IAS 7

Accounting Standard (AS) 7

(revised 2002)

Construction Contracts

Contents

OBJECTIVE

SCOPE Paragraph 1

DEFINITIONS 2-5

COMBINING AND SEGMENTING CONSTRUCTION

CONTRACTS 6-9

CONTRACT REVENUE 10-14

CONTRACT COSTS 15-20

RECOGNITION OF CONTRACT REVENUE AND

EXPENSES 21-34

RECOGNITION OF EXPECTED LOSSES 35-36

CHANGES IN ESTIMATES 37

DISCLOSURE 38-44

APPENDIX

The followingAccounting Standards Interpretation (ASI) relates toAS 7

(revised 2002)

ASI 29 — Turnover in case of Contractors

The above Interpretation is published elsewhere in this Compendium.

Accounting Standard (AS) 7*

(revised 2002)

ConstructionContracts

(This Accounting Standard includes paragraphs set in bold italic type

and plain type, which have equal authority. Paragraphs in bold italic

type indicate the main principles. This Accounting Standard should be

read in the context of its objective and the Preface to the Statements of

Accounting Standards1.)

Accounting Standard (AS) 7, Construction Contracts (revised 2002), issued

by the Council of the Institute of Chartered Accountants of India, comes into

effect in respect of all contracts entered into during accounting

periods commencing on or after 1-4-2003 and is mandatory in nature2

from that date. Accordingly, Accounting Standard (AS) 7, ‘Accounting for

Construction Contracts’, issued by the Institute in December 1983, is not

applicable in respect of such contracts. Early application of this

Standard is, however, encouraged.

The following is the text of the revised Accounting Standard.

Objective

The objective of this Statement 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 datewhen 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

* Originally issued in December 1983 and titled as ‘Accounting for Construction

Contracts’.

1 Attention is specifically drawn to paragraph 4.3 of the Preface, according to which

Accounting Standards are intended to apply only to items which are material.

2 Reference may be made to the section titled ‘Announcements of the Council

regarding status of various documents issued by the Institute of Chartered

Accountants of India’ appearing at the beginning of this Compendium for a detailed

discussion on the implications of the mandatory status of an accounting standard.

110 AS 7 (revised 2002)

performed. This Statement uses the recognition criteria established in the

Framework for the Preparation and Presentation of Financial Statements 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.

Scope

1. This Statement should be applied in accounting for construction

contracts in the financial statements of contractors.

Definitions

2. The following terms are used in this Statement 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 percentage of

these costs or a fixed fee.

3. 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

assetswhich 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.

4. For the purposes of this Statement, construction contracts include:

(a) contracts for the rendering of services which are directly related

Construction Contracts 111

to the construction of the asset, for example, those for the services

of project managers and architects; and

(b) contracts for destruction or restoration of assets, and the restoration

of the environment following the demolition of assets.

5. Construction contracts are formulated in a number of ways which, for

the purposes of this Statement, are classified as fixed price contracts and

cost plus contracts. Some construction contractsmay 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

22 and 23 in order to determine when to recognise contract revenue and

expenses.

Combining andSegmentingConstructionContracts

6. The requirements of this Statement are usually applied separately to

each construction contract. However, in certain circumstances, it is necessary

to apply the Statement 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.

7. When a contract covers a number of assets, the construction of

each asset should 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.

8. A group of contracts, whether with a single customer or with several

customers, should 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

112 AS 7 (revised 2002)

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

sequence.

9. 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 should 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.

Contract Revenue

10. Contract revenue3 should 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.

11. Contract revenue is measured at 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 to 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 contractmay increase

as a result of cost escalation clauses;

(c) the amount of contract revenue may decrease as a result of

3 See also Accounting Standards Interpretation (ASI) 29 published elsewhere in

this Compendium.

Construction Contracts 113

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.

12. 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.

13. 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.Aclaimmay 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 only included in contract revenue 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.

14. Incentive payments are additional amounts payable 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.

114 AS 7 (revised 2002)

ContractCosts

15. Contract costs should comprise:

(a) costs that relate directly to the specific contract;

(b) costs that are attributable to contract activity in general and

can be allocated to the contract; and

(c) such other costs as are specifically chargeable to the customer

under the terms of the contract.

16. Costs that relate directly to a specific contract include:

(a) site labour costs, including site supervision;

(b) costs of materials used in construction;

(c) depreciation of plant and equipment used on the contract;

(d) costs of moving plant, equipment and materials to and from the

contract site;

(e) costs of hiring plant and equipment;

(f) costs of design and technical assistance that is directly related to

the contract;

(g) the estimated costs of rectification and guarantee work, including

expected warranty costs; and

(h) claims from third parties.

These costs may be reduced by any incidental income that is not included in

contract revenue, for example income fromthe sale of surplus materials and

the disposal of plant and equipment at the end of the contract.

17. Costs that may be attributable to contract activity in general and can

be allocated to specific contracts include:

(a) insurance;

Construction Contracts 115

(b) costs of design and technical assistance that is not directly related

to a specific contract; and

(c) construction overheads.

Such costs are allocated using methods that are systematic and rational and

are applied consistently to all costs having similar characteristics. The

allocation is based on the normal level of construction activity. Construction

overheads include costs such as the preparation and processing of construction

personnel payroll. Costs thatmay be attributable to contract activity in general

and can be allocated to specific contracts also include borrowing costs as

per Accounting Standard (AS) 16, Borrowing Costs.

18. Costs that are specifically chargeable to the customer under the terms

of the contract may include some general administration costs and

development costs for which reimbursement is specified in the terms of the

contract.

19. Costs that cannot be attributed to contract activity or cannot be allocated

to a contract are excluded from the costs of a construction contract. Such

costs include:

(a) general administration costs for which reimbursement is not

specified in the contract;

(b) selling costs;

(c) research and development costs for which reimbursement is not

specified in the contract; and

(d) depreciation of idle plant and equipment that is not used on a

particular contract.

20. Contract costs include the costs attributable to a contract for the period

fromthe date of securing the contract to the final completion of the contract.

However, costs that relate directly to a contract and which are incurred in

securing the contract are also included as part of the contract costs if they

can be separately identified and measured reliably and it is probable that the

contract will be obtained. When costs incurred in securing a contract are

recognised as an expense in the period in which they are incurred, they are

not included in contract costs when the contract is obtained in a subsequent

period.

116 AS 7 (revised 2002)

Recognition of Contract Revenue and Expenses

21. When the outcome of a construction contract can be estimated

reliably, contract revenue and contract costs associated with the

construction contract should be recognised as revenue and expenses

respectively by reference to the stage of completion of the contract activity

at the reporting date. An expected loss on the construction contract

should be recognised as an expense immediately in accordance with

paragraph 35.

22. In the case of a fixed price contract, the outcome of a construction

contract can be estimated reliably when all the following conditions are

satisfied:

(a) total contract revenue can be measured reliably;

(b) it is probable that the economic benefits associated with the

contract will flow to the enterprise;

(c) both the contract costs to complete the contract and the stage

of contract completion at the reporting date can be measured

reliably; and

(d) the contract costs attributable to the contract can be clearly

identified and measured reliably so that actual contract costs

incurred can be compared with prior estimates.

23. 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:

(a) it is probable that the economic benefits associated with the

contract will flow to the enterprise; and

(b) the contract costs attributable to the contract, whether or not

specifically reimbursable, can be clearly identified and

measured reliably.

24. The recognition of revenue and expenses by reference to the stage of

completion of a contract is often referred to as the percentage of completion

method. Under this method, contract revenue is matched with the contract

Construction Contracts 117

costs incurred in reaching the stage of completion, resulting in the reporting

of revenue, expenses and profit which can be attributed to the proportion of

work completed. This method provides useful information on the extent of

contract activity and performance during a period.

25. Under the percentage of completion method, contract revenue is

recognised as revenue in the statement of profit and loss in the accounting

periods in which the work is performed. Contract costs are usually

recognised

as an expense in the statement of profit and loss in the accounting periods in

which the work to which they relate is performed. However, any expected

excess of total contract costs over total contract revenue for the contract is

recognised as an expense immediately in accordance with paragraph 35.

26. A contractor may have incurred contract costs that relate to future

activity on the contract. Such contract costs are recognised as an asset

provided 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.

27. When an uncertainty arises about the collectability of an amount already

included in contract revenue, and already recognised in the statement of

profit and loss, the uncollectable amount or the amount in respect of which

recovery has ceased to be probable is recognised as an expense rather than

as an adjustment of the amount of contract revenue.

28. An enterprise is generally able to make reliable estimates after it has

agreed to a contract which establishes:

(a) each party’s enforceable rights regarding the asset to be

constructed;

(b) the consideration to be exchanged; and

(c) the manner and terms of settlement.

It is also usually necessary for the enterprise to have an effective internal

financial budgeting and reporting system. The enterprise reviews and, when

necessary, revises the estimates of contract revenue and contract costs as

the contract progresses. The need for such revisions does not necessarily

indicate that the outcome of the contract cannot be estimated reliably.

29. The stage of completion of a contract may be determined in a variety

118 AS 7 (revised 2002)

of ways. The enterprise uses the method that measures reliably the work

performed.Depending on the nature of the contract, themethodsmay include:

(a) the proportion that contract costs incurred for work performed

upto the reporting date bear to the estimated total contract costs;

or

(b) surveys of work performed; or

(c) completion of a physical proportion of the contract work.

Progress payments and advances received from customers may not

necessarily reflect the work performed.

30. When the stage of completion is determined by reference to the contract

costs incurred upto the reporting date, only those contract costs that reflect

work performed are included in costs incurred upto the reporting date.

Examples of contract costs which are excluded are:

(a) contract costs that relate to future activity on the contract, such

as costs of materials that have been delivered to a contract site or

set aside for use in a contract but not yet installed, used or applied

duringcontractperformance, unless thematerials have beenmade

specially for the contract; and

(b) payments made to subcontractors in advance of work performed

under the subcontract.

31. When the outcome of a construction contract cannot be estimated

reliably:

(a) revenue should be recognised only to the extent of contract

costs incurred of which recovery is probable; and

(b) contract costs should be recognised as an expense in the period

in which they are incurred.

An expected loss on the construction contract should be recognised as

an expense immediately in accordance with paragraph 35.

32. During the early stages of a contract it is often the case that the outcome

of the contract cannot be estimated reliably. Nevertheless, itmay be probable

that the enterprisewill recover the contract costs incurred. Therefore, contract

Construction Contracts 119

revenue is recognised only to the extent of costs incurred that are expected

to be recovered. As the outcome of the contract cannot be estimated reliably,

no profit is recognised. However, even though the outcome of the contract

cannot be estimated reliably, it may be probable that total contract costs will

exceed total contract revenue. In such cases, any expected excess of total

contract costs over total contract revenue for the contract is recognised as

an expense immediately in accordance with paragraph 35.

33. Contract costs recovery of which is not probable are recognised as an

expense immediately. Examples of circumstances in which the recoverability

of contract costs incurred may not be probable and in which contract costs

may, therefore, need to be recognised as an expense immediately include

contracts:

(a) which are not fully enforceable, that is, their validity is seriously in

question;

(b) the completion of which is subject to the outcome of pending

litigation or legislation;

(c) relating to properties that are likely to be condemned or

expropriated;

(d) where the customer is unable to meet its obligations; or

(e) where the contractor is unable to complete the contract or

otherwise meet its obligations under the contract.

34. When the uncertainties that prevented the outcome of the contract

being estimated reliably no longer exist, revenue and expenses

associated with the construction contract should be recognised in

accordance with paragraph 21 rather than in accordance with

paragraph 31.

Recognition of Expected Losses

35. When it is probable that total contract costs will exceed total contract

revenue, the expected loss should be recognised as an expense

immediately.

36. The amount of such a loss is determined irrespective of:

(a) whether or not work has commenced on the contract;

120 AS 7 (revised 2002)

(b) the stage of completion of contract activity; or

(c) the amount of profits expected to arise on other contracts which

are not treated as a single construction contract in accordance

with paragraph 8.

Changes inEstimates

37. 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. Therefore, the effect of a change in the estimate of contract

revenue or contract costs, or the effect of a change in the estimate of the

outcome of a contract, is accounted for as a change in accounting estimate

(see Accounting Standard (AS) 5, Net Profit or Loss for the Period, Prior

Period Items and Changes in Accounting Policies). The changed estimates

are used in determination of the amount of revenue and expenses recognised

in the statement of profit and loss in the period in which the change is made

and in subsequent periods.

Disclosure

38. An enterprise should disclose:

(a) the amount of contract revenue recognised as revenue in the

period;

(b) the methods used to determine the contract revenue recognised

in the period; and

(c) the methods used to determine the stage of completion of

contracts in progress.

39. An enterprise should disclose the following for contracts in progress

at the reporting date:

(a) the aggregate amount of costs incurred and recognised profits

(less recognised losses) upto the reporting date;

(b) the amount of advances received; and

(c) the amount of retentions.

40. Retentions are amounts of progress billings which are not paid until the

satisfaction of conditions specified in the contract for the payment of such

Construction Contracts 121

amounts or until defects have been rectified. Progress billings are amounts

billed for work performed on a contract whether or not they have been paid

by the customer. Advances are amounts received by the contractor before

the related work is performed.

41. An enterprise should present:

(a) the gross amount due from customers for contract work as

an asset; and

(b) the gross amount due to customers for contract work as a

liability.

42. The gross amount due from customers for contract work is the net

amount of:

(a) costs incurred plus recognised profits; less

(b) the sum of recognised losses and progress billings

for all contracts in progress for which costs incurred plus recognised profits

(less recognised losses) exceeds progress billings.

43. The gross amount due to customers for contractwork is the net amount of:

(a) the sum of recognised losses and progress billings; less

(b) costs incurred plus recognised profits

for all contracts in progress for which progress billings exceed costs incurred

plus recognised profits (less recognised losses).

44. An enterprise discloses any contingencies in accordance with

Accounting Standard (AS) 4, Contingencies and Events OccurringAfter the

Balance Sheet Date4. Contingencies may arise from such items as warranty

costs, penalties or possible losses.

4 Pursuant to AS 29, Provisions, Contingent Liabilities and Contingent Assets,

becoming mandatory in respect of accounting periods commencing on or after 1-4-

2004, all paragraphs of AS 4 that deal with contingencies stand withdrawn except to

the extent they deal with impairment of assets not covered by other Indian

Accounting Standards. Reference may be made to Announcement XX under the

section titled 'Announcements of the Council regarding status of various documents

issued by the Institute of Chartered Accountants of India' appearing at the beginning

of this Compendium.

122 AS 7 (revised 2002)

Appendix

The appendix is illustrative only and does not form part of the Accounting

Standard. The purpose of the appendix is to illustrate the application

of the Accounting Standard to assist in clarifying its meaning.

Disclosure of Accounting Policies

The following are examples of accounting policy disclosures:

Revenue from fixed price construction contracts is recognised on the

percentage of completion method, measured by reference to the percentage

of labour hours incurred upto the reporting date to estimated total labour

hours for each contract.

Revenue from cost plus contracts is recognised by reference to

the recoverable costs incurred during the period plus the fee earned,

measured by the proportion that costs incurred upto the reporting date

bear to the estimated total costs of the contract.

The Determination of Contract Revenue and Expenses

The following example illustrates one method of determining the stage of

completion of a contract and the timing of the recognition of contract revenue

and expenses (see paragraphs 21 to 34 of the Standard). (Amounts shown

hereinbelow are in Rs. lakhs)

A construction contractor has a fixed price contract for Rs. 9,000 to build a

bridge. The initial amount of revenue agreed in the contract is Rs. 9,000.

The contractor’s initial estimate of contract costs is Rs. 8,000. It will take 3

years to build the bridge.

By the end of year 1, the contractor’s estimate of contract costs has increased

to Rs. 8,050.

In year 2, the customer approves a variation resulting in an increase in

contract revenue of Rs. 200 and estimated additional contract costs of Rs.

150. At the end of year 2, costs incurred include Rs. 100 for standard

materials stored at the site to be used in year 3 to complete the project.

The contractor determines the stage of completion of the contract by

Construction Contracts 123

calculating the proportion that contract costs incurred for work

performed upto the reporting date bear to the latest estimated total

contract costs. A summary of the financial data during the construction

period is as follows:

(amount in Rs. lakhs)

Year 1 Year 2 Year 3

Initial amount of revenue agreed in contract 9,000 9,000 9,000

Variation —— 200 200

Total contract revenue 9,000 9,200 9,200

Contract costs incurred upto the reporting date 2,093 6,168 8,200

Contract costs to complete 5,957 2,032 ——

Total estimated contract costs 8,050 8,200 8,200

Estimated Profit 950 1,000 1,000

Stage of completion 26% 74% 100%

The stage of completion for year 2 (74%) is determined by excluding from

contract costs incurred for work performed upto the reporting date, Rs. 100

of standard materials stored at the site for use in year 3.

The amounts of revenue, expenses and profit recognised in the statement of

profit and loss in the three years are as follows:

Upto the Recognised in Recognised in

Reporting Date Prior years current year

Year 1

Revenue (9,000x .26) 2,340 2,340

Expenses (8,050x .26) 2,093 2,093

Profit 247 247

124 AS 7 (revised 2002)

Year 2

Revenue (9,200x .74) 6,808 2,340 4,468

Expenses (8,200x .74) 6,068 2,093 3,975

Profit 740 247 493

Year 3

Revenue (9,200x 1.00) 9,200 6,808 2,392

Expenses 8,200 6,068 2,132

Profit 1,000 740 260

Contract Disclosures

A contractor has reached the end of its first year of operations. All its

contract costs incurred have been paid for in cash and all its progress billings

and advances have been received in cash. Contract costs incurred for

contracts B, C and E include the cost of materials that have been purchased

for the contract but which have not been used in contract performance upto

the reporting date. For contracts B, C and E, the customers have made

advances to the contractor for work not yet performed.

Construction Contracts 125

The status of its five contracts in progress at the end of year 1 is as follows:

Contract

(amount in Rs. lakhs)

A B C D E Total

Contract Revenue recognised in 145 520 380 200 55 1,300

accordance with paragraph 21

Contract Expenses recognised in 110 450 350 250 55 1,215

accordance with paragraph 21

Expected Losses recognised in — — — 40 30 70

accordance with paragraph 35

Recognised profits less 35 70 30 (90) (30) 15

recognised losses

Contract Costs incurred in the 110 510 450 250 100 1,420

period

Contract Costs incurred recognised

as contract expenses in the period

in accordance with paragraph 21 110 450 350 250 55 1,215

Contract Costs that relate to future

activity recognised as an asset in

accordance with paragraph 26 — 60 100 — 45 205

Contract Revenue (see above) 145 520 380 200 55 1,300

Progress Billings (paragraph 40) 100 520 380 180 55 1,235

Unbilled Contract Revenue 45 — — 20 — 65

Advances (paragraph 40) — 80 20 — 25 125

126 AS 7 (revised 2002)

The amounts to be disclosed in accordance with the Standard are as follows:

Contract revenue recognised as revenue in the period

(paragraph 38(a)) 1,300

Contract costs incurred and recognised profits

(less recognised losses)

upto the reporting date (paragraph 39(a)) 1,435

Advances received (paragraph 39(b)) 125

Gross amount due from customers for contract work—

presented as an asset in accordance with paragraph 41(a) 220

Gross amount due to customers for contract work—

presented as a liability in accordance with paragraph 41(b) (20)

The amounts to be disclosed in accordance with paragraphs 39(a), 41(a)

and 41(b) are calculated as follows:

(amount in Rs. lakhs)

A B C D E Total

Contract Costs incurred 110 510 450 250 100 1,420

Recognised profits less 35 70 30 (90) (30) 15

recognised losses

145 580 480 160 70 1,435

Progress billings 100 520 380 180 55 1,235

Due from customers 45 60 100 — 15 220

Due to customers — — — (20) — (20)

The amount disclosed in accordance with paragraph 39(a) is the same as the

amount for the current period because the disclosures relate to the first year

of operation.