is important that when you are dealing with construc-tion contract questions that you adopt a logical method of dealing with the numbers and are familiar with how to

depending on whether a con-

or uncertain. Once you have mastered the approach and understand how IAS 11 works, questions on construction contracts become a favourite topic. Lots of question prac-tise is the key to this area of

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