Types and Features of Construction Contracts



Types of Construction Contracts

There are two generic types of construction contracts:

  • Fixed Price Contracts: Price of the contract is fixed in advance and is independent of costs incurred in respect of the construction contract. Outcome of a fixed price contract can be reliably measured if:
    • Contract Revenue can be reliably measured. Revenue can usually be reliably measured if it is specified in the contract.
    • Contract costs incurred and to be incurred can be identified and measured reliably.
    • Stage of completion of contract can be reliably measured. It is necessary to know the stage of completion of construction contract to estimate the extent of future costs to be incurred to determine the expected outcome (profit and loss).
    • The inflow of economic benefits is probable.
  • Cost Plus Contracts: Price of the contract consists of the reimbursement of allowable construction expenses incurred along with a predetermined profit margin over and above the costs. Outcome of a cost plus contract can be reliably measured if:
    • Contract costs relating to the contract can be identified and measured reliably.
    • The inflow of economic benefits is probable.

Features of Construction Contracts

Construction contracts may also include the following features:

  • Cost Escalation Clauses: Contractors may be entitled to claim unanticipated increase in construction costs above a certain level defined in the cost escalation clause. This is usually included in fixed price contracts to protect against the risk of abnormal rise in prices which may render the performance of contract unfeasible for the contractor.
  • Incentive Payments: Contractors may be entitled to receive additional payments from clients upon fulfillment of a predefined criteria such as completion of project within a certain time frame.
  • Penalties & Claims: Contractors may be liable to reimburse clients for not performing according to the specifications of the contract. Reasonable estimate of losses that may be suffered due to non performance of a specific term of the contract may be defined in the penalty clause (e.g. amount payable for every day exceeding the project deadline).
    Conversely, contractor may be entitled to claims against losses suffered due to actions of the customers such as faulty specifications and delays caused by customer.
  • Variations: Contract terms and specifications may be subsequently varied by the mutual consent of the concerned parties. Variations may be necessary to accommodate unforeseen factors such as a change in customer requirements.

Accounting Implications

When determining the expected outcome of a construction contract for application of IAS 11, all terms of the contract must be considered at the start of the project and should be reviewed during the term of the contract. For example, if payment of potential penalties under the contract become probable, it may be necessary to account for the contract as a loss making contract if the expected outflow of economic benefits is likely to exceed the potential benefits.