Applicability / Objective

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1 By Rakesh Agarwal

2 Applicability / Objective APPLICABILITY: applicable to all contracts entered into on or after and is mandatory in nature from that date. Based on AS 7 (Construction Contracts) OBJECTIVE: - To prescribe accounting treatment of revenue and costs, if date on which contract is entered into and date on which completed falls in different accounting periods. - The primary issue is allocation of contract revenue and costs to accounting periods in which construction work is performed. - AS uses recognition criteria to determine when contract revenue and contract costs should be recognised. - Also provides practical guidance on the application of these criteria. Slide 2

3 Definitions Construction Contract: 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. Fixed Price Contract: 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. Cost Plus Contract: A construction contract in which the contractor is reimbursed for allowable or otherwise defined costs, plus percentage of these costs or a fixed fee. Slide 3

4 Construction Contracts Includes contracts for: Construction of single asset like bridge, building etc. or Construction of a number of assets closely interrelated or interdependent,- like construction of refineries Also includes: Rendering of services directly related to the construction of the asset, E.g. services of project managers and architects; and Destruction or restoration of assets, and the restoration of the environment following the demolition of assets. Can be classified as: - fixed price contracts or - cost plus contracts. Some construction contracts may contain characteristics of both a fixed price contract and a cost plus contract, E.g., A cost plus contract with an agreed maximum price. For recognition of contract revenue/expenses to consider conditions specified for both types of contracts. Slide 4

5 Combining/Segmenting Construction Contracts If contract covers a number of assets, then each asset should be treated as a separate contract when: - separate proposals have been submitted for each asset; - 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 - the costs and revenues of each asset can be identified. Slide 5

6 Combining/Segmenting Construction Contracts A group of contracts - with a single customer or with several customers is to be treated as a single contract if: - the group of contracts is negotiated as a single package; - the contracts are so closely interrelated that they are part of a single project with an overall profit margin; and - the contracts are performed concurrently or in a continuous sequence. Slide 6

7 Contract Revenue Contract revenue comprises of: the initial amount of revenue agreed; and variations in contract work, claims & incentive payments: - if it is probable that they will result in revenue; and - they are capable of being reliably measured. 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. Slide 7

8 Contract Revenue - cont d VARIATION is an instruction by the customer for a change in the scope of the work. E.g. changes in the specifications or design of the asset and changes in the duration of the contract. may lead to an increase/decrease in contract revenue. is included in contract revenue if: it is probable that the customer will approve the variation and revenue arising from the variation; and the amount of revenue can be reliably measured. Slide 8

9 Contract Revenue - cont d 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. E.g., customer caused delays, errors in specifications or design, and disputed variations in contract work. Due to high uncertainty only included in contract revenue if: negotiations have reached an advanced stage such that it is probable that the customer will accept the claim; and the amount accepted by the customer can be measured reliably Slide 9

10 Contract Revenue - cont d INCENTIVE PAYMENTS Are additional amounts payable to the contractor if specified performance standards are met or exceeded. E.g., an incentive payment for early completion of the contract. Are included in contract revenue when: the contract is sufficiently advanced that it is probable that the specified performance standards will be met or exceeded; and the amount of the incentive payment can be measured reliably. Slide 10

11 Claims, variations, incentive payments contd.. Sr No Background 1 Due to poor weather, the contract will overrun by 3 months. This will lead to an increase in costs of 3,000. The customer will probably not approve the amount of revenue arising from the variation. 2 Due to unforeseen circumstances the contractor incurred additional costs in the current year on the contract. Negotiations to obtain the customer s acceptance of these claims are in early stages. 3 The customer will probably accept a claim of 2,000 due to delays caused by the customer itself. Situation No, the customer will probably not approve the variation amount. The additional costs already incurred should be included in the calculation of WIP if the contract is still profitable. However, a lower expected profit margin should be recognised because of the additional costs incurred. The total expected loss should be recognised immediately if the additional costs will result in a loss on the contract. No, negotiations have not reached an advance stage where it is probable that the customer will accept the claim. The contractor should include the additional costs in the WIP calculation and recognise a lower expected profit margin due to the additional costs incurred. Yes, all criteria set out in AS -7 are met. The 2,000 can be included in the contract price (revenue). Slide 11

12 Contract Costs Contract costs comprises of Costs directly related to the specific contract; Costs attributable to contract activity in general and can be allocated to the contract; and Other costs as are specifically chargeable to the customer under the terms of the contract. Slide 12

13 Contract Costs cont d Cost directly related to specific contract include: Site labour costs, including site supervision. Cost of material, depreciation/hiring cost of plant & equipment. Cost of moving plant, equipment and materials to & fro. Cost of design/technical assistance. Estimated cost of rectification/guarantee work/warranty cost. Claim from third parties. Direct costs may be reduced by any incidental income that is not included in contract revenue. E.g. income from sale of surplus material and disposal of plant & equipment at the end of the contract. Slide 13

14 Contract Costs cont d Costs attributable to contract activity in general and can be allocated to the contract include: Insurance Costs of design & technical assistance not directly related. Construction overheads like preparation/processing of construction personnel payroll. Above costs (including Borrowing Costs as per AS 16) should be allocated by using systematic and rational method and the same should applied consistently to all costs of similar nature. The allocation should be based on the normal level of construction activity. Slide 14

15 Contract Costs cont d Costs specifically chargeable include some general administration and development costs for which reimbursement is specified in the terms of the contract. Costs that cannot be attributed or allocated to a contract are excluded from the costs of a construction contract. Such costs include: general administration costs/research and development cost for which reimbursement is not specified in the contract; selling costs; and depreciation of idle plant and equipment that is not used on a particular contract Slide 15

16 Contract Costs cont d Contract costs include costs attributable to a contract from the date of securing the contract to the final completion of the contract; Costs which are incurred in securing the contract are also included as part of the costs if they can be separately identified and measured reliably and it is probable that the contract will be obtained; If costs incurred in securing a contract are recognised as expense in the period in which they are incurred, the same should not be included again in contract costs on obtaining the contract in a subsequent period. Slide 16

17 Overall Snapshot for Inclusion of Cost.. Description of cost Included Excluded Labour costs (including supervision) Costs of materials used in construction Construction overheads Insurance (include contract-specific insurance and an allocation of general insurance) General administration and selling costs Depreciation of plant and equipment used on the contract Depreciation of idle plant and equipment that is not used on a particular contract Costs of moving plant, equipment and materials to and from the contract site Costs of hiring plant and equipment Costs for clean-up at end of contract Research and development costs Borrowing costs (follow requirements of AS - 16) Costs of design and technical assistance that is directly related to the contract Estimated costs of rectification and guarantee work, including expected warranty costs Claims from third parties relating to the contract * unless the reimbursement is specified in the contract a a a a a a a a a a a a a * a a * Slide 17

18 Recognition of Contract Revenue/ Expenses If outcome can be estimated reliably -- recognise contract revenue and costs by reference to the stage of completion of the contract activity (i.e. Percentage of Completion Method). Expected loss should be recognised as an expense immediately. Enterprise is able to make reliable estimates after it has agreed to a contract which establishes: each party's enforceable rights regarding the asset to be constructed; the consideration to be exchanged; and the manner and terms of settlement. Effective internal financial budgeting & reporting system is required. Reviews/Revision of the estimated contract revenue/costs as the contract progresses necessary to indicate final outcome. Slide 18

19 Recognition of Contract Rev./ Exp. cont d In the case of a Fixed price contract, the outcome can be estimated reliably when ALL the following conditions are satisfied: Total contract revenue can be measured reliably; It is probable that the economic benefits associated with the contract will flow to the enterprise; Both the costs to complete the contract and the stage of contract completion at the reporting date can be measured reliably; and The costs attributable to the contract can be clearly identified and measured reliably so that actual costs incurred can be compared with prior estimates. Slide 19

20 Recognition of Contract Rev./ Exp. cont d In the case of a Cost plus contract, the outcome of a construction contract can be estimated reliably when ALL the following conditions are satisfied: It is probable that the economic benefits associated with the contract will flow to the enterprise; and The contract costs attributable to the contract, whether or not specifically reimbursable, can be clearly identified and measured reliably. Slide 20

21 Recognition of Contract Rev./ Exp. cont d Under the percentage of completion method, contract revenue and cost is recognised as revenue and expenses in the accounting periods in which the work is performed. Any expected excess total costs over total revenue for the contract should recognised as an expense immediately. Contract cost incurred for the future activity on the contract should be recognised as an asset if it is probable that they will be recovered. Such costs represent an amount due from the customer and are often classified as contract work in progress. Slide 21

22 Recognition of Contract Rev./ Exp. cont d If contract revenue is already recognised but subsequently the same is not collectable than such amount should be considered as an expense and should not be adjusted against the contract revenue. Stage of completion of a contract may be determined in a variety of ways depending on the nature of the contract, say: the proportion that contract costs incurred for work performed upto the reporting date bear to the estimated total contract costs; or surveys of work performed; or completion of a physical proportion of the contract work. Slide 22

23 Recognition of Contract Rev./ Exp. cont d Progress payments and advances received from customers may not necessarily reflect the work performed hence should not be considered relevant; When the stage of completion is determined by reference to the contract costs incurred up to the reporting date, to consider only those costs that reflect work performed excluding costs relating to future activity and advance payments made to subcontractor. Slide 23

24 Recognition of Contract Rev./ Exp. cont d When outcome of a contract cannot be estimated reliably: revenue should be recognised only to the extent of contract costs incurred of which recovery is probable; and costs should be recognised as an expense in the period in which they are incurred. E.g. of such contracts are when: The validity of the contract is seriously in question. Completion of it depends on outcome of litigation/legislation. Customer/contractor is unable to meet its obligation. In relation to properties likely to be condemned/expropriated. When the uncertainties no longer exist, revenue and expenses should be recognised as per the normal criteria and not as per criteria mentioned above. Slide 24

25 Recognition of Expected Losses When probable that total contract costs will exceed total contract revenue, the expected loss should be recognised as an expense immediately. Loss is to be determined irrespective of: whether or not work has commenced on the contract; the stage of completion of contract activity; or the amount of profits expected to arise on other contracts which are not treated as a single construction contract. Slide 25

26 Changes in Estimates The percentage of completion method is applied on a cumulative basis in each accounting period to the current estimates of contract revenue and contract costs. (Refer Appendix to AS) Effect of a change in the estimate of contract revenue or costs, or the effect of a change in the estimate of the outcome of a contract, should be accounted for as a change in accounting estimate as per AS 5. The changed estimates should be used in determination of the amount of revenue and expenses to be recognised in the Profit and Loss in the period in which the change is made and in subsequent periods. Slide 26

27 Disclosures To disclose: the amount of contract revenue recognised as revenue in the period; the methods used to determine the contract revenue recognised in the period; and the methods used to determine the stage of completion of contracts in progress. For contracts in progress at the reporting date to disclose: the aggregate amount of costs incurred and recognised profits less recognised losses up to the reporting date; the amount of advances received; and the amount of retentions. Slide 27

28 Disclosures (cont d) To show the gross amount due from/to customers for contract work as an asset/liability Gross amount due from customers for contract work is the net amount of: costs incurred plus recognised profits; less the sum of recognised losses and progress billings For the above, consider all contracts in progress for which costs incurred plus recognised profits less recognised losses exceed progress billings. The gross amount due to customers for contract work is the net amount of: the sum of recognised losses and progress billings; less costs incurred plus recognised profits For the above, consider all contracts in progress for which progress billings exceed costs incurred plus recognised profits less recognised losses. Contingencies as per AS-4 for warranty costs, penalties or possible losses Slide 28

29 Practical Issues and Case Studies

30 Case study on Construction Contracts 1 Entity A manufactures large printing presses, which can take up to 18 months to complete. A contract can therefore be active over two accounting periods. Entity A can reliably estimate the outcome of the contract. Should a manufacturer of plant and machinery follow the guidance for construction contract accounting? Solution Yes. The date at which contract activity is entered into and the date when the activity is completed fall into different accounting periods. The work in progress system entity A uses to track its production processes should be used to determine the stage of completion of each contract at the balance sheet date. Revenue on contracts for the manufacture of the printing presses should be recognised by reference to the percentage of completion method. Slide 30

31 Case study on Construction Contracts contd.. 2 Entity A is constructing a building for its customer. The construction is in its second year of the three-year project. Management had originally assessed the contract to be profitable and recognised a profit in year 1 of 20,000, based on the percentage of the contract that had been completed at that time. Management now believes the contract will incur a loss of 30,000. Management has proposed that a loss of 30,000 on the contract is recognised in year 2, but has questioned how the profit of 20,000 recognised in year 1 should be treated. What amount should be recognised as profit or loss for the contract in each year? Solution Management should recognise a loss in respect of the contract of 50,000 in year 2. This represents a reversal of the 20,000 profit recognised in year 1 and the 30,000 loss expected on the contract as a whole. The loss has been assessed through a revision of the estimated costs to completion. The appropriate accounting entry is therefore to recognise the adjustment in the current year s results rather than record a prior-period adjustment. Slide 31

32 Case study on Construction Contracts contd.. 3. Entity A develops and sells computer software. The sales take the form of a license to use the software for a limited period of time, and include after-sales support during the period of the licence. The sales include a significant element of tailoring the basic software to meet the customer s needs. Entity A charges its customers a series of fees during the tailoring period. An additional fee is charged at the start of the period of the license once the tailoring is complete and the customer has accepted the software package. No further amounts are payable during the license period, either for the use of the software or for the maintenance support. A s management has questioned how the revenue from the contract should be recognised. Should a contract for an asset s construction and operation be accounted for as a single contract or separate contracts? Solution Management should account for the tailoring, the licensing and the maintenance support as separate elements. The tailoring of the software should be accounted for as a construction contract in accordance with the principles of AS-7, and the fee for the use of the software and the maintenance support should be recognised on a straight-line basis over the period of the license in accordance with AS 9. The allocation of the total contract revenue between the tailoring service, the right to use the software and the maintenance support should be made on the basis of the fair value of the services. The allocation of the revenue based on fair value is likely to differ from an allocation based on the billing schedule. Slide 32

33 Case study on Construction Contracts contd.. 4. Entity A has recently started to design and construct web sites for its customers. This is a new activity for entity A and it is not clear yet how long such work will typically take; however, it is clear that the activities will be likely to start in one accounting period and end in the subsequent one. Should an entity recognise a construction contract work in progress balance at year-end? Solution Management should not recognise construction contract WIP in respect of the costs incurred on the web sites. All costs should be expensed as incurred. Construction contract accounting also applies to rendering services. However, management does not have a clear and reasonable estimate of the costs likely to be incurred in the development of each web site. The costs therefore do not meet the recognition criteria for construction contract WIP. Revenue should be recognised only to the extent that management believes the costs will be recovered. Management will therefore need to defer all revenue until the end of the contract if there is uncertainty about collectability. Management will be able to recognise WIP and follow the normal principles for construction contract revenue recognition once it has established a track record of web site development costs. This is likely to be after the first financial year. Slide 33

34 Practical Issue - Case Study on Guidance Note v/s IFRIC 15

35 Case study on IFRIC 15 V/S Guidance Note An entity is developing residential real estate and starts marketing individual units (apartments) while construction is still in progress. Buyers enter into a binding sale agreement that gives them the right to acquire a specified unit when it is ready for occupation. They pay a deposit that is refundable only if the entity fails to deliver the completed unit in accordance with the contracted terms. Buyers are also required to make progress payments between the time of the initial agreement and contractual completion. The balance of the purchase price is paid only on contractual completion, when buyers obtain possession of their unit. Buyers are able to specify only minor variations to the basic design but they cannot specify or alter major structural elements of the design of their unit. In the jurisdiction, no rights to the underlying real estate asset transfer to the buyer other than through the agreement. Consequently, the construction takes place regardless of whether sale agreements exist. Slide 35

36 Case study on IFRIC 15 contd.. IFRIC 15 the terms of the agreement and all the surrounding facts and circumstances indicate that the agreement is not a construction contract. The agreement is a forward contract that gives the buyer an asset in the form of a right to acquire, use and sell the completed real estate at a later date and an obligation to pay the purchase price in accordance with its terms. Guidance Note - ICAI As price risk is transferred, the entity recognises revenue by reference to the stage of completion using the percentage of completion method taking into account the stage of completion of the whole building and the agreements signed with individual buyers Slide 36

37 Quick Quiz

38 Quick Quiz Quick Quiz 1 Per Volume 25, Query 23 of EOA Consulting organisation can account revenue using percentage completion method 2 Per Volume 20, Query 43 of EOA Material supplied on site and waiting to be used is included in percentage completion method 3 Per Volume 20, Query 29 of EOA Generally % of completion of work is needed before recognising profit under percentage completion method Slide 38

39 Questions?

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