07 Accounting Standard 7 - Construction Contract - AS 7

[Accounting Standards]

Query: Applicability of Accounting Standard (AS) 7 to an unsold site.


1. A public sector undertaking, registered under the Companies Act, 1956, undertakes as a part of its activities, construction of properties and sells the same. Following is the Accounting Policy followed by the company for accounting of profits in construction contracts:

“Profit is recognised on percentage of completion method which is further reduced to 80% for keeping an appropriate allowance for future unforeseeable factors in cost and sale prices till the project is fully completed.”

2. The querist has stated that the above accounting policy has been framed keeping in view Accounting Standard (AS) 7 on ‘Accounting for Construction Contracts’ which, inter alia, according to the querist, permits booking of profit on percentage of completion method. The above method of booking profit was chosen, since the project is spread over many financial years and booking of profit in one year would have given very erratic movement of the profit in that year. The calculation of percentage of completion is made by dividing work in progress by estimated cost of the project as on 31.3.1995.

3. One of the projects which the company undertook had two different sites. While one site was sold and part payment received, the other site was yet to be allotted/sold to any party. However, for the purpose of booking estimated profit, it was felt that the profit on unsold site should also be booked. Accordingly, the sale price for unsold site was also worked out on the basis of the price at which another site was sold and the total profit was calculated with reference to the total sale price of both the sites and the total estimated expenditure of all the sites which was further limited by applying percentage of completion worked out as stated above and the profit so calculated was further reduced to 80 percent as per the accounting policy and the result was included in the profit and loss account as notional profit.

4. Auditors are of the view that in the absence of agreement for sale, application of percentage of completion method in the case in against the accepted accounting principles and the Accounting Standard (AS) 7 is not relevant where an agreement for sale does not exist. However, the management is of the view that Accounting Standard 7 is applicable irrespective of the fact that one site is yet to be sold since outcome of the project/sale price has been reasonably estimated and is considered to be on low side keeping in view that an offer letter from a builder has been received who has offered higher prices than what was considered above for working out notional profit and the higher reserve prices fixed by company for unsold property.

5. The opinion of the Expert Advisory Committee is sought on whether notional profit can be booked using percentage completion method under Accounting Standard (AS) 7 on unsold site.


Opinion April 19, 1996

1. The Committee notes para 1 of Accounting Standard (AS) 7 on ‘Accounting for Construction Contacts’, issued by the Institute of Chartered Accountants of India, which states as below:

“The statement deals with accounting for construction contracts in the financial statements of enterprises undertaking such contracts (hereafter referred to as ‘contractors’). This statement also applies to enterprises undertaking construction activities of the type dealt within this statement not as contractors but on their own account as a venture of a commercial nature where the enterprise has entered into agreement for sale.” (emphasis added)

2. Based on the above, the Committee is of the opinion in respect of the issue raised at para 5 of the query that no profit can be booked using percentage of completion method in view of the fact that there is no agreement of sale. In any case, in accounting, no profit can be booked on a notional basis

[Accounting Standards]

A. Facts of the Case

1. A consultancy and engineering company engaged in design and project management activities in the petroleum sector undertakes work in the areas of petrochemicals, oil and natural gas, pipelines, ocean engineering, ports and harbours, power, metallurgy, cement, paper, etc.


2. According to the querist, during the course of audit of accounts for the year 1996-97, government auditors have expressed certain reservations with regard to non-provision of foreseeable losses and commented that the treatment adopted by the company is not in line with paragraph 13 of Accounting Standard (AS) 7, ‘Accounting for Construction Contracts’, read with paragraph 19 of the same Standard.


3. The accounting policy of the company for recognition of revenue is as below:
“I. Turnover Income from services rendered is accounted for:

(a) in the case of cost-plus jobs, on the basis of amount billable under the contracts;

(b) in the case of lumpsum contracts, as proportion of actual direct costs of the work to latest estimated total direct costs of the work or in proportion to work estimated to have been executed, whichever is less; and

(c) in the case of contracts providing for a percentage fee on equipment/project cost, on the basis of physical progress as certified; and after adjusting the obligation towards guarantees, warranties and penalties etc., provided/under negotiation in the respective contracts. However, in regard to contracts where guarantees, warranties, penalties etc. are to the extent of 100% of the contract value, the same is restricted to the exposure of the company towards such contracts by way of performance bond/guarantees etc.


II. Turnover/Work-in-Progress

(1) No income is taken into account in respect of jobs for which:

(a) the terms of remuneration receivable by the company have not been settled and/or scope of work has not been clearly defined and, therefore, it is not possible in the absence of settled terms to determine whether there is a profit or loss on such jobs. However, in cases where minimum undisputed terms have been agreed to by the clients, income has been accounted for on the basis of such undisputed terms though the final terms are still to be settled.


(b) the terms have been agreed to at lumpsum basis but:
(i) the physical progress is less than 25%;
(ii) supply of equipment is not complete in case of works contracts.
Costs of jobs as above are carried forward as work-in progress.


(2) While determining the work-in-progress overheads incurred at head office and other offices are not considered.”



4. According to the querist, as regards cost-plus jobs, the company recognises revenue as and when the expenditure is incurred. The invoices to the clients are raised broadly under the following heads:

(i) payroll cost;
(ii) out-of-pocket expenses; and
(iii) fee.


The overheads of the company are billed to the clients at a fixed percentage of the payroll cost. This percentage is worked out on the basis of previous year’s data and applied in the following year. As the payroll cost, out-of-pocket expenses, fee and overheads are recovered, there is no question of having any direct losses on these jobs since these are cost-plus jobs.



5. In respect of lumpsum contracts, the company raises its invoices on the clients on the basis of milestones stated in the contract. It recognises income on lumpsum jobs in the following manner:


(i) No income is recognised when the progress of job is less than 25%. While determining the work-in-progress, overheads incurred at head office and other offices are not included in work-in-progress and are charged to the profit and loss account in the respective years.


(ii) Income is recognised in the same proportion which the actual direct cost of the work done bears to the latest estimated total direct cost of the work, or in proportion to the work estimated to have been executed, whichever is less.


For this purpose, the company draws revised cost estimates at the end of each financial year.


6. According to the querist, the government auditors have pointed out three cases in which, according to them, the company has not provided for the foreseeable losses to the extent of Rs. 267.39 lakhs. As per the querist, the auditors, in their report, have stated that paragraph 13 of AS 7, read with paragraph 19 of the same Standard, requires that the foreseeable losses on the entire contract should be provided for in the financial statements irrespective of the amount of work done and method of accounting followed.


7. According to the querist, the government auditors, while working out the losses, have taken into account the indirect costs also besides direct costs. This, according to the querist, is not correct in the context of the accounting policy followed by the company in respect of indirect costs, viz., to charge them off to the profit and loss account in the year of incurrence. The querist’s contention is that there are no foreseeable direct losses on the jobs based on revised direct cost estimates.

B. Queries

8. The querist has sought the opinion of the Expert Advisory Committee on the following issues:


(a) Whether the treatment adopted by the company in respect of exclusion of indirect costs in computing the total contract cost as explained above is as per the generally accepted accounting principles.


(b) If the treatment adopted by the company is correct, whether any further disclosure in the accounting policy of the company is called for.


(c) If the treatment adopted by the company is not correct, what is the correct manner of accounting for foreseeable losses or disclosure thereof.

D. Opinion

Based on the above, the Expert Advisory Committee is of the following opinion on queries raised in paragraph 8 above:


(a) If the indirect costs under reference are of the nature described in paragraph 8.6 of AS 7, their non-inclusion in contract cost is not appropriate. On the other hand, if these costs are of the nature described in paragraph 8.7 of AS 7, they should not be included in contract cost (unless they are specifically attributable to a contract).


(b) See (a) above.


(c) The foreseeable losses should be provided for on the basis of the estimate of total contract cost including the indirect costs of the nature described in paragraph 8.6 of AS 7.

Opinion finalised by the Committee on 4.3.1999.

[Accounting Standards]

A. Facts of the Case

1. A company is a joint sector enterprise promoted jointly by West Bengal Housing Board and another private sector company. The company is engaged in the business of developing mass scale housing projects, which, inter alia, include development of small commercial complexes (hereinafter collectively referred to as ‘housing projects’).

2. The aforesaid activities are undertaken by the company on its own account and not on contractual basis, i.e., on a project being conceived, designs and drawings are finalised, land is procured, some initial developmental activities are carried out by the company, and thereafter flats/commercial spaces (shop, office, etc.) are offered to the public for booking/sale through advertisements followed by allotment of the same usually by way of lottery to the successful allottees (eventual owners). Allotment is documented by way of an allotment letter to each allottee. The letter bears reference to the brochure (i.e., offer document), which, inter alia, contains various terms and conditions. Consideration for a flat/commercial space is payable in a phased manner normally linked to various stages of completion of construction. Major construction activities pertaining to buildings are usually undertaken after allotment process as aforesaid is over. After completion of construction, possession of flats/commercial spaces is handed over to the respective allottees followed by execution of deeds/other legal documents in their favour evidencing ownership of properties.

3. The company has, hitherto, been recognising revenue under percentage of completion method and valuing work-in-progress in its books of account as per Accounting Standard (AS) 7, ‘Accounting for Construction Contracts’, issued by the Institute of Chartered Accountants of India in December 1983,as the said Standard was also applicable to enterprises undertaking construction activities not as contractors but on their own account as a ventureof commercial nature.

4. AS 7 has recently been revised and the same comes into effect in respect of all contracts entered into during accounting periods commencing on or after 01.04.2003, for the purpose of preparation of the financial statements of the contractors. The revised AS 7 is silent about its applicability to construction activities undertaken by enterprises on their own account and not as contractors.

B . Query

5. In the light of the above, the querist has sought the opinion of the Expert Advisory Committee on the following issues:

(a) Whether the revised AS 7 would be applicable to the company for accounting for new housing projects, which may be undertaken by the company on or after 01.04.2003 on the same business model as mentioned in the facts of the case.

(b) In case revised AS 7 is not applicable to the company, whether the company can value its inventories in accordance with Accounting Standard (AS) 2, ‘Valuation of Inventories’, issued by the Institute of Chartered Accountants of India, considering the definition of inventory as ‘an asset in the process of production for the purpose of sale’, i.e., whether the activity of developing housing projects on its own account as a commercial venture by the company can be construed as a production activity.

(c) If the activities of the company cannot be considered as a production activity and consequently AS 2 is also not applicable, which Accounting Standard should be followed for recognition of revenue and valuation of its construction work-in-progress?

D. Opinion

On the basis of the above, the Committee is of the following opinion on the issues raised by the querist in paragraph 5 above

(a) The revised AS 7 would not be applicable to the company for accounting for new housing projects which are undertaken by the company during the accounting periods commencing on or after 1.4.2003.

(b) The activity of developing housing projects on its own account as a commercial venture by the company is of the nature of production activity and, therefore, should be construed as such. The inventories should be valued by the company in accordance with AS 2 as explained in paragraph 9 above.

(c) AS 2 is relevant for valuation of inventories including construction work-in-progress and not for recognition of revenue. AS 9 would be relevant for recognition of revenue.


Opinion finalised by the Committee on 16.7.2003.

[Accounting Standards]

Disclosure of “Amounts Billed to Clients” and “Work-in-Progress”

Query

1. A Government of India company is mainly executing turnkey projects including jobs of civil works, erection and commissioning of coal and material handling plants, sugar projects, etc. The projects undertaken are spread over a number of years.


2. The accounting procedure followed by the company is as follows:


(i) As and when the running bills are raised on the clients, the clients accounts are debited and the corresponding credit is given to “Amount Billed to Clients A/c”, which is not an income head. The monies received from the clients are credited to their account and thus the amount shown as debtors goes down.


(ii) The amount to be credited to income is derived from the evaluation of work-in-progress. The method of evaluation is described in the notes forming part of the accounts. The relevant note is reproduced below:

“Accounting for valuation of work-in-progress:


(i) Work-in-progress has been valued by taking actual costs incurred plus profit allocated on “Percentage of Completion Method” which is as follows:


Extent to which job is completed

based on estimated cost


Percentage of profit taken into account

(a) Upto completion of 25% Nil

(b) Above 25% till completion 80% of estimated profit

(c) On completion of the job Balance of 100% profit


Estimated profit of each project has been worked out after taking into account the latest estimated costs, based on actuals plus commitments plus cost estimates for commitments yet to be made.

(ii) In respect of projects where loss is anticipated, work-in-progress has been valued after making adjustments for proportionate loss.

(iii) The additions to work-in-progress are credited as value of work done for the year and taken to income.


(iv) In view of the turnkey nature of contracts, the gross value of ‘amount billed to clients’ is carried forward and shown separately under liabilities till the projects are closed for accounting proposes. On closure of a project, the value of work-in-progress of corresponding project is set off against such credits”. Work-in-progress, i.e., value of work done for the year, connotes the debit, the corresponding credit being given to the income head “work done for the year.”


(iii) In view of the turnkey nature of the contracts, the gross value of amount billed to clients is carried forward and on completion of the project it is set-off against the value of work-in-progress. On completion of any project, the ‘Amount Billed to Clients A/c’ and ‘Work-in-Progress Account’ become equal.


(iv) The credit head “Amount Billed to Clients” is neither a present nor a future liability and correspondingly the work-in-progress denotes aggregated value of work done but is not an asset of the company.


(v) In past, i.e., upto 31-3-85, the company was exhibiting the “Amount Billed to Clients” under the head “Current Liabilities” and “Work-in-Progress” was exhibited under the head “Current Assets, Loans and Advances”. By exhibiting these two items under current liabilities and current assets, the company was of the view that the current ratio was not being indicated correctly. In view of this, the company in 1985-86 changed its policy and exhibited the “Amount Billed to Clients” under liabilities distinctly with a separate heading after the ‘Loan Funds’ (1985-86 Balance Sheet-Liabilities side). Similarly, the “Work-in-Progress” is shown distinctly under “Application of Funds” after ‘Fixed Assets’. As the company has changed its policy, the fact was mentioned in “Notes forming part of the Accounts”. The present joint statutory auditors have also concurred with the view of the company, explained above.


3. The Member Audit Board and Ex-officio Director of Commercial Audit was of the opinion that the two heads of accounts cannot be shown separately under ‘Liabilities’ and under ‘Application of funds’ as there is no provision in Schedule VI to the Companies Act, 1956 for such an exhibition. The company, in its reply, stated that as per section 211(1) of the Companies Act, 1956, the balance sheet is required to be drawn in the form set out in Part I of Schedule VI or as nearer thereto as circumstances admit. The member Audit Board, Ex-officio Director of Commercial Audit, however, has not accepted the view of the company.

4. The Querist has sought the opinion of the Expert Advisory Committee as to whether the method of accounting followed by the company is correct or not.


Opinion


1. The Committee notes that the method of accounting followed by the company gives rise to a notional liability for ‘Amount Billed to Clients A/c’. Progress payments received from clients are deducted from the clients’ accounts which are shown at the amount billed to them and shown as sundry debtors.


2. The Committee notes that the Institute of Chartered Accountants of India has issued Accounting Standard 7 (AS-7) on ‘Accounting for Construction Contracts’. AS-7 recognises that in case of construction contracts, including the turnkey type of contracts, revenue can be recognised on percentage of completion method, subject to certain conditions laid down in the Standard. The Committee presumes that the company has fulfilled those conditions in adopting the percentage of completion method.


3. The Committee further notes that para 15 of AS-7 recommends as below:


“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 Amount 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.”

4. On the basis of the above, the opinion of the Committee is as follows:

(i) The revenue should be recognised in respect of the value of work accomplished on the contracts by evaluating the work-in-progress.

(ii) Work-in-progress should be shown under the head ‘Current Assets’ and valued at cost incurred on the contract plus profit taken thereon in accordance with the formulae followed by the company, less cash received from the clients (progress payments). Alternatively, progress payments can be shown under the head ‘Current Liabilities’.

(iii) In view of the above, ‘Amount billed to clients A/c’ and the ‘Clients A/c’ will not appear any where on the ‘Liabilities’ and the ‘Assets’ side of the balance sheet.

[Accounting Standards]

Exposure Draft
Accounting Standard 7 (Revised 20XX)
(Corresponding to IAS 11)
Construction Contracts

The following is the Exposure Draft of the Accounting Standard (AS) 7 (Revised 20XX), Construction Contracts, issued by the Accounting Standards Board of the Institute of Chartered Accountants of India, for comments. The Board invites comments on any aspect of this Exposure Draft. Comments are most helpful if they indicate the specific paragraph or group of paragraphs to which they relate, contain a clear rationale and, where applicable, provide a suggestion for alternative wording.

Comments should be submitted in writing to the Secretary, Accounting Standards Board,

The Institute of Chartered Accountants of India, ICAI Bhawan, Post Box No. 7100, Indraprastha Marg, New Delhi – 110 002, so as to be received not later than April 30, 2010. Comments can also be sent by e-mail at edcommentsasb@icai.org or asb@icai.org.


(This Exposure Draft of the revised Accounting Standard includes paragraphs set in bold type and plain type, which have equal authority. Paragraphs in bold type indicate the main principles. This Exposure Draft of the revised Accounting Standard should be read in the context of its objective and the Preface to the Statements of Accounting Standards).

[Accounting Standards]

Objective of Accounting Standard 7 - Construction Contract - AS 7


The objective of this Standard is to prescribe the accounting treatment of revenue and costs associated with construction contracts. Because of the nature of the activity undertaken in construction contracts, the date at which the contract activity is entered into and the date when the activity is completed usually fall into different accounting periods. Therefore, the primary issue in accounting for construction contracts is the allocation of contract revenue and contract costs to the accounting periods in which construction work is performed. This Standard uses the recognition criteria established in the Framework for the Preparation and Presentation of Financial Statements issued by the Institute of Chartered Accountants of India to determine when contract revenue and contract costs should be recognised as revenue and expenses in the statement of profit and loss. It also provides practical guidance on the application of these criteria.

[Accounting Standards]

Scope of Accounting Standard 7 - Construction Contract - AS 7


1. This Standard shall be applied in accounting for construction contracts in the financial statements of contractors.


2. This Standard supersedes Accounting Standard (AS) 7, (Revised 2002) Construction Contracts in respect of the entities to which this Accounting Standard is applicable.

[Accounting Standards]

Definitions of Accounting Standard 7 - Construction Contract - AS 7


3. The following terms are used in this Standard with the meanings specified: A construction contract is a contract specifically negotiated for the construction of an asset 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.


A fixed price contract is a construction contract in which the contractor agrees to a fixed contract price, or a fixed rate per unit of output, which in some cases is subject to cost escalation clauses.
A cost plus contract is a construction contract in which the contractor is reimbursed for allowable or otherwise defined costs, plus a percentage of these costs or a fixed fee.


4. A construction contract may be negotiated for the construction of a single asset such as a bridge, building, dam, pipeline, road, ship or tunnel. A construction contract may also deal with the construction of a number of assets which are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use; examples of such contracts include
those for the construction of refineries and other complex pieces of plant or equipment.


5. For the purposes of this Standard, construction contracts include:

(a) 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


(b) contracts for the destruction or restoration of assets, and the restoration of the environment following the demolition of assets.


6. Construction contracts are formulated in a number of ways which, for the purposes of this Standard, are classified as fixed price contracts and cost plus contracts. Some construction contracts may contain characteristics of both a fixed price contract and a cost plus contract, for example in the case of a cost plus contract with an agreed maximum price. In such circumstances, a contractor needs to consider all the conditions in paragraphs 23 and 24 in order to determine
when to recognise contract revenue and expenses.

[Accounting Standards]

Combining and segmenting construction contracts of Accounting Standard 7 - Construction Contract - AS 7


7. The requirements of this Standard are usually applied separately to each construction contract. However, in certain circumstances, it is necessary to apply the Standard to the separately identifiable components of a single contract or to a group of contracts together in order to reflect the substance of a contract or a group of contracts.


8. When a contract covers a number of assets, the construction of each asset shall be treated as a separate construction contract when:


(a) separate proposals have been submitted for each asset;

(b) 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


(c) the costs and revenues of each asset can be identified.


9. A group of contracts, whether with a single customer or with several customers, shall be treated as a single construction contract when:


(a) the group of contracts is negotiated as a single package;

(b) the contracts are so closely interrelated that they are, in effect, part of a single project with an overall profit margin; and

(c) the contracts are performed concurrently or in a continuous sequence.


10. A contract may provide for the construction of an additional asset at the option of the customer or may be amended to include the construction of an additional asset. The construction of the additional asset shall be treated as a separate construction contract when:


(a) the asset differs significantly in design, technology or function from the asset or assets covered by the original contract; or

(b) the price of the asset is negotiated without regard to the original contract price.

[Accounting Standards]

Contract revenue of Accounting Standard 7 - Construction Contract - AS 7


11. Contract revenue shall comprise:

(a) the initial amount of revenue agreed in the contract; and

(b) variations in contract work, claims and incentive payments:

(i) to the extent that it is probable that they will result in revenue; and

(ii) they are capable of being reliably measured.

12. Contract revenue is measured at the fair value of the consideration received or receivable. The measurement of contract revenue is affected by a variety of uncertainties that depend on the outcome of future events. The estimates often need to be revised as events occur and uncertainties are resolved. Therefore, the amount of contract revenue may increase or decrease from one period to the next.


For example:

(a) a contractor and a customer may agree variations or claims that increase or decrease contract revenue in a period subsequent to that in which the contract was initially agreed;


(b) the amount of revenue agreed in a fixed price contract may increase as a result of cost escalation clauses;

(c) the amount of contract revenue may decrease as a result of penalties arising from delays caused by the contractor in the completion of the contract; or

(d) when a fixed price contract involves a fixed price per unit of output, contract revenue increases as the number of units is increased.

13. A variation is an instruction by the customer for a change in the scope of the work to be performed under the contract. A variation may lead to an increase or a decrease in contract revenue. Examples of variations are changes in the specifications or design of the asset and changes in the duration of the contract. A variation is included in contract revenue when:

(a) it is probable that the customer will approve the variation and the amount of revenue arising from the variation; and

(b) the amount of revenue can be reliably measured.


14. A claim is an amount that the contractor seeks to collect from the customer or another party as reimbursement for costs not included in the contract price. A claim may arise from, for example, customer caused delays, errors in specifications or design, and disputed variations in contract work.
The measurement of the amounts of revenue arising from claims is subject to a high level of uncertainty and often depends on the outcome of negotiations. Therefore, claims are included in contract revenue only when:

(a) negotiations have reached an advanced stage such that it is probable that the customer will accept the claim; and


(b) the amount that it is probable will be accepted by the customer can be measured reliably.


15. Incentive payments are additional amounts paid to the contractor if specified performance standards are met or exceeded. For example, a contract may allow for an incentive payment to the contractor for early completion of the contract. Incentive payments are included in contract revenue when:


(a) the contract is sufficiently advanced that it is probable that the specified performance standards will be met or exceeded; and


(b) the amount of the incentive payment can be measured reliably.