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CONSTRUCTION CONTRACTS
ACCOUNTING STANDARD-7 CONSTRUCTION CONTRACTS Complex 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 AGRWAL B.Com(Hons), LL.B., FCA
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OBJECTIVE & SCOPE To 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.
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OBJECTIVE & SCOPE This 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.
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DEFINITIONS CONSTRUCTION CONTRACT
is a contract specifically negotiated for the construction of an asset or combination of assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use. What about service contracts ?
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DEFINITIONS Fixed Price Contract is a construction contract in which
the contractor agrees to a fixed contract price or fixed rate per unit of output, which in some cases is subject to cost escalation. Contracts are of two types 1. Fixed Price Contracts and Cost plus contract.
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DEFINITIONS 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.
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Construction Contracts
It includes contracts for rendering of services which are directly related to the Construction of the asset Destruction or restoration of assets Restoration of the environment following demolition of assets.
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Combining 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 made Each asset has been subject to separate negotiation and the contractor and the customer has been able to accept or reject that part of the contract The costs and revenues of each asset can be identified Contract with one entity for construction of number of petrol pumps. Each petrol pump will be required to be seperately treated as a separate contract.
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Combining 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 package Contracts are closely interrelated that they are, in effect, part of a single project with an overall profit margin; and The contracts are performed concurrently or in a continuous sequence. Hotel project, Sugar Mill on turnkey basis.
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Contract 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.
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Contract Revenue A 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.
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Contract 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 AS Direct Costs to be reduced by incidental income. Attributable Costs: Insurance, costs of designs and technical assistance, overheads. Costs which cannot be allocated: General Administrative Expenses Selling Costs Research & Development Depreciation of idle plants.
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Recognition of Revenue and Expenses
To be recognised when the outcome can be estimated reliably Contract Revenue and Costs should be recognised as revenue and expenses by reference to the stage of completion of the contract activity at the reporting date. Expected Loss to be recognised immediately.
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Conditions for reliable estimate
In case of Fixed Price Contracts: Total revenue can be measured reliably; Economic benefits will flow to the enterprise Contract costs to complete and the stage of completion can be measured at the reporting date Contract costs attributable to the contract can be identified and measured The standard also provides 4 parameters for determination as to when the outcome can be reliably estimated.
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Conditions for reliable estimate
In case of Cost Plus Contracts: Economic benefits will flow to the enterprise Contract costs attributable to the contract can be identified and measured
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Stage of completion Proportion of costs to the estimated total cost
Surveys of work performed Physical proportion of contract work Three methods prescribed for determining the stage of completion.
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Estimation 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.
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Expected Loss Expected Loss be recognised immediately when the total costs are likely to exceed the total revenue. Loss is to be recognised even if no work has commenced on the project. Irrespective of the stage of completion Irrespective 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.
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Disclosure Amount of Contract Revenue recognised
Method used to determine the contract revenue Method used to determine the stage of completion For contracts in progress, it should also disclose: Aggregate amount of costs incurred and recognised profits;
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Disclosure Amount of advances received Amount of retentions
Gross amount due from and due to customers.
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Initial amount of revenue agreed in contract 9000
ILLUSTRATION Rs. In Lacs YEAR I YEAR II YEAR III Initial amount of revenue agreed in contract 9000 Variation 200 Total Contract Revenue 9200 Contract Costs incurred upto the reporting date 2093 6168 8200 Contract costs to complete 5957 2032 Total Estimated costs 8050
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ILLUSTRATION YEAR I YEAR II YEAR III Estimated Profit 950 1000 Stage of Completion 26% 74% 100%
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ILLUSTRATION Year I Revenue (9000 x 0.26) 2340 Expenses (8050 x 0.26)
Upto Reporting date Recognised in prior year Recognised in current year Year I Revenue (9000 x 0.26) 2340 Expenses (8050 x 0.26) 2093 Profit 247
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ILLUSTRATION Year II Revenue (9200 x 0.74) 6808 2340 4468
Upto Reporting date Recognised in prior year Recognised in current year Year II Revenue (9200 x 0.74) 6808 2340 4468 Expenses (8200 x 0.74) 6068 2093 3975 Profit 740 247 493
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ILLUSTRATION Year III Revenue (9200 x 1.00) 9200 6808 2392
Upto Reporting date Recognised in prior year Recognised in current year Year III Revenue (9200 x 1.00) 9200 6808 2392 Expenses (8200 x 1.00) 8200 6068 2132 Profit 1000 740 260
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ILLUSTRATION - DISCLOSURE WORKING
B C D E TOTAL A. Contract Revenue recognised 145 520 380 200 55 1300 B. Contract Expenses recognised 110 450 350 250 1215 C. Expected Losses recognised 40 30 70 D. Recognised Profits less losses 35 (90) (30) 15 E. Contract Costs incurred in the period 510 100 1420 F. Contract Costs incurred recognised as contract expense in the period D + E Progressive billing I Due from Customers Due to Customers (20)
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ILLUSTRATION - DISCLOSURE WORKING
B C D E TOTAL G. Contract Costs that relate to future activity 60 100 45 205 H. Contract Revenue 145 520 380 200 55 1300 I. Progress Billing 180 1235 J. Unbilled Contract Revenue - 20 65 K. Advances 80 25 125
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ILLUSTRATION Contd… Construction Contracts Contract revenue recognised as revenue for the year ended 31st December XXX 1300 Aggregate amount of Contract costs incurred and recognised profits (less recognised losses) upto 31st December XXX for all the contracts in progress 1435
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ILLUSTRATION Contd… The amount of customer advances outstanding for contracts in progress as at 31st December XXXX 125 Gross amount due from customers for contract work presented as an asset 220 Gross amount due to customers for contract work presented as a liability (20)
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From Published Accounts
TRF LIMITED Profit 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 Standard Para 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.
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Mukand Limited Accounting for Long Term Engineering Contracts:
From Published Accounts Mukand Limited Accounting 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.
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Mukand Limited Accounting for Long Term Engineering Contracts:
From Published Accounts Mukand Limited Accounting 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.
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Mukand Limited Accounting for Long Term Engineering Contracts:
From Published Accounts Mukand Limited Accounting 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.
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Mukand Limited Accounting for Long Term Engineering Contracts:
From Published Accounts Mukand Limited Accounting 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.
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Issues 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.
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