AS 7: Construction Contracts

& ASI 29 Turnover in case of Contractors

Applicable only to Contractors & Not to Contractee

IPCC Paper 1: Accounting Chapter 1 Unit 2

CA. Yagnesh Desai, FCA

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Subject Matter

This Standard deals with Recognition of Revenue & Costs associated with Construction Contracts And that’s prime issue – in which year the revenue & associated cost to be

allocated ?

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Construction Contract

A contract specifically negotiated for the construction of an asset or a combination of closely interrelated or interdependent assets is termed as

Construction Of Bridge

Construction Of Dam Laying Rails Etc

EXAMPLES “Construction of a Single Asset “ :

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TYPES OF CONTRCTS

Construction Contracts

Fixed Price Contract

Cost Plus Contract

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Construction Contracts

• The contractor agrees to a fixed contract price, may be added with cost escalation clause by which the customer will grant increase if input cost rises beyond a certain index.

FIXED PRICE

CONTRACT

• The contractor gets reimbursement of

the identified costs on actual basis as per terms of the contract and a defined percentage of cost as fee.

COST PLUS CONTRACT

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Combining and Segmenting Construction Contracts

Segmenting Contracts

Combining Contracts

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Combining & Segmenting Construction Contracts

Often a contractor bids for construction of a number of assets. Each contract is separately accounted for if :

There were separate bids for each asset.

They are separately negotiated such that the contractor/customer had an option to accept /reject the bid.

Costs & revenues of each asset can be separately identified.

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Recognition Contract Revenue & Expenses

It depends on whether outcome of the contract (profit or loss) can be reliably estimated.

If it is possible to reliably measure the outcome, then stage of completion method is employed.

Otherwise contract revenue is recognized only to the extent the contract costs can be recovered; but all contract costs are expensed in the period in which they are incurred.

Provide for Costs & Losses.

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Recognition Contract Revenue & Expenses

In accounting for construction contracts following steps are followed :

1. • Identify total contract revenue which comprises of price initially agreed upon, variations

granted by the customer, claims and incentives.

2. • Identify costs incurred and cost estimates for the unfinished contract works.

3. • Check if outcome of the contract can be reliably measured on basis of contract revenue &

cost estimates.

4. • Review whether uncertainties surrounding reliable measurement of contract.

5. • Recognize expected contract loss as an expense.

6. • Check disclosures.

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Contract Revenue

Contract Revenue

Initial Agreed

Upon Price Variations Claims Incentives

COMPRISED OF 4 COMPONENTS :

Revenue measurement is not affected by Billing.

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Initially Agreed Upon Contract Price

This may undergo changes because of variation, claims and incentives. There may be change in the initially agreed upon price because of -

• Cost escalation under fixed price contract 1.

• Penalties imposed for delay caused by the contractor or violations of work specification / standard. 2.

• The level of output changes in a fixed price contract. 3.

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Variations

Variation in contract price results from the change in the scope of work.

It is included in the contract revenue when the customer has approved AND its highly probable that the customer will approve the variations, and the amount of variation is measurable reliable.

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Claims

A claim arises because of costs not included in the contract price.

CHANGES IN SPECIFICATION OR DESIGN

DELAYS CAUSED BY CUSTOMERS

CHANGE IN QUALITY OF INPUTS

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CLAIMS

To be included in the contract revenue only when the negotiation has been concluded or

reached an advance stage. Under such inclusions check that –

1. Probability of customer’s acceptance.

2. Reliability in measurement of amount of claim

AND

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Incentives

They are the additional amount paid by the customer when the specified performance standard is met or exceeded.

Usually incentive payments are stated in the contract. They are included in the contract revenue only when the contract has reached a sufficiently advanced stage.

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Contract Costs

Contract Costs

Directly Attributable

Costs

Allocated Contract

Overhead Specific Costs

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Direct Costs

• Site labour cost. 1.

• Materials. 2.

• Transport charge. 3.

• Cost of design. 4.

• Technical assistance charge. 5.

• Depreciation of Plant & Machinery Used in Construction 6.

• Cost of Hiring Plant 7.

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Direct Costs II

• Cost of rectification and guarantee work, including warranty costs 8.

• Claims from third parties. 9.

• Cost of moving plant to and from contract site 10.

• Reduction of Direct Costs By : 11

• any incidental income resulting from sale of surplus material and • the disposal of equipment at the end of the contract. 12

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Cost Attributable Costs - Excluded

Depreciation on idle plant and equipment whose use cannot be attributable to any construction

contract

Research and development costs for which reimbursement is not specified in the contract

Selling and marketing costs

General and administrative costs for which the reimbursement is not specified in the contract

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Debate over Pre-Contract Costs

If such “pre-contract” costs are reliably measurable and it is probable that the contract will be secured, then such costs are included as part of the overall contract cost. If the contract has been secured by the time the financial statements are authorized for issue, then the condition of probability of securing the contract MAY DEEMED TO BE satisfied and the costs can be included. Once such “pre-contract” costs have been expensed, they cannot be reinstated once the contract is secured.

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Allocated Contract Overhead

It includes :

• Insurance. 1.

• Design and technical assistance charges (not specific to a contract.) 2.

• Contract overhead including administration and personnel preparing pay roll’s cost. 3.

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Recognition Of Contract Revenue And Expenses

When it is likely that contract costs will exceed contract revenue, then the entire loss must be

recognized in the income statement immediately, regardless of the stage of completion.

Both Above to be recognized by reference to the stage of completion at the balance sheet date.

Recognise Contract revenue and contract costs - WHEN the outcome of the contract can be estimated reliably.

Contract wise not netting off unless contracts can be combined

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Measurement of Outcome FIXED COST CONTRACT - The outcome can be estimated reliably when : • Total contract revenue can be measured reliably; AND • It is probable that the economic benefit of the contract will flow to the entity; AND • Both the costs to complete the contract and the stage of completion can be reliably estimated:

AND • The costs attributable to the contract can be clearly identified and measured.

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Measurement of Outcome

COST-PLUS CONTRACT: • It is probable that the economic benefit of the contract will flow to the entity; AND • The costs attributable to the contract, whether specifically reimbursable or not, can be clearly identified and measured.

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Percentage Of Completion Method - I

The recognition of revenues and expenses by references to the stages of completion of a contract is referred to as the percentage of completion method.

The contract revenues are matched with the contract costs incurred in reaching the stage of completion.

Such comparison results in the reporting of revenue, expenses, and profit that can be attributed to the proportion of the work completed

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Percentage Of Completion Method II

AS 7 recognizes only the percentage of completion method of recognition of revenues and expenses. The “completed contract method” whereby no contract revenues or profits are recognized until the contracts are completed or are substantially complete is not permitted under AS 7

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Evaluation of Stage of Completion

3 Principal methods by which stage of completion of a contract is evaluated :

Ratio of costs incurred for work performed till date to estimated total cost.

Survey of works performed.

Physical work performed to total work.

OR

OR

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Determination Contract Profit

Determination contract profit ( Estimated contract revenue

Estimated contract costs )

Stage of completion

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Future Costs ?

Care must be taken in estimating percentage complete to exclude costs that relate to future activity, such as materials delivered to site. Such costs are recognized as an asset, provided it is probable that they will be recovered. Such costs represent amounts incurred on behalf of the customer and are thus amounts due from a customer. These costs are often classified as “contract work in progress.”

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Revenue = Cost

This in other words mean , No profit , No Loss. This situation arises when….

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Revenue = Cost

When as a matter of prudence, revenue is recognized only to the extent of costs incurred (i.e., zero profit is recognized). How far is “sufficiently far advanced” is a matter of judgment. Many entities state that a contract should be at least 50% complete; others, 75%; some, much lower percentages.

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Summary

Profit Loss No Loss No Profit

Where out come is uncertain

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DISCLOSURES

PARAS DISCLOSURE REQUIREMENTS

39 a) Amount of contract revenue recognized during the period.

b) Method used for the determination of recognized contract revenue.

c) Method used to determine stage of completion.

Disclosure requirements are stated as : 33

DISCLOSURES

PARAS DISCLOSURE REQUIREMENTS

40 a) Aggregate amount revenue & profit recognized till date.

b) Advance received.

c) Amount retained by customer.

42 a) Gross amount due from customers (cost incurred + profit. )

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Illustration

The following information relates to a contract :

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Estimated contract revenue 100

Costs to date 48

Costs to complete 32

Total estimated costs 80

PARTICULARS AMOUNT ( CU’000 )

Using the “costs incurred” method, the stage of completion is 60%.

(CU48,000 as a % of CU80,000)

Illustration

Solution : The amounts to be recognized in the statement of

comprehensive income are :

Revenue (60% of CU100,000) 60

Cost of sales (60% of CU80,000) 48

Profit (CU100,000 – CU80,000)

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PARTICULARS CU’000

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Illustration

The following information relates to a cost plus contract by a business with a 30 June year end.

2007 2008

CU’000 CU’000 Cumulative costs incurred on work to date

100 150

Agreed profit as a % of costs

20% 20%

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Illustration

Solution : The outcome of the contract can be estimated reliably at both year ends:

2007 Costs CU100,000

Profit CU100,000 20% = CU20,000

Revenue Costs + profit = CU100,000 + CU20,000 =

CU120,000 38

Illustration

Costs CU150,000 to date, less CU100,000 recognized in 2007 = CU50,000

Profit CU50,000 20% = CU10,000

Revenue Costs + Profit = CU50,000 + CU10,000 = CU60,000

2008

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Illustration

A business is not able to measure reliably the outcome of a contract, but estimates that all costs incurred are recoverable from the customer. The following details are available :

CU’000

Estimated contract revenue

100

Cost to date 30

40

Illustration

The amounts to be recognized in the statement of comprehensive income are :

CU’000

Revenue 30

Cost of sales (cost to date )

30

Profit NIL

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Illustration

The following details relate to a contract expected to be loss making :

Stage of completion (costs incurred method) 60 % Estimated overall loss (CU120,000 – CU100,000) 20

Estimated contract revenue 100

Costs to date 72

Costs to complete 48

Total estimated costs 120

CU’000

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Illustration

The amounts to be recognized in the statement of comprehensive income are :

Revenue (60% of CU100,000) 60 Cost of sales 72

Loss 12

Provision for full contract 8

Expected contact loss 20

CU’000

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Multiple Choice Questions

For Practice 44

MCQ - 1

1. Lazy Builders Inc. has incurred the following contract costs in the first year on a two-year fixed price contract for $4.0 million to construct a bridge:

• Material cost =………………………………………………….. $2 million

• Other contract costs (including site labor costs) = $1 million • Cost to complete = ……………………………………………..$2

million How much profit or loss should Lazy Inc. recognize in the first year of the three-year construction contract? (a) Loss of $0.5 million prorated over two years. (b) Loss of $1.0 million (expensed immediately). (c) No profit or loss in the first year and deferring it to second year. (d) Since 60% is the percentage of completion, recognize 60% of loss

(i.e., $0.6 million).

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MCQ - 2 2. Brilliant Inc. is constructing a skyscraper in the heart of town and has signed a

fixed price two-year contract for $21.0 million with the local authorities. It has incurred the following cost relating to the contract by the end of first year:

• Material cost =……………………………………………………………… $5 million • Labor cost =………………………………………………………………….. $2 million • Construction overhead =………………………………………………. $2 million • Marketing costs = ………………………………………………………..$0.5 million • Depreciation of idle plant and equipment = …………………$0.5 million. At the end of the first year, it has estimated cost to complete the contract =………………………………………………….. $9 million. What profit or loss from the contract should Brilliant Inc. recognize at the end

of the first year? (a) $1.5 million (9/18× 3.0) (b) $1.0 million (9/18 × 2.0) (c) $1.05 million (10/19 × 2.0) (d) $1.28 million (9.5/18.5 × 2.5)

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MCQ - 3

3. Mediocre Inc. has entered into a very profitable fixed price contract for constructing a high-rise building over a period of three years. It incurs the following costs relating to the contract during the first year:

• Cost of material =……………………………………………………………….. $2.5 million • Site labor costs = ………………………………………………………………….$2.0 million • Agreed administrative costs as per contract to be reimbursed by the customer =………………………………………... $1 million • Depreciation of the plant used for the construction = …………$0.5 million • Marketing costs for selling apartments when they are ready $1.0 million Total estimated cost of the project =……………………………………. $18 million The percentage of completion of this contract at the year-end is (a) 33% (= 6.0/18.0) (b) 27% (= 4.5/16.5) (c) 25% (= 4.5/18.0) (d) 39% (= 7.0/18)

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MCQ - 4

• 4. A construction company is in the middle of a two-year construction contract when it receives a letter from the customer extending the contract by a year and requiring the construction company to increase its output in proportion of the number of years of the new contract to the previous contract period. This is allowed in recognizing additional revenue according to IAS 11 if

(a) Negotiations have reached an advanced stage and it is probable that the customer will accept the claim.

(b) The contract is sufficiently advanced and it is probable that the specified performance standards will be exceeded or met.

(c) 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.

(d) It is probable that the customer will approve the variation and the amount of revenue arising from the variation, whether the amount of revenue can be reliably measured or not.

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MCQ - 5

• 5. A construction company signed a contract to build a theater over a period of two years, and with this contract also signed a maintenance contract for five years. Both the contracts are negotiated as a single package and are closely interrelated to each other. The two contracts should be

(a) Combined and treated as a single contract. (b) Segmented and considered two separate contracts. (c) Recognized under the completed contracted method. (d) Treated differently—the building contract under the

completed contract method and maintenance contract under the percentage of completion method.

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Thank You.

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