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Introduction
Revenue recognition and accounting for Construction business is
different from other businesses because unlike most other businesses,
there can be a long gap between the commencement of work in a construction
business and its completion. This gap can sometimes spread over various
accounting periods also. This is what necessitates a different approach
for revenue recognition in the construction business. Besides this,
various legal agreements form the basis for the business. These agreements
can vary for almost each contract entered into for construction activities
and the entire accounting and tax treatment of the transactions depends
on the terms and conditions contained in the said agreements.
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Section 145 of the Income-tax
Act, 1961
Under section 145 of the Income-tax Act 1961, an assessee can
maintain accounts either on cash or mercantile basis. If any other
method is followed by an assessee, it will entitled the assessing
officers to reject the book results and to make a best judgment assessments
under section 144. The same consequence will follow if there is non
compliance with the standards notified by the Central Government.
These have been notified by Notification No. S. O. 69(E) dated 25th
January, 1996. The notification applies in respect of assessee following
mercantile system of accounting. The first stated deals with disclosure
of accounting policies. The standard requires an assessee to follow
such policies as would disclose a true and fair view of his business.
The concepts of prudence, substance over form and materiality have
been endorsed. It should therefore be borne in mind that when we look
at compliance with the mercantile method for accounting, the concept
of materiality will also have to be considered. An accidental omission
to make a provision of insignificant impact will not result in violation
of section 145. The second standard deals with disclosure relating
to prior period and extraordinary items and changes in accounting
policies. Both the standards are in consonance with all generally
accepted accounting principles and the pronouncements to the Institute
of Chartered Accountants of India and therefore do not need any further
comment.
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Accounting Standards
The Institute of Chartered Accountants of India (ICAI) looking
to the importance of the construction business and its accounting
implications has issued an Accounting Standard (AS) on the same in
1995. Since the said AS was not in line with the international practices
and also since it permitted alternative treatments, the same was revised
in 2002. AS 7 (Revised) is applicable for all contracts entered into
during accounting periods commencing on or after 1st April, 2003.
The revised AS is more or less in line with IAS 11.
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What is a construction contract?
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The old AS 7 did not specifically
define the term. However, para 3 thereof stated that a construction
contract is a contract for the construction of an asset or of
a combination of assets that together constitute a single project.
It also stated that the contracts for provision of services also
come within the scope of the statement to the extent they are
directly related to contract for the construction of an asset.
Examples of such service contracts are contracts for the services
of project managers, architects and for technical engineering
services related to the construction of an asset.
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AS 7 (Revised) specifically defines
a Construction Contract 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 of their ultimate purpose for use. It
is also stated that construction contracts include contracts for
the rendering of services that are directly related to the construction
of the asset. Examples are those for services of project managers
and architects. It is also provided here that construction contracts
include contracts for destruction or restoration of assets, and
the restoration of the environment following the demolishing of
assets.
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The old AS 7 applied both to
persons carrying on construction work on contract for others as
well as builders and developers who carry on construction work
for themselves. However, paragraph 1 giving the scope of AS 7
(Revised) mentions that the standard should be applied in accounting
for construction contracts in the financial statements of contractors.
This suggests that the revised AS would not cover builders and
developers who carry on construction work entirely on their own
account. In such cases, the general principles of Revenue Recognition
as per AS 9 would become applicable.
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AS 7 (revised) also defines 2
types of contracts, viz., a Fixed Price contract and a Cost Plus
contract. A Fixed Price contract is a construction contract in
which the contractor agrees to a fixed contract price, or fixed
rate per unit of output, which in some cases is subject to cost
escalation clauses. As against this, a Cost Plus contract is defined
as a construction contract in which the contractor is reimbursed
for allowable or otherwise defined costs, plus percentage of these
costs or a fixed fee.
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It is also provided that construction
contracts can be combined or segmented in certain cases. Paragraph
7 of AS 7 (revised) provides that when the contract covers a number
of assets, the construction of each asset should be treated as
a separate construction contract when certain criteria are met.
Guidance is also provided for a group of contracts, whether with
a single customer or with several customers, which are to be treated
as a single construction contract.
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It is also provided that a contract
may provide for construction of an additional asset at the option
of the customer or the same maybe amended to include the construction
of an additional asset. In such cases also, guidance is provided
as to when the construction of the additional asset should be
treated as a separate construction contract.
- What is contract revenue?
- The definition of contract
revenue was not given in the old AS 7. However, AS 7 (revised) mentions
that contract revenue should comprise of:
- 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.
- Contract revenue is normally measured at the
consideration received or receivable.
- The measurement of
contract revenue as above can be affected by a variety of uncertainties.
Thus, depending on the outcome of future events and as and when
uncertainties are resolved, contract revenue may increase or decrease.
Such increase or decrease also can be due to:
- Claims made by the contractor for extra
work done or on account of incentive payments or
- Penalties agreed to be paid by the contractor
due to delays cost in the completion of the contract.
- There can be even a variation in the contract
revenue, which can arise when there is a change in the scope of
the work to be performed under the contract. Such variation can
be included in the contract revenue if it is probable that the customer
may approve the variation and the amount of revenue due to such
variation can be reliably measured.
- There can be claims
that the contractor may seek to collect from the customer for reimbursements
of extra costs not forming part of the contract price. Such claims
can be due to customer caused delays, errors in specification of
design and disputed variations in the contract work. Since the recoverability
of such claims is highly uncertain, they can be included in contract
revenue only when:
- Negotiations have reached an advanced stage
such that it is probable that the customer will accept the claim
and
- The amount of the claim can be 5
- There can also be incentive payments that are
additional payments payable to the contractor if the specified standards
are met or exceeded. For example, an incentive of 2% of the contract
price if the work is completed 1 month before the stipulated time.
Such incentive payments can be included in the contract revenue
only when:
• The contract is sufficiently advanced which
makes it probable that the specified performance standards will be met
or exceeded and• The amount of the incentive payment can be measured
reliably.
- What are contract costs?
- As per the old AS 7,
costs incurred by a contractor could be divided into:
- Costs that related directly to a specific
contract;
- Costs that can be attributed to the contract
activity in general and can be allocated to specific contracts;
- Costs that relate to the activities of the
contractor generally, or that relate to contract activity but
cannot be related to specific contracts.
- AS 7 (revised) however
provides a more detailed discussion of contract costs. Paragraph
15 provides that contract costs should comprise of:
- 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.
- Costs that relate directly
to the specific contract include:
- Site labour costs, including site supervision;
- Costs of materials used in the construction;
- Depreciation of plant used in the contract;
- Costs of hiring equipments and shifting
equipments and materials to and from the contact site;
- Costs of design and technical assistance
which is directly related;
- Estimated costs of rectification and guarantee
work (including warranty costs); and
- Third party claims.
- It is also possible that the contractor has
earned some income that is incidental like say, from sale of equipments
scrap. This incidental income has to be reduced from the above direct
costs.
- Costs that can be attributable
to contract activity in general and which can also be allocated
to specific contracts will include:
- Insurance;
- Costs of design and technical assistance
that is not directly related to a specific contract and;
- Construction overheads
Such costs are to be allocated
to a particular contract using a systematic and rational method
to be applied consistently to all costs having similar characteristics.
Such allocation is also to be based on the ‘normal’ level
of construction activity. Such costs will also include any borrowing
costs incurred (as per AS 16) for any specific contracts.
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Costs specifically chargeable
to the customer under the terms of the contract will include costs
like general administration costs, development costs, etc. for
which reimbursement is specified in the terms of the contract.
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Other costs that cannot be attributed
to any contract activity or allocated as per 6.5 and 6.6 above
are to be excluded from contract cost. Thus, general administration
costs (other than covered by 6.6 above), selling costs, depreciation
of idle plant and equipments, etc. are to be excluded.
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Contract costs as above include
all costs for the period from the date of securing the contract
till the date of the final completion of the contract. If however,
costs directly related and incurred for securing a contract can
be included as part of contract costs if they can be separately
identified and measured reliably and it is probable that the contract
will be obtained. However, as a measure of conservatism, it is
also mentioned that if any costs incurred for securing a contract
are recognised as an expense in the period when incurred, the
same cannot be included as part of contract costs in any subsequent
period.
- How is recognition of
contract revenue and expenses to be done?
- As per the old AS 7, two methods were permitted
for recognising revenue on construction contracts, i.e. Percentage
of Completion Method and the Completed Contract Method.
- However, AS 7 (revised) permits recognition
of revenue and expenses only by the "Percentage of Completion Method".
Under this method, contract revenue is recognised as revenue in
the statement of profit and loss in the accounting periods in which
the work is performed. Paragraph 21 of AS 7 (revised) states that
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
and the reporting date. The contract costs are also to be recognised
in normal cases as expenses in the statement of profit and loss
in the accounting periods in which the work to which they relate
is performed. In other words, the contract revenue is matched with
the contract costs incurred in reaching the stage of completion,
resulting in the reporting of revenue, expenses and profit that
can be attributed to the proportion of work completed.
- AS 7 (revised) gives detailed guidance as to
how the recognition of profit is to be done as per the "Percentage
of Completion Method". The conservatism principle is pre dominant
in all these paragraphs, which are briefly discussed below.
- As per AS 7 (revised),
in the case of fixed price contracts, 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.
- In the case of cost
plus contracts, 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.
- If, however, there is an expected loss on the
construction contract, it should be recognised as an expense immediately.
Further, construction costs incurred that relate to future activity
on the contract are to be recognised as an asset (as contract work
in progress) if it is probable that these costs will be recovered.
- If there is an uncertainty about the collectability
of any amount already included and recognised as contract revenue,
the uncollectible amount is to be recognised as an expense rather
than as an adjustment to contract revenue.
- To be able to make
reliable estimates for contract revenue and costs, the enterprise
should have an effective internal reporting system, which will also
make, review and revise estimates as and when required. As a guideline,
the standard mentions that an enterprise is generally able to make
reliable estimates when the contract establishes:
- Each party’s enforceable rights regarding
the asset to be constructed;
- The consideration to be exchanged and
- The manner and terms of settlement.
- For determining the
stage of completion of the contract, the standard states that it
can be done in a variety of ways and depending on the nature of
the contract it may include:
- The proportion that contract costs incurred
for work performed up to the reporting date bears to the estimated
total contract costs; or
- Surveys of work performed; or
- Completion of a physical proportion of the
contract work.
It is very clearly stated that
progress payments and advances received from customers may not
necessarily reflect the work performed. Further, when the stage
of completion is determined by reference to the contract costs
incurred up to the reporting date, only those contract costs that
reflect work performed are included in costs incurred up to the
reporting date.
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The standard also provides that
when the outcome of a construction contract cannot be estimated
reliably:
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Revenues should be recognised
only to the extent of contract costs incurred of which recovery
is probable; and
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Contract costs should be
recognised as an expense in the period in which they are incurred.
- If, during the early stages of a contract, the
outcome of the contract cannot be estimated reliably, but it is
probable that the enterprise will recover the contract costs, contract
revenue is recognised only to the extent of costs incurred that
are expected to be recovered. In such cases, no profit can also
be recognised. In all such cases also, if there is an excess of
the contract costs over contract revenues the same is to be immediately
recognised as an expense.
- Contract costs whose
recovery is not probable are recognised as an expense immediately.
Such circumstances can arise when:
- The contract is not fully enforceable and
its validity is in question;
- The completion of the contract is subject
to the outcome of pending litigation or legislation;
- Contracts relating to properties are likely
to be condemned or expropriated;
- When the customer is unable to meet its
obligations; or
- Where the contractor is unable to complete
the contract or meet its obligations under the contract.
- If however, 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 of the AS; i.e., when
the outcome of the contract can be estimated reliably – refer paras
7.2 to 7.8 of this article, rather than in accordance with 10 para
31 of the AS; i.e., when the outcome of the contract cannot be estimated
reliably – refer paras 7.10 to 7.12 of this article.
- Recognition of expected
losses
- As per the old AS 7,
when current estimates of total contract costs and revenues indicated
a loss, provision is to be made for the entire loss on the contract
irrespective of the amount of work done and the method of accounting
followed. Such provision for loss was to be done irrespective of:
- As per AS 7 (revised)
also when it is probable that the total contract costs will exceed
the total contract revenue, the expected loss should be immediately
recognised as an expense. Such loss is to be 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 rise on
other contracts that are not treated as a single construction
contract.
- Changes in estimates
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As per the old AS 7, amounts
due in respect of claims made by the contractor and variations
in contract work are to be recognised as revenue only when, and
only to the extent that, the contractor has evidence of the final
acceptability of the amount of the claim or variation.
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As per AS 7 (revised), the Percentage
of Completion Method is to be applied on a cumulative basis in
each accounting period while making estimates of contract revenue
and contract costs. Any change in the estimates of contract revenue
or contract costs, or the effect of a change in the estimates
of the outcome of a contract, is accounted for as a change in
Accounting Estimate (as per Accounting Standard 5 on "Net Profit
or Loss for the period, prior period items and changes in accounting
policies).
- Disclosures
- The old AS 7 had laid
down disclosures as follows:
- The amount of construction work in progress;
- Progress payments received and advances
and retention is on account of contracts included in construction
work in progress; and
- The amount receivable in respect of income
accrued under cost-plus contracts not included in construction
work in progress.
- If the contractor simultaneously uses both
the methods, the amount of contract work should be analysed
to disclose separately the amounts attributable to contracts
accounted for under each method.
- Disclosure should also be made for any changes
in accounting policy giving effect of the change in its amount.
- However, as is the
case with all recent standards issued by ICAI, AS 7 (revised) has
laid down more detailed disclosures. The same are as follows:
- 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.
- Disclosure of the following is also required
for contracts in progress at the reporting date:
- The aggregate amount of costs incurred and
recognised profits up to the reporting date;
- The amount of advances received; and
- The amount of retention.
- Disclosure is also required for:
- 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.
- In addition to the above, disclosure is
also required for any contingencies that may arise from such
items as warranty costs, penalties or possible losses.
- Conclusion
The mandatory applicability of AS 7 (revised) is going to force
a lot of contractors and developers to change their accounting policy
for recognition of profits from contracts. Though, apparently it may
seem that by following the "Percentage of Completion Method" profits
of these enterprises may increase, it may not always happen so since
the recognition of profits by this method is to be done by following
the strict guidelines laid down in this standard.
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