AS 7- Accounting for construction contracts

AS 7 Accounting for construction contracts:

Introduction:

 This AS is formed to give the contractors a proper method of accounting to record their transaction in the financial statements. Earlier the contractor were facing difficulty regarding the recording of revenue in their financial statement cause as we know construction work takes long time to construct, normally more than 1 year, this created confusing situation that whether to record the transaction in the year in which the construction get finished or before, and if they recognized the revenue before; that would be the violation of prudence principal. If they recorded the revenue in the year of completion then what about those past years the contractor spent to make the work? To remove these confusion this AS is formed.

Explanation:

Meaning of construction contracts: it means the contract taken by an enterprise (contractor) to construct the assets. These assets may be single or the combination of inter dependent or interrelated assets. Example of single asset—road, ship, pipeline, tunnel, etc, and examples of interrelated is – complex pieces of plants and equipments

Included in definition: for the purpose of this standard, construction contract include-

1)      Contracts for rendering Services directly related to the construction like service of architecture, and

2)      Contract for destruction of assets.

Additional assets:

If it is required to construct additional asset at the option of customer, this asset will be regarded as separate contract when, a) the price of this asset can be negotiated separately and b) it is different in design, technology or function.

Number of assets:

When construction contract contain number of assets, each assets will be regarded as separate assets when cost and revenue of each asset can be separately identifiable, proposal of each asset are submitted separately, and the negotiation of each asset is possible.

Contract revenue:

Contract revenue include initial amount of contract plus or minus, variation in contract..variation occurs in many cases like claims of contractor, penalty charge by customer for late work, or increase of other inter related assets or modification in existing asset etc etc.

Contract cost:

Contract cost include a) direct cost related directly to construction like labor cost, material cost, depreciation of plant and equipment cost, etc.. b) Allocated cost like insurance, and borrowing cost  related to construction…c) specific cost like general and administrative costs that are reimbursable.

Cost not included under construction cost:

a)      General and administrative cost that are non reimbursable.

b)      Selling cost

c)       Research and Development cost that are non reimbursable

d)      Depreciation of idle machinery.

TYPES OF CONTRACT:

There are two types of contracts 1) fixed price contracts and 2) cost plus contracts.

Fixed price contract: in this contract, the price is fixed before commencing the construction, and in some cases enterprise requires its customer to pay extra price as cost escalation.

Cost plus contracts: in this contract, the customer reimbursed the cost of the construction and in addition to this, the fee of the contractor (determined as a percentage of that cost) is also paid by the customer.

Methods of accounting of construction contract:

PERCENTAGE COMPLETION METHOD:

This method says an enterprise under construction contract can record the revenue and its corresponding cost annually, in its books, in proportionate to the progress of the work during the year.

For example, 30% of the construction of bridge is completed during the year. Contract price was 10 crore, cost incurred during the year is 1.3 crore. According to this method, 3 crore will be the revenue and 1.7 crore(3.00-1.3) will be the profit of that year.

This AS allows the enterprise to apply this method only when it’s possible to estimate the final outcome of the contract.

In case of fixed price contract the outcome can be estimated reliably when:

The total contract revenue, expected cost to complete that contract, and the stage of completion of contract can be measured reliably and it’s probable that the economic benefit will flow to the enterprise.

Outcome of cost plus contract can be estimated reliably when:

It’s probable that the economic benefit will flow from that contract and the contract cost require to complete the contract can be measured reliably

If the outcome can’t be estimated the PCM will not be applicable and in that case:

1)      Revenue should be recognized only to the extent the cost is incurred,

2)      Contract cost should be recognized as expense.

Expectation of losses:

At certain point of construction if realized that we will have loss in the future the expected loss will be recorded immediately in the profit and loss account.

Suppose— contract price = 10 crore, at the end of the year cost incurred is 4 crore, at that point, cost required to complete the whole construction was estimated 8 crore by contractor. Now contractor can determine the total cost which is 4+8= 12 crore, he can determine from this; the percentage of work completed which is 4/12*100=33.33% now he can easily determine the revenue of that work during the year which is 10*33.33/100=3.33 crore. Now the contractor can see that cost during the year=4 crore, revenue during the year=3.33 crore so loss during the year=0.67, but he can also see that the future loss will be (2 -0.67) which is 1.33 crore, this AS advise the contractor to recognize this future loss of 1.33 immediately in the books of account. After doing all these work the scenario of the profit and loss account during the year will be : contract price (as revenue)=3.33 crore,

Contract cost =4 crore,

Provision for loss=1.33 crore,

Total loss of the profit and loss account during the year=2 crore.

Here It’s to be noted that in cost plus method the above provision will not be apply because the contractor get the fee above cost price so no chance of expected loss.

Change in estimates—if there is a change in estimates it will be treated as per AS 5 That is, change in estimates will be recognize in the financial statement in the year in which change takes place.

DISCLOSURE:

A)     An enterprise required to disclose;

1)      Amount of contract revenue recognized as revenue during the year,

2)      Method used to recognize the revenue,

3)      The method used to determine the stage of completion of contract,

B)      For contract in progress:

1)      Aggregate amount of cost incurred and recognized profit upto the reporting date.

2)      Amount of advance received,

3)      Amount of retention.

C)      Gross amount due from or due to customer for contract work.

e)      Contingencies in relation to penalty cost, or possible loss.

EXCEPTION OF AS 7:

The revised AS 7 will not be applicable for the accounting of new housing projects undertaken by the company on or after 1/4/2013.

The AS 7, will also not applicable for real estate developers, for them AS 9 will be applicable.

These was all about this Accounting standard; hope you all like it.