AS 7 - Accounting for Construction Contracts

Purpose: The statement deals with accounting for construction contracts in the financial statements of enterprises undertaking such contracts. It also applies to enterprises undertaking construction activities not as contractors but on their own account as venture of a commercial nature where the enterprise has entered into agreements for sale.

Explanations

A construction contract is a contract for the construction of an asset or of a combination of assets which together constitute a single project. Eg. Construction of bridges, dams, ships, buildings etc.

Contracts for the provision of services come within the scope of this statement to the extent that they are related to a contract for the construction of an asset; Eg. Contracts for the services of project managers and architects etc.

This statement covers two types of contracts

1. Fixed Price Contracts: wherein the contractor agrees to a fixed contract price or rate, in some cases subject to cost escalation clauses.
2. Cost Plus Contracts: wherein the contractor is reimbursed for allowable or otherwise defined costs, and is also allowed a percentage of these costs or a fixed fee.

In accounting for construction contracts in financial statements, either the percentage of completion method or the completed contract method may be used. When a contractor uses a particular method of accounting for a contract, then the same method should be adopted for all other contracts which meet similar criteria. This method of accounting selected by the contractor represents an accounting policy and therefore if there is any change in the accounting policy the effect of the change and its amount needs to be disclosed.

Percentage of Completion Method

Under the percentage of completion method, revenue is recognised as the contract activity progresses based on the stage of completion reached even though in certain circumstances it may not be realised & this method can be used only if the outcome of the contract can be reliably estimated.

For this method the stage of completion is to be measured in an appropriate manner taking into account all relevant factors for example, the proportion that costs incurred to date bear to the estimated total costs of the contract, by the surveys which measure work performed and completion of a physical proportion of the contract work. Progress payments and advances received from customers may not necessarily reflect the stage of completion and therefore cannot usually be treated as equivalent to revenue earned.

While recognising the profit under percentage of completion method, an appropriate allowance for future unforeseeable factors should be made on either a specific or a percentage basis.

The profit in fixed price contracts is not recognised unless 20 to 25% of the work is not completed.

Completed Contract Method

Under the completed contract method, revenue is recognised only when the contract is completed or substantially completed and costs and progress payments received are accumulated during the course of the contract. Therefore the risk of recognising profits that may not have been earned is minimised.

Other Explanations

Costs not specially attributable to any contract, incurred by the contractor before a contract is secured are treated as expenses of the period in which they are incurred. However if it can be separately identified or there is a clear indication that the contract will be obtained the costs are sometimes treated as applicable to the contract and are deferred.

Costs attributable to a contract include expected warranty costs and they are provided for when such costs can be reasonable estimated.

A foreseeable loss on the entire contract should be provided for in the financial statements irrespective of the amount of work done and the method of accounting followed. The determination of such loss may be subject to a high degree of uncertainty. In some of the cases it is possible to provide for the future loss and in other cases only the existence of a contingent loss is disclosed.

Amounts due in respect of claims made by the contractor and of variations in contract work, approved by the customer are recognised as revenue in the financial statements only in circumstances when, and only to the extent that the contractor has evidence of the final acceptability of the amount of the claim or variation.

Disclosures

1. Following should be disclosed in the financial statements:
• The amount of construction work-in-progress,
• Progress payments received and advances and retentions on account of contracts included in construction work-in-progress, and
• The amount receivable in respect of income accrued under cost plus contracts not included in construction work-in-progress.
2. If both the percentage of completion method and the completed contract method are simultaneously used by the contractor, the amount of contract work described in (1) above should be analysed to disclose separately the amounts attributable to contracts accounted for under each method.
3. Disclosure of changes in an accounting policy used for construction contracts should be made in the financial statements giving the effect of the change and its amount. However, if a contractor changes from the percentage of completion method to the completed contract method for contracts in progress at the beginning of the year, it may not be possible to quantify the effect of the change. In such cases, disclosure should be made of the amount of attributable profits reported in prior years in respect of contracts in progress at the beginning of the accounting period.