AS-7Construction

Contracts

Sunil Arora

M.Com, FCA

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 completion

40% 50% 80%

Revenue recognised

100 50 170

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.