ACCOUNTING STANDARD - 7

ACCOUNTING STANDARD – 7
13 CONSTRUCTION CONSTRACTS

Quote:
“Limitations live only in our Minds, But if we use our imaginations,
Our Possibilities become Limitless”

1. INTRODUCTION

AS 7 defines Construction Contract as 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, function, ultimate purpose or use.

The construction contracts in AS 7 include contracts for:

(a)The rendering of services which are directly related to the construction of the asset; &
Example: Contract for the services of project managers, architects& Labour.

(b)The destruction or restoration of assets, and the restoration of the environment following the
demolition of assets.
Example: Contract for Demolition of Factory Building to save Environment.

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2. TYPES OF CONSTRUCTION CONTRACT

Construction Contracts are of two types:

a. Fixed price contracts - In this case of contract, contractor agrees for fixed price of the
contract or fixed rate/unit. However, in some cases the contract price is subject to escalation.
b. Cost-plus contract - In these contracts, contractor is reimbursed the Cost plus fixed
percentage of profit.
c. Hybrid - Mixed of above two.

EXAMPLE 1 (Cost Plus Contract):

ABC Constructions has a contract to build an office building. The terms and conditions are as under:
1. ABC’s profit is agreed at:

● 25% on expected contract’s cost; For this purpose, the expected cost cannot exceed ₹ 22
crores.

2. The agreed price will be revised depending upon the actual cost incurred.

● The cost for fixation will be taken actual cost or ₹ 22 crores whichever is less.

Price fixation based on expected cost:

Assume that the costs expected to be incurred by ABC are ₹ 16 crore. Thus, ABC can charge a profit
of ₹ 4 crores (25% on actual cost).
The contract price will be ₹ 20 crores. (₹ 16 crores plus ₹ 4 crores)

Price fixation based on actual cost incurred – Scenario 1:

However, if cost incurred by ABC is ₹ 15 crore, in that case, it would be able to charge a profit of:
= 25% on ₹ 15 crore = 15 x 25% = ₹ 3.75 crore
Thus, Total Value of the contract will stand revised as follows:
= Actual Costs + Profit (25% of costs) = ₹ 15 crore + ₹ 3.75 crore = ₹ 18.75 crores.

Price fixation based on actual cost incurred – Scenario 2:

For any unavoidable reasons, if total cost incurred by ABC is ₹ 25 crore, it can only charge a profit on
the expected costs of ₹ 22 crore as under:
Thus, Total Value of the contract will stand revised as follows:
= Expected Costs + Profit (25% of costs) = ₹ 22 crore + ₹ 5.50 crore = ₹ 27.50 crores.

Analysis of the above scenario:

Cost actually incurred by ABC = ₹ 25 crores.
Actual profit earned by ABC = Total Value of the contract – Actual costs incurred
= ₹ 27.50 Crores – ₹ 25 Crores = ₹ 2.50 Crores.

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3. CALCULATING THE PROFIT OR LOSS OF A CONSTRUCTION

CONTRACT

Profit or Loss on Construction contract is = Contract Revenue - Contract Cost

A. CONTRACT REVENUE:
Contract revenue can be recognised when there is no significant uncertainty exits regarding the
amount of collection. It is calculated as below:
Price Agreed as per contract (Fixed Price) XXX
(+) Revenue arising due to escalation clause XXX
(+/-) Variations due to change in scope of Work (Modification) XXX
(+) Claims recoverable from customers in the form of reimbursements XXX
(+) Incentives recoverable from customers on achieving the Targets XXX
(-) Penalties Payable to customers for any delay XXX
Total Contract Revenue XXXX

Note:
Variations, Claims, Incentives and Penalties are considered only when:
(i) When there is certainty of collection/payment; and
(ii) they can be measured reliably

B. CONTRACT COSTS
Contract costs consist of the following:
Specific Costs of Completing the Contract:
Material Cost (Opening + Purchase – Closing) XXX
Labour Cost XXX
Depreciation of PPE used in Contract XXX
Cost of Hiring the PPE XXX
Cost of design & technical assistance XXX
(-) Incidental income (sale of scrap material) XXX
Cost Attributable to Contract:
Insurance Exp XXX
Overhead cost allocated to the Contract XXX
Pre contract cost (cost incurred to secure the contract) XXX
Total Contract Cost XXXX
Contract Cost incurred during the year Also means =
Work Certified + Work Uncertified

These expenses are not a part of Contract Cost: General administration cost, Selling cost, Research
and development & Abnormal Loss.

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4. PERCENTAGE OF COMPLETION METHOD (PCM)

As per AS 7, the contract revenue will be recognised with reference to the Percentage of Completion
(PCM) at the reporting date.
Determination of Percentage of Completion:
Cost Approach Technical Survey Approach
% of Completion = % of Completion is calculated in reference to the
Cost Incurred Till date X 100 survey conducted by Certified Engineer for each
Total Est. Cost of Project and every part of the project.

Cost Incurred Till date also means = Work Refer Example below
Certified + Work Uncertified

Example 2: A construction contract of a two floor building for Rs. 15 lakhs (with a 50% margin)
Divisions of contract Technical Completion Cost to complete
Foundation 35% 5
1st Floor 10% 1
nd
2 Floor 15% 1
Tiling, painting, fitting etc., 40% 3
100% 10
Foundation work was completed.

Conclusion:
a) Under the cost to cost method, revenue of Rs.7.5 lakhs (15 Lakhs X 5/10 Lakhs) would be
recognised & cost of Rs.5 lakhs would be recognised and profit of Rs. 2.5 lakhs would be
recognised.
b) Under the Technical survey method, revenue of Rs. 5.25 lakhs (35% of Rs. 15 lakhs) would be
recognised, cost of Rs.3.5 lakhs (35% of Rs. 10 lacs) would be recognised and a profit of Rs. 1.75
lacs would be recognised.

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5. IMPORTANT PROVISIONS FOR REVENUE RECOGNITION

Outcome of Contract Revenue Recognition is based on Outcome of Contract as under:

1) When the outcome of the contract is estimated reliably, Revenue should
be recognised as per % of Completion Method
2) When the outcome of the contract cannot be estimated reliably, Revenue
should be recognised only to the extent of contract costs incurred of
which recovery is probable. (i.e. Revenue = Cost incurred i.e. No
Profit/Loss)

Total Contract Cost will When it is probable that total contract cost may exceed total contract
exceed Total Contract revenue, then Expected loss should be immediately provided for.
Revenue (Refer Example 6 & 8)
Subsequent uncertainty Once revenue is recognised and then uncertainty of collection arise, in
in collection such case it is better to make provision for doubtful debts instead of
reversing the revenue.

Example 3:
X Ltd. commenced a construction contract on 01/04/X1. The contract price agreed was reimbursable
cost plus 10%. The company incurred Rs.1,00,000 in 20X1-X2, of which cost of Rs.90,000 is
reimbursable. The further non-reimbursable costs to be incurred to complete the contract are
estimated at Rs.5,000. The other costs to complete the contract cannot xbe estimated reliably.
SOLUTION:
Profit & Loss Account
Rs.000 Rs.000
To Construction Costs 100 By Contract Price 99
(90+9)
To Provision for loss 5 By Net loss 6
105 105

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6. PRESENTATION IN FINANCIAL STATEMENTS

An enterprise should present:

(i) the Gross Amount due from customers for contract work as an asset; and
(ii) the Gross Amount due to customers for contract work as a liability.
Particulars Amount
Cost Incurred (Work Certified + Uncertified)
(+) Profits Recognised till date
(-) Losses Recognised till date (Recoveries Not
Possible)
(-) Progress Billings
Total Amount XXX
If Amt. is positive then Due from Customer
If Amt. is Negative then Due to Customer

Note:
PROGRESS BILLING MEANS = PAYMENT RECEIVED + RETENTION

7. SUMMARY of ABOVE

Based on above Discussion we can summarize following Key Points-

1. Contract Revenue shall be recognized based on PCM until and unless the outcome of contract
cannot be estimated probably.
2. If Outcome cannot be estimated probably then do not apply PCM, Revenue shall be recognize
only to the extent of Actual Cost Incurred till date of which recovery is Probable.
3. Contract Cost shall be recognized based on Actual Cost incurred during the Period. PCM shall
not be applied on Contract Cost.

EXAMPLE 4:
Contractual Team = 3 Years
Year 1 2 3
Contract Cost incurred during the year 7,20,000 11,70,000 15,60,000
Further Estimated cost to be incurred 25,00,000 14,00,000 -
Calculate % of Completion for Every Year.
SOLUTION
1st Year = 7,20,000 / (7,20,000 + 25,00,000) x 100 = 22.36%
2nd Year = 18,90,000 / (18,90,000 + 14,00,000) x 100 = 57.45%
3rd Year = 100%

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EXAMPLE 5:
(₹ IN Cr.)
1 2 3
Cost incurred till date 1,500 3,750 6,200
Further estimated cost to be incurred 4,500 2,400 0
Total fixed price agreed with customer = 8,000
SOLUTION
1 2 3
% of completion 25% 61% 100%
Cumulative Revenue 2,000 4,880 8,000
Current Year Revenue 2,000 2,880 3,120
Current Year Cost 1,500 2,250 2,450
Profit 500 630 670 1,800

% = Cost incurred till date/Total Estimated Cost

EXAMPLE 6: (Provision for Expected Loss)

Contractual Term = 3 Years
Contract Revenue = 3000 Cr.
1 2 3
Contract Cost incurred till date 800 1900 3200
Further Estimated cost to be incurred 1750 1300 -
Calculate Contract Profit/Loss every year.

SOLUTION:
1 2 3
800/2,550 x 100 = 1,900/2,550 x 100 100%
31.37% = 59.38%
Cumulative Revenue 941 1,781 3,000
Current Year Revenue 941 840 1,219
Current Year Cost 800 1,100 1,219**
Current Year Profit/Loss 141 (260) 0
Loss till date Recognised - 260-141 = 119
Loss to be Recognised - 200-119 = 81*
* As per AS 7 (Contract Cost) when total Construction Cost is expected to be in excess of Contract
Revenue then Loss should be provided for immediately.
**Cost to be recognised = 3,200 – 1,900 1,300
(-) Loss already Recognised (81)
Cost to be Recognised 1,219

EXAMPLE 7:
Consider the following % of Completion in a 3 Years Construction Project:
Year 1 – 25%

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Year 2 – 61%
Year 3 – 100%
Total agreed price of contract = 2,50,00,000
Year 1 2 3
Addition / deduction in Price (4,50,000) 7,00,000 20,00,000
penalty Escalation Modification
clause (Additional Assets)
How much Revenue shall be recognised every year?
SOLUTION:
Year 1
Agreed Price 2,50,00,000
(-) Penalty 4,50,000
Revised Price 2,45,50,000
% of Completion 25%
Revenue 61,37,500/-

Year 2
Earlier Agreed Price 2,45,50,000
(+) Escalation 7,00,000
Revised Price 2,52,50,000
% of Completion 61%
nd
Cumulative Revenue till 2 Year 1,54,02,500
st
(-) Revenue Recognition in 1 Year (61,37,500)
Current Year Revenue 92,65,000

Year 3
Earlier Agreed Price 2,52,50,000
(+) Modification 20,00,000
Cumulative Final Price 2,72,50,000
(-) Revenue already Recognised till date 1,54,02,500
Current Year Revenue 1,18,47,500

EXAMPLE 8:
Agreed Price = 5,000 lakhs
Term = 3 Years
Year 1 2 3
Contract Cost incurred till date 1,750 4,500 5,200
Estimated Total Cost 4,650 5,200 5,200
PCM (%) 37.63% 86.54% 100%
SOLUTION:
Year 1
Revenue 1,881.50
(-) Cost 1,750
Profit 131.50

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Year 2
Cumulative Revenue 4,327
(-) Last Year Revenue 1,881.50
Current Year Revenue 2,445.50
(-) Cost of Current Year 2,750
Current Year Loss 304.50

Position of Profit/Loss till 2nd Year = 131.5 – 304.5 = 173

Loss Already Recognised till Date = 173
*When entity estimates that overall contract Cost will exceed overall Contract Revenue, then Loss to
the Contract will be Recognised Immediately.

Therefore,
Revenue 5,000
Estimated Cost (5,200)
Estimated loss of entire Contract 200
Loss already Recognised (173)
Extra Loss to be recognised immediately 27

How to Measure Revenue when there is Incentive but such incentives are Variable?

Example 9:
Agreed Price = 50 lakhs
Total Term = 3 Years
Inventive is: -
(a) Either 5%, if work completed within 3 Years
(or)
(b) 10%, if work completed within 30 months
There is a 80% Probability that work will be Completed within 30 months & 20% Probability of beyond
30 months.
Calculate total revenue expected from contact.
SOLUTION: -
Total Revenue = Agreed Revenue + Incentives (Estimated)
Estimated Incentive: -
10% x 80% = 8%
5% x 20% = 1%
Weighted Average Incentive = 9%
Total Revenue = 50,00,000 + 9% = 54,50,000

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How to Solve the Full Question Covering Maximum adjustments of AS 7?

Step 1 Calculate % of Completion of Contract (PCM):

Cost Incurred till date (work certified + work uncertified) X 100

Total Estimated Cost of Project

Step 2 Recognise Contract Revenue & Cost and Calculate Contract

Profit/loss:

Contract Revenue = Total Price x PCM (%) = XXX

(less) Revenue Recognised till last year

Contract Cost = Work Certified + Uncertified = XXX

Contract Revenue (-) Contract Cost = Contract Profit/loss

Step 3 Recognise Provision of Foreseeable Loss:
(if total contract cost is expected to exceed contract revenue)

Total Contract Revenue XXX

(-) Total Contract Cost of Project XXX
Total Loss in a Contract XXX
(-) Loss already recognised XXX
(+) Profit already recognised XXX
Provision for Foreseeable Loss XXX
Step 4 Calculation of “Amount due from Customer or due to Customer”

Contract Cost incurred till date XXX

(+) Profit Recognised till date XXX
(-) Loss Recognised Till date XXX
(-) Progress Billings (XXX)
Amount Receivable or (Payable) from/to Customer XXX/(XXX)

Progress Billing = Payment Received + Payment Retained by Client

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8. IDENTIFYING CONSTRUCTION CONTRACT

Single Contract of Multiple Treat Separate Contract for each Asset if all these conditions are
Assets satisfied:
a) Separate proposals are submitted for each asset;
b) Each asset is subject to separate negotiation i.e. both
contractor and customer have the ability to accept some part
and reject some part of the contract;
c) Cost and Revenue of Each Asset can be identified separately.

Contract Combinations: Conditions:

Two or More contracts with a) The contracts are negotiated as a package.
Same party entered into or OR
near the same time be b) All or major assets are contracted for a common objective. It
considered a “Single Contract” means assets are dependent or inter-related with each other.
if any one of these conditions
are met.
Here in this case, Single PCM shall be calculated for all the Assets
Contract combined.
Additions to the Contract When there is any addition to the existing contract then such
additional assets are treated as separate contract if any one condition
is satisfied:
a) The additional Asset is clearly distinct from the Existing Asset
under the contract in respect of design, location, function or
technology. (OR)
b) The Price of additional asset is negotiated separately without
considering the original contract (i.e. Contractor is Charging
Standalone price for that Additional Asset)

Example 10:
B Limited has taken a construction contract from the authority to develop a township.
The contract involves several other contracts such as residential complexes, roads, power stations,
reservoirs and commercial complex. Separate tenders were floated and separate proposals have been
submitted for the same. Negotiations have been separate. However, all the contracts have been
awarded to B Limited. This will be a case of segmenting the contracts as there are separate proposals,
separate negotiations, the award of one contract has no relationship with the other and costs and
revenues of each contract are separately identifiable.

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9. (MCQ’s from ICAI Material)

The below information relates to Questions 1 – 3:

XY Ltd. agrees to construct a building on behalf of its client GH Ltd. on 1 st April 20X1. The expected
completion time is 3 years. XY Ltd. incurred a cost of ₹ 30 lakh up to 31st March 20X2. It is expected
that additional costs of ₹ 90 lakh. Total contract value is ₹ 112 lakh. As at 31st March 20X2, XY Ltd.
has billed GH Ltd. For ₹ 42 lakh as per the agreement. Assume that the work is completed to the
extent of 75% by the end of Year 2.
1. Revenue to be recognized by XY Ltd. for the year ended 31st March 20X2 is
(a) ₹ 28 lakh
(b) ₹ 42 lakh
(c) ₹ 30 lakh
(d) ₹ 32 lakh

2. Total expense to be recognised in Year 1 is

(a) ₹ 30 lakh
(b) ₹ 120 lakh
(c) ₹ 38 lakh
(d) ₹ 36 lakh

3. Revenue to be recognised for year 2 is

(a) ₹ 84 lakh
(b) ₹ 42 lakh
(c) ₹ 56 lakh
(d) ₹ 28 lakh

Below information relates to Questions 4 – 6

M/s AV has presented the information for Contract No. XY123:

Total contract value ₹ 370 lakh
Certified work completed ₹ 320 lakh
Costs incurred to date ₹ 360 lakh
Progress Payments received ₹ 300 lakh
Expected future costs to be incurred ₹ 50 lakh

4. Revenue to be recognised by M/s AV is

(a) ₹ 320 lakh
(b) ₹ 370 lakh
(c) ₹ 360 lakh
(d) ₹ 400 lakh

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5. Total expense to be recognised by M/s AV is

(a) ₹ 360 lakh
(b) ₹ 400 lakh
(c) ₹ 320 lakh
(d) ₹ 360 lakh

6. LP Contractors undertakes a fixed price contract of ₹ 200 lakh. Transactions related to the
contract include:
Material purchased: ₹ 80 lakh
Unused material: ₹ 30 lakh
Labour charges: ₹ 60 lakh
Machine used for 3 years for the contract. Original cost of the machine is ₹ 100 lakh. Expected
useful life is 15 years.
Estimated future costs to be incurred to complete the contract: ₹ 80 lakh. Loss on contract to
be recognised is:
(a) ₹ 40 lakh
(b) ₹ 10 lakh
(c) ₹ 90 lakh
(d) ₹ 50 lakh

ANSWERS 1 2 3 4 5 6
a d c a d b

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Student Notes:-

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