CONSTRUCTION CONTRACTS

Question 1

Why are construction contracts different to other contracts?

Answer 1

Generally last over a long period of time, longer than one accounting period.

Question 2

IAS 11 CONSIDERATIONS

Answer 2

Deals with profit allocation - focus on the income statement.
IASB Framework concentrates on identification of assets and liabilities - Focus on SofP

Question 3

Why are special rules required for construction contracts?

Answer 3

To recognise a true and fair view, profit from the activity should be recognised over the period that the contract activity takes place.
This would imply recognition of turnover & matching of costs and consequently the recognition of profit.
To avoid manipulation of results (IS)
-Delay recognition delaying completion
-By separation/aggregation of project or accelerating profit.

Question 4

CONSTRUCTION CONTRACT

Answer 4

Is a contract specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use.

Question 5

What are the two types of construction contract?

Answer 5

Fixed price contract

Cost plus contract

Question 6

FIXED PRICE CONTRACT

Answer 6

A construction contract in which the contractor agrees to a fixed contract price or a fixed rate per unit of output, which in some cases is subject to cost escalation clauses.

Question 7

COST PLUS CONTRACT

Answer 7

A construction contract in which the contractor is reimbursed for allowable or otherwise defined costs, plus a percentage of these costs or a fixed fee.

Question 8

What happens when more than one item is being constructed?

Answer 8

Many contracts can cover the construction of a number of assets and in these cases each asset must be treated as a separate contract if (para 8):

• separate proposals have been submitted for each asset.
• each asset has been subject to separate negotiations and the contractor and customer have been able to accept or reject that part of the contract relating to each asset
• The costs and revenues of each asset can be identified

Question 9

What should contract revenue comprise of?

Answer 9

para 11:
Contract revenue shall comprise:
a) the initial amount of revenue agreed in the contract; and
b) variations in contract work, claims and incentive payments:
i) to the extent that it is probable that they will result in revenue; and
ii) they are capable of being reliably measured.

variations are common due to the time taken to complete these contracts
Can only be included if it is probable the customer will accept the claim AND amount can be reliably measured.

Question 10

What do contract costs comprise of?

Answer 10

para 16:
Contract costs shall comprise:
a)costs that relate directly to the specific contract;
e.g. material, labour, Depn of P&M used on construction, plant hire etc.

b) costs that are attributable to contract activity in general and can be allocated to the contract;
e. g. insurance, overheads (such as processing payroll) provided these are allocated systematically.

c) such other costs as are specifically chargeable to the customer under the terms of the contract.

Question 11

How much do we recognise as revenue and expenses?

Answer 11

IAS 11 (para 22)
When the outcome of a construction contract can be estimated reliably, contract revenue and contract costs associated with the construction contract shall be recognised as revenue and expenses respectively by reference to the stage of completion of the contract activity at the end of the reporting period. 
An expected loss on the construction contract shall be recognised as an expense immediately in accordance with para 36.

Question 12

How do we judge the stage of completion?

Answer 12

Revenue and expenses are calculated by reference to stage of completion.

The stage of completion of a contract is determined by the method that measures reliably the work performed and this could be:

• proportion that costs incurred for work to date bear to total estimated costs
• surveys of work performed; or
• completion of a physical proportion of the contract work

Question 13

Assessment of percentage completion method.

Answer 13

The percentage completion method:

• Smooths the profit over the life of the contract rather than taking all profit at the end of the contract life.
• Depends on reliable assessment by management of percentage complete
• Depends on a subjective judgement by management on the future outcome of the contract

useful information will be provided if the percentage completion method provides relevant information that gives a faithful representation of the transaction.

Question 14

Conceptual Framework considerations

Answer 14

• Information given in relation to construction contracts is prudent
• information given tries to follow the accruals concept with revenue and expenses matched with the period they are earned.
• information should be relevant, but is there a question over faithful representation of the transaction? (complete, neutral and free from error?)

Question 15

AMOUNT OF THE CONTRACT EARNED

Answer 15

41 Appropriate methods of measuring progress include output methods and input methods

Question 16

OUTPUT METHOD

Answer 16

B15-B17
B15 … Output methods include methods such as surveys of performance completed to date
B17 The disadvantages of output methods… outputs used to measure progress may not be directly observable and the information required to apply them may not be available to an entity without undue cost/ Therefore and input method may be necessary.

Question 17

INPUT METHOD

Answer 17

B18 Input methods recognise revenue on the basis of the entity’s efforts or inputs to the satisfaction of a performance obligation.