When you’re studying IAS 11 Construction Contracts, if a loss is expected on the contract, the entire loss should be recognised immediately in the income statement. This is an application of the prudence concept under which anticipated losses are recognised immediately in the income statement.
This is also consistent with the terms of IAS 37 Provisions, Contingent Liabilities and Contingent Assets which requires losses on onerous contracts to be expensed in the period they become probable.
If the stage of completion method is calculated using the cost method, the cost incurred to date is recognised as the contract cost. Also recognise the entire net loss immediately in the income statement. Revenue is then calculated as the difference between the costs incurred and net loss.
If the stage of completion is calculated using the sales basis or physical proportions basis, the revenue is recognised to the work certified as complete. The entire net loss should be recognised immediately and the contract cost is calculated as the difference between revenue and the net loss.
Once this takes place, in the following periods the contract costs and revenue should be the same. This means no further profit or loss will be recorded, so long as estimates remain the same.
Step 1 – Calculate expected loss on contract
Compare the total expected contract costs against the contract value. This will give you an estimate of the expected loss which must be recognised in the period.
Step 2 – Calculate the stage of completion
The stage of completion can be calculated either using
- Costs basis
- Sales basis
- Physical proportions
Step 3 – Determine amounts to be recognised in income statement
If the contract is a fixed price contract, multiply the stage of completion by the total expected costs to get the costs figure for the period. If the contract is a cost plus contract, use the actual costs incurred in the period.
Deduct the total expected loss from these costs to get a figure for revenue.
So if costs are €1,500,000 and the expected loss will be €500,000, the revenue will be €1,000,000.
Don’t double count.
When you’re calculating the figures to use for revenue and costs, make sure you deduct any previous amounts already recognised in earlier financial statements.
So if a company was 40% of the way through the contract last year, and is 70% through at the end of this year, only recognise the revenue and costs on the basis of the 30% of the contract carried out this year.
Step 4 – Calculate receivables/payables
Now calculate the amount of progress payments billable to the customer, this will be based on stage of completion compared to the overall contract costs, or by costs incurred. This all depends on whether it’s a fixed price contract or a cost plus contract.
Compare this to the amount of progress payments actually received by the customer. This will show you if there’s a receivable or payable to the customer in relation to the contract.
What is the outcome if the contract is uncertain, the company doesn’t know if it’ll make a profit or a loss? If this happens, and it’s not possible to make a reasonable estimate, no profit or loss should be recognised for the contract.
Make revenue equal the total costs incurred on the contract so far, this will result in no profit or loss figure for the period.
4 disclosures required for Construction Contracts
Under IAS 11, an entity must disclose the following about construction contracts:
- The amount of contract revenue recognised as revenue in the period.
- The methods used to determine the amount of revenue and the stage of completion of contracts in progress (e.g. fixed price contract)
- For each contract in progress at the end of the reporting period, the total costs incurred and profits/losses recognised to date, plus the amounts of any retentions or advances received from the customer. Advances are payments received before the work is carried out, and retentions are the amounts held back by a customer until the work completed is assessed as satisfactory.
- The gross amount due from customers or the gross amount due to customers for contract work. This is the amount of progress payments billable compared to progress payments actually billed.