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Accounting Standards

AS 7, 9 and 3
DTRTI Lucknow
AS 7

REVENUE RECOGNITION IN
CONSTRUCTION CONTRACTS
AS 7 for Construction Contracts

• The significance- long term contracts –when


revenue to be recognized and how to measure
it in the hands of the contractor
• How should the profit be determined?
• The percentage completion method justifies
the accrual system of accounting

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Why the accrual system is joined with the

• Both contractor and contractee obtain


enforceable rights.
• Right of customer—legal owner ship to the work
in progress
• Right of contractor-right to claim payment
• CONTINUOUS SALE OCCURS-point of view of
contractor
• Primary objective allocation of ‘contract revenue’
and ‘ revenue costs’ to the accounting period
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Applicable to?
• Applies only to the contractor and not to
customer
• Not to construction projects undertaken by
the enterprise on its own account
• Not to-Sale of already constructed flats .

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What is a construction contract?
• Contract specifically negotiated for the
construction of an asset or a combination of
assets closely interrelated or interdependent
• Also for rendering of services directly related
to the construction of assets
• Contract for destruction of asset and
restoration of the environment following the
demolition.

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Types of construction contract
• Fixed price
o Subject to cost escalation
o Not subject to escalation
• Cost plus
– Reimbursement of Cost as defined plus a fixed
percentage of profit / or fixed fee

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Combining and segmenting contracts
• Each contract to be treated as separate entity
• Combined as single project if in substance
these contracts are part of a single project with
overall profit margin
• Additional asset constructed at the option of
the customer—to be treated separately if
– Asset differs significantly from original contract
– Price of addl asset is independent of original
contract
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As per AS 7 the contractor is required to to disclose following

• Policy disclosure-
• The method of determination of stage of completion
• Method used to determine the revenue
• In addition required to disclose-
– Amt of contract revenue recognized in the period
– Contract cost incurred
– Advance recd
– Gross amount due from customers…(cost incurred +recognized
profit)-(sum of recognized losses+ progress billing)
– Gross amount due to customer for contract work---(sum of
recognized losses +progress billing)—(cost incurred+ recognized
profit0

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Calculating the profit or loss
• Determination of contract revenue-
o Revenue or price agreed as per contract
o Revenue arising due to escalation clause
o Claims- amt that the contractor seeks to collect as
reimbursement of cost not included in contract price
o Increased revenue due to increase in units of output
o Incentive payments to the contractors
o Decrease in revenue due to penalties
o Increase / decrease in revenue due to change in scope
of work to be performed

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Calculating the profit or loss
• What does not form part of contract revenue?
• Contract cost that relate to future activities of the
contract
• Payment made to sub contractor in advance
• Uncertainty in collection amounts to expenses

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Contract costs
• Determination of Contract costs-
• 3 types of costs
1. Specific costs to contracts
2. Costs attributable to contract
3. Costs specifically chargeable from customers under
the terms of the contract

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Contract costs
• Determination of Specific costs to contracts
• Site labor cost including supervision
• Cost of material
• Depreciation of plants and equipments
• Cost of moving plant and equipment from site
• Cost of hiring plants
• Cost of design and technical assisstance
• Estimated cost of rectification
• Claim from third parties
• Pre-contract cost if it is probable that contract may be
obtained

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• All these costs to be reduced by incidental
income if any which is not included contract
rev eg- sale of scrap and surplus, disposal of
plant at the end of contract

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• Determination of Costs attributable to contract
» Insurance
» Cost of design and technical assistance not
specifically related to the contract
» Construction overheads

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• Costs specifically chargeable from customers under
the terms of the contract
• Some general admn costs for which
reimbursement is specified
• Development cost
• Any other cost which is reimbursed

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• PROVISION FOR EXPECTED LOSSES
• Expected losses are to be recognized as an expense
irrespective of the following:
• Work has commenced or not
• Stage of completion of contract
• The amount of profit on other contracts
• UNCERTAINTY IN COLLECTION
• When uncertainty arises regd collection of an amount
already included in contract revenue and already
recognized in P&L statements it shall amount to
expense and not an adjustment of contract amounts

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Costs that are to be excluded
• General administrative costs
• Selling costs
• Research and development
• Depreciation cost of idle plant and machinery
• Pre contract costs-if it is not probable that the
contract will be obtained

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Stage of completion of contract
• How do we determine the stage of
completion?
1. Cost to cost method- by determining the
total cost till date with reference to the total
cost expected for the entire contract
2. Completion of physical proportion of the
contract work

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Calculating the profit or loss
• How do we measure the contract revenue?
– reference to the stage of completion
– Percentage of completion of work

• Percentage of completion of work

Percentage of completion = Cost to date_____________ x 100


Cumulative cost incurred + estimated cost to
complete

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• Current revenue from the contract

Current revenue Contract price x Percentage of Revenue


from contract = completion -- previously
recognized

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Illustration
• Gammon India Ltd has undertaken to construct a bridge in 03 years as per
details below;
a. Initial Contract revenue- 900 Cr
b. Initial contract cost- 800 Cr
c. At the end of 2nd yr cost incurred includes 10 Cr for material stored
to be used in 3rd year
Year 1 Year 2 Year 3
Estimated 805
contract cost
Increase in 20
contract revenue
Estimated addl 15
increase in cost
Contract cost 161 584 820
incurred
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Illustration cont..
Year 1 Year 2 Year 3
a) Initial revenue agreed 900 900 900

b) Variation 20 20
c) Total contract value 900 920 920

d) Contract cost 161 584 (including 10 cr 820


incurred of material)
e) Estimated cost to 644 236 -
complete
f) Total estimated cost 805 820 820
g) Estimated profit 95 100 100
h) Stage of completion (161/805 X100) (584-10/820 X100) (820/820 X100)
(d/f X 100) 20% 70% 100%

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Illustration cont..
Up to reporting date Recognized in previous Recognized in current yr
yr

Year 1
Rev (900 x20/100) 180 180
expenses 161 161
Profit 19 19
Year 2
Rev 920 X 70/100 644 180 464
Exp 820 X 70/100 574 161 413
PROFIT 70 19 51
Year 3
Rev 920 644 276
Exp 820 574 246
Profit 100 70 30

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Problems
• 1. Induga ltd undertook construction contract
to construct a subway for rs 100 cr. Initial cost
estimate was Rs 70 cr. No of yrs- 03 .when
starting work found rocks underground and
cost to increase by 36 cr. The co wants to
provide for estimated loss of 2 cr per year.

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AS 9

REVENUE RECOGNITION
• WHEN REVENUE IS TO BE RECOGNIZED
• WHEN REVENUE RECOGNITION CAN BE
POSTPONED

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• WHAT IS REVENUE?

• Gross inflow of cash, receivable or any other


consideration in the course of ordinary
activities like:
– Sale of goods
– Rendering of services
– Use of resources by others yielding interest,
dividend and royalties
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Timing of revenue recognition
• At the time of sale
• If there is some uncertainty I collection of
revenue-only when it becomes certain that
collection will be made

• (escalation of price, export earnings)

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Revenue from Sale of Goods
• Seller has transferred the ownership of goods
to buyer
• Seller does not have any effective contrail over
transferred goods
• There is no significant uncertainty in collection
of consideration
• Suppose delivery delayed at buyer’s request?

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• Suppose sale made subject to conditions-
– Installation: goods installed to buyer’s satisfaction or goods
accepted and received
– Sale on approval: buyer confirms his desire to buy by
communication
– Warranty sale- immediately
– Consignment sale: when goods sold to third party
– Special orders: when goods ready for delivery
– Installments sale: revenue of sale price recognized on date
of sale ; interest to be recognized proportionate to unpaid
balance

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Revenue from rendering of services

1. Completed service contract method : when


service is about to be completed and no
significant uncertainty is recognized about
collection
2. Proportionate completion method : by
reference to performance of each act

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When is revenue recognized?
• Installation fees- when installation completed
and accepted by clients
• Advertising commission: whn advertising
appears before public
• insurance agency commission: on the effective
commencement or renewal date of the
policies

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• Financial services commission:
– Whether service provided once and for all
– Whether service provided on continuing basis
• Performance fee, banquets: when event takes place
• Tuition fee: over period of instruction
• Membership fees:
• Interest : time proportion basis
• Royalties: accrual basis
• Dividend: when company declares dividend
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Revenue recognition of real estate sales

• Real estate- land + buildings


• Refers to builders, developers
• When the 03 conditions below are satisfied:-
– Seller transfers to buyers all significant risks and
rewards of ownership and seller retains no
effective control
– Ultimate collection is expected
– No significant uncertainty exists regarding amount
of consideration
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AS 3

CASH FLOW STATEMENT


Cash flow statement
• Exhibits the flow of incoming and outgoing
cash
• A tool for assessing the liquidity and solvency
of the business

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Applicable to
• Turnover above 50 Cr
• Non SMC (non listed, not a bank, turnover<
50Cr, borrowings<10 cr, not a holding co)
• Borrowing > 10 CR
• Banks and insurance company

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Cash Flow statement under 03 heads
• Cash movement under 03 heads
– From operating activities
– From investing activities
– From financing activities
• Sum of the above shows the net cash or cash
equivalent
– NET CASH - cash in hand & demand deposits
– CASH EQUIVALENT - short term highly liquid investments
having maturity less than 03 months, can be converted
to cash without decline in value.
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Cash Flow from Operating Activities

• Principal revenue producing activities


 Sale of goods and rendering of services
 Cash receipts from royalties, fees, commissions
 Cash payments to suppliers for goods and
services
 Cash payments to and on behalf of employees

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Cash Flow from Investing Activities
• Cash payments to acquire fixed assets-capitalization,
research and development costs, self constructed
assets
• Cash receipts from disposal of assets
• Cash payments to acquire shares and interests in joint
ventures (other than held for trading or cash
equivalents)
• Cash receipts to dispose offshares and interests in
joint ventures (other than held for trading or cash
equivalents)
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Cash Flow from Financing Activities
• Activities resulting in change in size and
composition of owner’s capital and
borrowings of the organization
• Sale of shares
• Buy back of shares
• Redemption of preference shares
• Issue/ redemption of debentures
• Long term loan / payment thereof
• Dividend/ interest paid

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Treatment of certain items
• Interest-
• From investment—Investment activities
• Short term investments (cash equivalent)- operating
activities
• On trade advances and operating receivables- operating
activities
• Interest paid-
• On loans/ debts- financing activity
• On working capital loan- operating activities

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• Dividend recd
– For financial enterprises- in operating activiies
– For other than financial enterprises- investing activities
• Dividend paid
– Always financing activities
• Cash flow from foreign exchange-reported as a
part of reconciliation of cash equivalent
• Unrealized gains and losses from foreign exchange
rates are not cash flows
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