AS 7: CONSTRUCTION CONTRACTS

an analysis

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 Overview
 Terminologies
 Accounting aspects
 Disclosure
 Case studies

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 The present standard was introduced wef
01.04.2003 as replacement to erstwhile AS – 7
Accounting for Construction Contracts
 The erstwhile standard allowed completed
contract method for revenue recognition, which
is now dispensed with
 Presently, only ‘percentage of completion
method’ is allowed to be followed

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 About percentage of completion method
› Recognition of revenue and expenses is with reference to the stage of
completion of a contract
› Contract revenue is matched with the contract costs incurred in reaching the
stage of completion
› 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
› Examples of methods to determine the stage of completion of a contract:
 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.
› Examples of contract costs which are to be excluded are: (Also see EAC –
Vol. XX – Pg. 150)
 Cost of unused materials at contract site or in transit; and
 payments made to subcontractors in advance of work performed under the
subcontract.

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 The primary issue in this accounting standard is to
match the contract revenues and costs that often fall
in more than one accounting periods
 This standard shall be applied in accounting for
construction contracts in the financial statements of
contractors. The inference is that the standard
applies only with reference to construction contracts
and that too undertaken in the capacity as a
contractor

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 Construction Contract
› A construction contract is a contract specifically
negotiated for the construction of
 an asset (e.g. building, dam, bridge etc.) 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. (e.g. a plant covering factory,
township, logistics etc.)
› 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.

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 Fixed price contracts
› The contractor agrees to a fixed contract price for
completing the contract or for a fixed rate per unit of
output. The contract may or may not have an escalation
clause
 Cost plus contracts
› The contractor gets reimbursement of all allowable or
otherwise defined costs. Over and above he gets a fixed
percentage of costs or a fixed fees
 Composite contracts
› These contracts possess the features of both the above
types. E.g. the contractor may get cost plus 10% limited to
Rs. 10 crores.

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 Splitting of a big contract
› When a contract covers a number of assets, the construction of
each asset should be treated as a separate construction contract
when: (conditions are cumulative)
 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.
› E.g. Setting up a factory may be a single contract, but separate
negotiation would have taken place for machinery, civil works,
furnishing, infrastructure etc.

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 Combining of small contracts
› A group of contracts, whether with a single customer or
with several customers, should be treated as a single
construction contract when: (conditions are cumulative)
 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
› E.g. Installation of a machinery may involve many
contracts like design, lay out, purchase, installation, civil
work, electrical work etc.

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 Treatment of additional work
› The construction of additional asset shall be treated as
a separate contract when: (conditions not cumulative)
 The asset differs significantly in design, technology or
function from asset or assets covered in the original
contract (or)
 The price of the asset is negotiated without regard to the
original contract price

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 Contract revenue
 Contract costs
 Recognition of contract revenue
and cost

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 Contract revenue shall comprise of:
› The initial amount of revenue agreed in the contract
(and)
› Variations in contract work (e.g. additional work,
escalation clause etc.), claims (e.g. reimbursement of
costs) and incentive payments (e.g. completing work
ahead of deadline):
 To the extent that it is probable that they will result in
revenue (and) (CERTAINITY)
 They are capable of being reliably measured
(MEASURABILITY)

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 Contract costs should comprise:
› costs that relate directly to the specific contract (e.g. Para.
16 of AS 7). 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.;
› costs that are attributable to contract activity in general
and can be allocated to the contract. (e.g. Para. 17 of AS
7); and
› such other costs as are specifically chargeable to the
customer under the terms of the contract.

S. S. AYYAR AND CO. - AS 7 13

 Examples of Costs that are not includible
› 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
 Accounting treatment of costs incurred for securing a contract
› The same is included subject to the following points:
 Costs are separately identified
 measured reliably and
 it is probable that the contract will be obtained

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 When to recognise revenue /costs
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 .
(See slides 16 and 17)

 What is the criteria for recognising the same?

The stage of completion of the contract activity at the reporting date.
(Refer slide 4) (refer the illustration circulated)

 What is the rule for recognising loss arising from a

contract?
An expected loss on the construction contract should be recognised as an
expense immediately. 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

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 Determining the outcome in the case of fixed price
contract
› 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.

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 Determining the outcome in the case of cost plus
contract
› 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.

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 Treatment of costs incurred which pertains to future activities:
› 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

 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 (see examples in para.
33 of AS 7)

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 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
 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 the normal principles (Refer slide
15)
 Changes in accounting estimates vis-à-vis contract revenues
and costs shall be dealt with in the manner laid down in AS
5.

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 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.

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 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.

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 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.
 Contingencies like warranty costs, penalties or
possible losses etc. shall disclosed as per AS 29
 Please see sample disclosures given in appendix
to the standard

S. S. AYYAR AND CO. - AS 7 22

 Applicability of AS 7 to enterprises undertaking
construction activities on their own account
(EAC – vol. XXIII – pg. 95)
› According to Paragraph 1 of AS 7, ‘This standard
should be applied in accounting for construction
contracts in the financial statements of contractors’.
Therefore, AS 7 does not apply in this case. They will
have to follow AS 9 for revenue recognition and AS 2
for inventory valuation

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 Applicability of AS 7 to real estate developers (Refer
guidance note on recognition of revenue by Real Estate Developers
– CA journal June 2006 – page 1764)
› For Services done till transfer of risks and rewards – Developer cannot be
considered as a contractor and therefore AS 9 applies. Here revenue
recognition depends on paragraphs 10 and 11 of the said standard:
 Paragraph 10 – whether ultimate collection is assured (and)
 Paragraph 11 – transfer of risks and rewards of ownership and no
ambiguity as to consideration Transfer of risks and rewards and
ownership take place depending on the terms of agreement
› For Services done after transfer of risks and rewards – The developer
steps into the shoes of a contractor and hence AS 7 applies

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 Interpretation of the term ‘turnover’ vis-à-vis
construction contracts (ASI 29)
› The amount of contract revenue recognised as ‘revenue’ in
the statement of profit and loss as per the requirement of
AS 7 shall be considered as ‘turnover’
› Turnover implies the incomings from the revenue
generating activities of an enterprise. Vis-à-vis a
contractor, ‘revenue’ as per AS 7 is the incoming from the
revenue generating activities of the enterprise and hence
rightly treated as ‘turnover’

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 Applicability of AS 7 to turnkey projects
involving supply of goods and related services:
(EAC – Vol. XX – Pg. 156)
› E.g. Supply of machinery and related erection,
installation and commissioning
› In such cases if the supply of machinery (i.e. contract
of sale) is predominant then AS 9 shall apply
› Alternatively if the works contract is predominant
then AS 7 shall apply

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 Applicability of AS 7 to engineering
consultancy services: (CA Journal –
March 2006 – Pg. 1350)
› If consultancy is incidental to a construction
contract, AS 7 shall apply
› In all other case, AS 9 shall apply

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 Applicability of AS 7 to entities not following
accrual method of accounting (refer compendium of
accounting standards 2005 edition – Page A-21)
› This generally applies in the case of non corporate entities
› Here the fact that accrual method of accounting is not
followed shall be stated and compliance of AS shall be
viewed based on the method of accounting followed
› Moreover, since CBDT has not issued any accounting
standard on construction contracts, a non corporate
assessee can still follow completed contract method. This
view was upheld in Madhuvana House Building Co-
operative society vs. ACIT (2002) 76 TTJ 948 (Bang)

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THANK YOU

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