CA Intermediate · Advanced Accounting

AS 7 Construction Contracts: formula sheet

Full chapter guide

Key formulas

Definition of construction contract: Construction contract = contract specifically negotiated to construct an asset or closely interrelated/interdependent assets; Interdependence is tested in terms of design, technology and function, or ultimate purpose or use.
Fixed price contract: Contractor receives a fixed contract price or fixed rate per unit of output (may have escalation clauses); Contractor bears the risk of cost overruns unless an escalation clause covers them.
Cost plus contract: Contract revenue = allowable costs reimbursed + (percentage of costs or fixed fee); Customer bears most cost risk. Only costs allowed under the contract are reimbursed.
Scope rule: AS 7 applies to the accounts of contractors only; It does not apply to the customer's books. It also does not cover other contracts, which are dealt with by other standards.
Segmenting test (all three needed): Separate proposals + separate negotiation (right to accept or reject each part) + identifiable revenue and costs for each asset; If all three are met, treat each asset as a separate construction contract. If any one fails, keep it as one contract.
Combining test (all three needed): Single package negotiation + closely interrelated (single project, overall profit margin) + concurrent or continuous performance; If all three are met, treat the group as one construction contract. The group can be with one or more customers.
Option for additional asset (either one): Asset differs significantly in design, technology or function from original asset OR price negotiated without regard to original contract price; If either holds, the option or additional asset is a separate construction contract. If neither holds, it is part of the original contract.
Effect on recognition: Percentage of completion, revenue and expected loss are worked out for each resulting unit; After segmenting or combining, apply AS 7 recognition rules to each unit, not to the legal contract.
Contract revenue: Contract revenue = Initial agreed amount ± Variations + Claims + Incentives; Include variations, claims and incentives only when the AS 7 conditions of probability and reliable measurement are met. A variation can also reduce revenue.
Contract cost: Contract cost = Direct costs + Allocated contract-activity costs + Costs specifically chargeable to customer; Allocate shared costs on a systematic, rational and consistently applied basis.
Incidental income: Contract cost = Costs above − Incidental income related to the contract and not in revenue; Only incidental income related to the contract is deducted, for example income from the sale of surplus materials or the disposal of plant and equipment at the end of the contract. Do not deduct income unrelated to the contract, such as interest on surplus funds. Deduct only if the income is not included in revenue.
Exclusions: Exclude: non-reimbursable general administration, selling, non-reimbursable R&D, depreciation of idle plant; These cannot be attributed to contract activity, so they never enter contract cost.
Stage of completion (cost method): Stage of completion % = Contract costs incurred for work performed to date ÷ Estimated total contract costs × 100; Estimated total cost = cost to date + estimated cost to complete. Exclude costs of future work, such as unused general materials and advances to subcontractors.
Cumulative revenue: Cumulative revenue = Stage of completion % × Total contract revenue; Use the latest estimate of total contract revenue.
Revenue of the current year: Revenue for the year = Cumulative revenue to date − Revenue recognised in earlier years; Always work on cumulative figures and subtract earlier years. Do not apply the year's own percentage to the total.
Cost recognised (cost method): Contract cost for the year = Cost of work performed in the year; Profit for the year = Revenue for the year − Cost for the year.
Expected loss: Expected loss = Estimated total contract costs − Total contract revenue (when positive); Recognise the whole expected loss immediately, whatever the stage of completion.
Gross amount due from / to customers: Costs incurred + Recognised profits − Recognised losses − Progress billings; Costs incurred here is the same cost of work performed figure used for the stage of completion. It excludes costs of future activity. A positive result is an asset (due from customers). A negative result is a liability (due to customers). Work this out contract by contract.
Outcome not reliably estimable: Revenue = Contract costs incurred that are probable of recovery; Cost = Costs incurred; No profit is recognised. Costs are expensed as incurred.
Expected loss test: Total estimated contract costs > Total contract revenue → recognise the entire loss at once; Apply when the excess is probable. Recognise the loss in full in the period it becomes probable.
Stage of completion (cost proportion): Stage of completion = Contract costs incurred to date ÷ Total estimated contract costs; Costs for future work, such as materials not yet used, are excluded from costs incurred. Use this method only if the question does not give another basis.
Cumulative revenue to date: Cumulative revenue = Contract price × Stage of completion; Revenue for the year = cumulative revenue − revenue recognised in earlier years. Use the latest estimate of contract price.
Provision for foreseeable loss: Provision = Total expected loss − Loss already shown through revenue less costs to date; Make sure the cumulative loss shown in the books equals the total expected loss.
Uncertain outcome: Revenue = Recoverable costs incurred; Expense = Costs incurred; Profit = 0; Applies when outcome cannot be estimated reliably, as long as costs are probable of recovery.
Gross amount due from customers: Costs incurred + Recognised profits − Recognised losses − Progress billings (if positive); Shown as an asset. If negative, it is shown as gross amount due to customers, a liability.
Uncollectable revenue: Uncollectable amount → expense, not a reduction of revenue; AS 7 treats it as an expense when uncertainty arises about collecting an amount already in revenue.

Quick revision

AS 7 applies to the contractor's accounts for construction contracts, including related service contracts directly tied to the construction.
A fixed price contract has an agreed price, possibly with escalation clauses; a cost plus contract pays cost plus a percentage or fixed fee.
Segment a contract covering several assets when separate proposals were submitted for each asset, each asset was separately negotiated so the contractor and customer could accept or reject it, and the cost and revenue of each asset can be identified. Combine a group of contracts when the group is negotiated as a single package, the contracts are so closely interrelated that they are in effect part of a single project with an overall profit margin, and they are performed concurrently or in a continuous sequence.
Contract revenue includes the agreed amount plus variations, claims and incentive payments, subject to the standard's conditions.
Contract costs have three components: (a) costs that relate directly to the specific contract; (b) costs attributable to contract activity in general that can be allocated to the contract, such as insurance, design and technical assistance not directly related to a specific contract, and construction overheads; and (c) other costs specifically chargeable to the customer under the terms of the contract. Excluded costs are: general administration costs, selling costs and research and development costs, unless the contract provides for their reimbursement, and depreciation of idle plant and equipment not used on the contract.
Use the percentage of completion method when the outcome can be estimated reliably.
Reliable estimate for a fixed price contract: total contract revenue can be measured reliably; it is probable that economic benefits will flow; the costs to complete and the stage of completion can be measured reliably; and the costs attributable to the contract can be clearly identified and measured reliably.
Reliable estimate for a cost plus contract: it is probable that economic benefits will flow, and the costs attributable to the contract can be clearly identified and measured reliably.
Stage of completion may be determined by (a) the proportion of contract costs incurred for work performed to date to the estimated total contract costs, (b) surveys of work performed, or (c) completion of a physical proportion of the contract work. Under the cost method, only costs reflecting work done count. Costs of materials not yet used in contract performance are excluded, unless the materials were specially made for the contract. Payments in advance to subcontractors for work to be performed in future are also excluded.
Revenue for the year = revenue to date − revenue recognised in earlier years.
Expected loss = total expected contract cost − total contract revenue, when cost is higher. Recognise it as an expense in full immediately when it is probable that total contract costs will exceed total contract revenue, whatever the stage of completion. The provision is the full expected loss less any loss already recognised.
If the outcome cannot be estimated reliably, the percentage of completion method does not apply. Recognise revenue only to the extent of contract costs incurred that are probable of recovery, and recognise contract costs as an expense in the period they are incurred. So no profit is recognised. Any expected loss on the contract is still recognised immediately as an expense.
A change in estimate is applied in the period of change, not by restating earlier years.
Write disclosures in answers: contract revenue recognised in the period, the method used to determine it and the stage of completion, and for contracts in progress at the reporting date, the aggregate of costs incurred and recognised profits (less recognised losses) up to that date, the advances received and the retentions.

Common mistakes

Treating any long-term supply or sale as a construction contract. Fix: Check for a negotiated asset or closely interrelated assets. Standard goods fall outside AS 7.
Applying AS 7 to the customer's accounts. Fix: Remember that AS 7 deals only with the contractor's books.
Treating segmenting or combining as true when only one or two conditions are met. Fix: List the three conditions and tick each against the facts. If any fails, keep the original unit.
Mixing up the tests for segmenting and combining. Fix: Link segmenting to separate proposals and rights to accept or reject each part. Link combining to a single package and an overall profit margin.
Including every claim the contractor makes in revenue. Fix: Include only if negotiations are advanced and acceptance is probable, and the amount is reliably measurable.
Adding general administration and selling costs to contract cost. Fix: Exclude them unless the contract specifically allows reimbursement. Selling costs are always excluded.
Using progress billings or advances received to find the stage of completion. Fix: Billings show what you have invoiced, not work done. Find the stage from costs for work performed, a survey, or the physical proportion. Use billings only in the amount due from or to customers.
Including unused general materials or advances to subcontractors in cost incurred when finding the stage. Fix: Read the cost details. Exclude costs of future activity from the costs incurred used for the stage calculation and for the gross amount due. Use one costs incurred figure (cost of work performed) in both. Show the excluded items separately as inventory or advances until the work is done.
Recognising only the percentage-of-completion share of the expected loss. Fix: Recognise the entire expected loss immediately. Show the portion not yet reflected in revenue less costs as a provision.
Reducing contract revenue for an uncollectable amount. Fix: AS 7 says to recognise the uncollectable amount as an expense. Revenue stays as computed.

Exam tips

Start every answer with the definition of a construction contract, then apply it to the facts. This earns step marks.
In a compare-and-contrast question, write who bears the risk, how the price is set and what revenue is based on. Present these as separate points.
Expect MCQs that test the scope: contractor's books only, and which contracts count. Read each option for the word "customer".
Watch for hybrid contracts in case facts. Name the features of both types, then state which is dominant.
If the question asks for accounting treatment, first classify the contract in one line, then move on.
Write the unit of accounting decision first. Examiners give marks for the tested conditions even if the arithmetic goes wrong.
Quote the facts against each condition in one line each. Do not just list the conditions from memory.
In MCQs, check whether the question says all conditions are met. One missing condition usually means the answer is 'no change'.