AS 7: Construction Contracts

& ASI 29 Turnover in case of Contractors

Applicable only to Contractors & Not to Contractee 1

IPCC Paper 1: Accounting Chapter 1 Unit 2

CA. Yagnesh Desai, FCA

 Subject Matter
2

 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 ?
 Construction Contract
3

 A contract specifically negotiated

 for the construction of an asset or
 a combination of closely interrelated or
 interdependent assets is termed as

EXAMPLES
“Construction of a Single Asset “ :

Construction Construction
Laying Rails Etc
Of Bridge Of Dam
 TYPES OF CONTRCTS
4

Construction
Contracts

Fixed Price Cost Plus

Contract Contract
 Construction Contracts
5

• The contractor agrees to a fixed

FIXED contract price, may be added with cost
PRICE escalation clause by which the
customer will grant increase if input cost
CONTRACT rises beyond a certain index.

COST PLUS • The contractor gets reimbursement of

the identified costs on actual basis as
CONTRACT per terms of the contract and a defined
percentage of cost as fee.
 Combining and Segmenting
Construction Contracts
6

Segmenting
Contracts

Combining
Contracts
 Combining & Segmenting
Construction Contracts
7

 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.
 Recognition Contract
Revenue & Expenses
8

 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.
 Recognition Contract Revenue &
Expenses
9

 In accounting for construction contracts following steps are

followed :
• Identify total contract revenue which comprises of price initially agreed upon, variations
1. granted by the customer, claims and incentives.

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

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

• Review whether uncertainties surrounding reliable measurement of contract.

4.

• Recognize expected contract loss as an expense.

5.

• Check disclosures.
6.
 Contract Revenue
10

COMPRISED OF 4 COMPONENTS :

Contract Revenue

Initial
Agreed Variations Claims Incentives
Upon Price

Revenue measurement is not affected by Billing.

Initially Agreed Upon Contract Price
11

 This may undergo changes because of variation,

claims and incentives. There may be change in
the initially agreed upon price because of -

1. • Cost escalation under fixed price contract

• Penalties imposed for delay caused by the contractor or

2. violations of work specification / standard.

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

 Variations
12

 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.
 Claims
13

 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
 CLAIMS
14

 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.
AND
2. Reliability in
measurement of amount of
claim
 Incentives
15

 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.
 Contract Costs

Contract
Costs

Directly Allocated
Specific
Attributable Contract
Costs
Costs Overhead

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 Direct Costs
1. • Site labour cost.

2. • Materials.

3. • Transport charge.

4. • Cost of design.

5. • Technical assistance charge.

6. • Depreciation of Plant & Machinery Used in Construction

7. • Cost of Hiring Plant

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

9. • Claims from third parties.

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

11 • Reduction of Direct Costs By :

• any incidental income resulting from sale of surplus material and

12 • the disposal of equipment at the end of the contract.

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 Cost Attributable Costs - Excluded
19

Selling and marketing costs

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

Research and development costs for which reimbursement is not specified in

the contract

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

any construction
contract
 Debate over Pre-Contract Costs
20

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.
 Allocated Contract Overhead
21

 It includes :

1. • Insurance.

• Design and technical assistance charges

2. (not specific to a contract.)

• Contract overhead including administration

3. and personnel preparing pay roll’s cost.
 Recognition Of Contract
Revenue And Expenses
22

Recognise Contract revenue and contract costs - WHEN the

outcome of the contract can be estimated reliably.

Both Above to be recognized by reference to the stage of completion at the

balance sheet date.

Contract wise not netting off unless contracts can be combined

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.
 Measurement of Outcome
23

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.
 Measurement of Outcome
24

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.
 Percentage Of Completion Method -
I
25

 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
 Percentage Of Completion Method II
26

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
 Evaluation of Stage of Completion
27

 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.
OR

Survey of works performed.

OR

Physical work performed to total work.

 Determination Contract Profit
28

 Determination contract profit

( Estimated contract revenue

Estimated contract costs )

Stage of completion
 Future Costs ?
29

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.”
 Revenue = Cost
30

This in other words mean ,

No profit , No Loss.

This situation arises when….

 Revenue = Cost
31

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.
 Summary
32

No Loss
Profit Loss
No Profit

Where out come

is uncertain
 DISCLOSURES
33

Disclosure requirements are stated as :

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.

 DISCLOSURES
34

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. )
 Illustration
35

 The following information relates to a contract :

PARTICULARS AMOUNT
( CU’000 )

Estimated contract revenue 100

Costs to date 48

Costs to complete 32

Total estimated costs 80

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 :
PARTICULARS CU’000

Revenue (60% of CU100,000) 60

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

Profit (CU100,000 – 12
CU80,000)
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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 100 150
on work to date

Agreed profit as a % of 20% 20%

costs
37
 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

2008
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

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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 100

revenue
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 30

date )
Profit NIL

41
 Illustration
 The following details relate to a contract expected to be loss making :

CU’000
Estimated contract revenue 100
Costs to date 72
Costs to complete 48
Total estimated costs 120

Stage of completion (costs incurred method) 60 %

Estimated overall loss (CU120,000 – CU100,000) 20

42
 Illustration
 The amounts to be recognized in the statement of
comprehensive income are :

CU’000
Revenue (60% of CU100,000) 60
Cost of sales 72
Loss 12
Provision for full contract 8

Expected contact loss 20

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 For Practice
44

Multiple Choice Questions

 MCQ - 1
45

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).
 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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