ACCOUNTING STANDARD-7

CONSTRUCTION CONTRACTS

CA. PANKAJ AGRWAL

B.Com(Hons), LL.B., FCA

OBJECTIVE & SCOPE

To prescribe the accounting treatment of revenue and costs associated with construction contracts because the date at which contract activity is entered into and the activity gets completed fall in different accounting periods.

Therefore, the primary issue is the allocation of contract revenue and contract costs to the accounting periods in which construction work is performed.

OBJECTIVE & SCOPE This statement uses the recognition criteria

established in the ‘Framework for the Preparation and Presentation of Financial Statements to determine when contract revenue and contract costs should be recognised.

It applies to the accounting for construction contracts.

DEFINITIONS

CONSTRUCTION CONTRACT

is a contract specifically negotiated for the

construction of an asset or combination of assets

that are closely interrelated or interdependent

in terms of their design, technology and function or their ultimate purpose or use.

DEFINITIONS

Fixed Price Contract

is a construction contract in which

the contractor agrees to a

fixed contract price or fixed rate per unit of output, which

in some cases is subject to cost escalation.

DEFINITIONS Cost plus Contract

is a construction contract in which

the contractor is reimbursed for allowable or otherwise defined costs,

plus percentage of these costs or a fixed rate.

Construction Contracts

It includes contracts for rendering of services which are directly related to the

Construction of the asset

Destruction or restoration of assets

Restoration of the environment following demolition of assets.

Combining and Segmenting

If the contract covers number of assets, construction of each asset be treated as a separate construction contract when:

Separate proposals have been made

Each asset has been subject to separate negotiation and the contractor and the customer has been able to accept or reject that part of the contract

The costs and revenues of each asset can be identified

Combining and Segmenting

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

The group of contracts is negotiated as a single package

Contracts are closely interrelated that they are, in effect, part of a single project with an overall profit margin; and

The contracts are performed concurrently or in a continuous sequence.

Contract Revenue

It Comprises:

Initial amount agreed

Variations in the contract work, claims and incentive payments to the extent it is probable that they will result in revenue and can be measured.

Contract Revenue A variation is an instruction by the customer for a

change in the scope of the work to be performed under the contract.

A claim is an amount that the contractor seeks to collect from the customer or another party as reimbursement for costs not included in the contract price.

Incentive payments are additional amounts payable to the contractor, if specified performance standards are met or exceeded.

Contract Costs It comprises of :

Direct Costs

Attributable Costs

Specifically chargeable costs as per the terms of the contract.

Recognition of Revenue and Expenses

To be recognised when the outcome can be estimated reliably

Contract Revenue and Costs should be recognised as revenue and expenses

by reference to the stage of completion of the contract activity at the reporting date.

Expected Loss to be recognised immediately.

Conditions for reliable estimate

In case of Fixed Price Contracts:

• Total revenue can be measured reliably;

• Economic benefits will flow to the enterprise

• Contract costs to complete and the stage of completion can be measured at the reporting date

• Contract costs attributable to the contract can be identified and measured

Conditions for reliable estimate

In case of Cost Plus Contracts:

• Economic benefits will flow to the enterprise

• Contract costs attributable to the contract can be identified and measured

Stage of completion

• Proportion of costs to the estimated total cost

• Surveys of work performed

• Physical proportion of contract work

Estimation of Outcome not possible

• Revenue to be recognised to the extent of costs incurred of which recovery is probable.

• Contract costs be recognised as an expense of the period.

• When the uncertainties that prevented the outcome of the contract being estimated cease to exist, revenue and costs be recognised.

Expected Loss

• Expected Loss be recognised immediately when the total costs are likely to exceed the total revenue.

• Loss is to be recognised

• even if no work has commenced on the project.

• Irrespective of the stage of completion

• Irrespective of the profits accruing on other contracts.

Disclosure

• Amount of Contract Revenue recognised

• Method used to determine the contract revenue

• Method used to determine the stage of completion

• For contracts in progress, it should also disclose:

• Aggregate amount of costs incurred and recognised profits;

Disclosure

• Amount of advances received

• Amount of retentions

• Gross amount due from and due to customers.

ILLUSTRATION

YEAR I

YEAR

II

YEAR III

Initial amount of revenue agreed in contract

9000 9000 9000

Variation 200 200

Total Contract Revenue 9000 9200 9200

Contract Costs incurred upto the reporting date

2093 6168 8200

Contract costs to complete 5957 2032 0

Total Estimated costs 8050 8200 8200

Rs. In Lacs

ILLUSTRATION

YEAR I

YEAR

II

YEAR III

Estimated Profit 950 1000 1000

Stage of Completion 26% 74% 100%

ILLUSTRATION

Upto Reporting date

Recognised in prior year

Recognised in current year

Year I

Revenue (9000 x 0.26)

2340 2340

Expenses (8050 x 0.26)

2093 2093

Profit 247 247

ILLUSTRATION

Upto Reporting date

Recognised in prior year

Recognised in current year

Year II

Revenue (9200 x 0.74)

6808 2340 4468

Expenses (8200 x 0.74)

6068 2093 3975

Profit 740 247 493

ILLUSTRATION

Upto Reporting date

Recognised in prior year

Recognised in current year

Year III

Revenue (9200 x 1.00)

9200 6808 2392

Expenses (8200 x 1.00)

8200 6068 2132

Profit 1000 740 260

ILLUSTRATION - DISCLOSURE WORKING

A B C D E TOTAL

A. Contract Revenue recognised

145 520 380 200 55 1300

B. Contract Expenses recognised

110 450 350 250 55 1215

C. Expected Losses recognised

40 30 70

D. Recognised Profits less losses

35 70 30 (90) (30) 15

E. Contract Costs incurred in the period

110 510 450 250 100 1420

F. Contract Costs incurred recognised as contract expense in the period

110 450 350 250 55 1215

ILLUSTRATION - DISCLOSURE WORKING

A B C D E TOTAL

G. Contract Costs that relate to future activity

60 100 45 205

H. Contract Revenue 145 520 380 200 55 1300

I. Progress Billing 100 520 380 180 55 1235

J. Unbilled Contract Revenue

45 - - 20 - 65

K. Advances - 80 20 - 25 125

ILLUSTRATION Contd…

Construction ContractsContract revenue recognised as revenue for the year ended 31st December XXX1300

Aggregate amount of Contract costsincurred and recognised profits (less recognised losses) upto 31st December XXX for all the contracts in progress1435

ILLUSTRATION Contd…

The amount of customer advancesoutstanding for contracts in progressas at 31st December XXXX 125

Gross amount due from customers for contract work presented as an asset 220

Gross amount due to customers for contract work presented as a liability (20)

From Published Accounts

TRF LIMITED Profit on contract is recognised on percentage completion method. The stage of completion is determined as a proportion that contract costs [including the cost of WIP in factory relating to contracts entered into on or after 01.04.2003 to be in line with revised Accounting Standard 7, (AS7)] incurred for work performed upto the reporting date bear to the estimated total costs. Profit (contract revenue less contract cost) is recognised only when stage of completion is 40% or more when the outcome of the contract can be estimated reliably. When it is probable that the total cost will exceed the total contract revenue the expected loss is recognised immediately.

From Published Accounts

Mukand Limited Accounting for Long Term Engineering Contracts:

(a) Revenue for engineering contract work executed (including supplies & services) is recognised on the basis of percentage completion method and only after the work has progressed to the extent of 10% in each composite contract. Till such time, all the costs are carried forward to the next accounting year as “Accumulated Contract Costs” under “Inventories”. Recognition of revenue is matched with expenses incurred (on accrual basis) after considering the contract value with associated costs. Costs and Revenue are both recognised upto 90% and debtors are reflected accordingly. Balance is recognised only upon the Preliminary/Final acceptance of job by the client. Periodic advances received from customers are not considered as income.

From Published Accounts

Mukand Limited Accounting for Long Term Engineering Contracts:

(b) Income which arises out of invoicing of contract work and the contract costs which are accounted on accrual basis, are, both credited to income or charged to revenue, as the case may be, only after at least 10% of the total estimated contract costs (i.e. direct and indirect costs) are incurred (on accrual basis). Till such time, all the costs are carried forward to the next accounting year as “Accumulated Contract Costs” under “Inventories” and recognition of revenue is correspondingly postponed. Direct costs include all expenses specifically attributable to the contract. Variation in estimates of contract costs are updated each year by technical certification.

From Published Accounts

Mukand Limited Accounting for Long Term Engineering Contracts:

(c) “Accumulated Contract Costs”, after the stage when they are not any further to be carried forward in terms of (b) above, are charged to revenue to the extent not specifically attributable to the contract and balance is transferred to “Incomplete Contract Work” under “Inventories”.

(d) Variations by way of escalation in price and quantum of work is recognised as revenue in the year in which claims are lodged as per the terms of contract. Other claims are recognised as revenue only upon final acceptance by customer.

From Published Accounts

Mukand Limited Accounting for Long Term Engineering Contracts:

(e) All facilities in the nature of assets created at the customer’s site and which are to be abandoned at the end of the contract, are, when under construction, carried forward at Direct cost-to-date as “Facilities at Customer’s site – Under construction”. Upon subsequent completion, they are carried forward as “Facilities at Customer’s site – Completed” (both being grouped as “Other Current Assets”). The completed facilities are written off in equal annual installments over the period commencing from the year of completion of the facility upto the contracted year for completion of the contract. Billable reimbursements against such facilities, if separately identified in a contract, are similarly credited in equal annual installments against the write-off over the said period.

Issues

Builder Vs Contractor

Value of Turnover