Accounting for construction contract under IAS 11 says that contract costs and estimated earnings in excess of billings occurred—in a contractor company which uses ‘percentage-of-completion method’—should be classified as an asset. If billings exceed costs and estimated earnings, the difference should be classified as a liability. So, what costs are incurred in a construction contract? How’s construction costs recognized and measured?
What is Contract costs?
Contract costs comprise costs that are identifiable with a specific contract, plus those that are attributable to contracting activity in general and can be allocated to the contract and those that are contractually chargeable to a customer.
Generally, contract costs would include all direct costs (such as direct materials, direct labor) and direct expenses and any construction overhead that could specifically be allocated to specific contracts. Direct costs or costs that are identifiable with a specific contract include:
- Costs of materials consumed in the specific construction contract
- Wages and other labor costs for site labor and site supervisors
- Depreciation charges of plant and equipment used in the contract
- Lease rentals of hired plant and equipment specifically for the contract
- Cost incurred in shifting of plant, equipment, and materials to and from the construction site
- Cost of design and technical assistance directly identifiable with a specific contract
- Estimated costs of any work undertaken under a warranty or guarantee
- Claims from third parties
With regard to claims from third parties, these should be accrued if they rise to the level of “provisions” as defined by IAS 37. This requires that an obligation that is subject to reasonable measurement exist at the date of the statement of financial position. However, if either of the above mentioned conditions is not met (and the possibility of the loss is not remote), this contingency will only be disclosed. Contingent losses are specifically required to be disclosed under IAS 11.
Contract costs may be reduced by incidental income if such income is not included in contract revenue. For instance, sale proceeds (net of any selling expenses) from the disposal of any surplus materials or from the sale of plant and equipment at the end of the contract may be credited or offset against these expenses.
Drawing an analogy from the principle, it could be argued that if advances received from customers are invested by the contractor temporarily (instead of being allowed to lie idle in a current account), any interest earned on such investments could be treated as incidental income and used in reducing contract costs, which may or may not include borrowing costs (depending on how the contractor is financed, whether self-financed or leveraged). On the other hand, it may also be argued that instead of being subtracted from contract costs, such interest income should be added to contract revenue.
In my opinion, the latter argument may be valid if the contract is structured in such a manner that the contractor receives lump-sum advances at the beginning of the contract (or for that matter, even during the term of the contract, such that the advances at any point in time exceed the amounts due the contractor from the customer). In these cases, such interest income should, in fact, be treated as contract revenue and not offset against contract costs.
The reasoning underlying treating this differently from the earlier instance (where idle funds resulting from advances are invested temporarily) is that such advances were envisioned by the terms of the contract and as such were probably fully considered in the negotiation process that preceded fixing contract revenue.
Thus, since negotiated as part of the total contract price, this belongs in contract revenues. (It should be borne in mind that the different treatments for interest income would in fact have a bearing on the determination of the percentage or stage of completion of a construction contract.)
Indirect costs or overhead expenses should be included in contract costs provided that they are attributable to the contracting activity in general and could be allocated to specific contracts. Such costs include construction overhead, cost of insurance, cost of design, and technical assistance that is not related directly to specific contracts.
Those indirect costs should be allocated using methods that are systematic and rational and are applied in a consistent manner to costs having similar features or characteristics. The allocation should be based on the normal level of construction activity, not on theoretical maximum capacity.
Example Of Contract Costs
A construction company incurs $700,000 in annual rental expense for the office space occupied by a group of engineers and architects and their support staff. The company utilizes this group to act as the quality assurance team that overlooks all contracts undertaken by the company.
The company also incurs in the aggregate another $300,000 as the annual expenditure toward electricity, water, and maintenance of this office space occupied by the group. Since the group is responsible for quality assurance for all contracts on hand, its work, by nature, cannot be considered as being directed toward any specific contract but is in support of the entire contracting activity.
Thus, the company should allocate the rent expense and the cost of utilities in accordance with a systematic and rational basis of allocation, which should be applied consistently to both types of expenditure (since they have similar characteristics).
Although the bases of allocation of this construction overhead could be many (such as the amounts of contract revenue, contract costs, and labor hours utilized in each contract) the basis of allocation that seems most rational is contract revenue. Further, since both expenses are similar in nature, allocating both the costs on the basis of the amount of contract revenue generated by each construction contract would also satisfy the consistency criteria.
Other examples of construction overhead or costs that should be allocated to contract costs are:
- Costs of preparing and processing payroll of employees engaged in construction activity
- Borrowing costs that are capitalized under IAS 23.
Note: IASB eliminated the choice of recognizing borrowing costs immediately as an expense, in IAS 23, Borrowing Costs, as revised in 2007, to the extent that they are directly attributable to the acquisition, construction, or production of a qualifying asset.
Certain costs are specifically excluded from allocation to the construction contract, as the standard considers them as not attributable to the construction activity. Such costs may include:
- General and administrative costs that are not contractually reimbursable
- Costs incurred in marketing or selling
- Research and development costs that are not contractually reimbursable
- Depreciation of plant and equipment that is lying idle and not used in any particular contract
Types Of Contract Costs
Contract costs can be broken down into two categories: ‘costs incurred to date‘ and ‘estimated costs to complete‘. The costs incurred to date include pre-contract costs and costs incurred after contract acceptance. Pre-contract costs are costs incurred before a contract has been entered into, with the expectation that the contract will be accepted and these costs will thereby be recoverable through billings.
The criteria for recognition of such costs are:
- They are capable of being identified separately.
- They can be measured reliably.
- It is probable that the contract will be obtained.
Pre-contract costs include costs of architectural designs, costs of learning a new process, cost of securing the contract, and any other costs that are expected to be recovered if the contract is accepted.
Contract costs incurred after the acceptance of the contract are costs incurred toward the completion of the project and are also capitalized in the construction-in-progress (CIP) account. The contract does not have to be identified before the capitalization decision is made; it is only necessary that there be an expectation of the recovery of the costs. Once the contract has been accepted, the pre-contract costs become contract costs incurred to date. However, if the pre-contract costs are already recognized as an expense in the period in which they are incurred, they are not included in contract costs when the contract is obtained in a subsequent period.
Estimated Costs to Complete
These are the anticipated costs required to complete a project at a scheduled time. They would be comprised of the same elements as the original total estimated contract costs and would be based on prices expected to be in effect when the costs are incurred. The latest estimates should be used to determine the progress toward completion.
Although IAS 11 does not specifically provide instructions for estimating costs to complete, practical guidance can be gleaned from other international accounting standards, as follows: The first rule is that systematic and consistent procedures should be used. These procedures should be correlated with the cost accounting system and should be able to provide a comparison between actual and estimated costs. Additionally, the determination of estimated total contract costs should identify the significant cost elements.
A second important point is that the estimation of the costs to complete should include the same elements of costs included in accumulated costs. Additionally, the estimated costs should reflect any expected price increases. These expected price increases should not be blanket provisions for all contract costs, but rather, specific provisions for each type of cost. Expected increases in each of the cost elements such as wages, materials, and overhead items should be taken into consideration separately.
Finally, estimates of costs to complete should be reviewed periodically to reflect new information. Estimates of costs should be examined for price fluctuations and should also be reviewed for possible future problems, such as labor strikes or direct material delays.
Accounting for contract costs is similar to accounting for inventory. Costs necessary to ready the asset for sale would be recorded in the construction-in-progress account, as incurred. CIP would include both direct and indirect costs but would usually not include general and administrative expenses or selling expenses since they are not normally identifiable with a particular contract and should therefore be expensed.
Since a contractor may not be able to do all facets of a construction project, a subcontractor may be engaged. The amount billed to the contractor for work done by the subcontractor should be included in contract costs. The amount billed is directly traceable to the project and would be included in the CIP account, similar to direct materials and direct labor.
Contract costs may have to be adjusted for back charges. Back charges are billings for costs incurred that the contract stipulated should have been performed by another party. The parties involved often dispute these charges.
Example Of A Back Charge Situation
The contract states that the subcontractor was to raze the building and have the land ready for construction; however, the contractor/seller had to clear away debris in order to begin construction. The contractor wants to be reimbursed for the work; therefore, the contractor back charges the subcontractor for the cost of the debris removal.
The contractor should treat the back charge as a receivable from the subcontractor and should reduce contract costs by the amount recoverable. If the subcontractor disputes the back charge, the cost becomes a claim. Claims are an amount in excess of the agreed contract price or amounts not included in the original contract price that the contractor seeks to collect. Claims should be recorded as additional contract revenue only if the requirements set forth in IAS 11 are met.
The subcontractor should record the back charge as a payable and as additional contract costs if it is probable that the amount will be paid. If the amount or validity of the liability is disputed, the subcontractor would have to consider the probable outcome in order to determine the proper accounting treatment.