Indian Accounting Standard 11 – Construction Contracts

The Indian Accounting Standard 11 prescribes the accounting treatment of the revenues and costs associated with construction contracts. One of the primary assumptions of accounting is the matching concept. Under this concept, the revenues are matched with the costs in the period in which they are incurred. However, construction contracts are long-term in nature and hence, the revenue and costs are carried over from one accounting period to another. Hence, the need for this standard arose. This standard clearly explains the recognition of contract revenue and its expenses.

What is the scope of the standard?

This standard shall be applied while accounting for construction contracts. Financial statements of contractors including the financial statements of real estate developers are usually aligned to this standard.

What are the key terms explained in the standard?

To understand this standard, we must first understand the meaning of the terms used in the standard, which are primary to the accounting treatment of construction contracts. The standard defines the following:

• Construction contract 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. It also includes agreements of real estate development to provide services together with construction material in order to perform the contractual obligation to deliver the real estate to the buyer.Construction of a specific asset as stated in the definition can be the building of a bridge, dam, pipeline, and much more. Construction of closely interrelated assets can be the construction of refineries.
• Contract Revenue Contract revenue comprises the initial amount of revenue agreed in the contract; and variations in contract work, claims, and incentive payments, to the extent that they may result in revenue. These need to be capable of being reliably measured.
• Contract costs Contract costs shall consist of:
  • Costs that relate directly to the specific contract.
  • Costs that are attributable to contract activity in general and can be allocated to the contract.
  • Such other costs as are specifically chargeable to the customer under the terms of the contract.

The other terms defined are the fixed-price contract, which means that the contractor agrees with a fixed price for the contract and cost-plus contract, which refers to a price for the defined costs plus a percentage of these costs or a fixed fee. The requirements of this standard are usually applied separately to each construction contract. However, in certain circumstances, it is necessary to apply the standard 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 group of contracts.

How are contract revenue and costs recognised?

To recognise the costs and revenues of the contract for the purpose of accounting, it must be ensured that the outcome of the construction contract can be estimated reliably. The outcome of a fixed price contract can be estimated reliably when:

• Total contract revenue can be measured reliably
• It is probable that the economic benefits associated with the contract will flow to the entity.
• The contract costs to complete the contract and the stage of contract completion at the end of the reporting period can be measured reliably.
• 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.

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 entity.
• The contract costs attributable to the contract, whether or not specifically reimbursable, can be clearly identified and measured reliably.

Once the outcome of the contract can be estimated reliably the contract costs and revenue will be recognised as revenue and expenses by reference to the stage of completion of the contracting activity at the end of the reporting period. This method is called the percentage of completion method. The stage of completion can be determined by either of the following:

• The proportion of the contract costs incurred till date to the estimated total contract costs Surveys.
• By the completion of a physical proportion of the contract work.

When the outcome of a construction contract cannot be estimated reliably:

• Revenue shall be recognised only to the extent of contract costs incurred, which are probable and recoverable.
• Contract costs shall be recognised as an expense in the period in which they are incurred.

Another important aspect that the standard covers is the recognition of losses. When it is probable that the total contract costs will exceed the total revenue, then the loss must be expensed out (recorded) immediately.

What should an entity disclose with respect to a contract?

The entity must disclose:

• The revenue recognised during the period.
• The methods used to determine the contract revenue.
• The methods used to determine the stage of completion of the contract.

In case of contracts that are in progress at the end of the reporting period, an entity must disclose the aggregate amount of costs incurred and recognised profits or losses, the advances received so far and the number of retentions (if any).

What does the Appendix to the Accounting Standard cover?

Infrastructure such as roads, tunnels, flyovers, hospitals, and prisons are financed through the public budget by the public sector. However, off late, the government is encouraging private companies to undertake the task by constructing, operating and maintaining the same. This arrangement is referred to as the Service Concession Arrangement. Under this arrangement, there is a grantor (public sector company) and an operator (private company) entering into an arrangement for the construction, operation and maintenance of a public asset. Appendix A sets out general principles on recognising and measuring the obligations and related rights in these service concession arrangements. Requirements for disclosing information about service concession arrangements are in Appendix B of this Indian Accounting Standard. Here:

• The operator is the service provider and must account for the revenue as per Ind AS 11 and Ind AS 18 The operator has no rights on the assets.
• Any consideration received as a financial asset must be accounted for as per Ind AS 32,39 and 107. If the consideration is in the form of an intangible asset, then it must be accounted for as per Ind AS 38.

Construction contracts are long-term and also have a lot of contingencies attached to it. So an entity needs excellent tools for calculating estimates; following this standard for accounting them surely helps.