Presentation on theme: "CONSTRUCTION CONTRACTS"— Presentation transcript:
1CONSTRUCTION CONTRACTS ACCOUNTING STANDARD-7CONSTRUCTION CONTRACTSComplex ways in which business is conducted.44 Paragraphs + appendix. Bold Paragraph are 12.Revised in 2002 applicable from 1st April 2003.Applies only to contractors and not to the contractees.Now only one method i.e. Proportional method permitted.CA. PANKAJ AGRWALB.Com(Hons), LL.B., FCA
2OBJECTIVE & SCOPETo 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.Standard – It facilitates comparability, reduces number of options.
3OBJECTIVE & SCOPEThis 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.
4DEFINITIONS CONSTRUCTION CONTRACT is a contract specifically negotiated for theconstruction of an asset or combination of assetsthat are closely interrelated or interdependentin terms of their design, technology and function or their ultimate purpose or use.What about service contracts ?
5DEFINITIONS Fixed Price Contract is a construction contract in which the contractor agrees to afixed contract price or fixed rate per unit of output, whichin some cases is subject to cost escalation.Contracts are of two types 1. Fixed Price Contracts and Cost plus contract.
6DEFINITIONS 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.
7Construction Contracts It includes contracts for rendering of services which are directly related to theConstruction of the assetDestruction or restoration of assetsRestoration of the environment following demolition of assets.
8Combining 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 madeEach asset has been subject to separate negotiation and the contractor and the customer has been able to accept or reject that part of the contractThe costs and revenues of each asset can be identifiedContract with one entity for construction of number of petrol pumps. Each petrol pump will be required to be seperately treated as a separate contract.
9Combining 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 packageContracts are closely interrelated that they are, in effect, part of a single project with an overall profit margin; andThe contracts are performed concurrently or in a continuous sequence.Hotel project, Sugar Mill on turnkey basis.
10Contract 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.
11Contract RevenueA 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.
12Contract Costs It comprises of : Direct Costs Attributable Costs Specifically chargeable costs as per the terms of the contract.What about costs incurred prior to award of the contract ? Para 20 of the ASDirect Costs to be reduced by incidental income.Attributable Costs: Insurance, costs of designs and technical assistance, overheads.Costs which cannot be allocated:General Administrative ExpensesSelling CostsResearch & DevelopmentDepreciation of idle plants.
13Recognition of Revenue and Expenses To be recognised when the outcome can be estimated reliablyContract Revenue and Costs should be recognised as revenue and expensesby reference to the stage of completion of the contract activity at the reporting date.Expected Loss to be recognised immediately.
14Conditions for reliable estimate In case of Fixed Price Contracts:Total revenue can be measured reliably;Economic benefits will flow to the enterpriseContract costs to complete and the stage of completion can be measured at the reporting dateContract costs attributable to the contract can be identified and measuredThe standard also provides 4 parameters for determination as to when the outcome can be reliably estimated.
15Conditions for reliable estimate In case of Cost Plus Contracts:Economic benefits will flow to the enterpriseContract costs attributable to the contract can be identified and measured
16Stage of completion Proportion of costs to the estimated total cost Surveys of work performedPhysical proportion of contract workThree methods prescribed for determining the stage of completion.
17Estimation 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.Para 28 “It is necessary to have an effective internal financial budgeting & reporting system.
18Expected LossExpected Loss be recognised immediately when the total costs are likely to exceed the total revenue.Loss is to be recognisedeven if no work has commenced on the project.Irrespective of the stage of completionIrrespective of the profits accruing on other contracts.As a prudent policy, the standard requires for provision of loss at the first instance irrespective of the stage of contract. It may so happen that in the first year, there may be profit and in second year it may turn out to be loss affair and in the subsequent year, it may again turn around.
19Disclosure Amount of Contract Revenue recognised Method used to determine the contract revenueMethod used to determine the stage of completionFor contracts in progress, it should also disclose:Aggregate amount of costs incurred and recognised profits;
20Disclosure Amount of advances received Amount of retentions Gross amount due from and due to customers.
21Initial amount of revenue agreed in contract 9000 ILLUSTRATIONRs. In LacsYEAR IYEARIIYEAR IIIInitial amount of revenue agreed in contract9000Variation200Total Contract Revenue9200Contract Costs incurred upto the reporting date209361688200Contract costs to complete59572032Total Estimated costs8050
22ILLUSTRATIONYEAR IYEARIIYEAR IIIEstimated Profit9501000Stage of Completion26%74%100%
23ILLUSTRATION Year I Revenue (9000 x 0.26) 2340 Expenses (8050 x 0.26) Upto Reporting dateRecognised in prior yearRecognised in current yearYear IRevenue (9000 x 0.26)2340Expenses (8050 x 0.26)2093Profit247
24ILLUSTRATION Year II Revenue (9200 x 0.74) 6808 2340 4468 Upto Reporting dateRecognised in prior yearRecognised in current yearYear IIRevenue (9200 x 0.74)680823404468Expenses (8200 x 0.74)606820933975Profit740247493
25ILLUSTRATION Year III Revenue (9200 x 1.00) 9200 6808 2392 Upto Reporting dateRecognised in prior yearRecognised in current yearYear IIIRevenue (9200 x 1.00)920068082392Expenses (8200 x 1.00)820060682132Profit1000740260
26ILLUSTRATION - DISCLOSURE WORKING BCDETOTALA. Contract Revenue recognised145520380200551300B. Contract Expenses recognised1104503502501215C. Expected Losses recognised403070D. Recognised Profits less losses35(90)(30)15E. Contract Costs incurred in the period5101001420F. Contract Costs incurred recognised as contract expense in the periodD + EProgressive billing IDue from CustomersDue to Customers (20)
27ILLUSTRATION - DISCLOSURE WORKING BCDETOTALG. Contract Costs that relate to future activity6010045205H. Contract Revenue145520380200551300I. Progress Billing1801235J. Unbilled Contract Revenue-2065K. Advances8025125
28ILLUSTRATION Contd…Construction Contracts Contract revenue recognised as revenue for the year ended 31st December XXX 1300Aggregate amount of Contract costs incurred and recognised profits (less recognised losses) upto 31st December XXX for all the contracts in progress 1435
29ILLUSTRATION Contd…The amount of customer advances outstanding for contracts in progress as at 31st December XXXX 125Gross amount due from customers for contract work presented as an asset 220Gross amount due to customers for contract work presented as a liability (20)
30From Published Accounts TRF LIMITEDProfit 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 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.Old StandardPara 9.8 Normally, the profit is not recognised in fixed price contract unless the work on a contract has progressed to a reasonable extent. Ordinarily, this test is not considering as having been satisfied unless 20% to 25% of the work is completed.Para 17.2 (Standard Part)Profits in case of fixed price contracts normally should not be recognised unless the work on a contract has progressed to a reasonable extent.No such provision in new standard instead new standards requires the recognition of revenue to the extent the cost incurred is probable of recovery and the cost to be expensed out till there are circumstances because of which the outcome cannot be estimated reliably.
31Mukand Limited Accounting for Long Term Engineering Contracts: From Published AccountsMukand LimitedAccounting 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.
32Mukand Limited Accounting for Long Term Engineering Contracts: From Published AccountsMukand LimitedAccounting 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.
33Mukand Limited Accounting for Long Term Engineering Contracts: From Published AccountsMukand LimitedAccounting for Long Term Engineering Contracts:“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”.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.
34Mukand Limited Accounting for Long Term Engineering Contracts: From Published AccountsMukand LimitedAccounting 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.
35Issues Builder Vs Contractor Value of Turnover Builder Vs Contractor : Issue settled by guidance note issued by the Institute. It stresses on the transfer of significant risks and rewards and states that in such contracts price is the main risk which gets transferred on the execution of the contract to the buyer. If significant work is to be done by the builder, proportionate completion method is to be followed otherwise completion method is to be adopted.