ACCOUNTING STANDARD-7 CONSTRUCTION CONTRACTS (Revised 2002) by:Rawat

4/27/12

Presented Gaurav

B.com., ACA
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Points Covered
Introduction Object and scope Old v/s Revised AS Basic Terminology Combining and Segmenting Contract revenue and adjustment to it. Contract Cost Recognition of Contract Revenue and cost Issues Related Rawat, 9414783674 to recognition CA Gaurav
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INTRODUCTION
This AS issued by ICAI comes into effect in respect of all the

contracts entered into during accounting period commencing on or after 01.04.2003 and is mandatory in nature from that date.

Therefore

from that date Accounting Standard(AS) 7, Accounting for Construction Contracts, issued by institute in December 1983 is not applicable in respect of such contracts

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OBJECTIVE AND SCOPE

OBJECTIVE
Main

objective is to prescribe the accounting treatment of revenue and costs associated with construction contracts accounting periods in which construction work is performed.

Allocation of contract revenue and contract costs to the Determines

when contract revenue and contract costs should be recognized as revenue and expenses in the statement of profit and loss.

SCOPE
This statement is applied in accounting for construction

contracts inCA Gaurav Rawat, 9414783674 the financial statements of contractors. CA Gaurav Rawat, 4/27/12
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Old v/s Revised

Basis of difference Applicability Old Revised It applies on theApplies in contractor as well asaccounting for to enterprisesconstruction undertaking contracts in the construction financial activities not asstatements of contractor but oncontractors. their own account as a venture of commercial nature. Methods of Recognize twoRecognize only accounting CA Gaurav Rawat, 9414783674 methods:one method:55 CA Gaurav Rawat, 4/27/12 1) Percentage of1)Percentage of 9414783674

BASIC TERMINOLOGY
Construction Contract

Contract specifically for the construction of an asset or combination of assets that are closely interrelated / independent in terms of their design, technology and function or their ultimate purpose or use.

Fixed Price Contract

Contract in which the contractor agrees to fix contract price or a fixed rate per unit of output which may be subject to escalations.
Cost Plus CA Gaurav Rawat, 9414783674 Contract CA Gaurav Rawat, 4/27/12 Contract 9414783674 the contractor is reimbursed in which

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CONSTRUCTION CONTRACTS
It includes:1. Contracts for the rendering of services which

are directly related to the construction of the assets, for example, those for the services of project managers and architects; asset, and the restoration of the environment following the demolition of assets. This included in the revised AS 7 and was not finding place in the previous AS7

2. Contracts for destruction or restoration of

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Combining and Segmenting

For applying this AS each construction contract is treated separately but sometimes it is combined or segmented:1.
a) b)

Contract of number of assets should be treated as separate construction contract when:Separate proposals have been submitted for each assets, Each asset has been subject to separate negotiation and the contractor and customer have been able to accept or reject that part of the contract relating to each asset. Costs and revenue of each asset can be identified.

c)

2.
a) b)

Group of contract, with single/several customers should be treated as single contract when:Contracts is negotiated as a single package. Contracts are Gaurav Rawat, that they are 4/27/12 single project a part of CA Gaurav Rawat, 9414783674 88 CA so interrelated with an overall profit margin. 9414783674

Combining and Segmenting

3.

Construction of an additional asset should be treated as a separate construction contract when:-

a)

Asset differ significantly in design, technology or function from the asset/assets covered by the original contract.

a)

Price of the asset is negotiated without regard to the original contract price.

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CONTRACT REVENUE
Contract Revenue comprises of:1. 2. a)

the initial amount of revenue agreed in the contract Variations in contract work, claims and incentive payments; To the extent that it is probable that they will result in revenue. They are capable of being reliably measured.

b)

) 1. 2.

Further, the amount of contract revenue may increase or decrease from one period to the next Due to variations and claim, Due to cost escalation clauses 9414783674
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Adjustments to contract Revenue

When to Recognize variations:-

Contractor and theYes, the recognize the contractee agree variationsvariation agreed upon or claims that increase or decrease contract revenue in period subsequent to the period when initial amount was agreed upon Is there any cost escalationYes, recognize cost as compared to the agreedescalations in the contract upon measures of cost, andrevenue. is such cost escalation allowed to theGaurav Rawat, 9414783674 contractor CA Gaurav Rawat, 11 CA 4/27/12 as per contract clause. 11 9414783674

Adjustments to contract Revenue

Variations:- Generally Contracts includes a variation clause. It is an

instruction by the customer for a change in the scope of the work. This may be a change in the specification or design of the asset and change in the contract duration

Whether to include variations in contract revenue Include when it is probable that the customer will approve the variation and the amount of revenue arising from the variation. Amount of revenue can be measured reliably. CA Gaurav Rawat, 9414783674 CA Gaurav Rawat, 4/27/12

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Adjustments to contract Revenue

Claims:- It 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. Claims may arise from delays on the part of the customer, change in specifications or design and undisputed variations in the contract work.

When to recognize claim in the contract revenue

Negotiations with customers reached on advance level. Amount that is probable to be accepted by the customer.

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Adjustments to contract Revenue

Incentive Payments:- It is an additional payment to be

paid to the contractor if the specified performance standards are met or exceeded. It may be available for early completion of the contract.

When to recognize claim in the contract Contract is sufficiently revenue advanced It is probable that the specified standard will be achieved Amount of incentive can be reliably measured
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ILLUSTRATION
Contract Revenue Rs 10 lacs. Contract period 5 years. Incentive of Rs .5 Lacs will be paid if the contract is

completed within a period of 4.5 years.

There will be variations allowed in case of specification is

changed.

Contractee is willing to pay 2lacs, while contractor is

demanding 2.5lacs

Should the variation & incentive be recognized as contract revenue?

The constructor should recognize Rs 2 Lacs variations as there is no evidence Rawat, suggests that the customer will not that 9414783674 CA Gaurav 15 CA Gaurav Rawat, 4/27/12 agree to the variation demand of the contractor. 15 9414783674

ILLUSTRATION conti
Further for the incentive of Rs .5 lacs following should be noted
1.

Degree of certainty of the work completion within a period of 4.5 years;

2.

Possible cause which are hindrances to achieve the desired target completion date.

3.

Payment behavior of the customer to ascertain whether the agreed upon incentive will be recoverable.
CA Gaurav Rawat, 9414783674 CA Gaurav Rawat,

If on the appraisel of the above mentioned points if it 9414783674

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CONTRACT COSTS
Contract Cost comprises of:1.

Costs directly related to specific contract.

Sr. no Type of Cost a b. c. d. e. f. g. Site Labour cost including site super-vision Cost of material Depreciation of Plant used in the contract Transshipment cost of plant, equipment and materials to and from contract site Cost of Hiring plant and machinery CostGaurav Rawat,and technical assistance CA Gaurav Rawat, 9414783674 CA of design 4/27/12 9414783674 Estimated cost of rectification and

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CONTRACT COSTS
2.

Costs that are in general and can be allocated to the contract

Sr. no Type of Cost Insurance Cost of designs and specification not directly related to contract 3. Construction overheads 4. Portion of general administrative overhead Sr. no Type of Cost the contract as per chargeable to agreement. 2. Expenses not included in the contract 1. General administration expenses not to be reimbursed by the customer 2. Selling Cost CA Gaurav Rawat, 3. Research and development 4/27/12 costs 9414783674 reimbursement of which is not specified in 1. 2.

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CONTRACT COSTS
Contract cost which are not recoverable are recognized as

an expenses immediately. Examples of such cost are:1. 2. 3. 4. 5.

Which are not fully enforceable, that is, their validity is seriously in question. The completion of which is subject to the outcome of pending litigation or legislature. Where the customer is unable to meet its obligations Relating to properties that are likely to be condemned or expropriated. Where the contractor is unable to complete the contract or otherwise meet its obligation under the contract.

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Recognition of Contract Revenue and Expenses

On the reliable estimation of the outcome of construction

contract , cost associated with the construction contract shall be recognized as revenue and expenses respectively considering the stage of completion of the contract at the reporting date.

On the basis of class of contract revenue has to be recognized

considering the various requirements separately for:-

1. 2.

Fixed Price contract Cost Plus contract

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Recognition
At the time of recognition of revenue it should be noted

that:Fixed price contract

1. 2. 3. 4.

Total contract revenue can be measured reliability Probability that economic benefit associated with it will flow Future expected cost and cost incurred till reporting date can be measured reliably Costs attributable to the contract can be identified and measured so that actual cost can be compared with estimates.

CA Gaurav Cost Plus ContractRawat, 9414783674 CA Gaurav Rawat,

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Issue related to Recognition

Issues Requirements Basic criteria for -Is the outcome of the recognition of revenue and contract reliably expenses . measurable? Yes. -Recognize revenue and expenses related to a contract. -Recognition should be on the basis of stage of completion. Recognition of an expected-Is estimated contract cost losses. is higher than contract revenue? Yes -Recognize estimated 22 CA Gaurav Rawat, 4/27/12 contract loss. 22 9414783674

Issue related to Recognition

Issues Requirements Recognition when-Recognize revenue only to the outcome cannot beextent cost is recoverable. measured reliably -Recognize contract cost incurred during the accounting period as an expenses -Recognize expected loss which is automatic -In the early stage of contract outcome may not be estimated with reliability Which portion of-Expenses for which the costs are notcontractor do not have recoverable CA Gaurav Rawat, 9414783674 right to recover. enforceable 23 CA Gaurav Rawat, 4/27/12 23 9414783674 -If completion of contract is

Issue related to Recognition

Issues Requirements When should the outcome-Total contract revenue of a fixed prize contractcan be measured; can be reliably estimated -It is likely that contract revenue will be collected -Cost to be incurred to complete the contract and the stage of completion at the balance sheet date can be measured reliably. -Contract costs attributable to the contract can be reliably measured. CA Gaurav Rawat, 9414783674 24
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A contract may involve supply of goods supervision of installation, testing and training.
1.

Issue related to Recognition

and

2.

3.

Supply of goods is governed by AS 9 where as contracts involving supervision of installation will be governed by AS 7. In composite contract relative value of supervision work to the total value will have to be compared. In a particular case it was held by EAC that if value of supervision work not being significant in relation to the overall contract value, the contract is treated as mainly for supply of material and may not be construed as a construction contract. Consultancy fees for design engineering and project CA Gaurav Rawat, 9414783674 25 managementGaurav Rawat, CA 4/27/12 25 9414783674 Consultancy fees received only for design

1.

Expected Future Revenue Expected Future Loss A contractor has justA contractor has signed a entered into a contractcontract at 31.12.2010, at with the local municipalthe balance sheet date, body for building a Flyover.total revenue is estimated As per contract terms, heat Rs 15 Crores and total will receive an additionalcost is estimated at Rs 16 Rs 10 Million if the flyoverCrores, no work is begun is constructed with in aon the contract. period of 3 years. He want to recognize this revenueSolution:since in the past it hasExpected losses are been able to meet theserequired to be account for targets easily immediately hence the Solution:loss of Rs 1 crore is to be CA Gaurav Rawat, 9414783674 26 CA Gaurav will be 4/27/12 Additional Revenue Rawat, accounted in the current 26 recognized 9414783674 subject toyear.

Illustration

Percentage of Completion method Income is recognizes as work progresses.

Revenue is recognized annually in proportion of progress of work

to be matched with the corresponding contract costs incurred in the year, i.e. revenue and expenses are recognized with reference to the stage of completion.

revenue in the statement of profit and loss is recognized in the

accounting period in which the work is performed.

Cost is recognized as an expenses in the statement of profit and

loss in the accounting period in which the work is performed.

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Illustration
On 1st December 2010 A limited undertook a contract for Rs

85 lacs. On 31.03.2011 company found that Rs 6499000 has already been spent. Addition expected cost is Rs 3201000. Solution Total Cost incurred Expected Cost to be incurred % of completion is Revenue for the year (85lacs*67%) Less: cost incurred in Current Year Loss for the year 8,04,000 67% 56,95,000 64,99,000 Amount in Rs 64,99,000 32,01,000

Further foreseeable loss due to addition cost is :Total contract Revenue 85,00,000
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CA Gaurav Rawat, 9414783674 CA Gaurav Rawat, 4/27/12 Less: Total contract Cost(64,99,000+32,01,000) 97,00,000 9414783674

OLD v/s NEW

Basis ofOld AS Revised AS difference Recognition Profit is notIt does not prescribe recognized inthe extent of work fixed pricewhich should be contract unlesscompleted. It the work hasemphasizes the need progressed to ato estimate reliably reasonable the contract revenue extent. and contract cost. Conditions 4th1, 2 and 4th with an additional condition probability of the CA Gaurav Rawat, 9414783674 that 4/27/12 29 CA Gaurav Rawat, 29 9414783674 economic benefits 1, 3 and condition.

Manner of Estimation
1.

Determination of stage of completion

Method used should measure reliably the work performed, which depends upon the nature of the each contract. It can be on the ratio of costs incurred to date and estimated total cost.

Stage of completion =

Cumulative cost incurred X 1oo till reporting date Total Estimated Cost

It can also be ascertained with reference to surveys of work performed. Completion of physical proportion of the contract work. It should be noted that progress payments and advances 30 receivedCA Gaurav Rawat, 9414783674 not necessarily reflect stage from customers CA Gaurav Rawat, may 4/27/12 30 9414783674 of completion

Manner of Estimation
2.

Provision for expected Losses

If it is viewed that a contract will generate loss on its completion than provision for such loss should be made, irrespective of:Whether or not work has been commenced on the contract the stage of completion of contract activity amount of profit expected to arise on other contract which are not treated as a single construction contract.

i. ii. iii.

Estimated Loss:- Total estimated cost on completion [-] Total Contract revenue
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Calculation of profit & loss

Step-1 Calculate Revenue to be Recognized

Revenue to be recognized Till date

Total Revenue Till date X [%] stage of completion

Profit Loss Revenue to be Cost recognized Step-2 Calculate Profit/ Loss Till date Till date recognized Till - till date = date

Current Year = Profit/Loss - Profit - Expecte Profit/ Loss Tillcurrent year Date Previously d Loss Step-3 Calculate Rawat, 9414783674 profit/Loss CA Gaurav 32 CA Gaurav Rawat, 4/27/12 recognized 32 9414783674

Treatment of Cost related to Future activity

future activity on the contract.

At times a contractor may incur contract costs that relate to any

If probability of such cost being recovered is there than such cost

should be recognized as an asset.

While calculating the

percentage of completion of work such cost will be excluded and also will not be considered as cost in that year, rather will be recognized as costs in the year to which it relates.

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Uncollectable Contract Revenue At times an uncertainty relating to the collectability of the

amount that has been already taken in revenue arises, such uncontrolled amount or the amount, in respect of which there is no chance of recovery, should be recognized as an expense rather than as an adjustment of the amount of contract revenue.

Change in Estimates

Percentage of completion method is applied on a cumulative basis therefore if there is any change in the estimates in determination of the amount of revenue and expenses , same are recognized in the profit & loss in the period in which the change is made and in subsequent periods. CA Gaurav Rawat, 9414783674 34 CA Gaurav Rawat, 4/27/12
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Illustrations
Query
Initial contract revenue Initial Contract cost Rs 900 Crores Rs 800 Crores

Particulars

Further at the end of 2nd year cost includes Rs 10 Crores CA Gaurav Rawat, 9414783674 35 CA Gaurav Rawat, 4/27/12 for material stored at the site to be used in 3rd year to 35
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Ist Year 2nd Year 3rd Year Estimated Contract cost 805 Increase in contract 20 revenue Estimated additional 15 increase cost Contract cost incurred 161 584 820 upto

Solution
Calculation of percentage of completion

PARTICULARS Year 1 Contract cost 161 incurred up to the date of reporting Estimated cost to complete Total estimated contract Estimated Profit Stage of Completion 644 805

Year 2 584*

Year 3 820

236 820 820 100 100% (820/820 36 X100) 36

95 100 20% 70% (161/805X1 (584CA Gaurav Rawat, 9414783674 CA Gaurav Rawat, 4/27/12 00) 10/820X100) 9414783674

Solution
Particulars Up to reporting date Recognized Recognized in prior in current year yr 180 161 19 180 161 19
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Year 1 Revenue 180 (900X20%) Expenses 161 Profit 19 Year 2 Revenue 644 (920X70%) Expenses 574 CA Gaurav Rawat, Profit 70 9414783674

464 413 51
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Guidance Note- Real Estate DevelopersAS 7 doesnt apply to the accounting for As discussed earlier
the real estate developers, so matters related to the Real estate developers are taken care in the Guidance Note in this regard. Revenue in case of real estate sales should be recognized when all the following conditions are satisfied:i.

The seller has transferred to the buyer all significant risks and rewards of ownership and the seller retains no effective control of the real estate to a degree usually associated with ownership. No significant uncertainty exists regarding the amount of the consideration that will be derived from the real estate sales. It is not unreasonable to expect ultimate collection.
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ii.

iii.

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Guidance Note- Real Estate Developers

Determination of transfer ownership:1. 2.

of risks and rewards of

Legal title passes to the buyer Seller enters into an agreement for sale and gives possession of the real estate to the buyer under agreement for sale. If seller has entered into a legally enforceable agreement for sale with the buyer and all the following conditions are satisfied even though the legal title is not passed or the possession of the real estate is not given to the buyer: buyer

3.

. Significant risk i.e. price risk has been transferred to the . Buyer has a legal right to sell or transfer his interest in the

property, without any condition or subject to only such conditionsCAwhich Rawat, 9414783674 do not materially affect his right to 39 CAGaurav Rawat, Gaurav 4/27/12 benefits in the property 39 9414783674

EXAMPLE
B Ltd is a real estate developer, Flats are booked and

allotted by way of allotment letter. Major work is undertaken after allotment, later same has been executed by legal document. Comment on revenue recognition.
Before deciding on recognition 3 basic points should be

considered:1. 2. 3.

All significant risk and rewards have been transferred No significant uncertainty exist in respect of consideration . Ultimate collection is certain.

The facts of the case suggest that above mentioned conditions are satisfied hence revenue is to be recognized by applying the percentage of completion method .
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DISCLOSURES
The methods used to determine the stage of completion of

contract in progress
The method used to determine the contract revenue

recognized in the period

The amount of contract revenue recognized in the period Contract cost incurred and recognized profit (less recognized

losses up to the reporting date)

Advance received Gross amount due from customers for contract work i.e. cost

incurred +recognized profit-recognized losses-progress billing

Gross amount due to customers for contract work

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ou kY an Th

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