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Semester 2
2013/2014

TOPIC 6
CONSTRUCTION CONTRACTS
(MFRS111)

COURSE OUTCOME (CO5)

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At the end of this course, students should be

able to;
Describe

and demonstrate the account for

construction contracts

Introduction
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Imagine that you are an accountant at a construction company.

Your company is building a large tower block that will house
offices, under a contract with a client company. It will take three
years to build the block and over that time you will obviously
have to pay for building materials, wages of workers on the
building, architects' fees and so on. You will receive periodic
payments from the client at various predetermined stages of the
construction.

How do you decide, in each of the three years, what to

include as income and expenditure for the contract in the
income statement?
How to allocate contract revenue and contract costs to the
accounting periods in which construction work is performed?

The Main Issues

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A construction contract often takes a number of years to complete.

The date at which the contract activity commences and the date when the
contract activity is completed falls into different accounting periods.

Question arises as to when the revenue and gross profit arising there from
should be recognised.

Should all the revenue and gross profit be recognised only at the point of
completion (completed contract method)?

Or should the revenue and gross profit be recognised over each and every
accounting period during which the contract activity is performed (percentage
of completion method)?

How do we measure the amount of contract revenue and contract costs

attributable to a construction contract?

What information do we need to disclose in the financial statements?

This area of accounting is complicated by the need to rely on estimates of

revenues, costs, and progress towards completion, and by the principle of
recognition of losses when apparent.

MFRS 111: A Summary of the

Standard
Construction Contract Defined

A construction contract is a contract

specifically negotiated for the construction of
an asset or a combination of assets that are
closely interrelated or interdependent in terms
of their design, technology and function or their
ultimate purpose or use.
Includes contracts for the rendering of services
(e.g. the services provided by architects) and
contracts for the destruction or restoration of
assets.

Two Types of Contracts

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A fixed price contract where the contractor agrees to

a fixed price.
A cost plus contract where the contractor is
reimbursed for allowable costs plus a percentage of
these costs or a fixed fee.

To Combine or Separate?
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For internal control as well as for financial accounting

purposes, construction contracts shall be accounted
separately. However
When a contract covers a number of assets, the
construction of each asset should be treated as a
separate construction contract when:
separate proposals have been submitted for each
asset;
each asset has been subject to separate negotiation
and the contractor and customer have been able to
accept or reject that part of the contract relating to
each asset; and
the costs and revenues of each asset can be

To Combine or Separate?
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A group of contracts, whether with a single

customer or with several customers, should be
treated as a single construction contract when:
The

group of contract is negotiated as a single

package;
The contract are so closely interrelated that they
are, in effect, part of a single project with an
overall profit margin; and
The contracts are performed concurrently or in a
continuous sequence.

To Combine or Separate?
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The construction of an additional asset should

be treated as a separate construction contract
from the original contract when:
The

asset differs significantly in design,

technology or function from the asset or assets
covered by the original contract; or
The price of the asset is negotiated without
regard to the original contract price.

Measurement of Contract
Revenues
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Components of contract revenue in a construction

contract:
1.
2.
3.

4.

5.

The initial contract price; plus

Variations (instruction by customer for a change in
the scope of work to be performed); plus
Claims (amounts in excess of the agreed-on
contract price that a contractor seeks to collect from
a customer for customer-caused delays, etc); plus
Incentive payments (additional amounts paid to
contractor for meeting targets, for e.g., early
completion of contract).
But ... only include (2), (3), and (4) above if they are
probable and capable of being reliably measured.

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Measurement of Contract
Costs

Components of contract costs in a construction

contract:
a)

b)

c)

Costs directly related to the contract (e.g., site

labour costs, construction materials used,
depreciation of plant & machinery used on the
contract);
Costs attributable to contract activity in general and
can be allocated to the contract (e.g., insurance,
construction overheads);
Such other costs as are specifically chargeable to
the customer under the terms of the contract (e.g.,
some general admin costs for which reimbursement
is specified in the terms of the contract).

What items to include in

Contract Costs?
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Costs incurred in securing a contract (for e.g., at tendering

stage) a)
b)

include as part of contract costs only if it is probable that

contract will be obtained;
otherwise, expense-off to the income statement in the period
they were incurred without including them as part of contract
costs.

Construction materials, supplies, etc. which remained unused

at the end of the period should not be included as part of
contract costs. They should be carried forward as assets in
the balance sheet.
Payments made to subcontractors in advance of work
performed under the subcontract should not be included as
part of contract costs.

Example 1: Amounts to be included

in contract costs
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XYZ Sdn Bhd secured a contract to construct a bridge in early 2009.

Construction work commenced on 1 April 2009. As at 31 December 2009, the
following costs have been incurred or allocated to the contract:
RM'000

Materials issued to the construction site

3,500

Site labour & supervision

2,000

Plant & equipment purchased for the contract

2,600

Allocated construction overheads

400

In 2008, the co. incurred RM200,000 for tendering & lobbying for the contract.
The mgmt of the co. estimated at the end of 2008 that the likelihood of
securing the contract was possible. A further RM500,000 was incurred in
January 2009 to secure the contract.
As at 31 December 2009, estimates of unused materials at the construction
site totaled RM500,000. Expenses for sub-contracting work incurred but not
paid at year-end totaled RM200,000. The plant & equipment are depreciated
on a straight-line basis over five years.

Example 1
Required:
Calculate the amount of contract costs incurred for the
above contract as at 31 December 2009.
Answer:

Recognition of Contact Revenue

and Expenses
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Let say that we have a three-year construction

contract, currently in progress.
Question: At which stage of the construction
project can we safely take (i.e., recognise)
revenue and costs relating to the project in the
income statement?

Methods to recognise contract

revenue and costs
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Completed contract method - revenue and

costs are not recognised in the income
statement until the contract ends.
Advantage - based on actual results not on
estimates.
Disadvantage - income reported does not
reflect general contract activity level for the
company.

Methods to recognise contract

revenue and costs
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Percentage of completion method - revenue

and costs are recognised in the income statement
as the contract activity progresses, by reference
to the stage of completion of the contract (that is,
based on the proportion of work completed).
Advantage - income reported reflect general
contract activity level for the company; results in
fairer reporting; in accordance with accruals
concept.
Disadvantage - based on estimates, which may
result in error.

Methods to recognise contract

revenue and costs
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When the outcome of a construction contract can be

estimated reliably, contract revenue and contract
costs associated with the construction contract shall
be recognised as revenue and expenses respectively
by reference to the stage of completion of the contract
activity at the end of the reporting period.
The Standard mentions the following methods to
determine the stage of completion of a contract:
1.
2.

3.

Contract costs incurred to date as a proportion of the

estimated total contract costs;
Surveys of work performed, for e.g., value of work
certified to date as a proportion of the total contract
revenue; or
Completion of a physical proportion of the contract work.

Disclosure Requirements
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The Standard requires the following to be

disclosed:
The

amount of contract revenue recognised as

revenue in the period;
The amount of contract costs recognised as
expense in the period;
The methods use to determine the contract
revenue recognised in the period; and
The methods used to determine the stage of
completion of contracts in progress.

Disclosure Requirements
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An entity should disclose each of the following for

contracts in progress at the end of the reporting
period:
The aggregate amount of costs incurred and
recognised profits (less recognised loses) to date;
The amount of advances received; and
The amount of retentions.

An entity should present:

The gross amount due from customers for contract
work as an asset; and
The gross amount due to customers for contract work
as a liability.

Example 2: Extracts of Disclosure

in the Financial Statements
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Statement of Comprehensive Income (extract)

RM000

Contract revenue
Contract costs
Profit for the year

XX
(XX)
XX

Statement of Financial Position (extract)

Current assets:
Construction materials
Gross amount due from customers
Current liabilities:
Gross amount due to customers

Notes on Accounting
Materials
Costs incurred to date
Add: Attributable profits
Less: Recognised losses

RM000

Policies

Less: Progress billings

Gross amount due from customer
Gross amount due to customer

and

(1)

XX
XX

(2)

XX

RM000

Explanatory

(1)
(2)

XX
XX
(XX)
XX
(XX)
XX
(XX)

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Example 3: Measuring stage of

completion of contract, revenue and
cost

Refer to Example 1- Tan Liong Tong (page

281)

Contract Uncertainties
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When uncertainties surround the contract, the

outcome of the construction contract cannot be
estimated reliably. Under such circumstances:
use

of the stage of completion method is not

appropriate;
recognise revenue only to the extent of contract
costs incurred that are recoverable; and
contract costs should be recognised as an
expense in the period in which they are incurred.

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Example 4: Revenue and cost recognition

when outcome of contract cannot be
estimated reliably

Refer to Example 3 Tan Liong Tong (page

284)
When the uncertainties that prevented the
outcome of the contract being estimated
reliably no longer exist in a subsequent period
and the outcome can be estimated reliably, the
enterprise should revert (i.e., go back) to the
recognition of revenue and expenses based
on the stage of completion.

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Recognition of Expected
Losses

When it is probable that total contract costs will

exceed total contract revenue, the expected loss
should be recognised as an expense immediately.
In other words, a foreseeable loss should be
recognised in full, both:
for the stage of completion reached; and
for the future loss on the contract.

The amount of loss is determined irrespective of

whether work has started on the contract, the
stage of completion of the work, or profits made
on other contracts.
Refer to Example 5 Tan Liong Tong (page 286)

Appendix 1:
Main Journal Entries to record Construction
Contracts
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Percentage of Completion
Method
When contract costs are incurred
Dr. Contract costs
Cr. Cash/Creditors/etc
At each year end, carry forward Dr. Construction materials etc
unused contract costs as an asset
Cr. Contract costs
Activity

At year end, close off contract Dr. Contract costs (in I/S)
costs a/c to Income Statement
Cr. Contract costs
When customers are billed
Dr. Accounts Receivables
Cr. Progress billings
When customers pay up
Dr. Cash/Bank
Cr. Accounts receivables
At each year end, recognise Dr. Progress billings
contract revenue based on stage of Cr. Contract revenue (in I/S)
completion method

Appendix 2:
Summary of the Main Points
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A construction contract may take many years to complete, such that

contract activity spans across different accounting periods.

Revenues and costs should be taken to the income statement as the

contract activity progresses (percentage of completion method) and
not when the contract is fully completed or substantially completed
(completed contract method)

If contract outcome is uncertain & cannot be reliably estimated

recognise revenues and costs by reference to the stage of completion
(cost-to-cost basis/value of work certified basis/other bases)
If contract outcome is uncertain & cannot be reliably estimated
recognise revenues up to the amount of costs incurred that are
recoverable and recognise contract costs as expense in the period
incurred.

Appendix 2:
Summary of the Main Points
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Recognise losses immediately in full in the period the losses were

identified.

Generally the contract revenue = contract price. But in later years,

as the contract progresses, it may also include variations, claims
and incentive payments. However only include them if they are
probable and capable of being reliably measured.

Include under contract costs only those costs which reflect the
actual work done exclude:
depreciation on idle plant & machinery
costs of unusual materials,
advance payments to sub-contractors.