1.7 Query: Determination of cost of work-in-progress of consultancy projects.
1. A Government company is a consultancy and engineering organisation engaged in design, procurement, project management, technical and consultancy services for petroleum projects, refineries, oil fields, gas pipelines, petrochemical etc. The company undertakes purely consultancy projects in these areas. The company is not involved in fabricating any equipment. A project takes about 3-4 years for completion.
2.During the course of audit of the accounts of the company for the year 1989-90, the office of the Member, Audit Board and Ex-officio Principal Director, Commercial Audit, New Delhi, has expressed reservations with regard to treatment adopted by the company in the accounts in respect of work-in-progress and had suggested alternative course for future compliance. The treatment adopted by the company in the accounts and remarks of the Member, Audit Board, are given in the following paragraphs.
3. The company is following the undernoted accounting policies.
(i) Income from services rendered is accounted for:
(a) In the case of cost plus jobs, on the basis of amount billable under the contracts;
(b) In the case of lumpsum contracts, as proportion of actual direct costs of the work to estimated total direct costs of the work or in proportion to work estimated to have been executed, whichever is less; and……………
(ii) No income has been taken into account on jobs for which
(a) The terms of remuneration receivable by the company have not been settled and/or scope of work has not been clearly defined and, therefore, it is not possible, in the absence of settled terms, to determine whether there is a profit or loss on such jobs. However, in cases where minimum undisputed terms have been agreed to by the clients, income has been accounted for on the basis of such undisputed terms though the final terms are still to be settled.
(b) The terms have been agreed to at lumpsum basis but (i) the progress as defined in (i)(b) of the accounting policy is less than 25% (ii) supply of equipment is not complete in case of works contracts.
Cost of jobs as above (including actual/billed overheads) have been carried forward as work-in –progress.
(iii) While determining the WIP, overheads incurred at site office are not considered.
The above disclosures form an integral part of the accounts for the year 1989-90.
4.The querist has clarified that overheads incurred at site are not included in WIP [para 3 (iii) above] because they are negligible in amount.
5. The company is having head office at Delhi. The head office is engaged in two types of activities:
(i) Project execution work: It involves preparation of drawings and other activities related to execution of individual consultancy projects.
(ii) General administration activities such as personnel, finance and accounts, etc.
The querist has informed that insignificant amount of costs incurred at head office relates to general administration as per
(ii) above. In other words, project execution work costs form significant portion of head office costs.
6. Further, while working out the overhead percentage the company excludes:
i) Research and development cost;
ii) Financing cost;
iii) Bonus;
iv) Expenses of profit centres.
The overhead expenditure so derived after the deduction of above elements is divided by the chargeable payroll cost at the head office and at other offices elsewhere considered part of head office, but not those employed at sites and the percentage so derived is applied to WIP. This is done keeping in view the normal accounting practice on going concern basis that the revenue is not understated and the revenue is recognised only when realised. This has been done keeping in view the Accounting Standard (AS) 7 on ‘Accounting for Construction Contracts’, issued by the Institute of Chartered Accountants of India.
7. The querist has informed that the following costs are reimbursed by the client:
(a) Actual direct costs incurred on the job, e.g., personnel costs incurred at the site and personnel costs pertaining to project execution work at the head office and offices elsewhere.
(b) Overhead costs pertaining to general administration activities [para 5 (ii) above], excluding costs mentioned in para 6 above, are reimbursed on the basis of the payroll costs of personnel involved in project execution work at the head office and other offices elsewhere.
8. The Government Auditor has commented that the work-in-progress includes Rs. 464.33 lakhs relating to general administration overhead and financing charges. He has stated that the overhead percentage charged on WIP includes the general administration not directly related to WIP which is against the principle of matching expenditure with revenue. In this regard, he has quoted his office letter No. 14-CAIV/18/86 dated 11.1.88 relating to valuation of closing stock (based on AS 2). A copy of the said letter has been submitted by the querist for the perusal of the Committee. The querist has mentioned that Accounting Standard (AS) 2 defines inventory as tangible property held
i) for sale in ordinary course of business;
ii) process of production of such sales;
iii) for consumption in the production of goods and services for sale including maintenance, supplies and consumables other than machinery spares.
9. The opinion of the Expert Advisory Committee has been sought on the following points:
(i) Whether AS-2 relating to the valuation of inventory is applicable to work-in-progress in the present case.
(ii) Whether the treatment of WIP adopted by the company as explained above is correct.
(iii) If the treatment is correct whether any further disclosure is called for.
(iv) If the treatment adopted is not appropriate what should be the correct treatment in these circumstances as explained above. Opinion April 1, 1991
1.It appears to the Committee from the facts of the case, that the query relates to the propriety of inclusion of certain head office expenses in the valuation of work-in-progress. The opinion of the Committee given hereinafter is thus restricted to this aspect only.
2.The Committee notes that para 5 of Accounting Standard (AS) 2 on ‘Valuation of Inventories’, issued by the Institute of Chartered Accountants of India, states that the said standard does not apply, inter alia, to inventories of work-in-progress under long-term contracts, such as engineering, real estate development and construction projects, to which special considerations apply. The Committee is of the view that since the company in question carries on consultancy contracts of long-term duration, AS 2 is not applicable.
3. The Committee further notes paras 2, 3 and 4 of Accounting Standard (AS) 7 on ‘Accounting for Construction Contracts’, 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 for such contracts is essentially a 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 4. Contracts for the provision of services come within the scope of this Statement to the extent that they are directly related to a contract for the construction of an asset. Examples of such service contracts are contracts for the services of project managers and architects and for technical engineering services related to the construction of an asset.
4. The Committee is of the view that AS 7 would be applicable in the present case.
5. The Committee further notes paras 8.5, 8.6, 8.7 and 8.8 of AS 7, which are reproduced below:
“8.5 Examples of costs that relate directly to a specific contract include:
(i) Site labour costs, including supervision;
(ii) Materials used for project construction;
(iii) Depreciation of plant and equipment required for a contract;
(iv) Costs of moving plant and equipment to and from a site.
8.6 Examples of costs that can be attributed to the contract activity in general and can be allocated to specific contracts include:
(i) Insurance;
(ii) Design and technical assistance;
(iii) Construction overheads.
8.7 Examples of costs that relate to the activities of the contractor generally, or that relate to contract activity but cannot be related to specific contracts, include;
(i) General administration and selling costs;
(ii) Finance costs;
(iii) Research and development costs;
(iv) Depreciation of plant and equipment that cannot be allocated to a particular contract.
6.The Committee is of the view that the expenses pertaining to project execution work can be considered as costs attributable to the contract activity. In view of this, it would be appropriate to include such costs in the valuation of work-in-progress of the individual projects. Further, the expenses pertaining to the second category, i.e., the general administration overheads are of the type mentioned in para 8.7 of AS 7 and therefore are excluded in the valuation of work-in-progress as recommended in para 8.8 of the said standard. However, whether to segregate these expenses into the said two categories or not would be determined keeping in view the concept of materiality.
7.Subject to para 1 above, the opinion of the Committee, on the issues raised by the querists in para 8 of the query, is as below:
i) No.
ii) The accounting treatment of head office expenses should be as suggested in para 6 above.
iii) In the Statement on Accounting Policies the company should clearly state the valuation of work-in-progress as mentioned at para 6 above.
iv) The correct treatment of the valuation of work-in-progress is suggested in para 6 above.
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