Loss Making Construction Contracts
If a loss is expected in respect of a construction contract, the entire loss is recognized immediately in the income statement.
This is an application of the Prudence Concept under which anticipated losses are recognized immediately in the income statement. This accounting treatment is also consistent with IAS 37 Provisions, Contingent Liabilities and Contingent Assets which requires unavoidable losses in respect of onerous contracts to be expensed in the accounting period in which such losses become probable.
If stage of completion is calculated using cost method, then cost incurred to date is recognized in the income statement as contract cost. Entire net loss is recognized immediately in the income statement and revenue is calculated as the difference between costs incurred and net loss.
If stage of completion is calculated using value method, then revenue is recognized according to the work certified as complete. Entire net loss is recognized immediately and contract cost is calculated as the difference between revenue and net loss.
If the estimates relating to cost or revenue do not change in following periods, revenue recognized in subsequent accounting periods will equal to contract costs giving no profit and loss in later periods.
Example - Accounting for Loss Making Construction Contracts (Cost Method)
XYZ LTD is a construction firm. It enters into a 2 year fixed price contract for the construction of a building for one of its customers. Prices of construction raw materials have increased significantly since the start of the contract due to unforeseeable factors. XYZ LTD estimates stage of completion on the basis of cost. Following information is available in respect of the contract at the end of first year:
|Total Contract Price||2,000,000|
|Total Expected Costs||2,500,000|
|Costs incurred to Date||1,500,000|
|Amount billed to customer||900,000|
|Progress payments received from customer||700,000|
Step 1 - Determine Expected Outcome of the Contract
As total expected contract costs ($2.5m) exceeds total expected revenue ($2m), the contract is expected to generate a loss of $0.5m. Therefore, entire loss should be charged as expense in the first year and the contract costs and revenue should be accounted for using stage of completion method.
Step 2 - Determine the amounts to be recognized in Income Statement for Profit, Revenue and Cost
|Cost||(Cost incurred during the year)||1,500,000|
|Loss||Entire Expected Loss (2,500,000-2,000,000)||(500,00)|
|Revenue||(Balancing Amount: [1,500,000 - 500,000])||1,000,000|
Step 3 - Calculate amounts to be recognized in the Balance Sheet for Gross Amounts due to/ from Customers and Trade Receivables
Trade Receivable of XYZ LTD should be calculated as follows:
Trade Receivable = 900,000 (Amount Billed) - 700,000 (Amount Received) = $200,000
Gross Amount due from Customers of XYZ LTD must be calculated as follows:
Gross Amount due from Customer = -500,000 (Loss) + 1,500,000 (Cost Incurred) - 900,000 (Amount Billed) = $100,000
Step 4 - Prepare Extracts of Financial Statements in respect of Construction Contracts
|ABC Builders LTD|
Income Statement (Extracts for the Year 1)
|ABC Builders LTD|
Balance Sheet (Extracts at the end of the Year 1)
|Gross Amount due from Customers||100,000|
Step 5 - Prepare Construction Contract Control Account
XYZ LTD's control account would appear as follows:
|Contract Control Account|
|Revenue Recognized||1,000,000||Cost Recognized||1,500,000|
|Costs Incurred||1,500,000||Amount Received from customer||700,000|
|Amount due from customer||100,000|
In Year 2, if cost and revenue estimates do not change, following amounts will be recognized in the income statement:
|Income Statement (Year 2)|
|Cost||(2,500,000-1,500,000 (already expensed))||1,000,000|
|Profit||(No profit or loss since entire loss already recognized)||-|