CONDUCTIVIDAD TERMICA

Construction companies have different problems, as large construction con-tracts often span a number of years. Normally, revenue and profit can only be shown in the income statement once the full terms of the contract have been fulfilled. However, if a construction company waited until the project is finished before including a contract in the income statement, the accounts would not reflect a fair view of its financial performance. It might complete no contracts in one year and three in the following year. Consequently there is a different way of accounting for long-term contracts, and this is known as the percentage of completion method. This allows construction companies to include in their income statement an appropriate proportion of uncompleted profitable long-term contracts once the contract’s outcome can be reliably esti-mated. If you’re analysing a construction company you need to understand how they incorporate revenue and profit into their income statement.

IAS 11 Construction contracts applies to construction contracts, and contracts for services that are directly related to the construction of an asset. The first thing a company has to do when determining its revenue and costs for the period is to make a reliable estimate for the contract’s total profit or loss, and IAS 11 offers guidance for estimating the outcome of both fixed price contracts and cost-plus contracts. Then it estimates the contract’s stage, or

percentage, of completion, which is then applied to the contract’s total rev-enue and expenses to determine the revrev-enue and expenses that are shown in the current period’s income statement. The accounting standard provides detailed guidance on contract accounting including:

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O Bid costs – Companies can incur significant costs bidding for contracts, and these costs are usually allocated to the contract from the date the contract is secured. All the contract’s direct costs should be included in the contract’s costs as soon as they can be measured reliably, and it’s probable that the contract will be given to the company. (This happens when the company has been named the ‘preferred bidder’.)

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O Contract losses – If a company believes that a contract will make a loss, the full loss must be taken immediately in the income statement.

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O Inability to estimate the contract’s outcome – If a company can’t reliably estimate a contract’s outcome, no profit can be taken in the income statement. The revenue shown is the recoverable amount of the costs incurred, and the contract’s costs are expensed as they’re incurred.

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O Profitable contracts – If the contract is almost certainly profitable, the value of work completed is shown as revenue and any costs relating to the work done are charged to cost of sales. Then the ‘attributable profit’

is shown in the income statement. (A lot of companies believe that profitability can be assessed with some certainty when more than 30% of the contract has been completed.)

Companies determine the stage of completion by:

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O measuring the costs incurred for work performed to date as a percentage of the estimated total costs;

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O surveys of the work performed to date – this is usually done by the main contractor, who hires an architect to certify the contract’s progress;

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O completing a physical proportion of the contract work.

The contract’s billings are unlikely to follow the percentage of completion, and are more likely to be based on agreed milestones. Consequently, there will be assets, and possibly liabilities, on the balance sheet reflecting the amounts owed by, or to, the customer. The asset shows with trade and other receivables, and the liability shows with trade and other payables. The asset, or liability, is calculated by deducting the progress billings from the total of

the reported profit plus the costs. I’ve illustrated this in the example below, showing a three-year contract.

The contracting and engineering group Costain’s accounting policy is cov-ered in two of its accounting policy notes, and I’ve extracted the part of the revenue note and the trade and other receivables note relating to construc-tion contracts.

Construction contracts

Revenue arises from increases in valuations on contracts. Where the outcome of a construction contract can be estimated reliably and it is probable that the contract will be profitable, revenue and costs are recognised by reference to the stage of completion of the contract activity at the balance sheet date.

Stage of completion is assessed by reference to the proportion of contract costs incurred for the work performed to date relative to the estimated total costs, except where this would not be representative of the stage of completion.

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

Variations and claims are included in revenue where it is probable that the amount, which can be measured reliably, will be recovered from the customer.

When the outcome of a construction contract cannot be estimated reliably, contract revenue is recognised to the extent of contract costs incurred where it is probable those costs will be recoverable.

Contract costs are recognised as expenses in the period in which they are incurred.

Bid costs

Costs associated with bidding for contracts are written off as incurred. When it is probable that a contract will be awarded, usually when the Group has secured preferred bidder status, costs incurred from that date to the date of financial close are carried forward in the balance sheet.

Year 1 Year 2 Year 3

Cumulative costs to date 4,000 7,100 9,500

Cumulative profits 500 400 500

Cumulative billings (4,000) (8,000) (9,000)

Receivable/(payable) shown on the balance sheet 500 (500) 1,000 Example 2.1

In the notes to their 2007 balance sheet they disclosed:

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O In the note on trade and other receivables – The amounts due from customers for contract work was £45.8 million. The total amount of contract costs incurred plus recognised profits, less recognised losses, at the balance sheet date was £1,796.2 million.

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O In the note on trade and other payables – There were credit balances on long-term contracts of £7.2 million.

The major difference between IAS 11 and SSAP 9 Stocks and long term contracts is the presentation on the balance sheet, as the UK has always included contract work in progress with stock. Consequently, long-term contract balances are analysed as:

• amounts recoverable on contracts (included in debtors);

• work in progress (included in stock);

• payments on account (which can be deducted from the debtor and stock, or shown as a creditor).

When financial close is achieved on PFI contracts, costs are recovered from the special purpose vehicle and pre-contract costs within this recovery that were not previously capitalised are credited to the income statement. When the Group retains an interest in the special purpose vehicle and accounts for its interest as an associate or joint venture, the credit is recognised over the life of the construction contract to which the costs relate.

Trade and other receivables

Construction work in progress is stated at cost plus profit recognised to date less a provision for foreseeable losses and less amounts billed and is included in amounts due from customers for contract work. Amounts valued and billed to customers are included in trade receivables. Cost includes all expenditure related directly to specific projects and an appropriate allocation of fixed and variable overheads incurred in the Group’s contracting activities based on normal operating capacity. Where the cash received from customers exceeds the value of work performed, the balance is included in credit balances on long-term contracts.