1.29     Query

Profit accounting of mining contract works-in-progress.

1.A company, primarily a gold mining concern, having expertise in sinking, equipping and otherwise bringing new mines into production stage, undertakes the contracts of sinking mines, lining, equipping, etc., on commercial basis and handing over to the clients. These contracts generally extend between 1 year to 4 years and some times even more. The company undertakes broadly three types of contract works for clients both in public and private sectors, viz.;

                        (i) Cost plus contracts.

(ii) Fixed value contracts with in-built escalation clauses for materials, labour and other occurrences of foreseeable nature, not covered in scope of work.

(iii) Work sharing contract with a company ‘X’ in its exploration work.

2.The accounting policy presently followed by the company is extracted below. According to the querist, it is more or less in line with profit accounting for contracts as propounded by authors of text books on the subject:

“Value of contracts executed is to the extent certified. Income from Project & Contracts is accounted after retaining 25% of the profit on works exceeding 50% progress and retaining full profit on works where progress is less than 50% in respect of fixed rate contracts. Income from cost plus contracts is fully accounted.”

3.The querist has sought the opinion of the Expert Advisory Committee on the existing accounting policy followed by the company and as to whether the company should adopt Accounting Standard (AS) 7 on ‘Accounting for Construction Contracts’, issued by the Institute of Chartered Accountants of India.

4.The main features of the existing procedure and AS 7, as per the querist, are tabulated in Annexure attached.

5.The querist has also stated that the following special features of a typical mining contract work distinguish it from civil construction jobs and are to be reckoned in choosing a method which will satisfy to the maximum extent the cardinal object behind AS 7, i.e., the future contingencies of likely losses be taken care of as far as possible while accounting profit at intermediate stages of execution of work. The querist has also stated that the following facts read alongwith the information given in the Annexure, weigh in favour of continuing the existing procedure, as it takes care, if not more, of future contingencies:

(a) Unlike civil contract works where conditions to be encountered are always in view and very much within foreseeable parameters including the seasonal setbacks, with regard to mining contracts the condition that will exist as the work progresses deeper and deeper or horizontally in different directions underground, are difficult to forecast with adequate accuracy either at the beginning of contract or during various stages of execution. Thus, saving in cost or cost-over-run on this account is known only at that point of time and not sufficiently in advance. Generally, after inspection of the site and by use of data, if available with the client, as regards to conditions encountered in nearby excavations, requirements of input are made and costed while quoting. These may or may not prevail during the whole course of work. For example, if hardrock situation emerges unexpectedly during execution of a portion of work, the requirement of mechanical/electrical aids would be more pronounced than in normal conditions. Conversely, hardrock situation may occur in patches only where it was anticipated to be continuous. Cost structure will undergo radical changes in all these cases. It also depends upon the extent to which these are covered in agreement for additional reimbursement.

Quantities under various items of work carrying different margins of profit are likely to vary from estimates which will have a bearing on the profit position. These will not be known in advance. This situation generally does not arise in civil construction works.

(b) Secondly, while quoting for the contract work, tenders are submitted strictly in line with the client’s documents which call for only operation-wise rates and not stage-wise, i.e., first 100 meters, next 100 meters, etc. and so on. For this, the total input in financial terms in the form of manpower and machines, expected period of their deployment, materials, power and other infrastructural needs are evaluated and items of work mentioned in clients’ bill of quantities are so rated as to recover the total cost of such inputs plus desired percentage of profit for the whole work.

(c) Estimation of future cost based on past parameters may not be correct either way, since conditions are bound to vary.

(d) While drawing up the agreement, adequate provision is made by way of in-built clauses for possible types of situations and escalation for increase in cost of major inputs like materials, manpower etc., wherever possible. The agreement also provides for mutually agreed rates for new items of work. Therefore, incurrence of unprovided cost will be confined mainly to events which are beyond forecast even at latter stages in work execution.

(e) Generally, what could be foreseen is that during winding up, i.e., when work has to be handed over after client has satisfied himself in all respects and odd jobs are to be done, costs are bound to exceed income, if any. This will be amply taken care of by the reserve built-up out of profit.

(f) From the statutory auditors’ point of view, accepting a future estimate which is not verifiable from any data nor can be disputed, gives an element of indefiniteness to the whole issue of certification. It is also felt that recognising a future loss before it is incurred does not appear correct in preference to a general reserve made as a policy.

                                                                                                   Opinion                                         March 29, 1990

1.The Committee notes paragraphs 2 and 3 of the Accounting Standard (AS) 7, on ‘Accounting for Construction Contracts’, issued by the Institute of Chartered Accountants of India, which state as below:

“2. The feature which characterises a construction contract dealt with in this Statement is the fact that the date at which the contract is secured and the date when the contract activity is completed fall into different accounting periods. The specific duration of the contract performance is not used as a distinguishing feature of a construction contract. Accounting of such contracts is the process of measuring the results of relatively long-term events and allocating those results to relatively short-term accounting periods.

3. For the purposes of this statement a construction contract is a contract for the construction of an asset or of a combination of assets which together constitute a single project. Examples of activity covered by such contracts include the construction of bridges, dams, ships, buildings and complex pieces of equipment.”

2.The Committee notes from the facts of the query that the contracts referred to above have the following two characteristics:

(i) The contracts relate to the job of sinking mines, lining, equipping etc., on commercial basis and handing over to the clients.

(ii) The jobs extend from one to four years or even more.

The Committee is therefore, of the opinion that AS 7 would be applicable to these contracts in view of paras 2 and 3 of AS 7 reproduced above.

3.The Committee notes that the company in question is following percentage of completion method. With regard to this method, the Committee notes that AS 7 recommends as below:

“17. The percentage of completion method can be used if the outcome of the contract can be reliably estimated.

                        17.1     In case of fixed price contracts, the degree of reliability would be provided if the following conditions are satisfied:

                                    (i)            total contract revenues to be received can be reliably estimated;

(ii) both the costs to complete the contract and the stage of contract performance completed at the reporting date can be reasonably estimated; and

(iii) the costs attributable to the contract can be clearly identified so that the actual experience can be compared with prior estimates.”

17.2 Profit in the case of the fixed price contracts, normally should not be recognised unless the work on a contract has progressed to reasonable extent.

17.3 In the case of cost plus contracts, the degree of reliability would be provided only if both the conditions are satisfied:

                                    (i)            costs attributable to the contract can be clearly identified; and

(ii) costs other than those that are specifically reimbursable under the contract can be reliably estimated.

17.4 While recognising the profit under the percentage of completion method, an appropriate allowance for future unforeseeable factors should be made either on specific or percentage basis.”

4.The Committee notes from the above that as per AS 7 the percentage of completion method can be used if the outcome of the contract can be reliably estimated. The Committee further notes that the substance of the arguments advanced by the querist relates to lack of reliability of estimation of costs etc., pertaining to the contract activity in question. The Committee is, therefore, of the opinion that in case the conditions specified in para 17.1 and 17.3 with regard to fixed price contracts and cost plus contracts, respectively, are not met, the company should not follow the percentage of completion method, but should follow the completed contract method.

5.The Committee wishes to point out that estimation is inherent in the percentage of completion method. Also, the extent of ‘reasonableness’ as envisaged in AS 7 is to be determined with reference to every contract as all contracts carried out even by the same contractor may be different and the nature of contracts carried out by different contractors may differ substantially. The problems of estimation and reasonableness envisaged by the querist in application of AS 7 (as per the Annexure) may justify the non-adoption of percentage of completion method but not the non-adoption of AS 7. The value of work completed is arrived at on the basis of various factors for measuring the stage of completion as illustrated in Para 9.2 of AS 7, which is reproduced below:

“9.2            The stage of completion used to determine revenue to be recognised in the financial statements is measured in an appropriate manner. For this purpose no special weightage should be given to a single factor; instead, all relevant factors should be taken in to consideration; for example, the proportion that costs incurred to date bear to the estimated total costs of the contract, by surveys which measure work performed and completion of a physical proportion of the contract work.”

The Committee is of the view that value of work certified could be considered as one of the factors for measuring the stage of completion. Therefore, it would not be correct as argued by the querist that AS- 7 does not recognise value of work certified at all.

ANNEXURE

PROFIT ACCOUNTING OF MINING CONTRACTS

(as per the querist)

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