AS-7

Construction
Contracts
 Construction contracts
• X & Co receives a contract for construction
of a Fly Over in 2007
• Work of the contract is being carried on
during the FY ending 31/03/2007, 08 & 09
• The contract is likely to be completed in the
FY 2009-10
• Should the profit be booked on completion
of the contract in FY 2009-10
 Taxability of income
• Two options:
– Project completion method
– % completion method from year to year
• Cases pertain to contractors
• Held: Income assessable on yearly basis
Sri Sukhdeodas Jalan v. CIT 26 ITR 617 (Patna)
Tirath Ram Ahuja Pvt Ltd v. CIT 186 ITR 428 (SC)
CIT v. NM Associates 256 ITR 141 (Mad)
 Accounting of contractor
• Whether appropriate to wait till completion
of the project?
• AS 7 : Construction Contracts prescribes
treatment of revenue and costs associated
therewith in the financials of the contractor
• AS 7 revised in 2002 and applicable for
accounting periods commencing on or after
01/04/2003
 OBJECTIVE
• Accounting treatment in the books of
contractor.
• Contracts span over a number of financial
years.
• Allocation of contract revenue and contract
costs to various accounting periods
• Uncertainty attached with the total contract
 Recognition of Contract Revenue
& Expenses

If outcome of Construction contract can be reliably estimated

- Revenue & Costs pertaining to the contract should be recognized by the
stage of completion or % completion method
- Implication
Total Revenue -
Total Costs -
Profit ?
- Based on % of work completed
Revenue, Cost, Profits, etc.
up to the reporting date to be treated in F.S.
 Stage of completion
• Advance / progressive payments received
may not reflect the work performed
• How to ascertain stage of completion?
 Issues
(1) Revenue from contract how ascertained?
(2) How to ascertain cost of the contract ?
(3) Stage of completion of contract?
(4) How to deal with expected losses ?
(5) Various types of contracts?
(6) What is a reliable estimate of outcome of
contract ?
(7) If reliable estimates not possible ?
 Year wise allocation
• Contract revenue
• Contract cost
• Stage of completion
 Contract Revenue
• Consideration received or receivable
• Due to uncertainties and events which occur
during the contract; The estimates need to
be revised
• The amount of revenue from a contract may
increase or decrease from one period to the
next
 Contract Revenue
• Initial amount of revenue agreed
• Variations in the contract
• Claims
• Incentive payments
• Cost escalations
• Penalties
 Variations
• Instruction by the customer for a change in
the scope of work
• Variation may increase or decrease the
contract revenue
• Variation to be considered:
– It is probable that the costumer will approve the
effect on revenue; and
– the amount of revenue can be reliably measured
 Claims
• Amount which the contractor seeks to collect from
the customer on account of changes, delays,
errors, etc
• Revenue from claim is uncertain and depends on
negotiations
• To be included:
– Negotiations have reached advanced stage
– It is probable that customer will accept the claim
– Amount can be reliably measured
 Incentive payments
• Additional amounts if specified
performance standards met or exceeded
• To be included:
– The contract is sufficiently advanced
– It is probable that the specified standard will be
met or exceeded
– Incentive payment can be reliably measured
 Cost escalations
• Whether escalation clause in the agreement
legally enforceable against the customer
• Escalations can be related to the customer
• Escalations due to delay by the contractor
• It is probable that the escalation in cost will
be realised from the customer
• Whether cost escalation can be reliably
measured
 Penalties
• Cause for the levy of penalty or deduction
from the revenue
• Status of penalty clause in the agreement
• It is probable that the penalty may be
waived
• Penalty can be reliably measured
 Contract Costs
• Costs that relate directly to the specific
contract
• Costs that are attributable to contract
activity in general and can be allocated to
the contract
• Other costs chargeable to the customer
 Direct contract costs
• Site labour, supervision, etc
• Costs of material
• Design & technical assistance
• Cost of moving plant, equipment, etc to & from
the contract site
• Costs of hiring plant & equipment
• Depreciation?
• Cost of rectifications including expected warranty
costs.
 Allocation of general costs
• Insurance
• Cost of design and technical assistance not
directly related to a specific contract
• Construction overheads
• Borrowing costs as per AS 16
• Allocation to be systematic & rational
• Basis of allocation to be consistent for all
costs having similar characteristics
 Contract costs
• Contract costs include costs for the period
from securing the contract to the final
completion
• Costs incurred for securing a contract are
also included as a part of the contract costs;
– if they can be separately identified &
– reliably measured
 Recognition of Contract Revenue
& Expenses

If outcome of Construction contract can be reliably estimated

- Revenue & Costs pertaining to the contract should be recognized by the
stage of completion or % completion method
- Implication
Total Revenue -
Total Costs -
Profit ?
- Based on % of work completed
Revenue, Cost, Profits, etc.
up to the reporting date to be treated in F.S.
 Stage of completion
• Advance / progressive payments received
may not reflect the work performed
• Proportion of costs incurred vis-à-vis total
contract costs
• Surveys of work performed
• Completion of physical proportion of work
 Costs incurred
• Only those costs which reflect the work performed
• Advances to suppliers, sub contractors, etc
• Materials delivered not yet installed
– General procurement
– Specifically manufactured
• Whether vendor selection and issue of purchase
order can be taken as stage of contract?
 % completion method
• Contract costs are recognised as an expense in the
period in which work is performed
• Costs which relate to future activity is recognised
as an asset and classified as contract work in
progress
• Revenue upto the stage of completion at the
reporting date is recognised
• The estimates are revised, when necessary
• Need for revision does not indicate reliability of
measurement
 Stage of completion
31-03-07 31-03-08 31-03-09
Total revenue 250 300 400
Total cost 200 250 360
Cost incurred 80 125 288
Stage of 40% 50% 80%
completion
Revenue 100 50 170
recognised
Reliable estimate of outcome
(1) Fixed Price Contracts

(2) Cost Plus Contracts

 Reliable estimates possible
Fixed Price Contracts
a) Contract Revenue can be reliably measured
b) Contract costs to complete the contract can
be measured reliably
c) Contract cost attributable to the contract can
be clearly identified and reliably measured
d) Stage of completion can be reliably measured
e) Economic benefits will flow to the enterprise
 Cost plus contract
• Contractor is reimbursed for defined costs
plus % of these costs or a fixed fee
• Outcome can be reliably measured:
– Contract costs attributable to the contract
clearly identified & measured
– Economic benefit associated with the contract
will flow to the enterprise
 Changes in Estimates
• With the progress of the contract, the
estimates of costs & revenues to be revised
• Need for revision does not indicate that the
outcome cannot be reliably measured
• Consolidated review on each reporting date
• Balance after deducting amounts recognised
in the previous years to be treated in the FS
 Outcome cannot be reliably
estimated

a) Revenue to be recognized only to the extent

of costs of which recovery is possible
b) Costs to be recognized as an expense in the
period in which incurred
Applicable more in the early stages of
contract.
 Recognition of expected losses
Contract Costs > Total Contract Revenue
Expected Loss ?
a) Work commenced or not ?
b) Stage of completion of Contract ?
c) Profit from other contract not treated as
single contract ?
 Disclosure requirements
• Contract revenue:
– Revenue recognised
– Method used
– Basis to determine stage of completion
• Contracts in progress:
– Aggregate amount incurred and recognised
– Advances received
– Retentions
• Amounts due from or to the customers
 Other Issues
(1) Unertainty about collectivity of revenue
already recognized
(2) Contact costs where recovery is improbable.