Recognition of a provision for liquidated damages
Almost every construction contract has a “time is of the essence” provision and a completion deadline. The consequences for failure to meet the completion deadline may include termination of the contract for default, payment of the obligated party’s costs to supplement the labour force to mitigate delays, and the assessment of liquidated damages or actual damages due to a delay or a failure to complete the work in a timely manner.
Keywords: Mazars, Thailand, Accounting, Liquidated damages, COVID-19, Thai Accounting Standard 11, TFRS
20 May 2021
Significant project delays increase the surety provider’s risk of receiving both a performance bond claim from the obligated party and payment bond claims from lower-tier vendors seeking progress payments and reimbursement of delay/impact costs.
Scenario
Company A is a construction company in Thailand. In 2019, Company A entered into a construction contract to build a warehouse for a customer.
The agreement listed a milestone date of 30 November 2020 to complete and deliver the warehouse to the customer. Liquidated damages were also specified as the measure of recovery for a breach of contract or in the event that the project was delayed beyond the completion date outlined in the agreement.
Due to the current health concerns and disruption brought about by COVID-19, there has been a significant effect on Company A's construction work, which has led to Company A being unable to build the warehouse and deliver it to the customer as set out in the contract.
As a result, Company A must pay liquidated damages to the customer.
At the end of 2020, the total amount of liquidated damages had not yet been determined. Therefore, Company A did not record any provision for liquidated damages in its financial statements for 2020.
Subsequently, on 15 February 2021, the total amount of liquidated damages was determined. The amount of liquidated damages that Company A must pay to the customer is THB 6.5 million.
The financial statements of Company A will be authorized and issued on 30 April 2021.
Issue
In the scenario set out above, when should Company A recognize a provision for the liquidated damages in its financial statements?
Response
Paragraphs 17, 36, and 37 of Thai Accounting Standard 11, “Construction contracts”, states:
1. Contract costs that relate directly to a specific contract include:
- Site labour costs, including site supervision.
- Costs of materials used in construction.
- Depreciation of plant and equipment used for 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 are directly related to the contract.
- The estimated costs of rectification and guarantee work, including expected warranty costs.
- Claims from third parties.
These costs may be reduced by any incidental income that is not included in contract revenue, such as income from the sale of surplus materials and the disposal of plant and equipment at the end of the contract.
2. Recognition of expected losses
When it is probable that total contract costs will exceed total contract revenue, the expected loss shall be recognized as an expense immediately.
3. The amount of such a loss is determined regardless of:
- Whether work has commenced on the contract;
- 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 addition, paragraph 3 of Thai Accounting Standard 10, “Events After the Reporting Period”, states:
Event after the reporting period: An event, which could be favourable or unfavourable, that occurs between the end of the reporting period and the date that the financial statements are authorized for issue.
Adjusting event: An event after the reporting period that provides further evidence of conditions that existed at the end of the reporting period, including an event that indicates that the going-concern assumption in relation to all or part of the enterprise is not appropriate.
The scenario set out above indicates that an unfavourable event in the form of a delay in the project occurred in 2020. The total amount of liquidated damages was determined on 15 February 2021, which is before the financial statements will be authorized for issue.
As a result, Company A must recognize a provision for liquidated damage related to a delay in delivering the construction work of THB 6.5 million as contract costs in its financial statements for 2020.
References: FAP website and TFRS 10 and TFRS 11 and TFAC website
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