2020-01-02 16:07:41Accounting & TaxesEnglishAS 7 relates with accounting of construction contacts & the accounting treatment of revenue and costs associated with construction...https://quickbooks.intuit.com/in/resources/in_qrc/uploads/2020/01/AS-7-Construction-Contracts-Its-Disclosure.jpghttps://quickbooks.intuit.com/in/resources/accounting-taxes/as-7/AS 7: Construction Contracts and It’s Disclosure

AS 7: Construction Contracts and It’s Disclosure

10 min read

Accounting Standard 7 (AS 7) relates with accounting of construction contracts. The very purpose of this accounting standard is to specify the accounting treatment of revenue and costs associated with construction contracts.

Typically, the date at which a construction contract is entered into is different from the date at which such a contract is completed.

This means that the date of entry and the date of completion of a construction contract fall into different accounting periods. It is due to the nature of activity assumed under a construction contract.

Therefore, the fundamental concern in construction contract accounting is the distribution of contract revenue and costs to the accounting periods in which construction work is carried out.

Hence, Accounting Standard 7 provides guidelines to recognize contract revenue and costs in the statement of P & L.

I. Meaning of Contract

A construction contract is the one that is specifically agreed upon for construction of an asset or a combination of assets.

Such a combination of assets are the ones that are closely related or interdependent in terms of their design, technology and function or purpose or use. This is to say that a construction contract is worked out either for:

  • the construction of a single asset such as building, roads etc or
  • construction of multiple assets that are closely interrelated or interdependent in terms of their design, technology and function. Examples include construction of refineries etc

Furthermore, construction contracts refer to those contracts that include:

  • providing services directly related to the construction of the asset. Example services of project managers and architects
  • destruction and restoration of assets and restoration of environment subsequent to demolition of assets

In addition to this, a construction contract can be formed in a number of ways. Following section explains various types of construction contracts.

II. Types of Construction Contracts

Construction contracts can be categorized as Fixed Price Contracts and Cost Plus Contracts. However, there can be scenarios where construction contract has attributes of both a fixed price contract and a cost plus contract.

a. Fixed Price Contract

Fixed price contract is a construction contract in which the contractor agrees to a fixed contract price or a fixed rate per unit of output. However, in some cases such a contract is subject to escalation costs.

b. Cost Plus Contract

It is a construction contract in which a contractor is compensated for any allowable or other defined costs plus a percentage of these costs or a fixed fee.

III. Segmenting Construction Contracts

a. Separate Construction Contract

There are cases when a construction contract covers a number of assets. In such circumstances, the construction of each asset must be treated as separate construction contract only when:

  • separate proposals are submitted for each asset
  • independent negotiation is undertaken for each of the assets. Furthermore, such a contract enables both the customer and contractor to accept or reject that part of each asset for which negotiation has been undertaken.
  • costs and revenues of each asset can be identified

In addition to this, a construction contract may provide for a clause which states that a customer may demand construction of an additional asset. Or an existing construction contract may be amended to include construction of an additional asset.

Thus, the construction of such an additional asset must also be treated as a separate construction contract only when:

  • the additional asset is significantly different in terms of design, technology or function from the original contract assets
  • price of the additional asset is worked upon independent from the original contract price

b. Single Construction Contract

There can be scenarios when a contractor enters into a group of construction contracts either with a single customer or with several customers. And such a group of contracts are treated as a single construction contract.

Thus, such a group of contracts should be treated as a single construction contract only when:

  • group of contracts is agreed upon as a single package
  • contracts are closely interrelated. Such contracts are interrelated in a way that they are a part of a single project and thus have project – wide profit margin
  • contracts are performed all at once or in a continuous sequence

IV. What is Contract Revenue?

A contract revenue includes:

  • amount of revenue agreed upon in the contract originally
  • variations in contract work, claims and incentive payments:
    • to the extent it is likely that they will generate revenue
    • they have the potential of being reliably measured

Thus, contract revenue is measured when the consideration is received or it is receivable. Furthermore, such a measurement gets impacted by a number of uncertainties that depend upon the outcome of future events.

Therefore, you need to revise the estimates pertaining to contract revenue as and when future events occur and the uncertainties are settled. This means that the amount of contract revenue may vary from period to period.

a. Variation

A variation refers to the customer’s demand to change the scope of work to be performed under the original contract. Such a variation may lead to an increase or decrease in the contract revenue. Example – changes in the design of the asset. Thus, a contractor needs to include a variation in the contract revenue only when:

  • it is expected that the customer may approve the variation as well as the amount of revenue from such a variation and
  • it can be reliably measured

b. Claim

A claim refers to the amount that a contractor demands from the customer as a compensation of costs not included in the original contract price. Such claims may result due to customer delays or errors in the design of the asset.

Thus, a contractor needs to include a claim in the contract revenue only when:

  • negotiations have reached such a stage that it is expected that the customer will accept the claim
  • such an amount accepted by the customer can be measured reliably

c. Incentive

Incentive payments refer to the additional amounts that a contractor receives as a result of outstanding performance or exceeding the benchmarks.

For example, early completion of the project. Thus, a contractor needs to include an incentive payment in the contract revenue only when:

  • the contract has reached such a stage where it is expected that the performance standards would be met or exceeded
  • amount of incentive payment can be reliably measured

V. What are Contract Costs?

Contract costs must include:

  • costs directly related to the specific contract. Examples include site labour costs, cost of material used in construction etc
  • costs that are related to the contract activity in general and that can be allocated to the contract. For example insurance, construction overheads etc
  • other costs that are chargeable specifically to the customer as per the terms of the contract. For example general administration costs etc

Furthermore, there are costs that cannot be allocated to a contract and hence are excluded from the costs of the construction contract. These costs include:

  • selling costs
  • research and development costs for which compensation is not mentioned in the contract
  • general administration costs for which compensation is not mentioned in the contract
  • depreciation of plant and equipment not used on a particular contract

VI. Contract Revenue & Expense Recognition

The contract revenue and costs related to a construction contract must be recognized as revenue and expenses respectively. Provided it is possible to reliably estimate the result of the construction contract.

Such revenues and costs are recognized on the basis of the stage of completion of contract activity at the reporting date.

a. When to Recognize Revenue and Expense

(i) Revenue and Expense Recognition in Case of a Fixed Price Contract

A contractor can reliably estimate the result of a fixed price construction contract only when it is probable:

  • to reliably measure the total contract revenue
  • that economic benefits related with the contract move towards the enterprise
  • to reliably measure contract costs to complete the contract and stage of contract completion at the reporting date and to
  • clearly identify contract costs related to the contract and reliably measure such costs. This is important so that a contractor can compare the actual contract costs incurred with prior estimates.

(ii) Revenue and Expense Recognition in Case of a Fixed Price Contract

A contractor can reliably estimate the result of a cost plus construction contract only when it is probable:

  • that economic benefits related with the contract move towards the enterprise
  • to clearly identify and measure reliably the contract costs related to the contract, whether or not specifically reimbursable.

b. How to Recognize Revenue and Expense

(i) Percentage Completion Method

Percentage Completion Method refers to the one where revenues and expenses are recognized based on the stage of completion of a contract. Thus, the contract revenue is recognized as revenue in the statement of P&L in the accounting period in which the contract is performed.

Similarly the contract costs are recognized as an expense in the statement of P&L in the accounting periods in which the work is performed.

(ii) Work in Progress

Work in progress refers to costs due from the customer on account of such costs relating to the future activity on a contract.

Thus, these contract costs are recognized as an asset, provided it is expected that such costs will be recovered.

VII. Determination of Stage of Completion

There are different methods to determine the stage of completion of the contract. These include:

  • proportion of the contract costs incurred with respect to the estimated total cost. Contract costs incurred relate with a work performed up to the reporting date.
  • surveys of work performed
  • completion of physical proportion of the contract work

However, there are cases when the result of a construction contract cannot be measured reliably. In such cases, revenue should be recognized only to the extent of contract costs incurred whose recovery is probable.

Furthermore, the contract costs should be recognized as an expense in the period in which they are incurred.

VIII. Recognition of Expected Losses

There are scenarios when it is expected that the total contract costs will exceed the total contract revenue. In such cases, the expected loss must be recognized as an expense.

Furthermore, the amount of such a loss is determined irrespective of:

  • whether the work has commenced on the contract or not
  • stage of completion of the contract activity
  • profits arising from other contracts which are not treated as a single construction contract

IX. Disclosure

An organization must disclose:

  • the amount of contract revenue recognized in an accounting period
  • methods used to determine the contract revenue recognized in the accounting period
  • the methods used to estimate the stage of completion of contracts in progress

An organization having contracts in progress should disclose:

  • aggregate amount of costs incurred and net profits (recognized profits less recognized losses up to the reporting date) recognized
  • the amount of advances received (advances are the amounts received by the contractor before the related work is performed) and
  • the amount of retention (retention is the amounts paid to the contractor only when the conditions specified in the contract for payments for such amounts are satisfied or until the defects have been rectified )

Thus, an organization must present:

  • the gross amount due from customers for contract work as an asset and
  • gross amount due to customers for contract work as a liability
Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.

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