Construction contract is the specific contract in which suppliers agree to construct an asset or a group of assets for customers. IAS 11 provides guidance for accounting to allocate the revenue and expense base on the work completion. The revenue and expense can only be recognized when the construction work can be measure reliably. If the company cannot measure work completion, company should record revenue base on the construction costs. It means the compnay record revenue base on the construction cost plus profit margin.
The contract normally requires several years to complete, but the company needs to record revenue and expense every year to prepare the financial statements. So if we do not account for the revenue and expense carefully, it will show the fluctuate profit during the contract periods.
IAS 11 suggests that the company should record revenue and profit depend on the construction outcome.
2. The outcome of the contract can’t measure reliably
ABC is the construction company, on 01 Jan 202X, they have entered a contract with the customer. The contract price is $ 100,000 and management expects to spend around $ 70,000 for the costing. The construction will finish within 3 years.
The supplier will only accept the contract when they expect to make profit from it. They have estimated the total cost of the contract and compare it with the contract price. If the profit is higher than their required return, the will highly likely to accept it.
However, the work may not go as plan, the construction may increase significantly due to various factors such as price change, revised plan or the delay of work. At some points during the contract, the contractors realize that their cost will be overrun. The total cost will be higher than their previous calculation, it is even higher than the contract price. They expect the contract will make not make any profit, so they have to start recording loss into the accounting records.
The company is highly likely to know that the contract is going to make a loss even it is not yet complete. By that time, management has to evaluate the total loss of the contract. The loss equal to contract price less expected total cost.
The constructors usually bill customer by steps which base on work completion, and the stage of billing must be stated in the contract. The amount bill and percentage of completion are always different as the completed work and process bill later.
For example, Company A signed a contract amount $ 5,200,000 for the construction of the building. The construction expected to complete after 4 years with an estimated cost of $ 4,000,000. Company A expects to make a profit of $ 1,200,000.
However, at the end of year 3, management realizes that this project will not make any profit due to a significant increase of construction material and labor. The total cost will increase to $ 6,000,000 which will make a loss of $ 800,000.
At the end of year 3, management expects the total cost increase to $ 6,000,000.
As at the end of year 3, we have enough information to estimate that the total cost of $ 6,000,000 so this contract will make a loss of $ $ 800,000. If anything changes in the future, we will adjust the cost accordingly. The revenue will not change as it is fixed in the contract.
Base on this example, we assume the percentage of completion is 35% of the end of year 3.
The entire contract will make lose of $ 800,000 so at the end of 3 rd year, we should record accumulated loss of $ 280,000 ($800,000*35%). This balance includes:
In the 3rd year, this project loses $ 580,000. The accumulated loses is $ 280,000 for 3 years.
We have to exclude revenue and cost balance which already recognize in the previous period. However, the cost has increased significantly in year 3, because we just realize the new total cost of construction. So we have to account for the loss of contract base on the percentage of completion.