Wednesday, July 30, 2008

Construction Contract -Accounting-MF

1.0 INTRODUCTION
1.1 The Council of the Institute of Chartered Accountants
of India (ICAI) has issued Accounting Standard (AS)
7, Construction Contracts (revised). This was published
in June 2002 issue of the journal ‘The
Chartered Accountant’. The revised AS7 is effective
for all contracts entered into during accounting periods
commencing on or after 01-04-2003 and is
mandatory in nature from that date. Accordingly,
Accounting Standard (AS)7 'Accounting for
Construction Contracts' hereinafter referred to as
'the previous AS7', issued by the ICAI in December,
1983, is not applicable in respect of such contracts.
1.2 The nature of the activity undertaken in construction
contracts is such that the date at which the contract
activity is entered into and the date when the activity
is complete(usually fall into different accounting
periods. Therefore, the primary issue in accounting
for construction contracts is the allocation of contract
revenue and contract costs to the accounting
periods in which the work is performed.
2.0 MAJOR CHANGES
2.1 The revised AS 7 differs from the previous AS7 in
respect of the following main issues :
(a) The revised AS7 applies in accounting for construction
contracts in the financial statements of
contractors. As against this the previous AS7 also
applied to enterprises undertaking construction
activities not as contractor but on their own
account as a venture of commercial nature where
the enterprise has entered into agreement for sale.
(b) The previous AS7 recognized two methods of
accounting for contracts viz the percentage
completion method and the completed contract
method. The revised AS7 recognizes only
the percentage completion method.
2.2 The revised AS7 does not apply to the builders /
developers. They will be required to recognize the
revenue as per AS9 '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.
3.0 CONSTRUCTION CONTRACTS
3.1 A construction contract has been defined in the
◆ The Institute of Chartered
Accountants of India has issued
Accounting Standard (AS) 7 relating
to Construction Contracts
(Revised). The revised AS 7 is effective
for all contracts entered into
during Accounting Periods commencing
on or after 01-04-2003
and is mandatory in nature from
that date. The article below highlights
the major changes brought
about by the revised AS 7, the
method for recognition and measurement
of Contract Revenue and
Contract Cost and its disclosure
requirements.
<>
THE CHARTERED ACCOUNTANT AUGUST 2003
142
The author is member of the Institute. The views expressed herein
are the personal views of the author and do not necessarily represent
the views of the Institute.
Construction Contracts
Manoj Fadnis
ACCOUNTING
revised AS7 as a contract specifically negotiated for
the construction of an asset or a combination of
assets that are closely interrelated or interdependent
in terms of their design, technology and function or
their ultimate purpose or use.
3.2 A construction contract includes :
(a) contracts for the rendering of services which are
directly related to the construction of the asset,
for example, those for the services of project
managers and architects; and
(b) contracts for destruction or restoration of assets,
and the restoration of the environment following
the demolition of assets. This is included in revised
AS7 and was not finding place in the previous AS7.
3.3 A contract may involve supply of goods and supervision
of installation, testing and training. Normally
supply of goods is governed by AS-9 whereas contracts
involving supervision of installation will be
governed by AS7. Therefore in a composite contract
the relative value of supervision work to the total
value will have to be compared. In a particular case,
the Expert Advisory Committee (EAC) of the ICAI
held that where the value of supervision work not
being significant in relation to the overall contract
value, the contract was mainly for supply of material
and may not be construed as a construction contract
(Query No.. 44, Vol. No. XX).
3.4 The EAC has opined that the consultancy fees
received only for design engineering and project
management directly related to construction of an
asset is to be recognized as per AS7. Whereas revenue
from consultancy fees for design engineering
and project management not directly related to construction
of an asset would be recognized as per the
principles in this regard enunciated in AS9 (EAC
Query No. 20 Vol. No. XXI)
3.5 Construction contracts are formulated in a number
of ways which, for the purpose of the revised AS7,
are classified as fixed price contracts and cost plus
contracts. Some construction contracts may contain
characteristics of both a fixed price contract and cost
plus contract, for example, in the case of a cost plus
contract with an agreed maximum price.
3.6 The requirements of the Standard are generally to be
applied to each Construction Contract separately.
However, in certain circumstances, it is necessary to
apply the Standard to the separately identifiable
components of a single contract or to a group of
contracts together in order to reflect the substance
of a contract or a group of contracts.
3.7 A contract which covers the construction of a number
of assets is treated as a separate construction
contract for each asset when separate proposals are
submitted for each asset, each such asset is subjected
to separate negotiations and the costs and revenues
of each asset can be separately identified.
0 3.8 A group of contracts, whether with a single customer
or with several customers is treated as a single construction
contract when the group is negotiated as a
single package, the contracts are so closely inter
related 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.
3.9 A construction contract may provide for the construction
of an additional asset at the option of the customer
or may be amended to include the construction
of an additional asset. The construction of the additional
asset is treated as a separate contract when the
assets differ significantly in design, technology or
function from the asset or assets covered by the original
contract or the price of the asset is negotiated
without regard to the original contract price.
4.0 RECOGNITION OF CONTRACT REVENUE
AND CONTRACT COST
4.1 When the outcome of construction contract can be
estimated reliably, the associated contract revenue
and cost should be recognized by reference to the
stage of completion of contract activity at the
reporting date. In the previous AS 7 para 9.8 stated
that normally, the profit is not recognized in fixed
price contract unless the work on a contract has progressed
to a reasonable extent. This test was ordinarily
considered as not having been satisfied unless
20 to 25% of the work was completed. The revised
AS7 does not prescribe the extent of work which
should be completed. But it recognizes that in the
early stages of a contract it is often the case that the
outcome of a contract cannot be estimated reliably.
It emphasizes the need to estimate reliably the contract
revenue and the associated cost. The conditions
which must be satisfied before it can be held
that the outcome of construction contract can be
estimated reliably are prescribed in para 22 and para
23 for fixed price contract and cost plus contract
respectively. If these conditions are satisfied then
THE CHARTERED ACCOUNTANT AUGUST 2003 143
ACCOUNTING
contract revenue and contract costs can be recognized
irrespective of the degree of work completed.
4.2 In the case of fixed price contract, para 22 requires
that all the following conditions must be satisfied :
(a) Total contract revenue can be measured reliably.
(b) It is probable that the economic benefits associated
with the contract will flow to the enterprise;
(c) Both the contract costs to complete the contract
and the stage of contract completion at the
reporting date can be measured reliably; and
(d) The contract costs attributable to the contract
can be clearly identified and measured reliably
so that actual contract costs incurred can be
compared with prior estimates.
4.3 In the case of a cost plus contract, para 23 requires
that all of the following conditions must be satisfied.
(a) It is probable that the economic benefits associated
with the contract will flow to the enterprise; and
(b) The contract costs attributable to the contract,
whether or not specifically reimbursable, can be
clearly identified and measured reliably.
4.4 The condition regarding the probability of the economic
benefits associated with the contract will flow to the
enterprise is a new condition. All other conditions are
similar to the conditions mentioned in the previous AS7.
4.5 Under the percentage completion method, the contract
revenue is matched with the contract cost
incurred in reaching the stage of completion. This
results in reporting of revenue, expense and profit
which can be attributed to the proportion of work
completed. It may so happen that after recognizing
revenue an amount may become uncertain of being
collected. Such an amount is treated as an expense
and is not to be adjusted to the contract revenue.
4.6 The stage of completion of a contract may be determined
in a number of ways. No special weightage
should be given to any single factor. All relevant factors
should be taken into consideration. Para 29 of
the revised AS7 suggests the following factors :
(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.
4.7 The above factors should be considered as illustrative
rather than exhaustive. However it is certain that
progress payments or advances received from customers
may not necessarily reflect the work performed.
If the stage of completion is to be determined
by reference to the contract cost upto the
reporting date then care should be taken to exclude
advances paid, pre-paid expenses and closing inventory
of material purchased but not consumed.
4.8 Para 31 of the revised AS 7 lays down the principles for
recognizing contract revenue and contract costs when
the outcome of construction cost cannot be ascertained
reliably. The contract revenue is to be recognized
only to the extent of contract costs incurred of
which recovery is probable. The contract cost is recognized
as an expense in the period in which it is
incurred. As the outcome of the contract cannot be
estimated reliably, no profit is recognized. Contract
costs which are not recoverable are recognized as an
expense immediately. Examples of such cost include :
(a) Which are not fully enforceable, that is, their
validity is seriously in question;
(b) The completion of which is subject to the outcome
of pending litigation or legislation;
(c) Relating to properties that are likely to be condemned
or expropriated;
(d) Where the customer is unable to meet its obligations;
or
(e) Where the contractor is unable to complete the
contract or otherwise meet its obligations under
the contract.
4.9 It is necessary to appreciate a fine distinction between
revenue i.e. turnover and profit. Where the outcome
cannot be estimated revenue i.e. turnover may be
recognized but not profit. The EAC had an occasion
to bring out this fine distinction (Query No. 23 Vol.
No. XXI). Although that opinion was expressed in
context of the previous AS7, the principles enunciated
therein are still valid.
4.10 Once theuncertanities that prevented the outcome
to be estimated reliably cease to exist, the revenue
and the costs should be recognized on the percentage
completion method.
4.11 Irrespective of whether the outcome can be estimated
reliably or not, any expected loss on construction contract
is to be expensed immediately. Such a loss is to be
booked whether or not the work has commenced.
5.0 MEASUREMENT OF CONTRACT REVENUE
AND COSTS
5.1 The contract revenue includes the initial amount of
THE CHARTERED ACCOUNTANT AUGUST 2003 144
ACCOUNTING
revenue and any variation in contract work, claims
and incentive payment. The measurement of contract
revenue is affected by a variety of uncertainties
that depend on the outcome of future events. The
estimates often need to be revised as events occur
and uncertainties are resolved. Therefore the
amount of contract revenue may increase or
decrease from one period to the next. A variation is
an instruction by the customer for a change in the
scope of the work to be performed under the contract.
The Standard lays down that variation should
be accounted for when there is reasonable degree of
certainty that the variation will be approved and the
amount of revenue can be reliably measured. 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. A claim is to be included when it is probable
that the customer will accept the claim and that such
an amount can be reliably measured.
5.2 The use of the accounting estimates in measuring
contract revenue and costs involves judgments
based on the latest available information. Due to the
uncertainties in the business activities many items of
the financial statements cannot be measured with
precision. The use of reasonable estimates is an
essential part of the preparation of financial statements
and does not undermine their reliability.
Where in a contract the terms provided that the
actual payment made to the employees is billable and
thus, the additional cost, if any, incurred on account
of retrospective revision of pay scales will also be
billable. Therefore, if a reasonable estimate of the
amount of the additional cost can be made, there
would be no insignificant uncertainty in determining
the amount to be recovered from the clients. In such
circumstances it was opined that it would not be
unreasonable to expect the ultimate collection and
hence the contract revenue should be recognized.
(EAC Query No. 3, Vol. No. XVIII).
5.3 Contract costs include costs that relate directly to the
specific contract, costs that are attributable to contract
activity in general and can be allocated to the
contract and such other costs as are specifically
chargeable to the customer under the terms of the
contract. The costs to be allocated to a contract are
so allocated by using methods that are systematic
and rational and are applied consistently to all costs
having similar characteristics. The allocation is
based on the normal level of construction activity.
Costs that cannot be attributed to contract activity
or cannot be allocated to a contract are excluded
from the costs of a construction contract. Such costs
are expensed off in the period when they are
incurred.
5.4 Under the percentage of completion method, the
turnover in respect of the uncompleted contract is
recognized by reference to the stage of completion
of the relevant contract at the reporting date . In case
the turnover is calculated by reference to the proportion
of costs incurred to the estimated total cost,
only such costs should be considered for calculating
such proportion, which reflect the work performed.
The turnover achieved during a particular period on
a contract should equal to the value of the work
completed during that period (EAC Query No. 1.4
Vol. No. XIV) .
5.5 In a construction company the employees rendered
surplus on completion of a project were retained in
employment for deployment to other construction
projects. The salary was paid to these employees for
the intervening period i.e. for the period after completion
of one project and their transfer to some
other project. In this case the EAC opined that the
salary so paid was in the nature of a general expenditure
and should be expensed off in the period in
which it is incurred. (EAC Query No. 1.12 Vol. No.
VIII).
5.6 The percentage of completion method is applied on
a cumulative basis in each accounting period to the
current estimates of contract revenue and contract
costs. An estimate may have to be revised if change
occur regarding the circumstances on which the estimate
was based, or as a result of new information,
more experience on subsequent developments. The
revision of the estimate, by its nature, does not bring
the adjustment within the definition of an extraordinary
item or a prior period item.
6.0 DISCLOSURES
6.1 The financial statements of the contractor are
required to disclose the amount of contract revenue
recognized, the method used to determine the revenue
and the stage of completion. Also the aggregate
amount of costs incurred and recognized profits
(less recognized losses), the advance received and
the amount of retentions. The gross amount due
THE CHARTERED ACCOUNTANT AUGUST 2003 145
ACCOUNTING
THE CHARTERED ACCOUNTANT AUGUST 2003 146
ACCOUNTING
from customers for contract work as an asset and the
gross amount due to customers for contract work as
a liability are also required to be disclosed.
7.0 SIGNIFICANT ACCOUNTING AND TAXATION
ISSUES
7.1 The EAC had several occasions to issue opinions in
relation to AS7. The principles enunciated still hold
good. The gist of some of the opinions is mentioned
hereunder :
(a) The surplus construction material should be disclosed
under the head "Current Assets" irrespective
of whether the same are to be used for
other projects or to be disposed off. Only on
transfer of the material to another project, the
same should be considered as "Capital work - in
- progress" (EAC Query No. 27 Vol. XXI).
(b) The provisions of AS7 and not AS2 would apply
for the purpose of valuation of inventory of
machines and ship equipments that can be used
only in connection with a specific ship under
construction and is intended to be used in that
specific ship under construction (EAC Query
No. 37 Vol. No. XXI).
(c) The unconsumed material should be disclosed as
closing stock in the financial statements of a
company engaged in construction contracts.
This is so even if the cost in respect of such
unconsumed material is to be reimbursed by the
company and the same is lying with the company
to be returned to the client on completion
of the contract. However, on completion of the
project, the value of the material to be returned
to the client may be disclosed after netting off
the corresponding liability in this regard (EAC
Query No. 1.5, Vol. No. XVII).
(d) A company engaged in construction activities
appoints contractors to whom certain advances
were due to be paid under an agreement, but not
so paid. No accounting entry is required to be
passed in the books for the delay in the payment
of advances. No liability should be created for
an advance which is yet to be paid as at the balance
sheet date (EAC Query No. 1.22, Vol. No.
XV).
(e) In case of contracts of manufacture and supply
of long production cycle items which are complex
pieces of equipment, the recommendations
contained in Accounting Standard (AS) 7
on 'Accounting for Construction Contracts',
issued by the Institute of Chartered
Accountants of India, should apply because the
date at which the contract is secured and the
date when the contract activity is completed fall
into different accounting periods (EAC Query
No. 1.26 Vol. No. X).
7.2 Section 211 (3A) mandates each company to prepare
every profit and loss account and balance sheet of a
company to comply with the accounting standards.
Thus all companies will have to comply with the AS
7 (revised) and account for all the contracts entered
into on or after 01.04.2003 on the percentage completion
method basis. This will result in recognizing
revenue and cost and consequently the profits on
the basis of the work completed during the year. On
such contracts the company will be required to pay
advance tax, where ever applicable.
7.3 In Amrapalli Mercantile. P Ltd. Vs. Asst. CIT (Delhi)
(1993) 43 ITD 386 it has been held that assessee cannot
be permitted to maintain its accounts on cash
basis for income tax purposes and on mercantile system
for other purposes . The other view that it is not
prohibited seems to have received a set back in view
of Sec. 115 JB which requires the preparation of
annual accounts including profit and loss account
on the basis of the same accounting policies,
Accounting Standards and the depreciation method
and rates as have been adopted for the purpose of
preparing such accounts including profit and loss
account laid before the company at its AGM.
7.4 It is pertinent to note that the Accounting Standard
prescribed under section 145 of the Income Tax Act
do not include any standard on construction contracts.
Therefore it is possible that a non corporate
assessee may decide to adopt the completed contract
method as its method of accounting. In
Madhuvana House Building Co-operative Society
vs Asst. Comm. Income Tax (2002) 76 TTJ (Bang)
948 it was held that in the line of civil construction
and construction contracts where the duration of
the project is spread over several years, the completed
contract method of accounting is preferable.
During the pendency of works, the income or loss
cannot, be ascertained. The assessee was entitled to
adopt the completed contract method of accounting
for recognizing income from its project activity. ■

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