Statements of
Accounting Standards (AS 7)
Accounting for Construction Contracts
The following is the text of the Accounting
Standard (AS) 7 issued by the Institute of Chartered Accountants
of India on 'Accounting for Construction Contracts'. The Standard
deals with accounting for construction contracts in the financial
statements of contractors.
In the initial years, this accounting
standard will be recommendatory in character. During this period,
this standard is recommended for use by companies listed on a recognised
stock exchange and other large commercial, industrial and business
enterprises in the public and private sectors.
Introduction
1. This Statement deals with accounting
for construction contracts in the financial statements of enterprises
undertaking such contracts (hereafter referred to as 'contractors').
The Statement also applies to enterprises undertaking construction
activities of the type dealt with in this Statement not as contractors
but on their own account as a venture of a commercial nature where
the enterprise has entered into agreements for sale.
2. The feature which characterises a
construction contract dealt with in this Statement is the fact that
the date at which the contract is secured and the date when the
contract activity is completed fall into different accounting periods.
The specific duration of the contract performance is not used as
a distinguishing feature of a construction contract. Accounting
for such contracts is essentially a process of measuring the results
of relatively long-term events and allocating those results to relatively
short-term accounting periods.
3. For the purposes of this Statement,
a construction contract is a contract for the construction of an
asset or of a combination of assets which together constitute a
single project. Examples of activity covered by such contracts include
the construction of bridges, dams, ships, buildings and complex
pieces of equipment.
4. Contracts for the provision of services
come within the scope of this Statement to the extent that they
are directly related to a contract for the construction of an asset.
Examples of such service contracts are contracts for the services
of project managers and architects and for technical engineering
services related to the construction of an asset.
Explanation
5. The principal problem relating to
accounting for construction contracts is the allocation of revenues
and related costs to accounting periods over the duration of the
contract.
6. Types of Construction Contracts
Construction contracts are formulated
in a variety of ways but generally fall into two basic types:
(i) fixed price contracts—the contractor
agrees to a fixed contract price, or rate, in some cases subject
to cost escalation clauses;
(ii) cost plus contracts—the contractor
is reimbursed for allowable or otherwise defined costs, and is also
allowed a percentage of these costs or a fixed fee.
Both types of contracts are within the
scope of this Statement.
7. Accounting Treatment of Construction Contract Costs
and Revenues
7.1 Two methods of accounting for contracts
commonly followed by contractors are the percentage of completion
method and the completed contract method.
7.2 Under the percentage of completion
method, revenue is recognised as the contract activity progresses
based on the stage of completion reached. The costs incurred in
reaching the stage of completion are matched with this revenue,
resulting in the reporting of results which can be attributed to
the proportion of work completed. Although (as per the principle
of 'prudence') revenue is recognised only when realised, under this
method, the revenue is recognised as the activity progresses even
though in certain circumstances it may not be realised.
7.3 Under the completed contract method,
revenue is recognised only when the contract is completed or substantially
completed; that is, when only minor work is expected other than
warranty obligation. Costs and progress payments received are accumulated
during the course of the contract but revenue is not recognised
until the contract activity is substantially completed.
7.4 Under both methods, provision is
made for losses for the stage of completion reached on the contract.
In addition, provision is usually made for losses on the remainder
of the contract.
7.5 It may be necessary for accounting
purposes to combine contracts made with a single customer or to
combine contracts made with several customers if the contracts are
negotiated as a package or if the contracts are for a single project.
Conversely, if a contract covers a number of projects and if the
costs and revenues of such individual projects can be identified
within the terms of the overall contract, each such project may
be treated as equivalent to a separate contract.
8. Costs to be Accumulated for Construction Contracts
8.1 Costs attributable to a contract
are identified with reference to the period that commences with
the securing of the contract and closes when the contract is completed.
8.2 Costs not specifically attributable
to any contract incurred by the contractor before a contract is
secured are usually treated as expenses of the period in which they
are incurred. However, if costs attributable to securing the contract
can be separately identified and either the contract has been secured
or there is a clear indication that the contract will be obtained,
the costs are sometimes treated as applicable to the contract and
are deferred. As a practical measure, costs directly identifiable
with a contract are sometimes deferred until it is clear whether
the contract has been secured or not.
8.3 Costs attributable to a contract
include expected warranty costs. Warranty costs are provided for
when such costs can be reasonably estimated.
8.4 Costs incurred by a contractor can
be divided into:
(i) Costs that relate directly to a
specific contract;
(ii) Costs that can be attributed to
the contract activity in general and can be allocated to specific
contracts;
(iii) Costs that relate to the activities
of the contractor generally, or that relate to contract activity
but cannot be related to specific contracts.
8.5 Examples of costs that relate directly
to a specific contract include:
(i) site labour costs, including supervision;
(ii) materials used for project construction;
(iii) depreciation of plant and equipment
required for a contract;
(iv) costs of moving plant and equipment
to and from a site.
8.6 Examples of costs that can be attributed
to the contract activity in general and can be allocated to specific
contracts include:
(i) insurance;
(ii) design and technical assistance;
(iii) construction overheads.
8.7 Examples of costs that relate to
the activities of the contractor generally, or that relate to contract
activity but cannot be related to specific contracts, include:
(i) general administration and selling
costs;
(ii) finance costs;
(iii) research and development costs;
(iv) depreciation of plant and equipment
that cannot be allocated to a particular contract.
8.8 Costs referred to in paragraph 8.7
are usually excluded from the accumulated contract costs because
they do not relate to reaching the present stage of completion of
a specific contract. However, in some circumstances, general administrative
expenses, development costs and finance costs are specifically attributable
to a particular contract and are sometimes included as part of accumulated
contract costs.
Basis for Recognising Revenue on Construction Contracts
9. Percentage of Completion Method
9.1 Under the percentage of completion
method, the amount of revenue recognised is determined by reference
to the stage of completion of the contract activity at the end of
each accounting period. The advantage of this method of accounting
for contract revenue is that it reflects revenue in the accounting
period during which activity is undertaken to earn such revenue.
9.2 The stage of completion used to
determine revenue to be recognised in the financial statements is
measured in an appropriate manner. For this purpose no special weightage
should be given to a single factor; instead, all relevant factors
should be taken into consideration; for example, the proportion
that costs incurred to date bear to the estimated total costs of
the contract, by surveys which measure work performed and completion
of a physical proportion of the contract work.
9.3 Progress payments and advances received
from customers may not necessarily reflect the stage of completion
and therefore cannot usually be treated as equivalent to revenue
earned.
9.4 If the percentage of completion
method is applied by calculating the proportion that costs to date
bear to the latest estimated total costs of the contract, adjustments
are made to include only those costs that reflect work performed.
Examples of items which may need adjustment include:
(i) the costs of materials that have
been purchased for the contract but have not been installed or used
during contract performance; and
(ii) payments to subcontractors to the
extent that they do not reflect the amount of work performed under
the subcontract.
9.5 The application of the percentage
of completion method is subject to a risk of error in making estimates.
For this reason, profit is not recognised in the financial statements
unless the outcome of the contract can be reliably estimated. If
the outcome cannot be reliably estimated, the percentage of completion
method is not used.
9.6 While recognising the profit under
this method, an appropriate allowance for future unforeseeable factors
which may affect the ultimate quantum of profit is generally made
on either a specific or a percentage basis.
9.7 In the case of fixed price contracts,
the conditions which will usually provide this degree of reliability
are:
(i) total contract revenues to be received
can be reliably estimated;
(ii) both the costs to complete the
contract and the stage of contract performance completed at the
reporting date can be reasonably estimated; and
(iii) the costs attributable to the
contract can be clearly identified so that actual experience can
be compared with prior estimates.
9.8 Normally, the profit is not recognised
in fixed price contracts unless the work on a contract has progressed
to a reasonable extent. Ordinarily, this test is not considered
as having been satisfied unless 20 to 25% of the work is completed.
9.9 In the case of cost plus contracts,
the conditions which usually provide this degree of reliability
are:
(i) costs attributable to the contract
can be clearly identified; and
(ii) costs other than those that are
specifically reimbursable under the contract can be reliably estimated.
10. Completed Contract Method
10.1 The principal advantage of the
completed contract method is that it is based on results as determined
when the contract is completed or substantially completed rather
than on estimates which may require subsequent adjustment as a result
of unforeseen costs and possible losses. The risk of recognising
profits that may not have been earned is therefore minimised.
10.2 The principal disadvantage of the
completed contract method is that periodic reported income does
not reflect the level of activity on contracts during the period.
For example, when a few large contracts are completed in one accounting
period but no contracts have been completed in the previous period
or are to be completed in the subsequent period, the level of reported
income can be erratic although the level of activity on contracts
may have been relatively constant throughout. Even when numerous
contracts are regularly completed in each accounting period, and
reported income may appear to reflect the level of activity on contracts,
there is a continuous lag between the time when work is performed
and the related revenue is recognised.
11. Selection of Method
11.1 The selection of a method of accounting
for a construction contract depends on considerations discussed
earlier. The contractor may use both methods simultaneously for
different contracts depending upon circumstances.
11.2 When a contractor uses a particular
method of accounting for a contract, then in respect of all other
contracts that meet similar criteria, the same method is used.
11.3 The methods of accounting used
by the contractor and the criteria adopted in selecting the method/s
represent an accounting policy.
12. Change in Accounting Policy
When there is a change in the accounting
policy used for construction contracts, there is disclosure of the
effect of the change and its amount. If the contractor changes from
the percentage of completion method to the completed contract method,
it is sometimes not possible to quantify the full effect of the
change in the current accounting period. In such cases, there is
disclosure of at least the amount of attributable profits reported
in prior years, in respect of contracts in progress at the beginning
of the accounting period.
13. Provision for Foreseeable Losses
13.1 When current estimates of total
contract costs and revenues indicate a loss, provision is made for
the entire loss on the contract irrespective of the amount of work
done and the method of accounting followed. In some circumstances,
the foreseeable losses may exceed the costs of work done to date.
Provision is nevertheless made for the entire loss on the contract.
13.2 When a contract is of such magnitude
that it can be expected to absorb a considerable part of the capacity
of the enterprise for a substantial period, indirect costs to be
incurred during the period of the completion of the contract are
sometimes considered to be directly attributable to the contract
and included in the calculation of the provision for loss on the
contract.
13.3 If a provision for loss is required,
the amount of such provision is usually determined irrespective
of:
(i) whether or not work has commenced
on the contract; and
(ii) the stage of completion of contract
activity; and
(iii) the amount of profits expected
to arise on other unrelated contracts.
13.4 The determination of a future loss
on a contract may be subject to a high degree of uncertainty. In
some of these cases, it is possible to provide for the future loss
and in other cases only the existence of a contingent loss is disclosed.
14. Claims and Variations Arising Under Construction
Contracts
14.1 Amounts due in respect of claims
made by the contractor and of variations in contract work approved
by the customer are recognised as revenue in the financial statements
only in circumstances when, and only to the extent that, the contractor
has evidence of the final acceptability of the amount of the claim
or variation.
14.2 Claims or penalties payable by
the contractor arising out of delays in completion or from other
causes are provided for in full in the financial statements as costs
attributable to the contract. Claims in the nature of contingency
are treated as indicated in Accounting Standard 4 on 'Contingencies
and Events Occurring After the Balance Sheet Date'.
15. Progress Payments, Advances and Retentions
15.1 Progress payments and advances
received from customers in respect of construction contracts in
relation to the work performed thereon are disclosed in financial
statements either as a liability or shown as a deduction from the
amount of contract-work-in-progress.
15.2 In case progress payments and advances
received from customers in respect of construction contracts are
not in relation to work performed thereon, these are shown as a
liability.
15.3 Amounts retained by customers until
the satisfaction of conditions specified in the contract for release
of such amounts are either recognised in financial statements as
receivables or alternatively indicated by way of a note.
Accounting Standard
(The Accounting Standard comprises paragraphs
16–21 of this Statement. The Standard should be read in the context
of paragraphs 1–15 of this Statement and of the 'Preface to the
Statements of Accounting Standards'.)
16. In accounting for construction contracts
in financial statements, either the percentage of completion method
or the completed contract method may be used. When a contractor
uses a particular method of accounting for a contract then the same
method should be adopted for all other contracts which meet similar
criteria.
17. The percentage of completion method
can be used if the outcome of the contract can be reliably estimated.
17.1 In the case of fixed price contracts
this degree of reliability would be provided if the following conditions
are satisfied:
(i) total contract revenues to be received
can be reliably estimated;
(ii) both the costs to complete the
contract and the stage of contract performance completed at the
reporting date can be reasonably estimated; and
(iii) the costs attributable to the
contract can be clearly identified so that actual experience can
be compared with prior estimates.
17.2 Profit in the case of fixed price
contracts normally should not be recognised unless the work on a
contract has progressed to a reasonable extent.
17.3 In the case of cost plus contracts
this degree of reliability would be provided only if both the following
conditions are satisfied:
(i) costs attributable to the contract
can be clearly identified; and
(ii) costs other than those that are
specifically reimbursable under the contract can be reliably estimated.
17.4 While recognising the profit under
percentage of completion method an appropriate allowance for future
unforeseeable factors should be made on either a specific or a percentage
basis.
18. The costs included in the amount
at which construction contract work is stated should comprise those
costs that relate directly to a specific contract and those that
are attributable to the contract activity in general and can be
allocated to specific contracts.
19. A foreseeable loss on the entire
contract should be provided for in the financial statements irrespective
of the amount of work done and the method of accounting followed.
Disclosure
20. There should be disclosure in the
financial statements of
(i) the amount of construction work-in-progress;
(ii) progress payments received and
advances and retentions on account of contracts included in construction
work-in-progress; and
(iii) the amount receivable in respect
of income accrued under cost plus contracts not included in construction
work-in-progress.
If both the percentage of completion
method and the completed contract method are simultaneously used
by the contractor the amount of contract work described in (i) above
should be analysed to disclose separately the amounts attributable
to contracts accounted for under each method.
21. Disclosure of changes in an accounting
policy used for construction contracts should be made in the financial
statements giving the effect of the change and its amount. However
if a contractor changes from the percentage of completion method
to the completed contract method for contracts in progress at the
beginning of the year it may not be possible to quantify the effect
of the change. In such cases disclosure should be made of the amount
of attributable profits reported in prior years in respect of contracts
in progress at the beginning of the accounting period.
|
