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.

AS 4--CONTINGENCIES AND EVENTS OCCURRING AFTER BALANCESHEET DATE

Introduction:

As we know, at the end of an accounting year an enterprise prepares its financial statements and all the transactions (which are also called financial events) are taken into consideration while preparing those statements. Those prepared financial statements are then approved by the board of directors in case of company or by approving authority in case of others, there is a time lag between the date on which it is prepared and date on which it is approved say 15 days or 1 month. This AS is talking about the accounting treatment of all those events occurred between these two dates and the method of recording contingencies existing at the balance sheet date I,e 31^st march.

First we will know what is contingency and then the method of recording it In financial statements.

Contingency: contingencies are the situation the ultimate outcome of which, gain or loss, will be known or determined by the occurrence or non occurrence of one or more uncertain future events. Examples legal claims, warranty, etc.

IMPORTANT POINTS:

1.       The word “contingencies” used in this standard is restricted to the condition or situation at the balance sheet date, the financial effect of which is determined by the future events which may or may not occur.

2.       Pursuant to AS 29, the ASB has issued an announcement regarding applicability of AS 4 to the impairment of assets not covered by other accounting standards. They decided that all the paragraph in AS 4 which deals with the contingencies would remain operational to the extent they cover the impairment of assets like RECEIVABLES(I,E provision for doubtful debt).

3.       It is necessary to define clearly the word “uncertain “the future events on which the situation depends must be UNCERTAIN. For example we estimate the amount of depreciation for the assets but the wearing out of the assets is not uncertain we all know that one day the asset is going to be scrap and will have no value. So depreciation can’t be the contingency thus we can say that for contingency the future events must be uncertain.  

ACCOUNTING TREATMENT FOR CONTINGENCY:

Amount of contingent loss should be provided for by a charge in profit and loss account if it is probable that the future events will confirmed that asset has been impaired at the balance sheet date and the reasonable estimate of the amount of the loss can be made. If these conditions are not satisfied the existence of contingent loss should be disclosed in the financial statements.

No entry for contingent gain.

EVENTS OCCURRING AFTER BALANCE SHEET DATE:

Events occurring after balance sheet date are those significant events, both favorable and unfavorable those occur between the balance sheet date and the date on which the financial statements are approved by the approving authority.

There are two types of events that occur after balance sheet date:

a)      Those significant events which occurred between the balance sheet date and the date of approval of the financial statements but the condition related to that event was already existed before the balance sheet date. These are called the adjusting events because these type of events needs adjustments in the financial statements. For example – suppose the company was going through the legal case during the year 2012-13. The company made its balance sheet on 31^st march2013 and waiting for the approval from its board of director which happens on 15 may every year. In the meanwhile decision of that case came on 19 April 2013; require the company to pay 50 lakh, in that situation the company needs to adjust this event in its financial statements. Remember one thing events must be significant means it must bring the material effect on the financial statements. [Students should not confused that losses are only needed to adjust, if that court case brought 50 lakh in the company’s favor the adjustment would also require in that situation that’s why the definition says both favorable and unfavorable event].

b)      Those significant events which occurred between the balance sheet date and the date of approval of the financial statements and the condition related to those events also occurred in between these two dates is called Non-adjusting events. These are called Non- adjusting events because these types of events don’t require any adjustments, only disclosure is required in the financial statements. For example, earthquake took place after the balance sheet date but before approval of financial statements, in this case, we can see that no condition was existing during the year so no adjustment is required, only the disclosure (in the directors report) is required** regarding the event and loss of such event if possible to estimate, if it’s not possible to estimate the loss of this type of events, the report should state the loss on earthquake can’t be estimated.

If I were to say in one line I would say, in the adjusting events condition existed earlier and events occurred later to confirm that condition and in non-adjusting event condition and events both occurred later. 

** Disclosure is required to make the users of financial statements aware of the fact that material change in the near future will come.

Exception to the non-adjusting events:

1)      When we find that the destruction of the event is so major that, going concern of the company is affected by such event(means the company is in doubt whether it can continue its business or not), the adjustments in the financial statements of that event must be done no matter condition was earlier or later.

2)      The company proposed the dividend after looking out its profit so they will always propose the dividend after preparing its financial statements means after 31^st march. Although this is the event after balance sheet date and no condition for this was existed earlier I,e before 31^st ,(perfect qualities of non -adjusting events) it will require the adjustments in the financial statements.

THIS WAS ALL ABOUT THE THEORETICAL CONCEPT OF AS 4

Accounting Standard 3-- Cash Flows

INTRODUCTION:

Earlier the enterprises were used to prepare the statements of profit and loss account and balance sheet; the profit and loss account is prepared on accrual basis and the users of financial statements were getting the problem regarding “why the enterprise has not got any money to pay for dividends while the net profit of that company is good enough?” apart from this the users wanted to know from where the company was generating cash? and how the company was using that cash?  Thus, this create the need of preparing the statement which shows the inflows and the out flows of the cash during an accounting year. In June 1981 first time the AS introduced in the name “change in the financial position” later in 1997 the revised AS 3 INTRODUCED BY ICAI named “cash flow statements”and this AS is mandatory for the level 1 enterprises on or after 1 april 2001.

 

Definitions:

Cash flows: cash flows mean the inflows and the outflows of cash and cash equivalents.

Cash: cash means cash on hand and demand deposits with bank.

Cash equivalents: these are the short term investments that are readily converted into cash and which has no risk of change in value.

 

Now this cash flow statement is divided into 3 parts cash flow from 1)operating activities2)investing activities and 3)financing activities. The division was necessary to facilitate the users of financial statements so that they come to know from which category the cash is being generated and used.

              CASH FLOWS FROM OPERATING ACTIVITIES:

               First we need to understand what are the operating activities?

                All those activities that need to operate/run the principal (main) business of an enterprise are the operating activities. Now take a garment company, the principal business of that company is to manufacture and sale the garments, so all those activities which that company does like purchasing the raw-material, converting it into the finished products and selling them in to the markets are the operating activities. Similarly for a finance company giving loan and earning interests are the operating activities. So it depends upon the nature of the company. Apart from these, operating activities also include all those activities that are not investing and financing activities. For example purchase and sales of shares for trading purpose is not a principal revenue generating activities but because it’s not to be included in investing and financing activities it will be regarded as operating activity.

Now cash flows from operating activities mean the incoming (cash inflows) and outgoing (cash outflow) of cash from the operating activities during an accounting year. Thus cash purchase, cash sales, payment to supplier, receipts from debtor during the year, are some of the cash flows from operating activities of Non-Finance Company.

Some students misunderstand this concept and write the full amount of item written in p/l account. Let me give you an example suppose a company sold its garments at RS 5000 and customer paid 3000 during the year in this case we will take 3000 as cash inflow from operating activity but record full 5000 as revenue in profit and loss account, so both are completely different concepts.

Now once you understood this concept the rest of the work is pretty easy.

Methods:

There are two methods by which we can determine cash flows from operating activities, 1) direct and 2) indirect method.

In the direct method, we add all the cash inflows in the operating activities like cash sales, cash received from customer etc and deduct all those cash outflows in that process, for example- salaries of employees, administrative expenses, selling expenses, payment to supplier etc.

 

In the Indirect method, we write as a first step “Net profit before tax” amount taken directly from the profit and loss Account. (Now NPBT include both non operating and non cash items its definite, that’s why we need to refine that too, so)

As a second step we need to ADD BACK all the non cash expenses like depreciation, provisions etc and non operating expenses like loss on sale of fixed assets, interests paid on loan, etc and deduct all the non operating incomes like profit on sale of assets, interest received etc etc.

 In the third step, we will adjust the effect of change in working capital by keeping in mind that whenever there is an increase in current assets in comparison to the opening balance it always means that the cash is blocked in the business (like expenditure) so we have to deduct that much amount (from the balance remained in the second step) and if the C/A decrease in comparison to last balance it means that cash has come in the business so we have to add that much amount. Similarly if C/L decreases we will have to deduct that much amount because cash has been gone from the business (as we paid to the creditors) and if C/L increase vice versa.

Then at last, Tax paid during the year will be deducted from the balance amount left after following above three steps.

After that, the balance amount we got is cash from operating activities.  

So this was how you have to determine cash flows from operating activities.

             

              CASH FLOWS FROM INVESTING ACTIVITIES:

Apart from their operating activities enterprises are engaging in investing activities as other sources of income. Investing activities means purchasing and selling long term assets and investments. So in this head all the cash inflows will be added and outflows will be deducted and the resultant amount will be cash flows from investing activities.

             

CASH FLOWS FROM FINANCE ACTIVITIES:

Financing activities: these are the activities that change the size and the compositions of owner’s capital and the borrowings of an enterprise. It include issue of shares, debentures, loan taken from bank, etc etc

Some Important points relating to cash flows:

 

ASSETS:

Purchase and the sales of long term assets (including intangibles like patent, trademark etc) are the investing activities for all the enterprises as well as research and developments costs that are capitalized is also an investing activity that are not capitalized is an operating activity.

SHARES:

Purchase and sales of the shares of other enterprises for long term basis and dividend earned on them is an investing activity for non finance enterprise and operating activity for finance enterprise. For short term when taken for trading purpose, is an operating activity for all the enterprise.

Purchase and sales of the shares of subsidiary company is an investing activity for all enterprise.

 But when the company issues its own shares or debentures it will be financing activities.

LOANS AND ADVANCES:

Loans and advances given or taken and interests earned or paid on them are an operating activities for finance companies, and  Loans and advances given to the other enterprise and interests earned on them is an investing activity for non finance company. Loans and advances taken from other enterprise and interest paid on them is a financing activities.

  Loans and advances given to employees and interests earned on them are an operating activity for all enterprises. Interests earned from customer for late payment and vice versa are operating activities. Loans and advances given or taken to the subsidiary company and interests earned or paid on them is an investing activity for both finance and non-finance company.

TAX DEDUCTED FROM SOURCE:

TDS against the income is an operating activity if the concerned income is operating income or whereas it will be investing activity if related with investing incomes. TDS against expenses is an operating activity if related with operating expenses and financing activity if related with financing activity.

BUSINESS PURCHASE:

Cash flows from the business purchase should be regarded as investing activities.

RECORDING NET BASIS:

This AS tells that we can’t net of the items relating to investing and financing activities. Example cash received from the issue of debentures is 500000 and cash paid as repayment of borrowed money is 200000 should not be net off and written as 300000 (net)..

But for operating activities we can net of that, such as cash received from customer is 50000 and paid to customer 10000 can be written as 40000.

This AS allows to netting of the purchase and sales of investment.

Effect of foreign currency transaction:

The effect of foreign currency transaction should be written as separately in the reconciliation of change in the cash and cash equivalent during the year.

DISCLOSURE:

According to this AS we should disclose the amount of cash and cash equivalents held by an enterprise that are not available for use.

Amount of undrawn borrowing facilities that may be available for future operating activities should be disclosed.

This AS says cash flow arises on the extra ordinary items should be disclose separately in the respective head. For example:

The insurance claim received from the loss of stock or loss of fixed assets should be disclosed separately in cash from operating head and cash from investing head respectively, in such a way that the users can identify the effect of that transaction.

THIS WAS ALL ABOUT THE THEORETICAL CONCEPT OF AS 3 CASH FLOWS.