accounting standard applicable to construction industry

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Two day Conference by CTC onTwo day Conference by CTC on

“TAX & ALLIED ASPECTS OF“TAX & ALLIED ASPECTS OF

CONSTRUCTION INDUSTRY”CONSTRUCTION INDUSTRY”

Accounting StandardsAccounting Standards

Applicable toApplicable toConstruction IndustryConstruction Industry

By

Jayant Gokhale, FCA

8th Jan 2010 1Jayant Gokhale FCA

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Standards applicable to construction activities

Construction industry can be broken up into

Construction contracts

Developers

Builders

Leaving out the non-commercial players such as

Sellers of property &

Those subject to capital gains etc.

Those letting out property

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Standards Applicableto Construction Industry

Obvious standard Construction Contracts - AS 7 (revised 2002).

In fact this has the minimum issues in application & sholuld be least

applied.

Numerous other standards become applicable & are practically

relevant especially from a tax perspective namely : AS 9 Revenue Recognition

AS 2 Valuation of Inventories

AS 16 Borrowing Costs

AS 19 Leases

AS 11 The Effects of Changes in Foreign Exchange Rates (revised 2003)

To supplement this one may also mention certain guidance notes. Reference may also be made to IFRS, FASB, (US GAAP), IFRIC

(International Financial Reporting Interpretations Committee)

Last but not the least : Accounting Standards notified u/s 145A of the

Income Tax Act.

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Relevance of AS in the present seminar

The Supreme Court has earlier observed that “Taxability cannot be

decided on basis of entries which the assessee may choose to make in

his accounts.“CIT v. Mogul Limited 46 ITR 590 (Bom.) , Kedarnath Jute Mfg. Co. Ltd. v. CIT [1971] 82 ITR 363 (SC)

CIT v. A. Krishnaswamy Mudliar [1964] 53 ITR 122 (SC), CIT v. Sarangpur Cotton Mfg. Co. Ltd. [1938] 6 ITR 36 (SC),

CIT v. Sugauli Sugar Works Pvt. Ltd. [1999] 236 ITR 518 (SC)

Has also been held that : “The argument based on accountancy

practice has little merit if such practice cannot be justified by any

provision of the statute or is contrary to it.” in Tuticorin Alkalis’ case, 227 ITR 172 (SC).

Where however the law is silent, and an appropriate commercial

practice has to be considered in order to arrive at what would

constitute income from the perspective of a businessman; courts

increasingly relying upon accounting practices prescribed in AS.

The manner of accounting entries passed, in the books of account of

the assessee, though not conclusive may have persuasive value in

deciding the correct income. . [Challapalli Sugar 98 ITR 167 (SC), CIT v. Nagarjuna Steels 171 ITR

663.]

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Construction Contracts

AS 7 (revised 2002).What is a Construction Contract?

The activity of construction is not on the account of the

person undertaking the construction - i.e. he is a contractor

E.g.- a contract is awarded for construction of godown or a mall

The person awarded the contract is undertaking a " constructioncontract".

Objective of AS 7

The date when contract activity is entered into & is completed

usually fall in different accounting periods. Therefore, the primary

issue is the allocation of contract revenue and contract costs to theaccounting periods in which construction work is performed.

The objective of AS 7 is to prescribe the accounting treatment of

revenue and costs associated with the construction contracts.

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Construction Contracts AS 7 Provides

Meaning of a construction contract [#2] a contract specificallynegotiated for the construction of an asset or a group of assets

interrelated or interdependent in terms of design, technology,

function, use or purpose.

Either Fixed Price or Cost plus &includes contracts for the rendering

of services which are directly related or contracts for destruction or

restoration of assets, and the/or restoration of the environment [#4]

When to Combine / Segment Construction Contracts [# 6 to 9]

What is Contract Revenue : amount agreed initially in the contract,

+ revenue for variations, + claims and incentive payments that are

(a) expected to be collected and (b) that can be measured reliably.

What is Contract Cost : costs that relate directly to the specific

contract, + costs attributable to the contractor's general contracting

activity to the extent allocable to the contract, + other costs that can

be specifically charged to the customer under the terms of the

contract.

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Recognition of Contract Revenue and Expenses

Revenue and contract costs should be recognised when the outcome can beestimated reliably, by reference to the stage of completion of the contract.

This is known as the percentage of completion method of accounting.

To be able to estimate the outcome of a contract reliably,

total contract revenue should be capable of being measured reliably;

it is probable that the economic benefits will flow to the enterprise;

Possible to make a reliable estimate of total contract revenue, the stage of

, .

If the outcome cannot be estimated reliably, no profit recognised. Instead,

contract revenue recognised only to the extent that contract costs incurred are

expected to be recoverable & contract costs- expensed as incurred. [#31]

Completed Contract method not mentioned – unlike earlier - implications

Percentage of completion method is applied on a cumulative basis & the

effect of a change in the estimate of revenue or costs, is accounted for as a

change in accounting estimate .

An expected loss should be recognised as an expense immediately [#35].

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Measuring the work performed Depending on the nature of the contract, the methods may 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

necessar y re ec e wor per orme .

DISCLOSURE amount of contract revenue recognised;

method used to determine revenue;

method used to determine stage of completion; and For contracts in progress at balance sheet date:

aggregate costs incurred and recognised profit

amount of advances received

amount of retentions

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AS 9 “REVENUE RECOGNITION”

Deals with basis for recognition of revenue in the P & L

statement re: revenue arising in the course of the

ordinary activities of the enterprise from

the sale of goods,

the rendering of services, and …….

Specifically excludes application to “Revenue arising

from Construction Contracts” AS7

Does not apply to contractors

Is generic in application

i.e. does apply to Builders / Developers

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Principles for Revenue Recognition

Revenue is measurable & at time of sale or rendering of service

- not unreasonable to expect ultimate collection.

Where the ability to assess the ultimate collection with

reasonable certainty is lacking – postpone recognition.

Conditions for Recognition : The seller of goods hasrans erre o e uyer e proper y n e goo s or a pr ce or

all significant risks and rewards of ownership have been

transferred to the buyer and the seller

Seller retains no effective control of the goods transferred to a

degree usually associated with ownership; and

No significant uncertainty exists regarding the amount of the

consideration that will be derived from the sale of the goods.

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Implications

Recognition of Revenue by Real Estate Developers

GN 23 (Issued 2006) – Clearly states that only AS 9 applicable.

Guides when revenue is to be recognised [# 6]

No interpretation in NACAS standards

Agreements for the Construction of Real EstateIFRIC Interpretation 15 Effective Jan 2009

Whether Sale of Goods

Completed service contract method recognises revenue in the

rendering of services [#4.1 & # 7.1 (ii)]

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FAS 66Financial Accounting Standards Board (FASB)

has issued FAS 66 “Accounting for sales of Real Estate”

FAS 66 prescribe several methods of accounting for the sale of Real Estate Transactions

The various method specified by the standard are:

Installment Method: Installment method apportions each cash receipt or payment from

the buyer between Cost Recovered and the Profit in the ratio as total cost and total profit

bears to the sales value. Cost Recovery Method : Profit is recognized in the Cost recovery method when the

cash payment from the buyer for the principal payment and the interest payment exceeds

the seller’s cost of the property sold.

Deposit Method : Under the deposit method, the seller does not recognize any profit,

until virtual completion.

Reduced profit Method : This Method postpones recognition of other profit until lump

sum payments are made. A reduced profit is determined by applying discounting. Full Accrual Method : Full Recognition of Profit is done only when all the conditions

specified in the standard are fulfilled. Net receivable are discounted at the appropriate

interest rate.

Percentage of Completion Method

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AS 16 Borrowing Costs

Qualifying asset An asset that necessarily takes a substantial period of time to get ready for its

intended use or sale.

Does not distinguish between fixed assets and current assets - can include

inventory under certain circumstances

Substantial period - subjective - but ASI 1 (interpretation) issued by ASB

Carrying amount of the qualifying asset not to exceed NRV

Whether interest can be added

Opinion of Expert Advisory Committee of the ICAI(Vol. 52, No. 3) Revised AS 7 would not apply to builders carrying on construction

on their own account for sale of constructed units.

Query # 27 of 1999 – before AS 16 Borrowing cost came into effect notes paragraph 12 of AS 2 (revised) which states as below:

“12. Interest and other borrowing costs are usually considered as not relating to bringing the

inventories to their present location and condition and are, therefore, usually not included in the

cost of inventories.” The Committee notes the word ‘usually’ - indicates that the Standard

recognises that under certain circumstances, interest and other borrowing costs are included in

the cost of inventories. The Standard, however, does not specify the circumstances in which

inclusion of interest and other borrowing costs in the cost of inventories is appropriate.

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Borrowing Cost .. (continued)

Interest on funds borrowed generally and used for construction of

properties meant for sale - whether to be capitalised

company is engaged, inter alia, in the business of construction of properties and

selling the same. Therefore, the construction work-in-progress and the built-up

properties held by the company for sale are in the nature of its inventories and not

in the nature of fixed assets. paragraph 12 of AS 2 (revised) which states : “12. Interest and other borrowing

costs are usually considered as not relating to bringing the inventories to their

present location and condition and are, therefore, usually not included in the cost of

inventories.”The Committee notes that use of the word ‘usually’ in the above

paragraph indicates that the Standard recognises that under certain circumstances,

interest and other borrowing costs are included in the cost of inventories. The

Standard, however, does not specify the circumstances in which inclusion of interest and other borrowing costs in the cost of inventories is appropriate.

opinion that interest on funds utilised by the company for construction of properties to

be sold later, which are not borrowed specifically but are used out of the overall

borrowed funds available with the company, should not be included in the cost of

construction of the properties.

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A S – 2

(Revised) AS 2 (1981) - specifically excluded application of this standard as it stated:

This statements applies to valuation of all inventories except inventories of the

following to which special considerations apply:

(iii) Work-in-progress under long-term contracts, such as engineering, real estate

development and construction projects;

In contrast the revised AS 2 (Revised 1999) :This Statement should be a lied in accountin or inventories other than:

(a) work in progress arising under construction contracts, including directly

related service contracts (see Accounting Standard (AS) 7, Accounting for

Construction Contracts3 );

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Other Stnadards AS 19 Leases

EAC Opinion Vol XXVI – Co. engaged in development of

plots -may have lease income

AS 11 The Effects of Changes in Foreign

Effect of FDI financed projects

Applicability of IAS, FASB, transfer pricing

Impact on chargeable profits & inventory

8th Jan 2010




THANK YOUJayant Gokhale FCA

8th Jan 2010


accounting standard applicable to construction industry

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