Construction contracts usually:
- Run for more than one accounting period
- Involve huge costs and revenues
- Have uncertainty regarding completion and profit
If revenue is recognized wrongly, profits may be overstated or understated.
AS 7 provides clear rules on when and how revenue and costs related to construction contracts should be recognized.
Objective of AS 7
To prescribe the accounting treatment of revenue and costs associated with construction contracts, considering:
- Contract duration
- Stage of completion
- Expected profits or losses
Meaning of Construction Contract
A construction contract is a contract specifically negotiated for:
- Construction of an asset or
- A combination of assets
that are closely interrelated or interdependent.
Examples:
- Construction of a bridge, dam, road, building
- Shipbuilding contracts
Types of Construction Contracts
1. Fixed Price Contract
- Contractor agrees to a fixed contract price
- Risk of cost overrun lies with contractor
2. Cost Plus Contract
- Contractor is reimbursed for allowable costs
- Plus an agreed profit margin or fee
Contract Revenue
Contract revenue includes:
- Initial contract amount
- Approved variations
- Claims
- Incentive payments (if measurable reliably)
Revenue should be recognized only when measurable with reasonable certainty.
Contract Costs
Contract costs include:
- Direct material and labour
- Site overheads
- Depreciation of plant used in contract
- Design and technical assistance costs
Excludes:
- General administrative expenses
- Selling expenses
- Research costs (unless reimbursable)
Methods of Accounting under AS 7
Percentage of Completion Method (POCM)
This is the main and preferred method under AS 7.
Revenue and costs are recognized in proportion to the stage of completion.
How to Determine Stage of Completion
Stage of completion may be determined by:
- Cost incurred to date / Estimated total cost
- Work certified / Contract price
- Physical proportion of work completed
Cost-to-cost method is most commonly used in exams.
Numerical Illustration (Exam-Oriented)
Contract Price: ₹50,00,000
Cost incurred till date: ₹20,00,000
Estimated total cost: ₹40,00,000
Step 1: Calculate % Completion
= 20,00,000 / 40,00,000 = 50%
Step 2: Revenue to be recognized
= 50% × 50,00,000 = ₹25,00,000
Step 3: Profit recognized
= Revenue − Cost incurred
= 25,00,000 − 20,00,000 = ₹5,00,000
Treatment of Expected Losses
If total contract cost exceeds contract revenue: Expected loss should be recognized immediately irrespective of the stage of completion.
This follows the principle of prudence.
When Outcome of Contract Cannot Be Estimated Reliably
In such cases:
- Revenue is recognized only to the extent of costs incurred
- No profit is recognized
- Costs are expensed as incurred
Disclosure Requirements under AS 7
An enterprise should disclose:
- Contract revenue recognized
- Method used to determine stage of completion
- Amount of costs incurred and profits recognized
- Advances received
- Retentions
Shop Now: Books for Advance Accounting
Common Exam Mistakes
- Using completed contract method (not allowed now)
- Recognizing profit when outcome is uncertain
- Ignoring expected losses
- Wrong calculation of stage of completion
Exam Tip
Whenever you see a construction contract problem:
- Check whether outcome is reliably measurable
- Compute stage of completion
- Recognize revenue, cost, and profit
- Check for expected loss
Follow this order → full marks guaranteed.
Motivational Note
“Construction contracts teach a powerful accounting lesson, profit must follow progress, not hope.” – CA Rohit Sethi
