Accounting for Construction Contract
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.
Type of Construction Contract
There are two types of construction contracts which include:
- Fixed contract price: the price is fixed, so the supplier will face with gain or loss when the cost is not under control.
- Cost-plus pricing or reimbursement: is the contract which the customer will pay based on cost plus markup profit. This contract will guarantee the profit for the supplier by transfer the risk to the customer in case the construction cost is overrun.
Accounting Treatment for Construction Contract
IAS 11 suggests that the company should record revenue and profit depend on the construction outcome.
1. The outcome of the contract can measure reliably
- Profit: if the management expects to make a profit over the period of the contract, revenue and expense are recognized in the income statement base on the stage of completion.
- Loss: if management expects a loss from the entire contract, all the loss must record into income statement.
2. The outcome of the contract can’t measure reliably
- Uncertain: if the construction outcome is uncertain, company should not recognize any profit. Company only record expense which incur in the accounting period. Revenue only records to the extent which expects to recover, it means the revenue equal to construction cost incurred during the year.
Example of Construction Contract
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.
4 Steps to Account for Loss-making Contract
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.
Calculate the Entire Contract Lose
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.
Calculate the stage of completion
Next, we need to calculate the stage of completion (percentage of completion). The percentage can be calculated by using the following method:
- Cost basic: the percentage of completion may arise from the cost incurred over the estimated total cost. We assume that the cost incurred represents the work done and when cost is 100% it means the construction is completed.
- Another method is physical work done. We can access the percentage of work complete by accessing the actual building or construction. However, estimating the percentage of work complete is not as easy as it sounds. There must be a proper report from a qualified engineer who is able to estimate the percentage of completion base on actual work.
Determine amount to record in income statement
After we get the percentage of completion, we will be able to know the amount to be recorded in the income statement.
- Revenue: For the first year, revenue equals total contract price multiply with the percentage of completion. In the next year, we use the same formula, but we must minus the previous balance which already records in the prior period. We need to ensure that the revenue is not double record.
- Cost: Similar to revenue, cost equals the total estimated cost multiply with percentage of completion. And make sure we minus the previous balance to prevent double record.
Calculate Receivable and Payable
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.
- Receivable: when the company records revenue more than the amount paid by customers.
- Payable: when the company receives money more than the work complete.
Loss-making Contract Example
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.
| Year | Revenue | Cost | % of completion |
|---|---|---|---|
| 1 | 520,000 | 400,000 | 10% |
| 2 | 780,000 | 600,000 | 15% |
| 3 | 520,000 | 1,100,000 | 10% |
At the end of year 3, management expects the total cost increase to $ 6,000,000.
Calculate the Entire Contract Lose
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.
Calculate the stage of completion
Base on this example, we assume the percentage of completion is 35% of the end of year 3.
Determine Amount to Record in Income Statement
The entire contract will make lose of $ 800,000 so at the end of 3rd year, we should record accumulated loss of $ 280,000 ($800,000*35%). This balance includes:
- Revenue = [(5,200,000*35%)-(520,000+780,000)]= $ 520,000
- Cost = [(6,000,000*35%)-(400,000+600,000)]= $ 1,100,000
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.