1.4 Definitions
A construction contract is a contract
made for the construction of one or more assets that are closely-related, or
interdependent in their design, technology, and function, or their purpose or
use.
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Example:
Should
a manufacturer of plant and machinery follow the guidance for construction
contract accounting?
Background
K
is building a large currency printing press within the premises of the buyer,
which can take up to 18 months to complete.
A contract can therefore be active over three accounting periods.
Entity A can reliably estimate the outcome of the contract.
Solution
Yes. The date at which contract activity is
entered into and the date when the activity is completed fall into different
accounting periods.
The
work in progress system K uses to track its production processes should be
used to determine the stage of completion of each contract at the balance
sheet date. Revenue on contracts for
the manufacture of the printing presses should be recognised by reference to
the percentage of completion method (see below).
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Example:
Does
the production of a series of assets meet the definition of a construction
contract?
Background
An
entity entered into a contract with a retailer that sells furniture. The contract will last for a period of two
years. The entity is required to
manufacture 2,000 sofas over the two-year term to the retailer’s specification.
Solution
This
is not a construction contract. It is simply a contract between a supplier
and a purchaser for the production of goods. The contract is for the
construction of a series of assets that are not interrelated. The sofas are
not interrelated because one sofa is not connected to or dependent on another
sofa in any way.
The
sofas will be delivered to the retailer over the period of two years as they
are manufactured. There is no typical construction activity. Commencement and
completion of individual sofas will fall into a single accounting period.
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Fixed-price Contract
A fixed-price contract is a contract
in which the parties agree to a fixed price, or a fixed price per unit of
output.
Cost-escalation clauses may be a
feature of these contracts.
Example:
You
agree with a contractor to build an office block including a branch of your
bank over a 3-year period for $10million. For the contractor, at the end of
years 1 & 2, unbilled revenue will be increased by the national annual rate
of inflation recorded on the 31st of December.
This
is a cost escalation clause.
Cost-plus Contract
A cost-plus contract is a contract
where the contractor is reimbursed for allowable costs, plus a percentage
profit (or fixed fee). Cost plus is the standard for some contractees (for
example, some government bodies).
Example:
You
agree to buy a security vault for the contracted costs, plus a 10% profit.
This
is a cost-plus contract.
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