Accounting treatment
When outcome of a contract cannot be measured reliably, no profit should be recognized in the income statement in accordance with IAS 11 Construction Contracts. Cost must be recognized in the accounting period in which they are incurred whereas revenue recognized must be equal to the costs incurred that are considered likely to be recoverable from the customer.
When the uncertainty concerning the outcome of the contract is removed, the contract revenues and costs must be accounted for using stage of completion method.
Any contingencies and commitments arising from the contract must be disclosed in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets.
Example
DEF LTD is a construction firm. It enters into a 2 year 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. DEF LTD has claimed compensation of extra costs incurred from the customer but the recovery of these costs is uncertain. It cannot therefore be estimated reliably at the end of the first year of the contract, whether the contract will be profitable or not.
Following information is available in respect of the contract at the end of first year:
| $ | |
|---|---|
|
Total Contract Price |
2,000,000 |
|
Costs incurred to Date |
1,200,000 |
|
Costs considered likely to be recoverable |
1,000,000 |
|
Amount billed to customer |
900,000 |
|
Progress payments received from customer |
700,000 |
Step 1 – Determine Expected Outcome of the Contract
As the outcome of the contract cannot be estimated with sufficient reliability, no profit should be recognized in the accounting period.
Step 2 – Determine the amounts to be recognized in Income Statement for Profit, Revenue and Cost
| $ | ||
|---|---|---|
|
Revenue |
(Costs incurred expected to be recoverable) |
1,000,000 |
|
Cost |
(Costs Incurred) |
1,200,000 |
|
Loss |
(Balancing Amount) |
(200,000) |
Step 4 – Calculate amounts to be recognized in the Balance Sheet for Gross Amounts due to/ from Customers and Trade Receivables
Trade Receivable of DEF LTD should be calculated as follows:
Trade Receivable = 900,000 (Amount Billed) – 700,000 (Amount Received) = $200,000
Gross Amount due from Customers of DEF LTD must be calculated as follows:
Gross Amount due from Customer = -200,000 (Loss) + 1,200,000 (Cost Incurred) – 900,000 (Amount Billed) = $100,000
Step 5 – Prepare Extracts of Financial Statements in respect of Construction Contracts
| ABC Builders LTD - Income Statement (Extracts for the Year 1) | |
|---|---|
|
|
$ |
|
Revenue |
1,000,000 |
|
Cost |
(1,200,000) |
|
Loss |
(200,000) |
| ABC Builders LTD - Balance Sheet (Extracts at the end of the Year 1) | |
|---|---|
|
|
$ |
|
Current Assets |
|
|
Trade Receivables |
200,000 |
|
Gross Amount due from Customers |
100,000 |
Step 6 – Prepare Construction Contract Control Account
Although not a part of the double entry system, control accounts may be useful to confirm the overall accuracy of accounting entries relating to construction contracts. DEF LTD’s control account would appear as follows:
| Contract Control Account | |||
|---|---|---|---|
|
Debit |
Credit |
||
|
Revenue Recognized |
$1,000,000 |
Cost Recognized |
$1,200,000 |
|
Costs Incurred |
$1,200,000 |
Amount Received from customer |
$700,000 |
|
|
|
Trade Receivable |
$200,000 |
|
|
|
Amount due from customer |
$100,000 |
|
|
$2,200,000 |
|
$2,200,000 |