FR12 - Construction Contracts & Revenue (Stud)

Construction Contracts
& Revenue Recognition

Session 12
AC2091: Financial Reporting
1
Learning Outcomes
• Explain construction contracts and their accounting:
why they are treated differently; their profit
recognition
• Explain the impact of forthcoming changes in
standards on recognising revenues
2
• 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
• May be negotiated for the construction of
– Single asset (e.g. building, bridge)
– Multiple assets (e.g. complex plant or equipment,
refineries)
(IAS 11)
3
Fixed price contract Cost plus contract
o Fixed contract price or fixed o Allowable or defined costs

rate per unit of output reimbursed + percentage of costs
o May be subject to cost or fixed fee
escalation clauses
(IAS 11)
4
• Contract revenue
Variations in
Initial revenue
contract work, Contract
amount agreed in
claims & incentive Revenue
the contract
payments
• Variations are instructions by the customer for

change(s) in the scope of the work to be performed
under the contract
– Included in revenue to the extent that it is probable
that they will result in revenue and they are capable
of being reliably measured
(IAS 11)
5
• Contract costs comprise:
Costs that are Such other costs as

Costs that relate attributable to contract are specifically
directly to the specific activity in general and chargeable to the
contract can be allocated to the customer under the
contract terms of the contract
(IAS 11)
6
Contract Costs
Cost Example
Relate directly to a ▪ site labour costs
specific contract ▪ cost of materials
▪ depreciation of plant and equipment used on
the contract
▪ costs of moving plant, equipment and
materials to and from the contract site
▪ costs of hiring plant and equipment;
▪ costs of design and technical assistance that is
directly related to the contract
▪ estimated costs of rectification and guarantee
work, including expected warranty costs
▪ claims from third parties
7
Contract Costs
Cost Example
Attributable to ▪ insurance
contract activity in ▪ costs of design and technical assistance that
general and can be are not directly related to a specific contract
allocated to specific ▪ construction overheads
contracts
Specifically chargeable ▪ general administration costs and
to the customer under development costs for which reimbursement
the terms of the is specified in the terms of the contract
contract
8
• Costs that cannot be attributed to contract activity or
cannot be allocated to a contract are excluded from
the construction contract costs, including
– general administration costs for which reimbursement
is not specified in the contract
– selling costs
– research and development costs for which
reimbursement is not specified in the contract
– depreciation of idle plant and equipment that is not
used on a particular contract
9
– Profit Recognition
• Date at which the contract activity is entered into and
the date when the activity is completed usually fall into
different accounting periods
• Primary issue in accounting for construction contracts is
the allocation ofofcontract
allocation revenue
contract revenue and contract
and contract cost costs to
the accounting periods in which construction work is
performed
– If the realisation concept is applied strictly then the
profit will only be recognised on completion of the
contract, leading to fluctuations in profitability of
companies with significant construction projects
10
– Profit Recognition
• Possible approaches to revenue recognition
– Completed contract method
• All revenue and expenses (and thus profit) are
recognised only after the project has been completed
• Costs incurred and billings recorded in statement of
financial position prior to contract completion and only
transferred to income statement subsequently
– Percentage of completion method
• Revenue and expenses are recognised as a percentage
of the work completed during the period
11
under IAS 11
• General guidelines for revenue recognition provided
in IAS 18 Revenue
• IAS 11 Construction Contracts was established to
provide a separate set of rules in view of
complexities of construction contracts
• IAS 11 and 18 replaced by a joint revenue recognition
standard IFRS 15 Revenue from Contracts with
Customers with effect from 1 January 2018
12
under IAS 11
• Where the outcome of the 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 at the end of the reporting period.
13
under IAS 11
• Fixed price contracts
– Outcome is estimated reliably when:
▪ total contract revenue can be measured reliably
▪ probable that the economic benefits will flow to the
enterprise
▪ costs to complete the contract and the stage of
completion at the balance sheet date can be measured
reliably; and
▪ costs attributable to the contract can be clearly
identified and measured reliably so that actual contract
costs incurred can be compared with prior estimates
14
under IAS 11
• Cost plus contracts
– Outcome is estimated reliably when:
▪ total contract revenue can be measured reliably; and
▪ costs attributable to the contract, whether or not
specifically reimbursable, can be clearly identified and
measured reliably
15
under IAS 11
• Stage of completion method
– contract revenue is matched with the contract costs
incurred in reaching the stage of completion, resulting
in the reporting of revenue, expenses and profit which
can be attributed to the proportion of work complete
sfd
• Determining the stage of completion
– proportion that costs incurred for work performed to
date bear to the estimated total contract costs;
– surveys of work performed; or
– completion of a physical proportion of the contract
work
16
under IAS 11
Determining Stage of Completion
Method Formula
Proportion of costs incurred to Cost of work completed to date
▪
date Total estimated costs
Surveys of work performed Value of work certified to date

▪
Total contract price
Physical proportion of work Built−up area completed

▪
completed Total built−up area
17
under IAS 11
• Attributable profit
– Part of the total profit estimated to arise over the whole
contract that reflects the work performed up to the
balance sheet date
– Anticipated profit is spread over the life of the contract in
proportion to amount of work carried out
– E.g. under the proportion of costs incurred method:
Attributable profit for each year
Cost incurred to date
= [( ) X Total Expected Profit – Profit already recognized ]
Total estimated costs
* Total expected profit = Total contract price – (costs to date + Estimated costs to completion)
18
under IAS 11
• When the outcome of a construction contract cannot
be estimated reliably
– revenue should be recognised only to the extent of
contract costs incurred that it is probable will be
recoverable
– contract costs should be recognised as an expense in
the period in which they are incurred
• Expected loss on the construction contract should be

recognised as an expense immediately
19
under IAS 11
• Contract costs that are not probable of being recovered
are recognised as an expense immediately.
Circumstances include contracts that are:
a) that are not fully enforceable, ie their validity is seriously
in question
b) the completion of which is subject to the outcome of
pending litigation or legislation
c) relating to properties that are likely to be condemned or
expropriated
d) where the customer is unable to meet its obligations; or
e) where the contractor is unable to complete the contract
or otherwise meet its obligations under the contract
20
under IAS 11
• Gross amount due from/to customers
– Shown as an asset/liability respectively
– Costs incurred + recognised profits - the sum of
recognised losses - progress billings
[Progress billings are amounts billed for work performed on a
contract whether or not they have been paid by the customer]
• Construction contract balances

– Cost of a construction contract less amounts
transferred to cost of sales, less foreseeable losses
and less payments on account not matched with
turnover
21
under IAS 11
• Entity shall disclose
a) the amount of contract revenue recognised as
revenue in the period
b) the methods used to determine the contract
revenue recognised in the period; and
c) the methods used to determine the stage of
completion of contracts in progress
• For contracts in progress at balance sheet date

a) the aggregate amount of costs incurred and
recognised profits (less recognised losses) to date
b) the amount of advances received; and
c) the amount of retentions 22
Introduction to IFRS 15
Revenue from Contracts with Customers
• Establishes the principles that an entity shall apply to
report useful information to users of financial
statements about the nature, amount, timing and
uncertainty of revenue and cash flows arising from a
contract with a customer
– Contract: An agreement between two or more parties that
creates enforceable rights and obligations
– Customer: A party that has contracted with an entity to
obtain goods or services that are an output of the entity’s
ordinary activities in exchange for consideration
23
Revenue from Contracts with Customers
• Revenue is recognised when (or as) the entity satisfies a
performance obligation by transferring a promised good
or service (i.e. an asset) to a customer. An asset is
transferred when (or as) the customer obtains control of
that asset
– Performance obligation: A promise in a contract with a customer
to transfer to the customer either a good or service (or a bundle
of goods or services) that is distinct; or a series of distinct goods
or services that are substantially the same and that have the
same pattern of transfer to the customer
– Control: Ability to direct the use of, and obtain substantially all
of the remaining benefits from, the asset. This includes the
ability to prevent other entities from directing the use of, and
obtaining the benefits from, an asset
24
• Revenue recognised using 5-step model
(1) Identify the (2) Identify the

(3) Determine the
contract(s) with a performance
transaction price
customer obligations
(5) Recognise revenue

(4) Allocate transaction
when (or as) entity
price to performance
satisfies a performance
obligations
obligation
25
• Step 1: Identifying the contract(#9)
– Contract
• An agreement between two or more parties that
creates enforceable rights and obligations
– Customer
• A party that has contracted with an entity to obtain
goods or services that are an output of the entity’s
ordinary activities in exchange for
consideration
26
– contract is within the scope of the standard only when
all of the following criteria are met:
• parties to the contract have approved the contract and
are committed to perform their respective obligations
• each party’s rights regarding the goods or services to be
transferred can be identified
• payment terms for the goods or services to be
transferred can be identified
• contract has commercial substance
• it is probable that the entity will collect the
consideration to which it will be entitled 27
– An entity shall combine two or more contracts entered
into at or near the same time with the same customer
(or related parties of the customer) and account for the
contracts as a single contract if one or more of the
following criteria are met:
• the contracts are negotiated as a package with a single
commercial objective;
• the amount of consideration to be paid in one contract
depends on the price or performance of the other
contract; or
• the goods or services promised in the contracts (or
some goods or services promised in each of the
contracts) are a single performance obligation 28
• Step 2: Identify performance obligations (#22)
– assess the goods or services promised in a
contract with a customer and identify as a
performance obligation each promise to transfer
to the customer either:
• a good or service (or a bundle of goods or services) that
is distinct; or
• a series of distinct goods or services that are
substantially the same and that have the same pattern
of transfer to the customer
29
• Step 2: Identify performance obligations (#22)
– A good or service is distinct if:
• It is capable of being distinct
– customer can benefit from the good or service either on
its own or together with other resources that are readily
available to the customer
and
• It is distinct within the context of the contract
– entity’s promise to transfer the good or service to the
customer is separately identifiable from other promises
in the contract
30
• Step 3: Determining the transaction price (#47)
– amount of consideration to which an entity
expects to be entitled in exchange for transferring
promised goods or services
• may include fixed amounts, variable amounts, or both
– Consider uncertainty in variable consideration and
probability of significant reversal of revenue recognised
• adjusted for the effects of the time value of money
if the contract includes a
significant financing component
31
– Variable consideration can be estimated using:
• Expected value
– Sum of probability-weighted amounts in a range of
possible consideration amounts
– Used if an entity has a large number of contracts with
similar characteristics
• Most likely amount
– Single most likely amount in a range of possible
consideration amounts (i.e. the single most likely
outcome of the contract)
– Used if the contract has only two possible outcomes
(e.g. performance bonus) 32
– Financing component
• If the entity has provided settlement terms that include
an interest cost, the interest revenue should be
accounted for separately.
• Further, if the transaction price is not expected to be
paid for more than a year, then the transaction price
must be discounted to recognise the time value of
money.
• An entity shall use the discount rate that would be
reflected in a separate financing transaction between
the entity and its customer at contract inception
33
• Step 4: Allocate the transaction price to the
performance obligations (#73)
– allocates the transaction price to each
performance obligation on the basis of the relative
stand-alone selling prices of each
distinct good or service promised in the contract
– If the good or service is not sold separately, entity
should estimate its stand-alone selling price.
34
• Step 5: Recognise revenue when (or as) a
performance obligation is satisfied (#31)
– entity recognises revenue when (or as) it satisfies
a performance obligation by transferring a
promised good or service to a customer (which is
when the customer obtains control of
that good or service)
– A performance obligation may be satisfied
• at a point in time (typically for promises to transfer
goods to a customer); or
• over time (typically for promises to transfer services to
a customer
35
• Step 5: Recognise revenue when (or as) a performance
obligation is satisfied
– Performance obligations satisfied at a point in time
• Indicators of transfer of control include:
– entity has a present right to payment for the asset
– customer has legal title to the asset
– entity has transferred physical possession of the asset
– transfer of the significant risks and rewards of ownership
of an asset to the customer
– customer has accepted the asset
36
• Step 5: Recognise revenue when (or as) a performance
obligation is satisfied
– Performance obligations satisfied over time
• Control is transferred over time if:
– customer simultaneously receives and consumes the
benefits provided by the entity’s performance as the entity
performs
– the entity’s performance creates or enhances an asset the
customer controls as the asset is created or enhanced
– the entity’s performance does not create an asset with an
alternative use
– to the entity (see paragraph 36) and the entity has an
enforceable right to payment for performance completed
to date
37
• Step 5: Recognise revenue when (or as) a
performance obligation is satisfied
– Performance obligations satisfied over time
Methods for measuring progress include:
• Output methods
– recognise revenue on the basis of direct measurements of
the value of the goods or services transferred to date
– e.g. units produced, milestones, survey of work done
• Input methods
– recognise revenue on the basis of the entity’s efforts or
inputs to the satisfaction of a performance obligation
– e.g. costs incurred, labour or machine hours used
38
under IFRS 15
• Example [construction contract]
– Build-It Ltd commences a contract to construct an
office building for a customer on 1 January 20X7
and estimates that it will be completed by 31
December 20X8. The contract price is $12 million
and in the first year, to 31 December 20X7:
• Costs incurred amounted to $5 million
• Half the work on the contract was completed.
• Billings made for the year amounted to $4 million.
• It is estimated with reasonable certainty that further
costs to completion in 20X8 will be $3 million.
39
under IFRS 15
Step Description Answer
1. Identify the contract

with a customer
2. Identify the separate

performance
obligations in the
contract
40
under IFRS 15
3. Determine the
transaction
price
4. Allocate the transaction
price to the separate
performance
obligations in the
contract.
41
under IFRS 15
– Satisfaction of performance obligation
Criteria Answer
Simultaneous receipt &
consumption of benefit
Asset created or
enhanced by seller is
controlled by buyer
42
under IFRS 15
– Satisfaction of performance obligation
Criteria Answer
Asset has no alternative
use to seller and seller
has enforceable right to
payment for work done
• Thus, performance obligations are satisfied over time

and hence contract qualifies for revenue to be
recognised over time.
43
under IFRS 15
5. Recognise revenue Output method:

when (or as) the
entity satisfies a
performance
obligation
Input method:
44
under IFRS 15
• Inability to reasonably measure contract outcome
– Lack of reliable information to reasonably measure
progress and outcome of performance obligation
– Recognise revenue to the extent of costs incurred that
are expected to be recovered, i.e. no profit is
recognised
• Onerous contracts
– Contract in which the costs to fulfil contractual
obligations exceed the economic benefits derived
from them
– Provision for the present obligation under onerous
contract is to be recognised
45
- IAS 11 vs. IFRS 15
• Impact on construction contracts
– IAS 11 superseded by IFRS 15 w.e.f 1 Jan 2018
– Though much of the accounting treatment is very
similar to IAS 11, key issues include:
• Single or multiple performance obligation
• Possibility of revenue recognised at point of time
• Different guidelines in determining cost capitalisation
• Progress measured according to performance
• Refer to IAS 37 for loss-making (onerous) contracts
• Increased disclosure in notes to financial statements
46
Thank You
Q&A
47

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FR12 - Construction Contracts & Revenue (Stud)

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Construction Contracts

& Revenue Recognition

• Contract specifically negotiated for the construction

Fixed price contract Cost plus contract

o Fixed contract price or fixed o Allowable or defined costs

• Variations are instructions by the customer for

• Contract costs comprise:

Costs that are Such other costs as

Surveys of work performed Value of work certified to date

Physical proportion of work Built−up area completed

• Expected loss on the construction contract should be

• Construction contract balances

• For contracts in progress at balance sheet date

(1) Identify the (2) Identify the

(5) Recognise revenue

1. Identify the contract

2. Identify the separate

• Thus, performance obligations are satisfied over time

5. Recognise revenue Output method:

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