| Accounting
Standard 7 (REVISED), Construction Contracts
(In this Accounting Standard,
the standard portions have been set in bold italic type.
These should be read in the context of the background material
which has been set in normal type, and in the context of the
‘Preface to the Statements of Accounting Standards'.)
Accounting Standard (AS) 7, Construction
Contracts (revised), issued by the Council of the Institute
of Chartered Accountants of India, comes into effect in respect
of all contracts entered into during accounting periods commencing
on or after 1-4-2003 and is mandatory in nature from that date.
Accordingly, Accounting Standard (AS) 7, ‘Accounting for Construction
Contracts’, issued by the Institute in December 1983, is not
applicable in respect of such contracts. Early application of
this Standard is, however, encouraged.
The following is the text of the revised Accounting Standard.
Objective
The objective of this Statement
is to prescribe the accounting treatment of revenue and costs
associated with construction contracts. Because of the nature
of the activity undertaken in construction contracts, the date
at which the contract activity is entered into and the date
when the activity is completed 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 construction work is
performed. This Statement uses the recognition criteria established
in the Framework for the Preparation and Presentation of Financial
Statements to determine when contract revenue and contract costs
should be recognised as revenue and expenses in the statement
of profit and loss. It also provides practical guidance on the
application of these criteria.
Scope
1.This Statement should be applied
in accounting for construction contracts in the financial statements
of contractors.
Definitions
2. The following terms are used in
this Statement with the meanings specified:
A construction contract is 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.
A 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, 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.
3. A construction contract may
be negotiated for the construction of a single asset such as
a bridge, building, dam, pipeline, road, ship or tunnel. A construction
contract may also deal with the construction of a number of
assets which are closely interrelated or interdependent in terms
of their design, technology and function or their ultimate purpose
or use; examples of such contracts include those for the construction
of refineries and other complex pieces of plant or equipment.
4. For the purposes of this Statement, construction contracts
include:
-
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
-
contracts for destruction or restoration
of assets, and the restoration of the environment following
the demolition of assets.
5. Construction contracts are
formulated in a number of ways which, for the purposes of this
Statement, are classified as fixed price contracts and cost
plus contracts. Some construction contracts may contain characteristics
of both a fixed price contract and a cost plus contract, for
example, in the case of a cost plus contract with an agreed
maximum price. In such circumstances, a contractor needs to
consider all the conditions in paragraphs 22 and 23 in order
to determine when to recognise contract revenue and expenses.
Combining and Segmenting Construction
Contracts
6. The requirements of this Statement
are usually applied separately to each construction contract.
However, in certain circumstances, it is necessary to apply
the Statement 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.
7.When a contract covers a number
of assets, the construction of each asset should be treated
as a separate construction contract when:
-
separate proposals have been submitted for
each asset;
-
each asset has been subject to separate negotiation
and the contractor and customer have been able to accept
or reject that part of the contract relating to each asset;
and
-
the costs and revenues of each asset can
be identified.
8. A group of contracts, whether
with a single customer or with several customers, should be
treated as a single construction contract when:
-
the group of contracts is negotiated as a
single package;
-
the contracts are so closely interrelated
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.
9. A 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 should
be treated as a separate construction contract when:
-
the asset differs 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.
Contract Revenue
10. Contract revenue should comprise:
- the initial amount of revenue agreed in the contract;
and
- variations in contract work, claims and incentive payments:
- to the extent that it is probable that they will result
in revenue; and
- they are capable of being reliably measured.
11. Contract revenue is measured
at the consideration received or receivable. 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. For example:
-
a contractor and a customer may agree to
variations or claims that increase or decrease contract
revenue in a period subsequent to that in which the contract
was initially agreed;
-
the amount of revenue agreed in a fixed price
contract may increase as a result of cost escalation clauses;
-
the amount of contract revenue may decrease
as a result of penalties arising from delays caused by the
contractor in the completion of the contract; or
-
when a fixed price contract involves a fixed
price per unit of output, contract revenue increases as
the number of units is increased.
12. A variation is an instruction
by the customer for a change in the scope of the work to be
performed under the contract. A variation may lead to an increase
or a decrease in contract revenue. Examples of variations are
changes in the specifications or design of the asset and changes
in the duration of the contract. A variation is included in
contract revenue when:
-
it is probable that the customer will approve
the variation and the amount of revenue arising from the
variation; and
-
the amount of revenue can be reliably measured.
13. 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 may arise from, for example, customer caused
delays, errors in specifications or design, and disputed variations
in contract work. The measurement of the amounts of revenue
arising from claims is subject to a high level of uncertainty
and often depends on the outcome of negotiations. Therefore,
claims are only included in contract revenue when:
-
negotiations have reached an advanced stage
such that it is probable that the customer will accept the
claim; and
-
the amount that it is probable will be accepted
by the customer can be measured reliably.
14. 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:
-
the contract is sufficiently advanced that
it is probable that the specified performance standards
will be met or exceeded; and
-
the amount of the incentive payment can be
measured reliably.
Contract Costs
15. Contract costs should comprise:
-
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.
16. Costs that relate directly
to a specific contract include:
- site labour costs, including site supervision;
- costs of materials used in construction;
- depreciation of plant and equipment used on the contract;
- costs of moving plant, equipment and materials to and
from the contract site;
- costs of hiring plant and equipment;
- costs of design and technical assistance that is directly
related to the contract;
- the estimated costs of rectification and guarantee work,
including expected warranty costs; and
- claims from third parties.
These costs may be reduced by any
incidental income that is not included in contract revenue,
for example income from the sale of surplus materials and the
disposal of plant and equipment at the end of the contract.
17. Costs that may be attributable
to contract activity in general and can be allocated to specific
contracts include:
- insurance;
- costs of design and technical assistance
that is not directly related to a specific contract; and
- construction overheads.
Such costs are allocated 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. Construction
overheads include costs such as the preparation and processing
of construction personnel payroll. Costs that may be attributable
to contract activity in general and can be allocated to specific
contracts also include borrowing costs as per Accounting Standard
(AS) 16, Borrowing Costs.
18. Costs that are specifically
chargeable to the customer under the terms of the contract may
include some general administration costs and development costs
for which reimbursement is specified in the terms of the contract.
19.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
include:
-
general administration costs
for which reimbursement is not specified in the contract;
-
selling costs;
-
research and development costs
for which reimbursement is not specified in the contract;
and
-
depreciation of idle plant and
equipment that is not used on a particular contract.
20. Contract costs include the
costs attributable to a contract for the period from the date
of securing the contract to the final completion of the contract.
However, costs that relate directly to a contract and which
are incurred in securing the contract are also included as part
of the contract costs if they can be separately identified and
measured reliably and it is probable that the contract will
be obtained. When costs incurred in securing a contract are
recognised as an expense in the period in which they are incurred,
they are not included in contract costs when the contract is
obtained in a subsequent period.
Recognition of Contract Revenue and Expenses
21. When the outcome of a construction
contract can be estimated reliably, contract revenue and contract
costs associated with the construction contract should be recognised
as revenue and expenses respectively by reference to the stage
of completion of the contract activity at the reporting date.
An expected loss on the construction contract should be recognised
as an expense immediately in accordance with paragraph 35.
22. In the case of a fixed price
contract, the outcome of a construction contract can be estimated
reliably when all the following conditions are satisfied:
-
total contract revenue can be
measured reliably;
-
it is probable that the economic
benefits associated with the contract will flow to the enterprise;
-
both the contract costs to complete
the contract and the stage of contract completion at the
reporting date can be measured reliably; and
-
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.
23. In the case of a cost plus
contract, the outcome of a construction contract can be estimated
reliably when all the following conditions are satisfied:
-
it is probable that the economic benefits
associated with the contract will flow to the enterprise;
and
-
the contract costs attributable to the contract,
whether or not specifically reimbursable, can be clearly
identified and measured reliably.
24. The recognition of revenue
and expenses by reference to the stage of completion of a contract
is often referred to as the percentage of completion method.
Under this method, contract revenue is matched with the contract
costs incurred in reaching the stage of completion, resulting
in the reporting of revenue, expenses and profit which can be
attributed to the proportion of work completed. This method
provides useful information on the extent of contract activity
and performance during a period.
25. Under the percentage of completion
method, contract revenue is recognised as revenue in the statement
of profit and loss in the accounting periods in which the work
is performed. Contract costs are usually recognised as an expense
in the statement of profit and loss in the accounting periods
in which the work to which they relate is performed. However,
any expected excess of total contract costs over total contract
revenue for the contract is recognised as an expense immediately
in accordance with paragraph 35.
26. A contractor may have incurred
contract costs that relate to future activity on the contract.
Such contract costs are recognised 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.
27. When an uncertainty arises
about the collectability of an amount already included in contract
revenue, and already recognised in the statement of profit and
loss, the uncollectable amount or the amount in respect of which
recovery has ceased to be probable is recognised as an expense
rather than as an adjustment of the amount of contract revenue.
28. An enterprise is generally
able to make reliable estimates after it has agreed to a contract
which establishes:
-
each party's enforceable rights
regarding the asset to be constructed;
-
the consideration to be exchanged;
and
-
the manner and terms of settlement.
It is also usually necessary for
the enterprise to have an effective internal financial budgeting
and reporting system. The enterprise reviews and, when necessary,
revises the estimates of contract revenue and contract costs
as the contract progresses. The need for such revisions does
not necessarily indicate that the outcome of the contract cannot
be estimated reliably.
29. The stage of completion of
a contract may be determined in a variety of ways. The enterprise
uses the method that measures reliably the work performed. Depending
on the nature of the contract, the methods may include:
-
the proportion that contract
costs incurred for work performed upto the reporting date
bear to the estimated total contract costs; or
-
surveys of work performed; or
-
completion of a physical proportion
of the contract work.
Progress payments and advances received
from customers may not necessarily reflect the work performed.
30 When the stage of completion
is determined by reference to the contract costs incurred upto
the reporting date, only those contract costs that reflect work
performed are included in costs incurred upto the reporting
date. Examples of contract costs which are excluded are:
-
contract costs that relate to
future activity on the contract, such as costs of materials
that have been delivered to a contract site or set aside
for use in a contract but not yet installed, used or applied
during contract performance, unless the materials have been
made specially for the contract; and
-
payments made to subcontractors
in advance of work performed under the subcontract.
31.When the outcome of a construction
contract cannot be estimated reliably:
-
revenue should be recognised
only to the extent of contract costs incurred of which recovery
is probable; and
-
contract costs should be recognised
as an expense in the period in which they are incurred.
An expected loss on the construction
contract should be recognised as an expense immediately in accordance
with paragraph 35.
32. During the early stages of
a contract it is often the case that the outcome of the contract
cannot be estimated reliably. Nevertheless, it may be probable
that the enterprise will recover the contract costs incurred.
Therefore, contract revenue is recognised only to the extent
of costs incurred that are expected to be recovered. As the
outcome of the contract cannot be estimated reliably, no profit
is recognised. However, even though the outcome of the contract
cannot be estimated reliably, it may be probable that total
contract costs will exceed total contract revenue. In such cases,
any expected excess of total contract costs over total contract
revenue for the contract is recognised as an expense immediately
in accordance with paragraph 35.
33. Contract costs recovery of
which is not probable are recognised as an expense immediately.
Examples of circumstances in which the recoverability of contract
costs incurred may not be probable and in which contract costs
may, therefore, need to be recognised as an expense immediately
include contracts:
- which are not fully enforceable, that is, their validity
is seriously in question;
- the completion of which is subject to the
outcome of pending litigation or legislation;
- relating to properties that are likely to
be condemned or expropriated;
- where the customer is unable to meet its
obligations; or
- where the contractor is unable to complete
the contract or otherwise meet its obligations under the
contract.
34. When the uncertainties that
prevented the outcome of the contract being estimated reliably
no longer exist, revenue and expenses associated with the construction
contract should be recognised in accordance with paragraph 21
rather than in accordance with paragraph 31.
Recognition of Expected Losses
35. When it is probable that total
contract costs will exceed total contract revenue, the expected
loss should be recognised as an expense immediately.
36. The amount of such a loss
is determined irrespective of:
- whether or not work has commenced on the contract;
- the stage of completion of contract activity; or
- the amount of profits expected to arise on
other contracts which are not treated as a single construction
contract in accordance with paragraph 8.
Changes in Estimates
37. 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.
Therefore, the effect of a change in the estimate of contract
revenue or contract costs, or the effect of a change in the
estimate of the outcome of a contract, is accounted for as a
change in accounting estimate (see Accounting Standard (AS)
5, Net Profit or Loss for the Period, Prior Period Items and
Changes in Accounting Policies). The changed estimates are used
in determination of the amount of revenue and expenses recognised
in the statement of profit and loss in the period in which the
change is made and in subsequent periods.
Disclosure
38. An enterprise should disclose:
- the amount of contract revenue recognised as revenue in
the period;
- the methods used to determine the contract revenue recognised
in the period; and
- the methods used to determine the stage of completion
of contracts in progress.
39. An enterprise should disclose
the following for contracts in progress at the reporting date:
- the aggregate amount of costs incurred and recognised
profits (less recognised losses) upto the reporting date;
- the amount of advances received; and
- the amount of retentions.
40. Retentions are amounts of
progress billings which are not paid until the satisfaction
of conditions specified in the contract for the payment of such
amounts or until defects have been rectified. Progress billings
are amounts billed for work performed on a contract whether
or not they have been paid by the customer. Advances are amounts
received by the contractor before the related work is performed.
41. An enterprise should present:
- the gross amount due from customers for contract work
as an asset; and
- the gross amount due to customers for contract work as
a liability.
42. The gross amount due from
customers for contract work is the net amount of:
- costs incurred plus recognised profits; less
- the sum of recognised losses and progress billings
for all contracts in progress for
which costs incurred plus recognised profits (less recognised
losses) exceeds progress billings.
43. The gross amount due to customers
for contract work is the net amount of:
- the sum of recognised losses and progress billings; less
- costs incurred plus recognised profits
for all contracts in progress for
which progress billings exceed costs incurred plus recognised
profits (less recognised losses).
44. An enterprise discloses any
contingencies in accordance with Accounting Standard (AS) 4,
Contingencies and Events Occurring After the Balance Sheet Date.
Contingencies may arise from such items as warranty costs, penalties
or possible losses. |
