Presentation on theme: "ACCOUNTING STANDARD-7 CONSTRUCTION CONTRACTS (Revised 2002)"— Presentation transcript:
1 ACCOUNTING STANDARD-7 CONSTRUCTION CONTRACTS (Revised 2002)
2 Points Covered Introduction Object and scope Old v/s Revised AS Basic TerminologyCombining and SegmentingContract revenue and adjustment to it.Contract CostRecognition of Contract Revenue and costIssues Related to recognitionDisclosures
3 INTRODUCTIONThis AS issued by ICAI comes into effect in respect of all the contracts entered into during accounting period commencing on or after 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
4 OBJECTIVE AND SCOPE OBJECTIVE Main objective is to prescribe the accounting treatment of revenue and costs associated with construction contractsAllocation of contract revenue and contract costs to the accounting periods in which construction work is performed.Determines when contract revenue and contract costs should be recognized as revenue and expenses in the statement of profit and loss.SCOPEThis statement is applied in accounting for construction contracts in the financial statements of contractors.
5 Old v/s Revised Basis of difference Old Revised Applicability It applies on the contractor as well as to enterprises undertaking construction activities not as contractor but on their own account as a venture of commercial nature.Applies in accounting for construction contracts in the financial statements of contractors.Methods of accountingRecognize two methods:-1) Percentage of completion method2) Completed contract methodRecognize only one method:-1)Percentage of completion methodRevised AS 7 does not apply to the builders/developers, so they will be required to recognize the revenue as per AS 9 ‘Revenue Recognition’.A contractor has to necessarily follow the percentage completion method in respect of all construction contracts entered into on or after
6 BASIC TERMINOLOGY Construction Contract Fixed Price 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 ContractContract 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 ContractContract in which the contractor is reimbursed for costs, plus percentage of these costs or a fixed fee.
7 CONSTRUCTION CONTRACTS It includes:-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;Contracts for destruction or restoration of 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
8 Combining and Segmenting For applying this AS each construction contract is treated separately but sometimes it is combined or segmented:-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.Group of contract, with single/several customers should be treated as single contract when:-Contracts is negotiated as a single package.Contracts are so interrelated that they are a part of single project with an overall profit margin.Contracts are performed in continuous sequence .
9 Combining and Segmenting Construction of an additional asset should be treated as a separate construction contract when:-Asset differ significantly in design, technology or function from the asset/assets covered by the original contract.Price of the asset is negotiated without regard to the original contract price.
10 CONTRACT REVENUE Contract Revenue comprises of:- the initial amount of revenue agreed in the contractVariations 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.Further, the amount of contract revenue may increase or decrease from one period to the nextDue to variations and claim,Due to cost escalation clausesDue to penaltiesIf no. of units increase in fixed price contracts.
11 Adjustments to contract Revenue When to Recognize variations:-Contractor and the contractee agree variations or claims that increase or decrease contract revenue in period subsequent to the period when initial amount was agreed uponYes, the recognize the variation agreed uponIs there any cost escalation as compared to the agreed upon measures of cost, and is such cost escalation allowed to the contractor as per contract clause.Yes, recognize cost escalations in the contract revenue.Is there any penal clause in the contract agreement? Yes, and is penalty imposed under the penal clause? YesAdjust such penalty in the contract revenue.Fixed Price Contract with fixed price per unit of outputAdjust contract revenue proportionately for any increase in unit.
12 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 durationWhether to include variations in contract revenueInclude 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.
13 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 revenueNegotiations with customers reached on advance level.Amount that is probable to be accepted by the customer.
14 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 revenueContract is sufficiently advancedIt is probable that the specified standard will be achievedAmount of incentive can be reliably measured
15 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 that suggests that the customer will not agree to the variation demand of the contractor.In case it is reasonable to assume that the amount of variation will be settled between 2 lacs to 2.5lacs, then on the basis of spirit of negotiations the contractor has to fix the most likely sum variation.
16 ILLUSTRATION conti…Further for the incentive of Rs .5 lacs following should be notedDegree of certainty of the work completion within a period of 4.5 years;Possible cause which are hindrances to achieve the desired target completion date.Payment behavior of the customer to ascertain whether the agreed upon incentive will be recoverable.If on the appraisel of the above mentioned points if it satisfies the required considerations than the same should be recognized.
17 CONTRACT COSTS Contract Cost comprises of:- Costs directly related to specific contract.Sr. noType of CostaSite Labour cost including site super-visionb.Cost of materialc.Depreciation of Plant used in the contractd.Transshipment cost of plant, equipment and materials to and from contract sitee.Cost of Hiring plant and machineryf.Cost of design and technical assistanceg.Estimated cost of rectification and guaranteed workh.Claims from third parties
18 CONTRACT COSTSCosts that are in general and can be allocated to the contractExpenses not included in the contractSr. noType of Cost1.Insurance2.Cost of designs and specification not directly related to contract3.Construction overheads4.Portion of general administrative overhead chargeable to the contract as per agreement.Sr. noType of Cost1.General administration expenses not to be reimbursed by the customer2.Selling Cost3.Research and development costs reimbursement of which is not specified in the contract4.Depreciation of idle plant and equipment.
19 CONTRACT COSTSContract cost which are not recoverable are recognized as an expenses immediately. Examples of such cost are:-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 obligationsRelating 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.
20 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:-Fixed Price contractCost Plus contract
21 RecognitionAt the time of recognition of revenue it should be noted that:-Fixed price contractTotal contract revenue can be measured reliabilityProbability that economic benefit associated with it will flowFuture expected cost and cost incurred till reporting date can be measured reliablyCosts attributable to the contract can be identified and measured so that actual cost can be compared with estimates.Cost Plus ContractCosts attributable to the contract can be identified and measured
22 Issue related to Recognition IssuesRequirementsBasic criteria for recognition of revenue and expenses .-Is the outcome of the contract reliably measurable? Yes.-Recognize revenue and expenses related to a contract.-Recognition should be on the basis of stage of completion.Recognition of an expected losses.-Is estimated contract cost is higher than contract revenue? Yes-Recognize estimated contract loss.-Should such loss be recognized even if the work has not commenced? Yes-Should such loss be recognized at the early stage of completion? Yes, loss should be recognized irrespective of the stage of completion-should such loss be recognized even if there is profit in other contracts? Yes
23 Issue related to Recognition IssuesRequirementsRecognition when outcome cannot be measured reliably-Recognize revenue only to the extent cost is recoverable.-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 reliabilityWhich portion of costs are not recoverable-Expenses for which the contractor do not have enforceable right to recover.-If completion of contract is dependent on the outcome of the pending litigation-Contract relates to a property that is likely to be condemned or expropriated.-Customer is unable to meet obligation.
24 Issue related to Recognition IssuesRequirementsWhen should the outcome of a fixed prize contract can be reliably estimated-Total contract revenue can be measured;-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.When should the outcome of a Cost Plus contract can be reliably estimated.-It is likely that contract revenue will be collected;-Contract costs attributable to the contract can be reliable measured.
25 Issue related to Recognition A contract may involve supply of goods and supervision of installation, testing and training.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 managementConsultancy fees received only for design engineering and project management directly related to construction of an asset is to be recognized as per AS 7.Revenue from consultancy fees for design engineering and project management not directly related to construction of an asset would be recognized as per principles in this regard enunciated in AS 9.
26 Illustration Expected Future Revenue Expected Future Loss A contractor has just entered into a contract with the local municipal body for building a Flyover. As per contract terms, he will receive an additional Rs 10 Million if the flyover is constructed with in a period of 3 years. He want to recognize this revenue since in the past it has been able to meet these targets easilySolution:-Additional Revenue will be recognized subject to fulfillment of the conditions discussed i.e.1)Reasonable certainty of completion2)Hindrances that can be there in completion3)Payment behavior of customer.A contractor has signed a contract at , at the balance sheet date, total revenue is estimated at Rs 15 Crores and total cost is estimated at Rs 16 Crores, no work is begun on the contract.Expected losses are required to be account for immediately hence the loss of Rs 1 crore is to be accounted in the current year.
27 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.
28 IllustrationOn 1st December 2010 A limited undertook a contract for Rs 85 lacs. On company found that Rs has already been spent. Addition expected cost is RsSolution Amount in RsTotal Cost incurred ,99,000Expected Cost to be incurred 32,01,000% of completion is %Revenue for the year (85lacs*67%) 56,95,000Less: cost incurred in Current Year 64,99,000Loss for the year ,04,000Further foreseeable loss due to addition cost is :-Total contract Revenue ,00,000Less: Total contract Cost(64,99,000+32,01,000) 97,00,000Total loss to be recognized ,00,000Loss already recognized 8,04,000Provision for expected loss 3,96,000
29 OLD v/s NEW Basis of difference Old AS Revised AS Recognition Profit is not recognized in fixed price contract unless the work has progressed to a reasonable extent.It does not prescribe the extent of work which should be completed. It emphasizes the need to estimate reliably the contract revenue and contract cost.Conditions1, 3 and 4th condition.1, 2 and 4th with an additional condition that probability of the economic benefits associated with the contract will flow to the enterprise.1. revenue can be measured reliability, 2. Probability that economic benefit associated with it will flow, 3. Future expected cost and cost incurred till reporting date can be measured reliably, 4. Costs attributable to the contract can be identified and measured so that actual cost can be compared with estimates.
30 Manner of Estimation 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.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 received from customers may not necessarily reflect stage of completionIf the percentage of completion is to be determined by reference to the contract cost up to the reporting date then care should be taken to exclude advances paid, prepaid expenses and closing inventory of material purchased but not consumed.Stage of completion =Cumulative cost incurred till reporting dateX 1ooTotal Estimated Cost
31 Manner of Estimation 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 contractthe stage of completion of contract activityamount of profit expected to arise on other contract which are not treated as a single construction contract.Estimated Loss:- Total estimated cost on completion [-] Total Contract revenue
32 Calculation of profit & loss Step-1 Calculate Revenue to be RecognizedStep-2 Calculate Profit/ Loss Till dateStep-3 Calculate current year profit/LossRevenue to be recognized Till date=Total Revenue Till date X [%] stage of completionProfit Loss Till date=Revenue to be recognized Till date-Cost recognized till dateCurrent Year Profit/ Loss=Profit/Loss Till Date-Profit Previously recognizedExpected Loss
33 Treatment of Cost related to Future activity At times a contractor may incur contract costs that relate to any future activity on the contract.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.
34 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 EstimatesPercentage 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.
35 Illustrations… Query Initial contract revenue Rs 900 Crores Initial Contract cost Rs 800 CroresFurther at the end of 2nd year cost includes Rs 10 Crores for material stored at the site to be used in 3rd year to complete the project.ParticularsIst Year2nd Year3rd YearEstimated Contract cost805Increase in contract revenue20Estimated additional increase cost15Contract cost incurred upto161584820
36 SolutionCalculation of percentage of completion *Includes Rs 10 Crores of MaterialPARTICULARSYear 1Year 2Year 3Contract cost incurred up to the date of reporting161584*820Estimated cost to complete644236Total estimated contract805Estimated Profit95100Stage of Completion20%(161/805X100)70%(584-10/820X100)100%(820/820X100)
37 Solution Particulars Up to reporting date Recognized in prior year Recognized in current yrYear 1Revenue (900X20%)180Expenses161Profit19Year 2Revenue (920X70%)6444645744137051Year 3Revenue (920X100%)920276Expenses(820X100%)82024610030
38 Guidance Note- Real Estate Developers As discussed earlier AS 7 doesn’t apply to the accounting for 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:-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.
39 Guidance Note- Real Estate Developers Determination of transfer of risks and rewards of ownership:-Legal title passes to the buyerSeller 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:Significant risk i.e. price risk has been transferred to the buyerBuyer has a legal right to sell or transfer his interest in the property, without any condition or subject to only such conditions which do not materially affect his right to benefits in the property
40 EXAMPLEB 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:-All significant risk and rewards have been transferredNo 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 .
41 DISCLOSURESThe methods used to determine the stage of completion of contract in progressThe method used to determine the contract revenue recognized in the periodThe amount of contract revenue recognized in the periodContract cost incurred and recognized profit (less recognized losses up to the reporting date)Advance receivedGross amount due from customers for contract work i.e. cost incurred +recognized profit-recognized losses-progress billingGross amount due to customers for contract work