In this article, Gaukhar Narbekova, Partner of MinTax Group, Director of the Audit Department, describes the procedure for the presentation of transactions under long-term contracts in the accounting and tax records using an example taken from practical experience in the course of rendering audit and consulting services to organizations providing services to subsoil users.

In connection with the entry into force of the new IFRS[1] 15 “Revenue from Contracts with Customers”, accountants often ask questions about changes in the accounting treatment for transactions related to production and construction, the duration of which exceeds one reporting period, i.e. long-term contracts.

For example, an entity provides services and performs construction operations for organizations working in the oil and gas industry, which include logging, gas logging, well drilling, etc. Some contracts may be for turnkey well drilling, that is, for a full cycle of well construction at the customers’ territory.

So, the contracts are classified as long-term ones, that is, the construction of a well begins in one reporting period and ends in the next period.

Let’s consider an example of a long-term contract signed in July 2018 for the construction of XX-7 well, under which operations are supposed to be completed by September 2019. The Customer controls the performance of work, the well is located in the territory, which belongs to the Customer on the right of ownership.

According to the contract, the Contractor undertakes to perform and complete the work within the following deadlines:

–  to install special equipment by October 20, 2018;

– to reach a well depth of up to 2,000 meters by December 31, 2018;

– to complete well drilling at a depth of 4,100 meters and deliver the well to the Customer by April 15, 2019.

The cost of work under the contract is CU 3,792,500.  The interim payments are made in stages:

– after equipment installation CU185,000

– on reaching a well depth of 2,000 meters –   CU 600,000.

– on well commissioning and reaching a well depth of 4,100 meters – CU 3,007,500.

Actual costs under the contract comprised: CU 1,120,000 in 2018; CU 3,067,500 in 2019. In fact, the contract is unprofitable.

The following questions are often asked in connection with the accounting treatment:

• What is the right way to account for the costs arising from this contract and other long-term contracts during their performance (to recognize as future costs or as current costs) and how should they be reflected in financial and tax reports?
• If the contract is unprofitable, and the company recognizes tax income in the amount of expenses incurred – is it possible to further adjust the income for the amount actually received?
• What is the proper way to present income and expenses on long-term contracts in accounting and tax records, in particular – in the CIT[2] declaration?

Conclusions and justifications:

1. In accordance with paragraph 4 of Article 663 of CCRK[3], delivery of the work results by the contractor and acceptance of them by the customer shall be formalized by an act, signed by both parties, In case of failure of one party to sign the act, it is marked about this and shall be signed by the other party. An unilateral act of delivery or acceptance of the results of work can be recognized by a court as valid, only if the reasons for the refusal to sign the act were recognized unreasonable by the court. That is, if the customer proves to the court that he objectively could not sign the act, then the court will recognize the unilateral signing as invalid.

According to IFRS 15 ‘Revenue from Contracts with Customers’, an entity shall recognize revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service (ie an asset) to a customer. An asset is transferred when (or as) the customer obtains control of that asset.

For each performance obligation satisfied over time in accordance with paragraphs 35-37 of IFRS 15 ‘Revenue from Contracts with Customers’, an entity shall recognise revenue over time by measuring the progress towards complete satisfaction of that performance obligation.  The objective when measuring progress is to depict the entity’s performance in transferring control of goods or services promised to a customer (ie the satisfaction of the entity’s performance obligation).

An entity shall apply a single method of measuring progress for each performance obligation satisfied over time and the entity shall apply that method consistently to similar performance obligations and in similar circumstances.  At the end of each reporting period, an entity shall remeasure its progress towards complete satisfaction of a performance obligation satisfied over time.

There are two methods of measuring progress: the output method and the input method. Previously, such methods were referred to respectively as income method and expense method.

If the output method is applied, one can use a criterion which is a condition from the contract in the described example where three work stages are specified:

1)  installation of the machine;

2)  drilling to a well depth of 2,000 meters;

3)  drilling to a well depth of 4,100 meters;

Output methods recognise revenue on the basis of direct measurements of the value to the customer of the goods or services transferred to date relative to the remaining goods or services promised under the contract.  Output methods include methods such as surveys of performance completed to date, appraisals of results achieved, milestones reached, time elapsed. When a contractor evaluates whether to apply an output method to measure its progress, he shall consider whether the output selected would faithfully depict the contractor’s performance towards complete satisfaction of the performance obligation.

Input methods recognise revenue on the basis of the entity’s efforts or inputs to the satisfaction of a performance obligation (for example, resources consumed, labour hours expended, costs incurred, time elapsed or machine hours used) relative to the total expected inputs to the satisfaction of that performance obligation.

If the contractor’s efforts or inputs are expended evenly throughout the performance period, it may be appropriate for the contractor to recognise revenue on a straight-line basis.

Usually contractors choose the output method.

Thus, in this case, the performance obligation was satisfied on 31 December 2018 if the well drilling depth of 2,000 meters was reached. Therefore, revenue (income from work performed) is recognized in the amount of payments received as per the contract terms at that date, that is, in the amount of interim payments equal to KZT 240,500 + KZT 74,000 = KZT 314,500 thousand.

According to Article 282 of the Tax Code[4], a long-term contract is a contract (agreement) for production, installation, construction, which is not completed within the tax period in which the production, installation, construction under the contract began. Income under a long-term contract is determined using either the actual method or completion method, at the choice of a taxpayer, separately for each long-term contract. A method chosen for determining income is indicated in a tax register intended for reflecting the methods applied on each long-term contract, and cannot be changed during the effective period of the long-term contract. Without such a tax register or information in it on the method chosen, the actual method is recognized as the chosen one.

Thus, for CIT purposes, the taxpayer is obliged to choose a method for determining income from the proposed options. In this consultation we assume that the actual method has been selected.

Pursuant to paragraph 1 of Article 283 of the Tax Code, in the case of the actual method, income receivable (received) for the reporting tax period, but not less than total costs incurred for the same period under the long-term contract, shall be recognised as income under the long-term contract for the reporting tax period. If during the effective period of the long-term contract income under such contract defined according to paragraph 1 of this Article exceeds the total amount of income under the long-term contract defined for its entire effective period, the following shall be recognized as income under the long-term contract:

1) in the tax period in which such an excess occurred – income in the amount of the positive difference between the total amount of income under the long-term contract, determined for its entire period and the amount of income under such contract included in the aggregate annual income in the previous tax periods of the long-term contract;
2) in the subsequent tax periods of the long-term contract – an amount equal to zero.

Thus, due to the fact that expenses incurred by the taxpayer in 2018 exceeded the revenue to be recognized for this period in accordance with IFRS, the amount within the limits of incurred expenses, i.e. KZT 448,000 thousand, should be recognized as income for tax purposes in 2018.

That is, the given long-term contract should be recognized as follows in accounting and tax records, in the conditional units (CU):

Financial Accounting	2018	2019	Total
Income	786,250	3,006,250	3,792,500
Expenses	1,120,000	3,067,500	4,187,500
Result	-333,750	-61,250	-395,000

 

Tax Accounting	2018	2019	Total
Income	1,120,000	3,792,500-1,120,000= 2,672,500	3,792,500
Expenses	1,120,000	3,067,500	4,187,500
Result	0	-395,000	-395,000

According to the Standard Chart of Accounts[5], account 1730 “Current assets under contracts” is used to account for contracts with customers.

Therefore, expenses incurred should be accumulated on account 1730 up to the revenue recognition, that is, expenses incurred should be booked as Dr 1730 Cr 3310, 3350, 3100, 3200.

Upon recognition of the relevant income:

Dr 1210 Cr 6010 recognizing income corresponding to IFRS

Dr 7010 Cr 1730 writing off the period’s expenses.

In tax accounting, in the CIT declaration, expenses deductible in accordance with Articles 282-283 of the Tax Code should be presented under the relevant deduction items to book expenses on goods, works and services sold, on accounts 3310, 3350, taxes, etc. respectively.

2. According to Article 299 of the Tax code, a loss from entrepreneurial activity is recognized as an excess of deductions over aggregate annual income, subject to adjustments provided for in Article 241 of the Tax Code.

In the meantime, according to paragraph 1 of Article 300 of the Tax code, losses from entrepreneurial activity, as well as losses from the disposal of fixed assets of group I and losses from the sale of construction in progress, uninstalled equipment, except for assets purchased for state needs in accordance with the laws of the RoK are carried forward for the coming ten years inclusively, to cover them from taxable income of these tax periods.

Thus, the tax loss representing a loss from entrepreneurial activity, in particular – an excess of deductions over the aggregate annual income, taking into account all adjustments, including those due to a loss incurred under a long-term contract, should be carried forward for the next ten years.    

Income and expenses under a long-term contract are booked on accounts 6010 and 1730, as we mentioned above.

In tax accounting, income is presented in the ‘sales revenue’ line, and deductions in the corresponding expense items: expenses on goods, works and services sold (purchased works, services, wages, taxes and other expenses).

We hope that this article will be useful to accountants and tax specialists who have encountered problems in booking transactions under long-term contracts.

This material is subject to copyright. Reprinting and other use is prohibited by the copyright holder. This material expresses the author’s opinion and is a recommendation. This material is based on regulatory legal acts in force at the time of publication.

[1] International Financial Reporting Standard.

^[2] Corporate Income Tax.

[3] Civil Code of the Republic of Kazakhstan (Special part), as amended at October 6, 2020.

^[4] Code of the Republic of Kazakhstan No 120-VI dated 25 December 2017 “On Taxes and Other Obligatory Payments to the  Budget (Tax Code)”.

[5] Order of the Minister of Finance of the Republic of Kazakhstan No 185 dated 23 May 2007 “On approval of the Standard chart of accounts”.