IAS 11 Presentation

Submitted By :- Dushyant Chaturvedi

Flow Of Information

I. Purpose of Introduction of Standard.

II. Applicability of Standard

III. Combining and Segmenting of Contracts

IV. Major Definitions

V. Recognition of Revenue and Costs

VI. Disclosure Requirements

VII. Detailed Example of one Contract for three years covering each area of Standard

Purpose of Introduction of Standard.

Construction Contracts are generally long term in nature and

the activity usually falls into different accounting periods. Thus the date on which the contract is entered and the date when the activity is completed fall into different accounting periods.

Therefore an approach, different from ‘as earned’ approach as prescribed in IAS 18 for revenue recognition, was required to account for long term construction contracts.

Thus the primary purpose of introduction of IAS 11 is

To Prescribe the Accounting Treatment of Revenue & Cost Associated with Construction Contracts.

and To provide practical guidance on the application of above mentioned

criteria.

Does that mean a contract shall last for more than One Accounting Period ?

Noe.g.

A company completes a material short term contract just after the year end, but a substantial part of the work is completed before the year end.

In such a case IAS-11 shall apply because if revenue & cost is not attributed to the current period , this might not

give a fair picture of its results & financial position.

e.g.

Whether IAS 11 would apply to short term contracts, which do not take 3 months to complete? Assuming that these contracts complete in same accounting period, allocation of

contract revenue & cost to different accounting period does not arise. However, disclosure requirement of IAS 11 would nevertheless apply to such standards.

CONCLUSIONIf a short term contract straddle an accounting period - then both accounting & disclosure

requirement IAS 11 applies.If it doesn't - only disclosure requirement of IAS 11 applies.

THUS IAS 11 APPLIES TO CONSTROCTION CONTRACTS IRRESPECTIVE OF THE TIME OF EXECUTION OF THE CONTRACT.

Applicability of the Standard

Applied in accounting for construction contracts in the financial statements of contractors.

Where a Construction Contract• is a contract specifically negotiated for the• construction of an asset or combination of assets• that are closely interrelated or interdependent • in terms of their design, technology and function• or their ultimate purpose or use.

and includes:1) Contract for rendering of services which are directly related to the construction of asset(e.g. Architect ).2) Contract for destruction or restoration of assets, and the restoration of environment following the demolition if asset.

Further Analysis Of Applicability

Thus IAS 11 applies in case of Construction of asset and not Manufacturing.

“Manufacturing is a process dominated approach where manufacturer tends to make same product over and over. Whereas construction implies a project dominated approach, where constructor makes a unique product one at a time.”

Thus if a company constructs a piece of equipment for :• A third party in accordance with the specific needs of a customer

- IAS 11 applies• Future sale - IAS 2 applies• Own use - IAS 16 applies

Standard gives example of construction contracts such as a bridge, a building, a dam, a road, a ship, a tunnel etc.

Further Analysis Of Applicability

Also a construction contract may be for a number of asset that are closely related or interdependent.

For e.g. Construction of a Refinery would entail construction of various types of complex equipments and machineries. But the ultimate use of construction of all such individual assets is to assist the process of refining. Hence these could be said to be closely interrelated and interdependent.

Contracts for rendering of indirect service would not attract the applicability of IAS11 .

For e.g. Providing of strategic consulting service to an enterprise would not attract applicability of IAS 11.Whereas those for the service of project manager can be directly related to the construction of asset and hence accounted for in accordance with IAS 11.

Combining & Segmenting

A contract is generally negotiated as one package deal and therefore the margin on the contract as a whole is considered to be the margin

of its individual components too.

Thus usually IAS 11 applies to each construction contract separately.

However ,in certain circumstances, it is necessary to apply IAS 11 to Separate identifiable components of a single contract Or to a group of contracts together In order to reflect the substance of contract or a group of

contracts And hence the need for combining and segmenting.

Combining & Segmenting Contd….

Illustration (Combining & Segmenting)Suppose a company has invited tenders for construction of a factory and a township that includes a residential complex, school, garden, hospital, club, sewage system etc. The tender offer requires estimates to be made and disclosed in the tender for each of these components separately. However the contract will be awarded lump-sum.

Following are the noteworthy points in this contract:1). The group of contracts in this case is negotiated as a single package;

And

2). The group of contract are closely interrelated, in effect,

part of a single project with an overall profit margin;

And

3). The factory & township will be constructed simultaneously and

will be completed almost at the same time.

Since all these conditions are fulfilled, this becomes a perfect example of Combining of Construction Contracts.

In the above case construction of each asset cannot be treated as separate construction contracts because: Neither a separate proposal for each asset was submitted. Nor they has been subject to separate negotiation.

Combining & Segmenting Contd….

When a single contract covers several elements of a transaction-

“ they are needed to be unbundled and accounted for separately”.

But unbundling could be done only if:-

1). These several components are sold separately in ordinary course of business of the entity.

(+)

2). Fair value of each component could be objectively determined.

For e.g.Under a single contract an entity may supply customised computer system and also provides maintenance services for period after the system has been delivered. In such a situation it may be necessary to unbundle the element of the contract relating to the supply of the system from the element relating to the maintenance service.

Presuming that the above mentioned conditions have been duly fulfilled. Here, construction of customized computer system shall be accounted for as construction contract under IAS 11 & the maintenance services will be recognised as per IAS 18.

Major Definitions

Contract Revenue

Initial amount + Variations + Claims + Incentives

As agreed by customer and Due to instructions of Reimbursement for cost Additional amount

contractor customer for change in not included in contract payable for meeting

scope of work price the standards

Major Definitions Contd…..Contract Revenue –

is measured at the fair value** of the consideration received or receivable.

The measurement of contract revenue is affected by variety of uncertainties that depend on outcome of future events. Therefore the estimates often need to be revised when these uncertainties are resolved.

**

Since the IAS follows the fair value concept, then where the payment is received in arrears to such an extent that the fair value of the consideration is less than the nominal amount of cash received or receivable

Than it would be necessary to discount the revenue to fair value.

Such discount shall be credited to Finance Income.

Major Definitions Contd….

Contract Cost

Directly Related + Attributable Cost + Specifically Chargeable

e.g. Labour cost, Supervision, e.g. Insurance, Construction Overhead, e.g. Any Reimbursement Specified in Depreciation, Warranty etc. Borrowing cost as per IAS-23 the Contract.

Major Definitions Contd….

Cost of Securing a Contract.Cost incurred for preparing/presenting the bid including external consultancy fees etc.

Included as a Part of Contract Cost If Such Cost – Is Separately Identifiable. Could be Measured Reliably & it is Probable that the Contract will be Obtained.

“Therefore significant costs are treated as recoverable once the management consider that it is probable that the contract will be won. This is generally presumed to be when preferred bidder status is awarded”.

Generally if a contract is won before the date of signing of balance sheet than all costs related to securing such contract can be included as a part of contract cost.

But where costs of obtaining the contract have been written off in a period prior to that in which contract is obtained than such cost is not capable of any reversal in the subsequent period.

Major Definitions Contd….Contract Cost shall be Reduced by Incidental Income that is Not Included in Contract Revenue.For e.g. A construction contract for land reclamation involves clearing old collieries. As a by-product the company is entitled to sell of any coal that it recovers. Here incidental income from coal shall be reduced from the contract cost.

As per IAS-2 “ Valuation of Inventories “- If cost of main & by-product are not separately identifiable, the allocation of the

cost may be based on the value of relative sales.- But most of the by-products are immaterial. Hence they are measured at NRV &

their value is reduced from the cost of the main product. As a result carrying amount of main product is not materially different from its cost.

Major Definitions contd….

Following shall be Excluded from Cost of Construction:-1) General Admin Cost for which reimbursement is not specified in the contract.

2) Selling Costs.

3) R&D Cost for which reimbursement is not specified in the contract.

4) Depreciation of Idle Plant & Equipment .

Period for which Cost is Recognised :-

01.01.2006 01.04.2006 31.03.2007 06.11.2007 31.03.2008

Date of Securing

the Contract Date of Reporting Date of completion Date of Reporting

Cost Incurred in This Period Shall be Recognised as Contract Cost.

* Cost incurred to secure the contract, if separately identified and reliable measured can form part of contract cost.

Recognition of Contract Revenue and Contract Costs

Recognition of Contract Revenue and Contract Costs

* If it is probable that contract cost will exceed contract revenue – Expected losses will be recognised immediately.

Recognition of Contract Revenue and Contract Costs

It is usually assumed that during the early stages of the contract the outcome of contract cannot be reliably estimated.

These early stages could range between 20-25% of the contract revenue.

But these limits are subjective and to an extent a judgment have to be made.

Contractor with a high degree of experience may ignore these thresholds.

Recognition of Contract Revenue and Contract Costs

Variation, Claims, Incentives to be recognised :-

- to the extent that it is probable that they will result in revenue.

&- they are capable of

being reliably measured.

Other Conditions to be Satisfied For recognising the claims negotiations shall reach an

advanced stage. For recognising incentives contract should be sufficiently

advanced that it is probable that the specified performance standards will be met or exceeded.

Recognition of Contract Revenue and Contract Costs

Conditions for Including Cost of Variation in Contract Cost?

Where it is appropriate to include the amount in contract revenue

To the extent such cost are considered to be recoverable.

“ A degree of skepticism should be used in assessing the recoverability of such amount”.

An Extract from Annual Report and Account of

Aker ASA (31 December,2005)

“Revenue related to construction contracts is recognised using the percentage of completion method, based primarily on contract cost incurred to date, compared

to estimated overall contract cost.

If the final outcome of a contract cannot be estimated reliably, contract revenue is recognised only to extent cost incurred are expected to be recovered. Any projected losses on future work done under existing contracts are expensed and classified as accrued costs/provision in the B/S under short term debt. Losses on contracts are

recognised in full when identified. Recognised contract profit includes profit derived from change orders and disputed amounts when, in management’s assessment,

realisation is probable and reasonable estimate can be made”.

Some Concepts

Methods used for Measuring the Stage of Completion Proportionate Cost Incurred Survey of Work Performed Completion of Physical Proportion of Contract Work

Concepts of CWIP Contract Cost that Relates to Future Activity Recognised as an Asset (since such Amount is Due from the Customer)

Uncollectable Amount Sometimes Uncertainty Arises about the Recovery of an Amount Will be Recognised as an Expense (not as an adjustment to cost revenue)

Costs to be Excluded Cost Relating to Future Activity Advance Payment to Sub Contractors

Contract Costs – Recovery of Which is Not Probable will be Recognised as an Expenses

Immediately Contracts Which are Not Fully Enforceable Subject to Litigation Properties Likely to be Condemned or Expropriated.

Disclosures

The Amount of Contract Revenue Recognised. Method Used to Determine the Contract Revenue and Stage of

Completion.

For Contract in Progress it should also Disclose:

Costs Incurred and Recognised Profits upto the reporting date. Amount of Advance Received . Amount of Retentions. Gross Amount Due to the customer. Gross Amount Due from the customer.

ILLUSTRATION

Illustration cont……..

YEAR I

YEAR I I

YEAR I I I

Estimated Profit 950 1000 1000

Stage of Completion 26% 74% 100%

Illustration cont…………

Upto Reporting date

Recognised in prior year

Recognised in current year

Year I

Revenue (9000 x 0.26)

2340 2340

Expenses (8050 x 0.26)

2093 2093

Profit 247 247

Illustration cont…………

Upto Reporting date

Recognised in prior year

Recognised in current year

Year II

Revenue (9200 x 0.74)

6808 2340 4468

Expenses (8200 x 0.74)

6068 2093 3975

Profit 740 247 493

Illustration cont…

Upto Reporting date

Recognised in prior year

Recognised in current year

Year III

Revenue (9200 x 1.00)

9200 6808 2392

Expenses (8200 x 1.00)

8200 6068 2132

Profit 1000 740 260

ILLUSTRATION - DISCLOSURE WORKING

A B C D E TOTAL

A. Contract Revenue recognised

145 520 380 200 55 1300

B. Contract Expenses recognized

110 450 350 250 55 1215

C. Expected Losses recognized

40 30 70

D. Recognized Profits less losses

35 70 30 (90) (30) 15

E. Contract Costs incurred in the period

110 510 450 250 100 1420

F. Contract Costs incurred recognized as contract expense in the period

110 450 350 250 55 1215

ILLUSTRATION - DISCLOSURE WORKING

A B C D E TOTAL

G. Contract Costs that relate to future activity

60 100 45 205

H. Contract Revenue 145 520 380 200 55 1300

I. Progress Billing 100 520 380 180 55 1235

J. Unbilled Contract Revenue 45 - - 20 - 65

K. Advances - 80 20 - 25 125

Thank You