1. ACCOUNTING STANDARD-7 CONSTRUCTION CONTRACTS (Revised 2002)

2. 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

3. INTRODUCTION
This 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 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.

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 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

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 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.

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 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.

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 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.

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 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.

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 revenue
Negotiations 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 revenue
Contract is sufficiently advanced
It is probable that the specified standard will be achieved
Amount 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 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.

17. 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

18. 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.

19. 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.

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 contract
Cost Plus contract

21. 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

22. 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

23. 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.

24. 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.

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 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.

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

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 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

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 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

32. 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

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 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.

35. 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

36. 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)

37. 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

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 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

40. 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 .

41. 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

42. Thank You