Two day Conference by CTC on TAX & ALLIED ASPECTS OF CONSTRUCTION INDUSTRY

Accounting Standards
Applicable to Construction Industry
Downloaded from www.taxpertindia.blogspot.com
By

Jayant Gokhale, FCA

8th Jan 2010 Jayant Gokhale FCA 1

Standards applicable to construction activities

Construction industry can be broken up into

Construction Developers Builders

contracts

Leaving out the non-commercial players such as

Sellers of property & Those subject to capital gains etc. Those letting out property

8th Jan 2010

Jayant Gokhale FCA

Standards Applicable
to 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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Jayant Gokhale FCA

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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Jayant Gokhale FCA

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 " construction contract".

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 the accounting 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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Jayant Gokhale FCA

Construction Contracts

AS 7 Provides

Meaning of a construction contract [#2] a contract specifically negotiated 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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Jayant Gokhale FCA

Recognition of Contract Revenue and Expenses

Revenue and contract costs should be recognised when the outcome can be estimated 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 completion, and the costs to complete the contract. [#21 & 22] 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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Jayant Gokhale FCA

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 necessarily reflect the work performed.

DISCLOSURE

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amount of contract revenue recognised; method used to determine revenue; method used to determine stage of completion; and aggregate costs incurred and recognised profit amount of advances received amount of retentions
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For contracts in progress at balance sheet date:

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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Jayant Gokhale FCA

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 has transferred to the buyer the property in the goods for a price 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 Estate IFRIC 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 66
Financial 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 sellers 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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AS 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 applied in accounting for 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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Jayant Gokhale FCA

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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 Exchange Rates (revised 2003)

Effect of FDI financed projects Applicability of IAS, FASB, transfer pricing Impact on chargeable profits & inventory

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THANK YOU
Jayant Gokhale FCA

8th Jan 2010

Jayant Gokhale FCA

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