ACCOUNTING STANDARDS (AS 7 - CONSTRUCTION CONTRACT)

1.3 ACCOUNTING STANDARD – 7 (Construction Contract)

1. Definition
A construction contract is a contract for the construction of an asset or a combination of assets that are
closely interrelated. Construction contracts include, directly related service contracts and contracts for
destruction or restoration of assets, and the restoration of the environment following the demolition of
assets.
A fixed price contract is a construction contract in which the contractor agrees to a fixed contract price,
which in some cases is subject to cost escalation clauses.
A 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 fee.
Contract costs should comprise:
(a) costs that relate directly to the specific contract;
(b) costs that are attributable to contract activity in general and can be allocated to the contract;
Percentage Completion Method
2. When the outcome of a construction contract can be estimated reliably, contract revenue and
contract costs should be recognized as revenue and expenses respectively by reference to the stage of
completion at the reporting date. The method is called Percentage Completion method.
3. Cost incurred for future activity
A contractor may have incurred contract costs that relate to future activity on the contract. Such contract
costs are recognized as an asset provided it is probable that they will be recovered. Such costs represent
an amount due from the customer and are often classified as contract work in progress.
4. How to determine stage of completion
The stage of completion of a contract may be determined in following ways.
a) the proportion that contract costs incurred for work performed upto the reporting date bear to the
estimated total contract costs; or
b) surveys of work performed; or
c) completion of a physical proportion of the contract work.
5. When the outcome of a construction contract cannot be estimated reliably
a) revenue should be recognized only to the extent of contract costs incurred of which recovery is
probable; and
b) contract costs should be recognized as an expense in the period in which they are incurred.
6. Recognition of Expected Losses
When it is probable that total contract costs will exceed total contract revenue, the expected loss should
be recognized as an expense immediately. The amount of such a loss is determined irrespective of,
whether or not work has commenced on the contract or the stage of completion of contract activity.
7. Disclosure Requirements
An enterprise should disclose:
a) the amount of contract revenue recognized as revenue in the period;
b) the methods used to determine the stage of completion of contracts in progress.
c) the amount of advances received; and
d) the amount of retentions.

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 ACCOUNTING STANDARDS (AS 7 - CONSTRUCTION CONTRACT)

Illustrations
Q. 1
A company took a construction contract for `100 lakhs in January, 2016. It was found that 80% of the contract
was completed at a cost of `92 lakhs on the closing date i.e. on 31.3.2017. The company estimates further
expenditure of `23 lakhs for completing the contract. The expected loss would be `15 lakhs. Can the company
recognize the loss in the financial statements prepared for the year ended 31.3.2017?

Solution:
As per AS-7, an expected loss on the construction contract must be recognized irrespective of (i) whether or
not the work has commenced on the contract or (ii) the stage of completion of the contract or (iii) the amount
of profits expected to arise in other contracts. Hence, the company must recognize the loss immediately.

Q. 2
Mr. ‘X’ as a contractor has just entered into a contract with a local municipal body for building a flyover. As
per the contract terms, ‘X’ will receive an additional `2 crore if the construction of the flyover were to be
finished within a period of two years of the commencement of the contract. Mr. X wants to recognize this
revenue since in the past he has been able to meet similar targets very easily.
Is X correct in his proposal? Discuss.

Solution:
According to AS 7 (Revised) ‘Construction Contracts’, incentive payments are additional amounts payable to
the contractor if specified performance standards are met or exceeded. For example, a contract may allow
for an incentive payment to the contractor for early completion of the contract. Incentive payments are
included in contract revenue when: (i) the contract is sufficiently advanced that it is probable that the
specified performance standards will be met or exceeded; and (ii) the amount of the incentive payment can
be measured reliably. In the given problem, the contract has not even begun and hence the contractor (Mr.
X) should not recognize any revenue of this contract.

Q. 3
A firm of contractors obtained a contract for construction of bridges across river Revathi. The following details
are available in the records kept for the year ended 31st March, 2013.
(` in lakhs)
Total Contract Price 1,000
Work Certified 500
Work not Certified 105
Estimated further Cost to Completion 495
Progress Payment Received 400
To be Received 140
The firm seeks your advice and assistance in the presentation of accounts keeping in view the requirements
of AS 7 (Revised) issued by your institute.

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 ACCOUNTING STANDARDS (AS 7 - CONSTRUCTION CONTRACT)

Solution:
(i) Amount of foreseeable loss (` in lakhs)
Total cost of construction (500 + 105 + 495) 1,100
Less: Total contract price 1,000
Total foreseeable loss to be recognized as expense _100
According to AS 7 (Revised 2002), when it is probable that total contract costs will exceed total contract
revenue, the expected loss should be recognized as an expense immediately.
(ii) Contract work-in-progress i.e. cost incurred to date are `605 lakhs (` in lakhs)
Work certified 500
Work not certified 105
This is 55% (605/1,100 x 100) of total costs of construction. 605
(iii) Proportion of total contract value recognized as revenue as per AS 7 (Revised).
55% of `1,000 lakhs = `550 lakhs

Q. 4
M/s. Highway Constructions undertook the construction of a highway on 01.04.2013. The contract was to be
completed in 2 years. The contract price was estimated at `150 crores. Up to 31.03.2014 the company
incurred `120 crores on the construction. The engineers involved in the project estimated that a further `45
crores would be incurred for completing the work.
What amount should be charged to revenue for the year 2013-14 as per the provisions of Accounting Standard
7 "Construction Contracts”? Show the extract of the Profit &Loss A/c in the books of M/s. Highway
Constructions.

Solution:
Statement showing the amount to be charged to Revenue as per AS 7
` in crores
Cost of construction incurred up to 31.03.2014 120
Add: Estimated future cost 45
Total estimated cost of construction 165
Degree of completion (120/165 x 100) 72.73%
Revenue recognized (72.73% of 150) 109 (approx.)
Total foreseeable loss (165 -150) 15
Less: loss for the current year (120 -109) 11
loss to be provided for 4

` in crores ` in crores
To Construction Costs 120 By Contract Price 109
To Provision for loss __4 By Net loss _15
124 124

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 ACCOUNTING STANDARDS (AS 7 - CONSTRUCTION CONTRACT)

Q. 5
An amount of `9,90,000 was incurred on a contract work upto 31-03-2010. Certificates have been received
to date 10 the value of `12,00,000 against which `10,80,000 has been received in cash. The cost of work done
but not certified amounted to `22,500. It is estimated that by spending an additional amount of `60,000
(including provision for contingencies) the work can be completed in all respects in another two months. The
agreed contract price of work is `12,50,000. Compute a conservative estimate of the profit to be taken to the
Profit and Loss Account as per AS 7.
Solution:
Computation of estimate of profit as per AS 7
Expenditure incurred upto 31.3.2010 9,90,000
Estimated additional expenses (including provision for contingency) __60,000
Estimated cost (A) 10,50,000
Contract price (B) 12,50,000
Total estimated profit [(B-A)] 2,00,000
Percentage of completion (9,90,000/ 10,50,000) x 100 94.29%
Computation of estimate of the profit to be taken to Profit and loss Account:
•••••••• !•"#$$•% &!'' ().(.*+)+
Total estimates profit =
,-&/' ••&!0/&•% "-•&
1,1+,+++
2,00,000 × = 1,88,571
)+,3+,+++

According to AS 7 ‘Construction Contracts’, when the outcome of a construction contract can be estimated
reliably, contract revenue and contract costs associated with the construction contract should be recognized
as revenue and expenses respectively by reference to stage of completion of the contract activity at the
reporting date. Thus estimated profit amounting’ `1,88,571 should be recognized as revenue in the statement
of profit and loss.

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 ACCOUNTING STANDARDS (AS 7 - CONSTRUCTION CONTRACT)

ASSIGNMENTS FOR CLASS

1).
A Construction Contractor has a Fixed Price Contract for `9,000 Lakhs to build a bridge in 3 years timeframe.
A summary of some of the financial data is as under:
Amount ` in Lakhs
Year 1 Year 2 Year 3
Initial Amount for Revenue agreed in Contract 9,000 9,000 9,000
Variation in Revenue (+) – 200 200
Contracts Costs incurred up to the reporting date 2,093 6,168 * 8,100 **
Estimated Profit for the whole Contract 950 1,000 1,000
* Includes `100 Lakhs for Standard Materials stored at the Site to be used in Year 3 to complete the work.
** Excludes `100 Lakhs for Standard Material brought forward from Year 2.
The variation in Cost and Revenue in Year 2 has been approved by the customer.
Compute year–wise amount of Revenue, Expenses, Contract Cost to complete and Profit or Loss to be
recognized in the Statement of Profit or Loss as per AS–7.
2).
PRZ & Sons Ltd. are Heavy Engineering contractors specializing in construction of dams. From the records of
the company, the following data is available pertaining to year ended on 31st March, 2014. Using this data and
applying the relevant Accounting Standard you are required to:
(i) Compute the amount of profit/loss for the year ended 31st March, 2014.
(ii) Arrive at the contract work in progress (cost incurred till date) as at the end of financial year 2013-14.
(iii) Determine the amount of revenue to be recognized out of the total contract value.
(` crore)
Total Contract Price 2,400
Work Certified 1,250
Work pending certification 250
Estimated further cost to completion 1,750
Stage wise payments received 1,100
Progress payments in pipe line 300

3).
From the following data, show Profit and Loss A/c (Extract) as would appear in the books of a contractor
following Accounting Standard 7:
(` in lakhs)
Contract price (fixed) 480.00
Cost incurred to date 300.00
Estimated cost to complete 200.00

4).
M/s Excellent Construction Company Limited undertook a contract to construct a building for `3 Crore on 1st
September, 2011. On 31st March, 2012 the company found that it had already spent `1 Crore 80 Lakhs on the
construction. Prudent estimate of additional cost for completion was `1 Crore 40 lakhs. What amount should
be charged, to revenue in the final accounts for the year ended on 31 st March, 2012 as per the provisions of
Accounting Standard 7 “Construction Contracts (revised)”?

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