Under the new Ind AS 115, construction contract is treated exactly the same way as any other contract with customers.
As per Para 9 of Ind AS 115
‘An entity shall account for a contract with a customer that is within the scope of this Standard only when all of the following criteria are met:
(a) the parties to the contract have approved the contract (in writing, orally or in accordance with other customary business practices) and are committed to perform their respective obligations;
(b) the entity can identify each party’s rights regarding the goods or services to be transferred;
(c) the entity can identify the payment terms for the goods or services to be transferred;
(d) the contract has commercial substance (ie the risk, timing or amount of the entity’s future cash flows is expected to change as a result of the contract); and
(e) it is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer. In evaluating whether collectability of an amount of consideration is probable, an entity shall consider only the customer’s ability and intention to pay that amount of consideration when it is due. The amount of consideration to which the entity will be entitled may be less than the price stated in the contract if the consideration is variable because the entity may offer the customer a price concession’
Moreover as per para 35
‘An entity transfers control of a good or service over time and, therefore, satisfies a performance obligation and recognises revenue over time, if one of the following criteria is met:
(a) the customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs;
(b) the entity’s performance creates or enhances an asset (for example, work in progress) that the customer controls as the asset is created or enhanced; or
(c) the entity’s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date.’
If we try to understand the above paras, we may in short divide concept as under
1. Firstly we need to Identify contract with the customer;
Let's say a builder sold a flat to a customer when the construction has just begun for Rs.2 crore of which he has paid Rs.40 lakhs as down payment and have entered into agreement to sale, which defines how future payments will be made at what level of activity.
So the above point satisfies para 9 criteria of the approved contract
2. Identifying the performance obligations in the contract;
As per para 9 (h) ‘Depending on the contract, promised goods or services may include, but are not limited to, the following …
(h) constructing, manufacturing or developing an asset on behalf of a customer;’
Most construction contracts will contain just ONE performance obligation, because the contract would be to build or construct something for the customer and is negotiated as a whole package where a customer has no choice than to get the full package from the supplier.
Sometimes it’s not true and you will have TWO or more performance obligations there, for example purchase and installation of a lift by the builder
3. Determining the transaction price;
The transaction price in our case is Rs.2 crore. It may sometime be variable and need to be found on probability basis
4. Allocating the transaction price to the performance obligations in the contract;
As per para 39 ‘For each performance obligation satisfied over time in accordance with above paras, an entity shall recognize revenue over time by measuring the progress towards complete satisfaction of that performance obligation. The objective when measuring progress is to depict an entity’s performance in transferring control of goods or services promised to a customer (ie the satisfaction of an entity’s performance obligation)’
So in our example transaction price shall be allocated to each completion event defined in agreement to sale according to which the demand of payment can be made by the builder. Suppose 10% payment to be made on completion of construction of each floor. So a demand of Rs.20 lakhs can be made on completion of each floor
5. Recognizing revenue when an entity satisfies a performance obligation.
One can use either input or output methods to measure the progress towards completion.
In our example we are considering agreement to sale as the base as there may be no direct relationship between your inputs and the transfer of control of goods or services to a customer.
Therefore, one should exclude the effects of any inputs from input method that do not depict performance in transferring control of goods or services to the customer
So revenue to be recognized if 3 floors are completed during the current financial year and assuming agreement to sale amount of Rs.40 lakhs relates to plinth level.
Revenue to be recognized:
Plinth = Rs.40 lakhs
First floor completion = Rs. 20 lakhs
Second floor completion = Rs.20 lakhs
Third floor completion = Rs.20 lakhs
Total = Rs. 100 lakhs
Journal entries for the above
Debit Inventories: 100 lakhs
Credit Customer: 100 lakhs.
Labor costs, materials, etc. to complete the contracts are accounted for as contract costs (at the time when they are actually incurred):
Debit Contract costs (asset in balance sheet)
For the end of financial year, builder needs to amortize the contract costs based on progress towards completion.
As the progress is measured by input method (incurred costs), all costs incurred to date are amortized.
However if a different method is used to measure the progress to completion, then the company amortizes the cost based on the progress percentage.
Journal entry would be as follows:
- Debit Cost of construction in profit or loss
- Credit Contract costs
This is basically the method one should follow when accounting for your construction contracts.
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