What is a Construction Contract?
A construction contract is a contract specifically negotiated for the construction of an asset, (or combination of assets), that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use.
A fixed price contract is 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.
A cost plus contract is 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.
IAS 11 Construction Contracts is the accounting standard governing the recognition of revenue relating to construction contracts.
How do we Account for Construction Contracts?
- Initial agreed contract amount, and
- variations, claims, and incentive payments to the extent that it is probable that these will result in revenue and are capable of being measured.
Two or more contracts (same or different customers) should be accounted for as a single contract, if;
i) negotiated together
ii) work is interrelated, and
iii) performed concurrently.
- Direct contract costs (e.g. materials, labour, depreciation of site equipment)
- General contract costs (e.g. insurance, overheads etc.)
- Costs specifically chargeable to the customer in terms of the contract (e.g. admin)
Outcome can be estimated reliably
- Outcome can be reliably estimated if the entity can make an assessment of the revenue, the stage of completion and the costs to complete the contract.
- If the outcome can be measured reliably – revenue and costs on the contract should be measured with reference to stage of completion basis. Under this basis, 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 completed.
- When it is probable that the total contract costs will exceed contract revenue, the expected loss is recognised as an expense immediately.
Outcome cannot be estimated reliably
- No profit recognised.
- Revenue recognised only to the extent costs are recoverable.
- Costs recognised as an expense when incurred.
- An expected loss should be recognised as an expense in full as soon as the loss is probable.
If the contract covers multiple assets, the assets should be accounted for separately if
a) Separate proposals were submitted for each asset
b) The contract for each asset were negotiated separately, and
c) The costs and revenues of each asset can be identified.
Otherwise the contract should be accounted for in its entirety.
If the contract provides an option to the customer to order additional assets, the additional assets can be accounted for separately if
a) The additional asset differs significantly from the original asset, and
b) The price of the additional asset is negotiated separately.
In the ACCA F7 exam
When you’re studying construction contracts for the ACCA F7 paper, you’ll need to be able to:
- Define a constructon contracts
- Discuss the role of accounting concepts in the recognition of profit
- Describe the methods of calculating the stage of completion of a contract
- Prepare financial statemen extracts for construction contracts