CONSTRUCTION CONTRACT’S (AS-7)

A.      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 fixed percentage of profit.

B.   Calculating the profit or loss of a construction contract: Profit or loss on construction contract is Contract revenue - Contract Cost.

C.   Contract revenue: Contract revenue includes/ excludes the following:

    Add/Includes:

a.      Revenue/price agreed as per Contract.

b.      Revenue arising due to escalation clause.

c.       When a fixed price contract involves a fixed price per unit of output, contract revenue increases as the number of units is increased.

d.      Variations, Claims & Incentive payments.

Less/Excludes:

a.      Penalties arising from delays caused by the contractor in the completion of the contract.

b.      Variations.

E.    A variation is an instruction by the customer for a change in the work to be performed. It may lead to an increase/decrease in contract revenue. Variations are considered only when:

a.      There is a certainty of collection (it is probable that the customer will accept) the variation &

b.      There is a certainty of measurement.

F.    A claim is an amount that the contractor seeks to collect from the customer as reimbursement for costs not included in the contract price. Examples are customer caused delays. Claims are considered only when:

a.      There is a certainty of collection &

b.      There is a certainty of measurement.

G.   Incentive payments are additional amounts payable to the contractor if specified performance standards are met or exceeded. Ex. an incentive payment to the contractor for early completion of the contract. These are considered only when:

a.      There is a certainty of collection &

b.      There is a certainty of measurement.

H.   Percentage of completion method (PCM): As per AS 7, the contract revenue will be recognised with reference to STAGE OF COMPLETION at the reporting date. This is called PCM.

I.      Determination of stage of completion: 

a.      Cost to Cost method: The percentage of completion would be estimated by comparing total cost incurred to date with total cost expected for the entire contract:

           Percentage of Completion =                                           Cost to date                            

                                                             Cost incurred + Estimated cost to complete

Current period revenue from Contract = Contract price X Percentage of completion –          Revenue previously recognised.

b.      Technical survey method:

E.g.: A construction contract of a two floor building for15 lakhs (with a 50% margin)

Foundation work was completed.

Under the cost to cost method, revenue of Rs.7.5 lakhs (15 Lakhs X 5/10 Lakhs) would be recognised & cost of 5 lakhs would be recognised and profit of2.5 lakhs would be recognised. Under the Technical survey method, revenue of5.25 lakhs (35% of15 lakhs) would be recognised, cost of Rs.3.5 lakhs (35% of10 lacs) would be recognised and a profit of1.75 lacs would be recognised.

J.       Conditions for recognising the contract revenue:

a.      No significant uncertainty exists regarding the amount of consideration.

b.      No significant uncertainty exists regarding the collection of consideration.

K.   When outcome of contract cannot be estimated reliably: In those circumstances the revenue should be recognised only to the extent of contract costs incurred of which recovery is probable, thus no profit is recognised.

L.    Subsequent uncertainty in collection: When uncertainty of collection of revenue arises subsequently after the revenue recognition, it is better to make provision for the uncertainty in collection rather than adjustment in already recognised revenue.

M.  Contract costs consist of the following:

a.      Specific costs: Labour cost, Cost of material used in construction, Depreciation of plant and equipments used on the contract, Cost of hiring plant, Cost of design and technical assistance & Claim from third parties. These costs should be reduced by incidental income, for example, sale of scrap material.

b.      Cost attributable to contract: Insurance, Cost of design and technical assistance that is not directly related to a specific contract & Construction overheads.

c.       Pre contract cost: Contract costs include the costs incurred in securing the contract.

d.      Cost excluded: General administration cost, Selling cost, Research and development.

N.   Provision for expected losses: When it is certain that total contract cost will exceed total contract revenue, the expected losses should be immediately provided for.