ACCOUNTING FOR CONSTRUCTION CONTRACTS

Compiled by CA. Santu Dutta, Accounts Officer, BRPL & Kameng HEP site
In general, revenue from goods or services is recognised only upon the satisfaction of realisation and
when earned. That means revenue shall follow the principles of conservatism which is one of the
very basic ABC of accounting. This is the very principles of recognition of revenue in general. One of
the exceptions of this is construction contracts. Because of uncertainty of completion of the
project/ scope of revenue with in an accounting period, the revenue from these kinds of activities is
being accounted over the period of completion of project in a systematic manner.
BASIS FUNDA:
1. EXCEPTION TO THE GENERAL PRINCIPLES OF RECOGNITION OF REVENUE AND
2. MATCHING PRINCIPLES OF ACCOUNTING

WHY THIS EXCEPTION:
Since the project under long term is not possible to be completed within an accounting period,
general revenue recognition principles are not suitable to cope up with this problems which may
triggered a situation of booking & showing negative EPS in the initial years and subsequently
favourable EPS which may diverge the objective of comparativeness.
PERCENTAGE OF COMPLETION METHODS:










ER = Earned Revenue, CER = Cost of Earned Revenue
VALUATION ADJUSTMENT / WORK-IN-PROGRESS UNDER MATCHING PRINCIPLES
TURNOVER VS BILLING (Matching between Billing & Revenue):
Turnover > Billing: an asset called unbilled revenue
Turnover < Billing: a liability called pre-billed revenue
This assets / liability are called as work in progress & in BHEL-PSER its booked through valuation
adjustment a/c.
Suppose, actual cost incurred is 70, Revenue is 100 & corresponding billing in a period is 80, then
entries to be made as,
Account Description Debits Credits
1832 Debtors 80

1942 Valuation adjustment 20

4610 Sales

100


100 100



APPROACH I
REVENUE DRIVE COST
(Permissible under US GAAP)

Revenue on the basis of approved
physical measurement
APPROACH- II
COST DRIVE REVENUE
(Permissible both under US GAAP, IFRS &
Indian AS (Applicable for BHEL))
Revenue on the basis of percentage of cost
incurred out of total estimated cost
ER = TER * percentage of completion
by extent of progress
CER = TEC* percentage of
completion by extent of progress
PROFIT = ER - CER

ER = TER * percentage of completion
by cost-to-cost method
CER = actual cost incurred during a
period
PROFIT = ER - CER

Compiled by CA. Santu Dutta, Accounts Officer, BRPL & Kameng HEP site

Profit & Loss account



DEBIT SIDE CREDIT SIDE










******So, to maintain the matching principles of accounting, we must incorporate the actual billing
in our AS-7 MIR reporting every month/ annually & through valuation adjustment (WIP) this cash
basis of accounting has been converted to the accrual basis of accounting. This is important to
understand because, many of us, especially younger site finance has a little bit of confusion whether
we shall report the actual billing or an anticipated billing in the billing sheet under MIR. The guidance
as given by the EHQ from time to time to report by incorporating the anticipated billing for the
respective month is only for an hints to includes the actual billing to be made in the respective
periods. It doesnt in any way, means the inclusion of anticipated billing to fulfil the matching
principles. Many of us advocates that booking of GDPB is supports that billing should be on accrual
basis , but, this account is represent actual billing amount pending fulfilment of actual billing
formalities to the customer, that is preparation of invoices on the basis of engineers certificate,
which is as good as actual billing.

INHERENT ESSENCE OF PERCENTAGE OF COMPLETION METHOD:
For most of the contract for provision of related services to a buyers specifications, both the buyer
and the seller (contractor) obtain enforceable rights. The legal right of the buyer to require specific
performance of the contract means that the contractor has, in effect, agreed to sell his rights to
work-in-progress as the work progresses. This view is consistent with the contractors legal rights; he
typically has no ownership claim to the work-in-progress but has lien rights. Furthermore, the
contractor has the right to require the buyer, under most financing arrangements, to make progress
payments to support his ownership investment and to approve the facilities constructed to date if
they meet the contract requirements. The buyers right to take over the work-in-progress at his
option (usually with a penalty) provides additional evidence to support that view. Accordingly, the
business activity taking place supports the concept that in an economic sense performance is, in
effect, a continuous sale (transfer of ownership rights) that occurs as the work progresses. Also
under most contracts for the production of goods and the provision of related services that are
accounted for on the basis of units delivered, both the contractor and the customer obtain
enforceable rights as the services are performed. As units are delivered, title to and the risk of loss
on those units normally transfer to the customer, whose acceptance of the items indicates that they
meet the contractual specifications. For such contracts, delivery and acceptance are objective
measurements of the extent to which the contracts have been performed. The percentage-of-
completion method recognizes the legal and economic results of contract performance on a timely
basis. Financial statements based on the percentage-of-completion method present the economic
substance of a companys transactions and events more clearly and more timely than financial
statements based on the completed-contract method, and they present more accurately the
relationships between gross profit from contracts and related period costs. The percentage- of-
completion method informs the users of the general purpose financial statements of the volume of
economic activity of a company.



Actual
Cost



Actual Billing
PROFIT
Valuation
adjustment
Compiled by CA. Santu Dutta, Accounts Officer, BRPL & Kameng HEP site

ESTIMATE OF COST:
The nature of accounting for contracts is such that refinements of the estimating process for
changing conditions and new developments are continuous and characteristic of the process.
Revisions in revenue, cost, and profit estimates or in measurements of the extent of progress toward
completion are changes in accounting estimates and, as such, should be accounted for in accordance
with the applicable accounting standard (India AS-5, FASB Statement-3 under US GAAP & IAS-8
under IFRS) with the following two alternatives:
Cumulative Catch-up: Account for the change in estimate in the period of change so that the
balance sheet at the end of the period of change and the accounting in subsequent periods are as
they would have been if the revised estimate had been the original estimate.
Reallocation: Account for the effect of the change ratably over the period of change in estimate and
subsequent periods.
PROVISIONS FOR ANTICIPATED LOSSES ON CONTRACTS
When the current estimates of total contract revenue and contract cost indicate a loss, a provision
for the entire loss on the contract should be made. Consequently, the provision for loss should be
accounted for in the income statement as an additional contract cost rather than as a reduction of
contract revenue, which is a function of contract price, not cost. Provisions for losses on contracts
should be shown separately as liabilities on the balance sheet, if significant, except in circumstances
in which related costs are accumulated on the balance sheet, in which case the provisions may be
deducted from the related accumulated costs.
Emphasis has been drawn on the Para 36 of IAS-11 / Para 36 of Indian AS-11 (newly notified AS by
MCA) where it saying that when it is probable that total contract costs will exceed total contract
revenue, the expected loss shall be recognized as an expense immediately.

Illustration:
X Project has won a contract for 120 (contract price). Assuming its a no profit/loss contract.
N = 3 years (project completion time)
Sl No
PARTICULARS YEAR -1 YEAR -2 YEAR -3
A ACTUAL COST 24 80 16
B CUMULATIVE ACTUAL COST 24 104 120
C

ESTIMATED ADDITIONAL COST TO COMPLETE

72 26 0
D TOTAL ESTIMATED COST OF CONTRACT (B+C) 96 130 120
E PERCENTAGE OF COMPLETION (B/D) 25% 80% 100%
F CUMULATIVE REVENUE (120 * E) 30 96 120
G CURRENT REVENUE 30 66 24
H PROFIT (LOSS) (G-A) 6 (14) 8
Net Impact (Over the Period of Contract) is zero, which is at par with our AS-7 (BHEL PSER). But, on
an outset, its a violation of Para 36 of IAS-11/Indian AS-11. Here, in standing on Y2, our estimated
loss (130- 120) = 10, and remaining % = 20%, so immediate recognition of loss (10 * 20%) = 2.
Compiled by CA. Santu Dutta, Accounts Officer, BRPL & Kameng HEP site
Cross check:
Reversal of earlier profits (6) + expected loss (130-120) = loss of 16 (i.e., 14 + 2 = 16)
But, as far as my knowledge is concerned, we have provided, in our AS-7, for loss of Rs. 14, not for
Rs.16. It is not an acceptable logic that, we have provided the 2.5% of the CP as contractual
provision; its just a provision as per AS-29. It has nothing to do with the AS-7.

FIXED PRICE CONTRACT:
There was an amendment in the AS-7 through AS-7(R) in 2002, which is significant in this respect.
Old AS-7 was applicable for contractor as well as to enterprises undertaking construction activities
not as contractor but on their own account as a venture of commercial nature, real estate
enterprise. Whereas amended AS-7 is applicable only for construction contract. Standard setter has
come up with the newly issued Guidance Note (GN) to mitigate the difference of the treatment for
real estate developers.
Old AS: Profit is not recognized unless the work has progressed to a reasonable extent which is at
least 20 to 25% of the works.
Revised AS: It does not prescribe the extent of work which should be completed. It emphasizes the
need to estimate reliably the contract revenue and contract cost.
GN on real estate devel opers: emphasis the condition of 25% work completion as well as 10%
billing on customer.
BHEL perspective: now we can recognized the revenue for any state of completion for a project,
even if for a newly opened project where the work is only at the beginning stages.
SERVICE TAX TURNOVER:
As per Para 7 & 8 of IAS-18,
Revenue is the gross inflow of economic benefits during the period arising in the course of the
ordinary activities of an entity when those inflows result in increases in equity, other than increases
relating to contributions from equity participants.
So, Amounts collected on behalf of third parties such as sales taxes, goods and services taxes and
value added taxes are not economic benefits which flow to the entity and do not result in increases
in equity. Therefore, they are excluded from revenue.
Moreover, as per Expert Advisory Committee's opinion (1.34) on treatment of "sales tax collected on
sales -inclusion in the statement of P/L a/c", company has given an option to shown the sales figure
inclusive of sales tax & making a corresponding provision to the debit side of P/L a/c, thus, keep
intact the net figure in the revenue a/c. Though the above principle is solely on sales tax but keeping
in the mind the basic logic, our accounting process has been framed, whereby we are booking the
service tax as revenue through CH-4640.





Compiled by CA. Santu Dutta, Accounts Officer, BRPL & Kameng HEP site
Future of accounting as per proposed Exposure Draft (ED) as issued by IASB
(International accounting standard board)
History:
In 2010 IASB through Discussion Paper (DP) first made an attempt to amend the present standard to protect the
interest of stake holders, users of financial instruments as felt after the financial crises as followed in 2008 through
Goldmann Sach & simultaneous EURO zone crises. Subsequently, in 2011, both IASB & FASB (Financial Accounting
Standard Board US GAAP authority) revised its ED & make an attempt to converge their respective proposal into a
single path, which will get the birth of new standard in the next year.

The CORE PRINCIPLE of the revenue recognition model is that a vendor should recognize as revenue the amount that
reflects the consideration to which the vendor expects to be entitled in exchange for goods or services when it transfers
control to the customer.
Para 14 of the ED prescribe certain parameters, basically conditions for actual delivery / providing of services viz., whether
buyer will take the delivery of the goods, its past records of acceptance of the contract etc., fulfilment of which ED will be
applicable.

If the above condition, as enumerated in the Para 14 are not being made, accounting treatment shall be as below:
a) The consideration which so received is to be booked as revenue.
b) Entity shall derecognise any assets in the contract & recognised a new asset (Restricted assets) for the same.
c) The amount so received shall be deducted from the recognised asset & entity shall apply the paragraph 14 every
year & see whether the conditions are fulfilling or not.
Although, in the ED as well as staff paper as published by IASB, its not mentioned about the applicable scenario, but one can
presumed that it is for the cases of instalment sales accounting, which is not very interesting for BHEL peoples.

Example: A is a dealer of car (so, cars are an inventory items rather than an assets for a) & its business includes instalment
sales by paying 10% of its offer price. Customer B goes for that type of a car whose price is, suppose, Rs. 1 lac and the cost of
the same in hands of A is suppose, Rs. 80,000. The terms of payment includes a down payment of Rs. 10,000 & balance
payable in subsequent 2 years. The entity A has every right to reposed the title of the car till customer makes full payment.
From the past trends, especially the types of customer & its level of earning, A has made an assessment that contract may
get quashed due to non payment of balance instalment (90%).

Accounting as per Para 14 of the ED:
Date Particulars Debits Credits Remarks
1 Right to received (asset) 80000 Recognition & derecognition of asset subject
to restriction i.e., cost of the same.
Derecognised Asset (car) 80000

2 Bank 10000 Initial payment deducted from recognised
asset
Right to received (asset) 10000

3 Inventory / cost of goods sold (ca 10000 Recognition of revenue & matching its same
through cost of goods sold
Revenue 10000
Note: even if the customer paid entire amount of price the derecognised assets (stock) will be unchanged & its only
impacted through recognised asset named as Right to receive. Neither ED nor the staff paper has mentioned about the
debit entry for recognised revenue & we need to interpret that revenue can be matched through only by corresponding
expenditure booking & thus cost of goods sold.

Five-step model (as proposed in ED) on recognition of revenue:

1) Identification of contract with a customer;
2) Identification of separate performance obligations;
3) Determination of transaction price;
4) Allocation of transaction price to the separate performance obligations; and
5) Recognize revenue as and when the vendor satisfies a performance obligation.









Compiled by CA. Santu Dutta, Accounts Officer, BRPL & Kameng HEP site
Identification of contract:
Contract defines enforceable rights and obligations which can be enforceable by law and company must consider the
customary business practice & respective state laws in this respect.
Example:
A vendor receives a purchase order from a customer and the goods are shipped to the customer free on board
(FOB) shipping point before year-end, the vendor does not recognize revenue until a written sales agreement is

finalized with the customer if that is the vendors customary business practice. Under the proposed standard,
assuming control of the goods has been transferred to the customer, if the placement of the customer order and
shipment of the product constitute an enforceable legal contract, revenue would be recognized at the time of
shipment.
In case of foreign projects, co may not recognised revenue only on the basis of issuance of purchase order, if, it
does not constitute an enforceable law of that country. So, recognition of revenue shall be dependent on the basis
of respective law under which contract can be enforceable.

Identification of separate performance obligations:
Means obligation on the part of the contractor to perform its obligation i.e., transferring the goods or services to the
customer.
A promised good or service would be distinct, i.e., separate performance obligation, if:
(a) The vendor regularly sells the good or service separately, or
(b) The customer can benefit from the good or service either on its own or together with other resources that are readily
available to the customer. Readily available resources are goods or services that are sold separately by the vendor or by
another vendor or resources that the customer already has obtained from the vendor or from other transactions or events.
Implication on BHEL/ Example:
Suppose, customer has to offer two kinds of services, erection & commissioning of its New Captive Power Plant ( CPP) &
performance guarantee/ warranty services for its other Old Captive Power Plant ( CPP) to BHEL/PSER, as its followed in BRPL
site.
Situation I:
The activities at two CPP areas are totally independent & erection & commissioning of New CPP has nothing to do with
annual warranty services at Old CPP area. The two kinds of services are a separate performance obligations & we must
account for these two separately.
Situation II:
Because of its drawings specification (technical specification) warranty services cannot be started unless & until New CPP are
commission & power generation started. Thus, the E&C and warranty services are combined into a single performance
obligation under the proposed draft.

Implication on servicing warranties:
If a customer has the option to purchase the warranty separately, the vendor would account for the warranty as a separate
performance obligation because the vendor promises to provide a service to the customer in addition to the product or
service. Thus, the vendor would allocate a portion of the transaction price to the performance obligation for the warranty
service.
Implication on BHEL/ Example:
Taking on the same example on warranty of power plant contract in addition to general E&C as awarded to us by customer.
Total contract price, suppose, Rs. 1,00,000. Based on the past practice or company policy, we determined that 2.5% of the
Rs. 1,00,000 will be our cost of warranty.
BHEL /PSER have to recognise the revenue Rs. 97,500 over the contract period & Rs. 2,500 as & when we perform/ fulfil the
performance obligation of warranty. So, our AS-7(E&C) should recognised the revenue only for Rs. 97,500 over the period of
contract as turnover & balance revenue from servicing will be recognised only on completion of warranty period, unless
further micro breakup is there in the contract for warranty services.

This has a legitimated impact over the current accounting practice of recognition of provision by 2.5% for contractual
obligation on the cost to cost basis and booking revenue for the full value (provision adjacent to the revenue in the income
statement) and thus, by introduction of IFRS, our turnover/revenue will be drag down.

Determination of transaction price:

The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring
promised goods or services to a customer, excluding amounts collected on behalf of third parties (for example, sales taxes).

So, the transaction price does not include the effects of the customers credit risk, unless it depicts the significant
financial components.
Tax collected on behalf of exchequers are not revenue, which has already pointed out resulting a difference between
present BHEL practice of booking through CH-4640 & international standard.
But includes the concept of variable consideration (discount, price concession, rebate & other losses) under
transaction price.



Compiled by CA. Santu Dutta, Accounts Officer, BRPL & Kameng HEP site
Variable consideration:

The boards tentatively agreed that in contracts with variable consideration, an entity would recognize revenue by estimating
the consideration to which it is entitled and potentially adjusting that amount in accordance with the proposed
constraint guidance.
Under the constraint guidance, if the estimated consideration is subject to significant reversal, revenue would be recognized
on the basis of the minimum amount of consideration that would not result in a significant revenue reversal. The entity

would subsequently true up (not true down adjustment) the amount of revenue recognized on the basis of its estimate of
the minimum amount each period.

Implication on BHEL/ Example:
BHEL has taken up a contract for turnkey project for an amount of Rs. 100 (assumption price). The contract, as usual with
existing provision, has the provision of either LD or APR or any other types of reduction mechanism of contract price by
whatever named called (variable consideration). Assume, that percentage, on the basis of estimated as made by the
management, is 10%. By this estimation , BHEL has to recognised revenue only to the extent of 90%, but only if,
management concludes, on the basis of the factors listed in the proposed guidance, that subsequent changes in the
expected amount of variable consideration will not result in a significant revenue reversal ( i.e., ultimate collection should
not be less than 90).
But, on the other hand, if, management estimate that subsequent changes in the expected amount of variable consideration
can result in a significant revenue reversal, then, we have to book the revenue equal to minimum amount of variable
consideration that would not result in a significant revenue reversal. The minimum amount could be, by management
estimation, equal to 80 or 70. So, logically, our AS-7s scope with customer column will not fixed but variable.

Time Value of Money:
It is included in the estimation of the transaction price if the contract has a financing component.
Factors to be considered includes, but not limited to, the followings:
(a) The expected length of time between when the vendor transfers the promised goods or services to the customer and
when the customer pays for those goods or services, which , as per proposal is one year.
(b) Whether the amount of customer consideration would differ substantially if the customer paid cash promptly upon
transfer of control of the goods or services under the typical credit terms in the industry and jurisdiction; and
(c) The interest rate in the contract and prevailing interest rates.

BACKGROUND:
The Boards note in the Basis for Conclusions (BC Para) that in some circumstances, a payment in advance on terms that are
typical for the industry and jurisdiction may have a primary purpose other than financing.
For example, in BHEL, customer pays an advance payment on fulfilment of certain milestone such as kick off meeting
between BHEL & customer and in some cases, on mobilisation of manpower & materials at site. The primary purpose of
these payment terms may be to provide the customer with assurance that the vendor will perform its obligations under the
contract rather than provide financing to the customer. The Boards explicitly considered advance payments received by a
vendor for reasons other than financing, such as compensating the vendor for incurring upfront costs, but decided not to
exempt entities from accounting for the time value of money effect of advance payments. So, the conclusion is, BHEL has
also to account for the impact of time value of money in measuring transaction price.

Implication on BHEL/ Example:
BHEL enter into E&C contract (EPC) with a customer for 100 lakhs, with a payment terms of mobilisation & kick off advance
of Rs. 20 lakhs (20%) and accounted for under a single performance obligation. The tenure of the contract is, suppose, three
years.
The terms of this advance payment are such that when BHEL raises invoices progressively over the contract period as the
services are being provided (and as the performance obligation is progressively satisfied), 20% of the invoice amount is
considered to be settled from the advance payment. The customer is required to pay the remaining 80% of the invoice at or
near the time services are transferred to the customer.

Period Particulars Debits Credits Remarks
Y0 Bank 20
Advance Payment
(liability)
20 Deviating the current practice of
booking revenue for advance payment
rather booking through liability

Suppose, in Y-0 end, BHEL has raised an invoice for Rs. 10 lac, then, accounting entry will be :
Y0 end Debtors 8
Advance adjustment 2
Revenue / turnover 10


At the end of YO, BHEL has to charge interest on remaining unadjusted advance portion (6% on Rs. 18 lac)
Y0 end Interest 1.8 And this interest portion
simultaneously booked through
revenue
Advance Payment 1.8

Y0 end Advance 1.8
Revenue 1.8
So, net amount booked in profit & loss account will be 10 but bifurcating between credit side by 11.8 & debit side by 1.8 lac
through interest expenditure.
By this way, every year we have to book the interest expenditure in the current earning & simultaneously booking it through
turnover.

Allocate the Transaction Price to the Separate Performance Obligations
Vendor (BHEL) would allocate the transaction price to all separate performance obligations in proportion to the standalone
selling price of the services (E&C services).
From the business practice & management assessment of BHEL, it can be construed that PSER has business in the range of
installation & commissioning and performance guarantee services to its customer, which are separate performance
obligation as per proposed standard. Even though the contract price is farm & it includes guarantee apart from regular E&C
services, we need to bifurcate the total contract price between E&C services & guarantee services (two separate
performance obligation). From PSER business practice & commercial data, the regular guarantee services are being offered
to its customer, for 500 MW super critical projects, at a price of Rs. 10 lakh p.a. (assumption figure) and offer price for 500
MW E&C contract is RS. 450 lakhs.
Now, suppose, BHEL has got the contract of 2X500 MW E&C and guarantee/ maintenance services for two years after its
successful commissioning. Total Contract price is for Rs. 1000 lakhs.
As per proposal we have to bifurcate the total contract price of RS. 1000 Lakhs into E&C and guarantee services.

Performance
obligation
Stand alone selling
price
Ratio Price allocation
2x 500 MW E&C
services
900 97.83% 978.3 Lac
guarantee/ maintenan
services
20 2.17% 21.7 lac
TOTAL 920 1000 lac

So, we have to recognised revenue of Rs. 978.3 lac over the original contract terms (E&C services only) as per our extent
practice & balance amount of Rs. 21.7 lakhs only upon the satisfaction of guarantee / maintenance services are over , unless
otherwise established.

Recognize revenue as and when the vendor satisfies a performance obligation:
A vendor would recognize revenue when (or as) it satisfies a performance obligation by transferring control of a good or
service (i.e., an asset) to a customer.
A vendor first would determine whether the performance obligation is satisfied over time (BHEL PSER case) or at point of
time when customer obtains the control over the goods or services (BHEL manufacturing units).
The compliance of this condition is same as per present practice followed by BHEL (Our AS-7 factor based revenue
recognition practice as at par with the proposal).

There are numerous proposal which will be diverted our existing practice of revenue recognition principles into
modification or amendment of accounting principles that will be discussed in later.