accounting standard applicable to construction industry
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7/28/2019 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
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