A construction contract is signed between a construction company and a customer for the construction of an asset or combination of assets. Accounting treatment of revenue and costs associated with construction contracts is a challenging and complex process as construction contracts are mostly long-term and complex.
Objective
The allocation of contract revenue and contract costs to the accounting periods in which construction work is performed is the main objective in accounting for construction contracts. This is because the date at which the contract activity is entered into and the date when the activity is completed usually fall into different accounting periods. Accounting for Construction Contracts also aims to determine when contract revenue and contract costs should be recognized as revenue and expenses in the statement of profit and loss.
Examples
1. Fixed Price Contract
Under this contract, a fixed total price for the construction project is reported, and revenue is recognized based on the percentage of completion method in which the percentage of work completed is multiplied by the total contract price to evaluate the revenue recognized to date.
2. Cost Plus Contract
Under this contract, the contractor is reimbursed for all permissible expenses incurred during the construction process, plus a fee mainly based on a percentage of the total costs. In this case, revenue is recognized as costs incurred, plus the fee percentage applied to the estimated total costs.
3. Percentage of Completion Method
Under this method, revenue is recognized over the period of the construction work. This is done by calculating the percentage of completion based on the costs incurred to date relative to the total estimated contract costs. Under this method, revenue could be reported more evenly throughout the project.
4. Completed Contract Method
Under this method, revenue is recognized only after the entire contract is completed and all performance obligations are satisfied. This method is mostly used when it becomes difficult to accurately estimate total costs or when the project is short-term.
5. Change Order
Change orders involve modifications to the original contract, and it can impact the total contract price and costs incurred. In this case, revenue recognized to date is adjusted to account for the change order, with the recognition of profit or loss based on the new contract price and costs incurred.
6. Retention
Retention is that portion of the contract price that is withheld by the customer until the project is completed. In this case, revenue is recognized for the portion of the work completed, while the amount withheld by the customer is recognized separately as a liability until it is released.
7. Liquidated Damages
Liquidated damages are predetermined amounts that are specifically mentioned in the contract. These amounts are paid by one party to the other in the event of a breach. In this case, the revenue recognized is adjusted as the penalty amount.
8. Milestone Billing
In milestone billing, payments are made after a particular project is completed. In this case, revenue is recognized as each milestone is completed, which is mostly based on the percentage of the total contract price allocated for that milestone.
9. Overhead Allocation
Indirect costs incurred in the construction process are called overhead costs, which are allocated to individual projects based on a predetermined rate. In this case, the revenue recognized is adjusted to account for the allocation of overhead costs.
10. Warranty Provision
A warranty provision is an estimated amount that is kept aside to cover future warranty claims. In this case, the revenue recognized is reduced by the amount of the estimated warranty provision to show the potential future costs of fulfilling warranty claims.
11. Claims and Disputes
Claims and disputes, that arise during the construction process, may cause changes in the contract price or costs incurred. In this case, the revenue recognized is adjusted to report any changes due to these claims or disputes, with profit or loss recognized during the construction process.