The interpretation and application of an accounting standard could be a complex task especially in those cases where a slightly different interpretation could lead to materially different financial results. The most difficult part of an accountant’s work life is to accurately apply the accounting standards without compromising on the fair presentation of financial data and that’s a skill which needs a lot of patience and practice. The general guidance provided by IFRSs in all such cases is to follow an approach which is more ‘principle based’ rather than ‘rule based’. The same is the case with IAS – 11 which seems quite brief and straight forward when you study it for your accountancy exams, however later you realized that to implement it in more tender and intelligible way it becomes necessary to discuss more general questions which your mind had never broached earlier. Here we shall not discuss each and everything IAS 11 is all about, instead we shall look at a few matters covered therein which are trickier and require agile accounting approach.
Implementing IAS 11 requires an entity to establish and maintain an internal cost and budgeting department as the recognition of earning is highly dependent on the percentage completion of work, contrary to any other type of business where business cycle completes in a fairly short period of time. The construction contracts are usually long term spanning over multiple years and periodic recognition of revenue and cost becomes mandatory in order to conform with the very fundamental accounting concept of accrual. IAS 11 suggests different methods of estimating the stage of completion which include the following:
- the proportion that cost incurred for work performed to date bear to the estimated total contracts cost (commonly called cost-to-cost method)
- survey of work performed; or
- completion of a physical proportion of the contract work
Where IAS 11 suggests a variety of methods to choose from, it’s very important to have an insight into the pattern of the flow of economic benefits of each specific contract in order to choose the most appropriate method. The economic benefit could generally be defined as a quantifiable benefit in the form of revenue, net cash flow or earnings. The pattern of economic benefits for each individual project usually suggests the most appropriate method for estimating stage of completion. Let’s looks at the following scenarios.
- XYZ Company enters into a contract with a property developer for the provision of project management services from pre-construction design phase to final completion and handing over of building to buyer. The contract stipulates a tentative fixed fee for the provision of project management services over a period of 3 years, which would be billed to the client per actual man-hours spent by XYZ Company staff on the project every month. The actual management fee might be marginally different from the fixed fee agreed at the signing of contract pursuant to changing circumstances which are not accurately predictable at the inception.In this case the project management fee is not dependent on the physical completion of different parts of building but on the man-hours of service provided by XYZ Company to the client. The invoice for the provision of services is raised every month per the actual man hours worked. The pattern of economic benefits suggests to calculate of stage of completion either on cost-to-cost method or on the basis of proportion that progress billings to date bear to the total contract fee.
- XYZ Company enters into a contract with a property developer for the provision of project management services for building a residential tower which is expected to complete in 5 years. The total fee agreed is US$ 5 million. XYZ Company shall invoice the project management as per the following progress billing plan:
- Completion of planning phase – US$ 0.5 m
- Completion of design and government permitting phase – US$ 0.5 m
- Completion of construction phase – US$ 3.5 m
- After the provision of post completion services – US$ 0.5 m
The terms of contracts have made it mandatory to meet some KPIs (key performance indicators) that are non-financial metrics in this case in order to measure the progress of contract and the economic benefit associated therewith. The completion of physical phases would more appropriately measure the stage of completion and the same should be used in order to recognize cost and revenue over 5 year period. It’s important to note that whatever might be the pattern of cost, the earning and receipt of project management fee is dependent on meeting specific KPIs and the method to calculate the stage of completion should reflect this fact.
Moreover, In order to accurately estimate the stage of completion at a time, it’s very important to count the beans accurately as the earning recognition depends on it. IAS 11 provides guideline as to what to include in the contract cost:
- Costs that related directly to the specific contracts;
- Costs that are attributable to contract activity in general and can be allocated to the contract; and
- Such other costs that are specifically chargeable to customer under the terms of the contract. This may include some general administrative costs and development costs for which reimbursement is specified in the terms of the contract.
The business involved in the construction and construction related services usually have an internal budgeting department and it’s not uncommon with these business to assess the overall profitability of each contract individually where a share of general and administrative cost and taxes payable are also budgeted and included in the total cost of a project in order to calculate and manage the overall projected EAT (earnings after taxes) on each individual project. These budgets are reviewed and revised at regular intervals and the past performances are translated into future estimates. It is also a common practice in construction industry to charge the customer an additional fee in order to cover general and administration costs. As the projects are controlled and managed on the premise of overall profitability, the cost incurred to date must include a share of general and administrative costs and taxes in order to estimate the stage of completion while using cost-to-cost method. The general and administration costs and taxes may later be presented separately on the face of the statement of comprehensive income.
It’s also very interesting to know that in construction contract accounting the attributes of revenue are inverse to conventional revenue. Okay not quite like that, just the way how we account for it is a bit different.
The earnings equation for any business other than construction works out as follows:
Revenue – Cost = Earning/ (Loss)
However the estimation of stage of completion, especially cost-to-cost method, usually makes this equation to work other way round and it takes the following form:
Cost ± Earning/ (Loss) = Revenue
The equations mentioned above look alike with the only difference of transposition of its ingredients across the equation sign but it poses some complexity in applying a few accounting concepts and a good judgment and a good command over interpretation of financial figures is required while looking at the financial statements.
Let’s consider the following example:
On April 1, 20X5 XYZ Ltd entered into a fixed price contract of US$ 300,000 to construct an office building for ABC Ltd. At the contract date, XYZ Ltd estimated that it would take two years to complete the project. Assume that XYZ Ltd judges that project outcomes can be estimated reliably and that cost-to-cost method is used to estimate the stage of completion. During the year 20X5, XYZ Ltd incurred costs on the project of US$ 100,000 and estimated cost at 31 December 20X5 (the end of the company’s reporting period) to complete the project was US$ 100,000. ABC Ltd was billed US$ 190,000m against which XYZ recovered US$ 125,000.
The application of IAS 11 shall produce the following financials as of 31 December 20X5:
Statement of Comprehensive Income Revenue (US$ 300,000 x 50%) US$ 150,000 Cost (US$ 200,000 x 50%) US$ 100,000 Profit (US$ 100,000 x 50%) US$ 50,000 Statement of Financial Position Cash (125,000– 100,000) US$ 25,000 Receivables (190,000– 125,000) US$ 65,000 Total Assets US$ 90,000 Due to Customer (190,000 – 150,000) US$ 40,000 Earnings US$ 50,000 Total Liabilities and Equity US$ 90,000
The amount ‘Due to Customer’ represents the unrecognized revenue that has been billed to the client but not recognized in the statement of comprehensive income as the revenue recognition is the function of cost and recognized earnings with reference to the stage of completion. IAS 11 requires an entity to disclose the amount due to/from the customer depending on the status of project as of the end of reporting period. This amount is shown either among the assets or liabilities depending on its debit or credit balance. This amount has to be calculated as follows:
Cost Incurred to date US$ 100,000* Add/(Less): Profit / (Loss) recognized to date US$ 50,000 Total revenue recognized to date (Cost + Profit) US$ 150,000 Less: Progress Billings to Date US$ 190,000 Amount Due to Customer US$ 40,000
*Cost incurred to date shall be equal to Cost recognized to date whenever Cost-to-Cost method is used for estimated stage of completion.
Alternatively we can infer that:
Cost ± Profit (Loss) = Revenue; and
Progress Billings – Revenue = Amount due to/from customer
Cost ± Profit (Loss) – Progress Billings = Amount due to/from customer
Now let’s assume there arises a dispute before the year-end close of accounts over the outstanding receivables of US$ 65,000 and ABC Ltd doesn’t seem likely to make any payment over US$ 20,000. Consequently the recoverability of US$ 45,000 becomes very unlikely and the management of XYZ Ltd decides to write off this amount.
The fundamental accounting principle is that recognized revenue cannot be reversed on the premise of its uncollectibility, rather the uncollectible amount should be taken as an expenses against the recognized revenue. This fundamental principle is quite logical and doesn’t pose any complexity in normal business accounting where profit is usually a function of revenue and expenses. However construction contract accounting is a bit different for here the revenue is the function of cost and profit.
Let’s summarize this scenario in a more understandable way:
Amount billed to customer US$ 190,000 Revenue Recognized US$ 150,000 Unrecognized Revenue/ Progress Billings US$ 40,000 Receivable Amount US$ 65,000 Uncollectible Amount US$ 45,000
The unrecognized revenue is US$ 40,000 where outstanding receivables are US$ 65,000. We can safely assume that total receivable balance of US$ 65,000 comprises of the following:
a. Progress billings recognized US$ 25,000 as revenue and still outstanding (US$ 65K – US$ 40K) b. Progress billings not yet recognized US$ 40,000 as revenue and still outstanding a + b. Progress billings receivable US$ 65,000
A rule of thumb for this bifurcation is to compare the balance sheet amounts of receivables with the unrecognized revenue. The amount by which receivable balance exceeds the unrecognized revenue (if any) can be termed as recognized revenue that has not been recovered in cash as yet.
IAS 11 provides guidance about dealing with such a situation in the paragraph # 28:
“When an uncertainty arises about the collectability of an amount included in contract revenue, and already recognized in profit or loss, the uncollectible amount or the amount in respect of which recovery has ceased to be probable is recognized as an expense rather than adjustment of the amount of contract revenue”
In the above scenario we have to write off an amount of US$ 45,000 as customer is likely to pay only US$ 20,000 out of the receivable amount of US$ 65,000. It’s also evident that we do have an unrecognized revenue of US$ 40,000 which has not been yet recognized in the statement of comprehensive Income and forms part of unrecognized revenue/ amount due to customer in the statement of financial position at the end of reporting period. By following the guidance provided by IAS 11 in paragraph # 28, we should write off US$ 25,000 which has become uncollectible and has already been recognized in the profit.
However, writing off this amount doesn’t provide a complete solution as the account receivables and unrecognized revenue/amount due to customer on the balance sheet are still overstated by an amount of US$ 20,000 (US$ 45K – US$ 25K). IAS 11 is completely silent on this matter and doesn’t provide any guidance. However the only way out and that too endorsed by the Industry practice is to write off the remaining balance of US$ 20,000 through unrecognized revenue/amount due from customer. Consequently the receivable account and unrecognized revenue/ amount due from customer need to be reduced by US$ 20,000 in order to fairly present the financial position of business. In the language of debit and credit we can say:
Bad Debts US$ 25,000 Amount Due to Customer US$ 20,000 Account Receivables US$ 45,000
The statement of comprehensive Income and the statement of financial position should now be presented as follows:
Statement of Comprehensive Income Revenue (US$ 300,000 x 50%) US$ 150,000 Cost (US$ 200,000 x 50%) US$ 100,000 Gross Profit (US$ 100,000 x 50%) US$ 50,000 Bad Debts US$ 25,000 Net Profit US$ 25,000 Statement of Financial Position Cash (125,000– 100,000) US$ 25,000 Receivables (190,000– 125,000 – 45,000) US$ 20,000 Total Assets US$ 45,000 Due to Customer (190,000 – 150,000 – 20,000) US$ 20,000 Earnings US$ 25,000 Total Liabilities and Equity US$ 45,000
Let’s move to Year 20X6 now and see if this accounting goes well. Now assume that further cost of US$ 100,000 was incurred and the project was successfully completed. XYZ Ltd billed the remaining balance of US$ 110,000 to ABC Ltd and recovered it in full along with the outstanding balance as of 31 December 20X5.
The financial statements shall be presented as follows:
Statement of Comprehensive Income Revenue (US$ 280,000 x 100% - US$ 150,000) US$ 130,000 Cost (US$ 200,000 x 100% - 100,000) US$ 100,000 Profit US$ 30,000 Statement of Financial Position Cash (25,000 + 20,000 + 110,000 – 100,000) US$ 55,000 Receivables ____ -__ Total Assets US$ 55,000 Due to Customer - Earnings (25,000 + 30,000) US$ 55,000 Total Liabilities and Equity US$ 55,000
It might again be a good idea to do a little mathematics here.
Contract Price US$ 300,000 Less: Unrecovered amount US$ 45,000 Total amount recovered US$ 255,000 Less: Total Cost Incurred to complete the project US$ 200,000 Total profit US$ 55,000
The interpretation and implementation of IAS 11 requires extensive number crunching to ensure that figures in the financial statements present what they ought to as the financial reporting of construction contract is pretty different from what you would expect for ‘normal’ business.