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 recognised as revenue and expenses be

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
Rs. In Lacs

YEAR I Initial amount of revenue agreed in contract Variation Total Contract Revenue Contract Costs incurred upto the reporting date Total Estimated costs 9000 2093 9000

YEAR II 9000 200 9200 6168 2032 8200

YEAR III 9000 200 9200 8200 0 8200

Contract costs to complete 5957 8050

ILLUSTRATION YEAR I Estimated Profit Stage of Completion 950 26% YEAR II 1000 74% YEAR III 1000 100%

ILLUSTRATION
Upto Recognised Reporting in prior year date Recognised in current year

Year I Revenue (9000 x 0.26) Expenses (8050 x 0.26) Profit 2340 2093 247 2340 2093 247

ILLUSTRATION
Upto Recognised Reporting in prior year date Recognised in current year

Year II Revenue (9200 x 0.74) Expenses (8200 x 0.74) Profit 6808 6068 740 2340 2093 247 4468 3975 493

ILLUSTRATION
Upto Recognised Reporting in prior year date Recognised in current year

Year III Revenue (9200 x 1.00) Expenses (8200 x 1.00) Profit 9200 8200 1000 6808 6068 740 2392 2132 260

ILLUSTRATION - DISCLOSURE WORKING

A A. Contract Revenue recognised B. Contract Expenses recognised C. Expected Losses recognised D. Recognised Profits less losses E. Contract Costs incurred in the period F. Contract Costs incurred recognised as contract expense in the period
35 110 110 70 510 450 30 450 350 145 110

B
520 450

C
380 350

D
200 250 40 (90) 250 250 55 55 30 (30) 100 55

TOTAL
1300 1215 70 15 1420 1215

ILLUSTRATION - DISCLOSURE WORKING

A G. Contract Costs that relate to future activity H. Contract Revenue I. Progress Billing J. Unbilled Contract Revenue K. Advances
145 100 45 60 520 520 80

C
100 380 380 20

D
45 200 180 20 55 55 25

TOTAL
205 1300 1235 65 125

ILLUSTRATION Contd
Construction Contracts
Contract revenue recognised as revenue for the year ended 31st December XXX Aggregate amount of Contract costs incurred and recognised profits (less recognised losses) upto 31st December XXX for all the contracts in progress 1300

1435

ILLUSTRATION Contd

The amount of customer advances outstanding for contracts in progress as at 31st December XXXX Gross amount due from customers for contract work presented as an asset Gross amount due to customers for contract work presented as a liability

125 220 (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 customers site and which are to be abandoned at the end of the contract, are, when under construction, carried forward at Direct costto-date as Facilities at Customers site Under construction. Upon subsequent completion, they are carried forward as Facilities at Customers 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