ACCOUNTING STANDARD-7 CONSTRUCTION CONTRACTS (Revised 2002)

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 to recognition Disclosures

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

OBJECTIVE AND SCOPE OBJECTIVE Main objective is to prescribe the accounting treatment of revenue and costs associated with construction contracts Allocation 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. SCOPE This statement is applied in accounting for construction contracts in the financial statements of contractors.

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 accounting Recognize two methods:- 1) Percentage of completion method 2) Completed contract method Recognize only one method:- 1)Percentage of completion method Revised 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 01.04.2003

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 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 Contract Contract in which the contractor is reimbursed for costs, plus percentage of these costs or a fixed fee.

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

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 .

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.

CONTRACT REVENUE Contract Revenue comprises of:- 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. 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 Due to penalties If no. of units increase in fixed price contracts.

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 upon Yes, the recognize the variation agreed upon Is 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? Yes Adjust such penalty in the contract revenue. Fixed Price Contract with fixed price per unit of output Adjust contract revenue proportionately for any increase in unit.

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.

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.

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 revenue Contract is sufficiently advanced It is probable that the specified standard will be achieved Amount of incentive can be reliably measured

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.

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

CONTRACT COSTS Contract Cost comprises of:- Costs directly related to specific contract. Sr. no Type of Cost a Site Labour cost including site super-vision b. Cost of material c. Depreciation of Plant used in the contract d. Transshipment cost of plant, equipment and materials to and from contract site e. Cost of Hiring plant and machinery f. Cost of design and technical assistance g. Estimated cost of rectification and guaranteed work h. Claims from third parties

CONTRACT COSTS Costs that are in general and can be allocated to the contract Expenses not included in the contract Sr. no Type of Cost 1. Insurance 2. Cost of designs and specification not directly related to contract 3. Construction overheads 4. Portion of general administrative overhead chargeable to the contract as per agreement. Sr. no Type of Cost 1. General administration expenses not to be reimbursed by the customer 2. Selling Cost 3. Research and development costs reimbursement of which is not specified in the contract 4. Depreciation of idle plant and equipment.

CONTRACT COSTS Contract 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 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.

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 contract Cost Plus contract

Recognition At the time of recognition of revenue it should be noted that:- Fixed price contract 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. Cost Plus Contract Costs attributable to the contract can be identified and measured

Issue related to Recognition Issues Requirements Basic 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

Issue related to Recognition Issues Requirements Recognition 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 reliability Which 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.

Issue related to Recognition Issues Requirements When 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.

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 management Consultancy 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.

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 easily Solution:- Additional Revenue will be recognized subject to fulfillment of the conditions discussed i.e. 1)Reasonable certainty of completion 2)Hindrances that can be there in completion 3)Payment behavior of customer. A contractor has signed a contract at 31.12.2010, 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.

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.

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 Amount in Rs Total Cost incurred 64,99,000 Expected Cost to be incurred 32,01,000 % of completion is 67% Revenue for the year (85lacs*67%) 56,95,000 Less: cost incurred in Current Year 64,99,000 Loss for the year 8,04,000 Further foreseeable loss due to addition cost is :- Total contract Revenue 85,00,000 Less: Total contract Cost(64,99,000+32,01,000) 97,00,000 Total loss to be recognized 12,00,000 Loss already recognized 8,04,000 Provision for expected loss 3,96,000

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. Conditions 1, 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.

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 completion If 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 date X 1oo Total Estimated Cost

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 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. Estimated Loss:- Total estimated cost on completion [-] Total Contract revenue

Calculation of profit & loss Step-1 Calculate Revenue to be Recognized Step-2 Calculate Profit/ Loss Till date Step-3 Calculate current year profit/Loss Revenue to be recognized Till date = Total Revenue Till date X [%] stage of completion Profit Loss Till date = Revenue to be recognized Till date - Cost recognized till date Current Year Profit/ Loss = Profit/Loss Till Date - Profit Previously recognized Expected Loss

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.

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.

Illustrations… Query Initial contract revenue Rs 900 Crores Initial Contract cost Rs 800 Crores Further 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. Particulars Ist Year 2nd Year 3rd Year Estimated Contract cost 805 Increase in contract revenue 20 Estimated additional increase cost 15 Contract cost incurred upto 161 584 820

Solution Calculation of percentage of completion *Includes Rs 10 Crores of Material PARTICULARS Year 1 Year 2 Year 3 Contract cost incurred up to the date of reporting 161 584* 820 Estimated cost to complete 644 236 Total estimated contract 805 Estimated Profit 95 100 Stage of Completion 20% (161/805X100) 70% (584-10/820X100) 100% (820/820X100)

Solution Particulars Up to reporting date Recognized in prior year Recognized in current yr Year 1 Revenue (900X20%) 180 Expenses 161 Profit 19 Year 2 Revenue (920X70%) 644 464 574 413 70 51 Year 3 Revenue (920X100%) 920 276 Expenses(820X100%) 820 246 100 30

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.

Guidance Note- Real Estate Developers Determination of transfer of risks and rewards of ownership:- 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: Significant risk i.e. price risk has been transferred to the buyer Buyer 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

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:- 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 .

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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