Malaysia Financial Reporting Standard (FRS) 111:Construction Contracts

EFFECTIVE DATE

This Standard becomes operative for financial statements covering periods beginning on or after 1 July 2007.

OBJECTIVE

To prescribe the accounting treatment of revenue and costs associated with construction contracts. This is because the start data and complete/end date for construction contracts usually fall into different accounting period hence the primary issue in accounting for construction contracts is the allocation of contract revenue and contract costs to the accounting periods in which construction work is performed.

SCOPE:-

This Standard shall be applied in accounting for construction contracts in the financial statements of CONTRACTORS. This Standard supersedes FRS 1112004 Construction Contracts.

DEFINITION:

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.

The different type of contracts defined in FRS 111:-

A fixed price contract is a construction contract in which the contractor agrees to a fixed contract price, or a fixed rate per unit of output, which in some cases is subject to cost escalation clauses.
A cost plus contract is a construction contract in which the contractor is reimbursed for allowable or otherwise defined costs, plus a percentage of these costs or a fixed fee.

Combining and segmenting construction contracts

The requirements of this Standard are usually applied separately to each construction contract. However, there are certain circumstances where there is a need to apply the Standard to the separately identifiable components of a single contract or to a group of contracts together in order to reflect the substance of a contract or a group of contracts.

Situation: When a contract covers a number of assets:-

The construction of each asset shall be treated as a separate construction contract when:

(a) separate proposals have been submitted for each asset;

(b) 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

Situation: A group of contracts, whether with a single customer or with several customers, shall be treated as a single construction contract when:

(a) the group of contracts is negotiated as a single package;

(b) the contracts are so closely interrelated that they are, in effect, part of a single project with an overall profit margin; and

Situation: Additional asset in the construction contract:

The construction of the additional asset shall be treated as a separate construction contract when:

(a) the asset differs significantly in design, technology or function from the asset or assets covered by the original contract; or

(b) the price of the asset is negotiated without regard to the original contract price.

CONTRACT REVENUE DEFINITION

Contract revenue consists of initial amount of revenue agreed in the contract and variations in contract work, claims and incentive payments to the extent that it is probable that they will result in revenue; and are capable of being reliably measured

HOW TO MEASURE CONTRACT REVENUE:

Contract revenue is measured at the fair value of the consideration received or receivable.
Comprises initially agreed price, increase as a result of cost escalation clauses in a fixed price contract, penalties (reduction in revenue) arising from delays caused by the contractor in the completion of the contract; or number of units increase (higher revenue) when it is a fixed price contract which involves a fixed price per unit of output,

For Claims:

Claims are included in contract revenue only when:

(a) negotiations have reached an advanced stage such that it is probable that the customer will accept the claim; and

(b) the amount that it is probable will be accepted by the customer can be measured reliably.

For Incentive Payments:

Incentive payments are additional amounts paid to the contractor if specified performance standards are met or exceeded. For example, a contract may allow for an incentive payment to the contractor for early completion of the contract. Incentive payments are included in contract revenue when:

(a) the contract is sufficiently advanced that it is probable that the specified performance standards will be met or exceeded; and

(b) the amount of the incentive payment can be measured reliably

CONTRACT COSTS DEFINITION:

Contract costs are

(a) costs that relate directly to the specific contract;

(b) costs that are attributable to contract activity in general and can be allocated to the contract; and

Costs that relate directly to a specific contract include

site labor costs, including site supervision, costs of materials used in construction, depreciation of plant and equipment used on the contract, costs of moving plant, equipment and materials to and from the contract site, costs of hiring plant and equipment, costs of design and technical assistance that is directly related to the contract, the estimated costs of rectification and guarantee work, including expected warranty costs; and claims from third parties
These costs may be reduced by any incidental income that is not included in contract revenue, for example income from the sale of surplus materials and the disposal of plant and equipment at the end of the contract.

Costs that may be attributable to contract activity in general and can be allocated to specific contracts include insurance, costs of design and technical assistance that are not directly related to a specific contract and construction overheads. Such costs are allocated using methods that are systematic and rational and are applied consistently to all costs having similar characteristics. The allocation is based on the normal level of construction activity. Construction overheads include costs such as the preparation and processing of construction personnel payroll. Costs that may be attributable to contract activity in general and can be allocated to specific contracts also include borrowing costs

Costs that are specifically chargeable to the customer under the terms of the contract may include some general administration costs and development costs for which reimbursement is specified in the terms of the contract.

COSTS TO EXCLUDE:

Costs that cannot be attributed to contract activity or cannot be allocated to a contract. Such costs include general administration costs for which reimbursement is not specified in the contract, selling costs, research and development costs for which reimbursement is not specified in the contract and depreciation of idle plant and equipment that is not used on a particular contract

Costs that relate directly to a contract and are incurred in securing the contract are also included as part of the contract costs if they can be separately identified and measured reliably and it is probable that the contract will be obtained. When costs incurred in securing a contract are 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.

RECOGNITION OF CONTRACT REVENUE AND EXPENSES

Use the stage of completion of the contract activity at the balance sheet date when:

outcome of contract can be estimated reliably
any expected loss shall be recognized as expense immediately

CRITERIA TO ESTIMATE OUTCOME OF A CONSTRUCTION CONTRACT:

For fixed price contract, when following conditions are satisfied:

(a) total contract revenue can be measured reliably;

(b) it is probable that the economic benefits associated with the contract will flow to the entity;

(d) the contract costs attributable to the contract can be clearly identified and measured reliably so that actual contract costs incurred can be compared with prior estimates.

For cost plus contract, when following conditions are satisfied:

(a) it is probable that the economic benefits associated with the contract will flow to the entity; and

(b) the contract costs attributable to the contract, whether or not specifically reimbursable, can be clearly identified and measured reliably.

Para 25 of FRS 111 on Percentage of Completion Method:

The recognition of revenue and expenses by reference to the stage of completion of a contract is often referred to as the percentage of completion method.
Under this method, contract revenue is matched with the contract costs incurred in reaching the stage of completion, resulting in the reporting of revenue, expenses and profit which can be attributed to the proportion of work completed. This method provides useful information on the extent of contract activity and performance during a period.

Para 26 of FRS 111

Contract revenue is recognised as revenue in the income statement in the accounting periods in which the work is performed.
Contract costs are usually recognised as an expense in the income statement in the accounting periods in which the work to which they relate is performed. However, any expected excess of total contract costs over total contract revenue for the contract is recognised as an expense immediately

Para 27 of FRS 111 On Contract Cost recognized as Asset:

A contractor may have incurred contract costs that relate to future activity on the contract. Such contract costs are recognised as an asset provided it is probable that they will be recovered. Such costs represent an amount due from the customer and are often classified as contract work in progress

The outcome of a construction contract can only be estimated reliably when it is probable that the economic benefits associated with the contract will flow to the entity. However, when an uncertainty arises about the collectibility of an amount already included in contract revenue, and already recognised in the income statement, the uncollectable amount or the amount in respect of which recovery has ceased to be probable is recognised as an expense rather than as an adjustment of the amount of contract revenue.(para 28)

An entity is generally able to make reliable estimates after it has agreed to a contract which establishes:

(a) each party’s enforceable rights regarding the asset to be constructed;

(b) the consideration to be exchanged; and

It is also usually necessary for the entity to have an effective internal financial budgeting and reporting system. The entity reviews and, when necessary, revises the estimates of contract revenue and contract costs as the contract progresses. The need for such revisions does not necessarily indicate that the outcome of the contract cannot be estimated reliably. (para 29)

HOW TO DETERMINE THE STAGE OF COMPLETION OF A CONTRACT

Include the following:

(a) the proportion that contract costs incurred for work performed to date bear to the estimated total contract costs;

(b) surveys of work performed; or

Progress payments and advances received from customers often do not reflect the work performed. (para 30)

Excluded contract costs when using percentage of completion method are:

(a) contract costs that relate to future activity on the contract, such as costs of materials that have been delivered to a contract site or set aside for use in a contract but not yet installed, used or applied during contract performance, unless the materials have been made specially for the contract; and

(b) payments made to subcontractors in advance of work performed under the subcontract (para 31)

When the outcome of a construction contract cannot be estimated reliably:

revenue shall be recognised only to the extent of contract costs incurred that it is probable will be recoverable; and
contract costs shall be recognised as an expense in the period in which they are incurred.
An expected loss on the construction contract shall be recognised as an expense immediately

EARLY STAGE OF CONTRACT where outcome of contract cannot be estimated reliably:

Contract revenue is recognised only to the extent of costs incurred that are expected to be recoverable. As the outcome of the contract cannot be estimated reliably, no profit is recognised.
Any expected excess of total contract costs over total contract revenue for the contract is recognised as an expense immediately (para 33 of FRS 111)

EXAMPLES OF IRRECOVERABLE CONTRACT COSTS:

Contract costs that are not probable of being recovered are recognised as an expense immediately.
Examples of circumstances in which the recoverability of contract costs incurred may not be probable and in which contract costs may need to be recognised as an expense immediately include contracts:

(a) that are not fully enforceable, ie their validity is seriously in question;

(b) the completion of which is subject to the outcome of pending litigation or legislation;

(d) where the customer is unable to meet its obligations; or

(e) where the contractor is unable to complete the contract or otherwise meet its obligations under the contract. (para 34)

When the uncertainties that prevented the outcome of the contract being estimated reliably no longer exist, revenue and expenses associated with the construction contract shall be recognised in accordance with paragraph 22 rather than in accordance with paragraph 32. (para 35)

RECOGNITION OF EXPECTED LOSSES

When it is probable that total contract costs will exceed total contract revenue, the expected loss shall be recognised as an expense immediately.

The amount of such a loss is determined irrespective of:

(a) whether work has commenced on the contract;

(b) the stage of completion of contract activity; or

the amount of profits expected to arise on other contracts which are not treated as a single construction contract in accordance with paragraph 9.

CHANGES IN ESTIMATES

The percentage of completion method is applied on a cumulative basis in each accounting period to the current estimates of contract revenue and contract costs.
Any change in the estimate of contract revenue or contract costs are used in the determination of the amount of revenue and expenses recognised in the income statement in the period in which the change is made and in subsequent periods.

DISCLOSURE UNDER FRS 111:ACCOUNTING FOR CONSTRUCTION CONTRACT

An entity shall disclose:

(a) the amount of contract revenue recognized as revenue in the period;

(b) the methods used to determine the contract revenue recognized in the period; and

Contracts in progress at the balance sheet date, the entity to disclose:-

(a) the aggregate amount of costs incurred and recognized profits (less recognized losses) to date;

(b) the amount of advances received; and

[Retentions are amounts of progress billings that are not paid until the satisfaction of conditions specified in the contract for the payment of such amounts or until defects have been rectified. Progress billings are amounts billed for work performed on a contract whether or not they have been paid by the customer. Advances are amounts received by the contractor before the related work is performed.(para 41)]

PRESENTATION IN THE FINANCIAL STATEMENT UNDER FRS 111

An entity shall present:

(a) the gross amount due from customers for contract work as an asset; and

(b) the gross amount due to customers for contract work as a liability (para 42)

The gross amount due to customers for contract work is the net amount of costs incurred plus recognized profits less the sum of recognized losses and progress billings for all contracts in progress for which progress billings exceed costs incurred plus recognized profits (less recognized losses).(para 43 & para 44)

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