While the majority of the goods or services sold are standardized, there might be cases where two companies might enter into a construction contract that is tailored to particular circumstances. IAS 11 provides a framework and sets the rules for the accounting treatment of construction contracts.
Accounting for construction contracts
IAS 11 sets very straightforward rules for revenue recognition when a company enters into construction contract. The first thing that needs to be considered is whether a profit or loss is expected to be made from this contract. If the contract is expected to be profitable and, then IAS 11 gives two options:
- Recognize revenue based on the costs incurred to date (% as of total costs expected)
- Recognize revenue based on the stage of completion
The percentage of costs incurred might be more accurate if a straightforward and reliable budget can be created. On the other hand, a stage of completion can be easily determined when the project for example relates to a highway where the stage of completion is simple the miles of the highway built to date.
If the project is expected to be loss making, then the company should recognize any loss expected all at once. For example, if a company enters into a contract and at the year end, a loss of $10m is expected, then the full loss should be immediately recognized.
Finally, if the company is not able to reliably determine whether the contract will be profitable or not, then the full costs incurred should be recognized immediately and the revenue that should be recognized should be the costs that are expected to be recovered.
Examples for accounting treatment of construction contracts
Two examples are provided below. The first is for a profitable contract and the second is for a loss making contract.
Accounting example for profitable construction contract
Lets assume that company A enters into a construction contract with company B. The company chooses to recognize revenue based on the costs incurred up to date. The contract is expected to cost $50m total for company A. Company B has agreed to pay in total $70m. Company A has completed around 25% of the work but has incurred around $10m costs until now.
Solution: Company A chose to recognize revenue based on the level of costs incurred which is 20% of the total costs (10/50). Therefore, Company A should recognize revenue equal to:
Accounting example for loss making construction contract
Now, let’s change the scenario and instead of $50m costs, we will assume that the total costs expected are $80m giving a loss of $10m, The company will need to recognize revenue equal to $8.75m (70* (10/80)) since it uses the level of costs incurred. The loss will need to be recognized immediately, therefore the costs that will be recognized during the year are $10m (the loss) plus $8.75 (the revenue) or $18.75m.