Construction Contracts

Learning Outcomes: 1. 2. 3. 4. 5. 6. 7. 8. Explore the types of contract Understanding about the contract accounting Role of Contract Revenue and Costs? Identify basic concepts and rules Evaluate Cost to cost method and cost revenue Profit and loss recognition and preparing financial statement How to cost control in construction industry Treatment of plant in contract arrangement

Types of contract
Some common types of contracts are used in the engineering and construction industry. 1. Lump Sum Contract 2. Unit Price Contract 3. Cost Plus Contract 4. Incentive Contracts 5. Percentage of Construction Fee Contracts

Types of contract
1. Lump Sum Contract: With this kind of contract the engineer and/or contractor agrees to do the a described and specified project for a fixed price. Also named "Fixed Fee Contract". Often used in engineering contracts. A Fixed Fee or Lump Sum Contract is suitable if the scope and schedule of the project are sufficiently defined to allow the consulting engineer to estimate project costs.

Types of contract
2. Unit Price Contract: This kind of contract is based on estimated quantities of items included in the project and their unit prices. The final price of the project is dependent on the quantities needed to carry out the work. In general this contract is only suitable for construction and supplier projects where the different types of items, but not their numbers, can be accurately identified in the contract documents. It is not unusual to combine a Unit Price Contract for parts of the project with a Lump Sum Contract or other types of contracts.

Types of contract
3. Cost Plus Contract: A contract agreement wherein the purchaser agrees to pay the cost of all labor and materials plus an amount for contractor overhead and profit (usually as a percentage of the labor and material cost). The contracts may be specified as; Cost + Fixed Percentage Contract Cost + Fixed Fee Contract Cost + Fixed Fee with Guaranteed Maximum Price Contract Cost + Fixed Fee with Bonus Contract Cost + Fixed Fee with Guaranteed Maximum Price and Bonus Contract Cost + Fixed Fee with Agreement for Sharing Any Cost Savings Contract

This types of contracts are favored where the scope of the work is indeterminate or highly uncertain and the kinds of labor, material and equipment needed are also uncertain. Under this arrangement complete records of all time and materials spent by the contractor on the work must be maintained.

Types of contract
Cost + Fixed Percentage Contract: Compensation is based on a percentage of the cost. Cost + Fixed Fee Contract: Compensation is based on a fixed sum independent the final project cost. The customer agrees to reimburse the contractor's actual costs, regardless of amount, and in addition pay a negotiated fee independent of the amount of the actual costs.

Cost + Fixed Fee with Guaranteed Maximum Price Contract: Compensation is based on a fixed sum of money. The total project cost will not exceed an agreed upper limit. Cost + Fixed Fee with Bonus Contract: Compensation is based on a fixed sum of money. A bonus is given if the project finish below budget, ahead of schedule etc.

Types of contract
Cost + Fixed Fee with Guaranteed Maximum Price and Bonus Contract: Compensation is based on a fixed sum of money. The total project cost will not exceed an agreed upper limit and a bonus is given if the project is finished below budget, ahead of schedule etc. Cost + Fixed Fee with Agreement for Sharing Any Cost Savings Contract: Compensation is based on a fixed sum of money. Any cost savings are shared with the buyer and the contractor.

Types of contract
4. Incentive Contracts: Compensation is based on the engineering and/or contracting performance according an agreed target - budget, schedule and/or quality. The two basic categories of incentive contracts are Fixed Price Incentive Contracts Cost Reimbursement Incentive Contracts Fixed Price Incentive Contracts are preferred when contract costs and performance requirements are reasonably certain. Cost Reimbursement Contract provides the initially negotiated fee to be adjusted later by a formula based on the relationship of total allowable costs to total target costs. This type of contract specifies a target cost, a target fee, minimum and maximum fees, and a fee adjustment formula. After project performance, the fee payable to the contractor is determined in accordance with the formula.

a. b. a.

b.

Types of contract
5. Percentage of Construction Fee Contracts: Common for engineering contracts. Compensation is based on a percentage of the construction costs.

What is contract accounting

A construction contract is a contract specifically negotiated for the construction of an asset or a group of interrelated assets. [IAS 11.3] Under IAS 11, if a contract covers two or more assets, the construction of each asset should be accounted for separately if (a) separate proposals were submitted for each asset, (b) portions of the contract relating to each asset were negotiated separately, and (c) costs and revenues of each asset can be measured. Otherwise, the contract should be accounted for in its entirety. [IAS 11.8] Two or more contracts should be accounted for as a single contract if they were negotiated together and the work is interrelated. [IAS 11.9]

If a contract gives the customer an option to order one or more additional assets, construction of each additional asset should be accounted for as a separate contract if either (a) the additional asset differs significantly from the original asset(s) or (b) the price of the additional asset is separately negotiated. [IAS 11.10]

What Is Included in Contract Revenue and Costs?

Contract revenue should include the amount agreed in the initial contract, plus revenue from alternations in the original contract work, plus claims and incentive payments that (a) are expected to be collected and (b) that can be measured reliably. [IAS 11.11] Contract costs should include costs that relate directly to the specific contract, plus costs that are attributable to the contractor's general contracting activity to the extent that they can be reasonably allocated to the contract, plus such other costs that can be specifically charged to the customer under the terms of the contract. [IAS 11.16]

Basic concepts and rules

The primary accounting issue: The primary accounting issue in long term contracts is to determine the amount of profit to be recognized during a financial period. This involves a continuous evaluation of estimates and assessment of inherent uncertainties, as the performance extends over several years. Such uncertainties relate to the buyers ability to settle the bills, the contractors ability to perform work, estimating costs, unforeseen technical problems, and general economic conditions such as availability of credit and rate of inflation.

Basic concepts and rules

The percentage completion method: Under the percentage completion method, contract revenue and contract costs associated with the construction contract are recognized as revenue and expenses respectively by reference to the stage of completion of the contract at the balance sheet date. When the outcome of a contract can be estimated reliably, IAS 11 recommends percentage completion method for recognition of profits on incomplete contracts. Profit recognition under the percentage of completion method involves following four distinct steps: Ascertain stage of completion Determine amount of revenue to the recognized Determine costs to be recognized Determine the profit to be recognized

1. 2. 3. 4.

Basic concepts and rules

Stage of completion: Methods generally used for measuring extent of progress include

1. 2. 3.

Cost to cost method Quantity surveyors' measurement of work performed Units of work performed

Cost to cost method

Cost to cost method: Under cost to cost method the percentage completion is determined as a proportion of contract cost incurred up to the balance sheet date to the estimated total costs at completion of contract. For example, if the total cost of a contract at completion is estimated at Rs. 15 million, and the costs incurred to date are Rs. 6 million, the contract is considered to be 40% completed. At each balance sheet date, the costs incurred to date updated and fresh estimated is made for further costs to be incurred. In the above case, if during the second year additional costs of Rs. 7 million are incurred and the latest estimate of further costs to be incurred is Rs. 3 million, the stage of completion be excluded from costs incurred to date. In determining stage of completion under cost to cost method materials purchased for a contract, but not used should be excluded from costs incurred to date. Also payments made to contractors in advance of work performed should be excluded from costs incurred to date. The estimating procedure should be systematic and consistent. Estimated costs should include the effect of increase prices of material, labor and indirect costs.

Contract revenue
Contract revenue are recognized by reference to the stage of completion of the contract activity at the end of the accounting period. Under cost to cost basis, it is the fraction of total contract price that cost incurred to date bears to total cost to complete a contract. For example, if the costs incurred to date are Rs. 6 million; estimated further costs are Rs. 9 million, and contract price is Rs. 18 million, the revenue to be recognized would be Rs. 5.5=6 million (Rs. 18 million *0.3). In subsequent accounting periods, the revenue recognized in prior periods are deducted from cumulative revenue earned. For example, if at the end of year 2 the contract is 81.25% complete, gross revenue to be recognized in year 2 work out to be Rs. 7.425 million. (1)

Contract costs
Contract costs are recognized by the reference to stage of completion of the contract at the balance sheet date. That is, the cost recognized in a period would equal to total estimated costs on a contract multiplied by stage of completion, less cost recognized in prior periods. There is a list of elements of contract costs: General, administration and selling expenses are usually excluded from contract costs. (2)

Financial statement presentation

Contract revenue and contract accounts will be closed to profit and loss. The excess of work in progress over billings is reported on the balance sheet as amount due from customers for contract work. Excess of billings over work in progress will be reported as current liability under the heading accounts due to customers for contract work.

Where the details of amounts due from customers and due to customers are not reflected on the balance sheet, the appropriate details should be reported as notes to be accounts in the following manner.
The excess of costs or billings is reported on contract by contract basis and should not be netted off. The only exception is in the case where legal right to set off exists (for example, where the amounts due from and to customer relate to the work performed for the same owner) (3)

Contract costs
Plant and machinery cost associated with contracts: The plant and machinery is hired for a specific purpose contract, the hiring cost will be charged to such contracts. If plant has been acquired for a specific contract and at completion of contract it is disposed of, the cost less salvage value should be charged t the contract. Yearly depreciation may be charged on straight line method. In case the plant is used during the accounting period on several contracts, the charge for use of plant has to be allocated to contracts in a systematic manner. The suggested method is to establish hourly charge out rates for various machinery and equipment. Individual contracts should then be charged on the basis of number of hours the machinery is used on various contracts.

Profit recognition
Cumulative gross profit on contract is determined by applying the degree of completion to total estimated profit on contract. Profit for the year equals cumulative profit to be recognized less profit recognized in prior years.

In order to test the reliability of estimated further costs and profits recognized, it is desirable to compare gross profit percentage on uncompleted contracts with average gross profit percentage on completed contracts.
Gross profit margin/percentage is one of the best indicators of the operating efficiency of a business, and the strength of it's products in the market, the higher the gross profit percentage, the more likely that the business is in a commanding position against it's competitors, and with it's customers. Gross Profit Percentage/ Margin = Gross Profit / Sales In the example, Gross Profit is $12,400 and Sales for the period are $97,500. Applying the Gross Profit Formula, we get: $12400 / $97500 = 12.72%

Profit recognition
A general practice with the contractors is to reduce the profit earned by 1/3rd of total profit realized. Those who advocates this position contend that because of uncertainties associated with the contract, for example collection of revenue. Another fallacious and unacceptable method of profit recognition is to report gross profit as the difference of billing and cost incurred.

The billing cannot always be matched with work performed. Some times the consideration could be to ease the cash flow. Billings could also be made to finance the procurement of materials, supplies and equipment. Such purchases have no relationship with stage of completion of a contract.

Recognition of losses
When it is probable that the contract costs will exceed contract price, the entire amount of expected loss is to be provided in the period in which the loss becomes evident even if: Completed contract method is used or Work on contract has not been commenced. The estimated loss on the contract should include expected penalties. The provision for losses on contracts in progress is not an admissible expense for tax purpose in many countries. The provision should, therefore , be made after adjusting the tax effect on expected losses. Proportionate amount of tax paid should be charged to differed costs. Such adjustment is required to reflect net profit fairly in the period of loss and in the period when actual loss is deductible for tax purpose.

a. b.

Record transaction
There are number of transaction record for the cost incurred during the year. (4)

There is a list of construction industry terminology. (5)

Cost control in construction industry

The cost control in construction industry is focused on efficient and economic utilization of labor, materials and machinery. It is suggested that the contract budget be broken into certain distinct phases. The entity's costing system should provide for phase wise accumulation of costs so that corrective action may be taken well in time. An example of typical phases is:

In order to ensure that the entity's resources are use effectively and efficiently, some of the significant matter to considered are:
There is a list of some commonly used terms in the construction industry. (6)

Percentage completion cost to cost method

The stage of completion is determined in either of the following ways. Cost of cost method Survey of work performed Under the cost to cost method the stage of completion is find out by applying the proportion of costs incurred for work performed to date to the estimated total cost. When stage of completion is determined by reference to the contract costs incurred t date, only those contract costs that reflect construction work performed are included in cost to date. For example, contract costs which related to future activity on the contract or payments to sub contractors in advance of work performed are excluded.

a. b.

All accrued costs are included in costs incurred to date. (7)

Plant
If the plant is specifically purchased for a contract, the cost may be debited the particular contract. At the completion of contract, the plant is revalued and contract account is credited. Alternatively, the contract account may only be charged with depreciation. For example, an equipment costing Rs. 500,000 was purchased specifically for a contract. The contract commenced on October 1, 2005 and the duration of contract is estimated to be four years (48months).

At the end of contract, residual value of equipment s estimated to be Rs. 20000. year end of contractor is December 31. in this case monthly depreciation works out to Rs. 10000.

Depreciate charge for the contract will be: Year ended December 31, 2005 Rs.30,000 Year ended December 31, 2006 Rs. 120,000 Year ended December 31, 2007 Rs. 120,000 Year ended December 31, 2008 Rs. 120,000 Year ended December 31, 2009 Rs. 90,000 Total 480,000 (8)

Case studies/Research links/Study questions

Cases Practice exercises Review financial statement Research links http://stevehake.files.wordpress.com/2010/01/sample-contractor-financialstatement-by-stambaugh-ness.pdf

Study questions
1. Identify the effects of the cost to cost method?

Activity for students

Practice examples, exercises and review questions.