1.27 Query: Accounting for a construction contract.
1. Company ‘X’ entered into an agreement with company ‘Y’ for setting up of a technology institute on turn-key basis for company ‘Y’. In this agreement, company ‘X’ was fully responsible for the quality and structural safety of the construction. Further, company ‘X’ was responsible to company ‘Y’ for rectification of defects, if any, at its own cost, in respect of the building constructed by it. It was the responsibility of company ‘Y’ to nominate a representative as ‘observer’ in the committee constituted by company ‘X’ to ensure proper implementation and to monitor the progress of the work.
2. The contract was awarded to company ‘X’ on cost plus basis, i.e., a fee of 12% of the actual civil cost was agreed to be paid to company ‘X’ to cover all establishment expenses, overheads and margin of profit. With reference to the mode of payment, it was agreed that company ‘X’ shall give periodically (but not later than once in two months) copies of expenditures statement, incurred by it for reimbursement from company ‘Y’. The cost of work shown in the bills was to be checked and certified by the officials of company ‘X’.
3. There was a clause in the agreement, which stated that company ‘X’ will identify reputed, experienced and technically sound agencies for civil construction and obtain quotations and conduct cost and commercial negotiation with such agencies. On the basis of the above, company ‘X’ entered into an agreement with a civil contractor ‘Z’. This contract was, mainly, between company ‘X’ and ‘Z’ and company ‘Y’ was not involved or concerned directly in any manner with contractor ‘Z’.
4. During the preceding financial year, contractor ‘Z’ submitted certain bills to company ‘X’ duly verified by the civil engineer and architect appointed by company ‘X’. These bills were settled in the last year itself by company ‘X’ and payments were made accordingly to the contractor in the last year. But due to certain internal reasons company ‘X’ did not raise the claims on company ‘Y’ in respect of the above mentioned expenses incurred and paid by company ‘X’ in the last year. The above mentioned expenses, which were incurred in the last year by company ‘X’, were booked to the debit of the work-in-progress account and carried over to the subsequent year under heading ‘work-in-progress’ by company ‘X’. It may be mentioned here that company ‘X’ is following percentage of completion method for recognising revenue on turn-key projects. It is also clarified that (a) Costs attributable to this particular contract are identifiable easily and clearly, and (b) Other costs, which are not reimbursable, can be reasonably estimated.
5. The querist has sought the opinion of the Expert Advisory Committee that whether such expenditure incurred by the company ‘X’ in the last year should be debited to the work-in-progress, or should it be charged to the profit and loss account and corresponding income be taken to the credit of profit and loss account in respect of such expenditure?
Opinion August 17, 1992
1. The Committee notes that the company in question, follows percentage of completion method for recognising the revenue in respect of the construction contract. In accordance with the recommendation made in Accounting Standard (AS) 7, the percentage of completion method can be followed for recognising revenue on construction contracts, awarded on cost plus basis, only when following conditions are satisfied:
(a) Costs attributable to the contract can be clearly identified, and
(b) Costs other than those that are specifically reimbursable under the contract can be reliably estimated.
The Committee notes that company ‘X’ satisfies both the above conditions as informed by the querist in para 4 of the query.
2. The Committee further notes paras 17.4 and 19 of Accounting Standard (AS) 7 on Accounting for Construction Contracts, issued by the Institute of Chartered Accountants of India, which state as follows:
“17.4 While recognising the profit under percentage of completion method, an appropriate allowance for future unforeseeable factors should be made on either a specific or a percentage basis.
19. A foreseeable loss on the entire contract should be provided for in the financial statements irrespective of the amount of work done and the method of accounting followed.”
3. The Committee also notes para 9.2 of Accounting Standard (AS) 7 which states as follows:
“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 into 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."
In the light of the above, the Committee is of the view that the mere fact that the company did not raise claims in respect of work completed is not a sufficient reason for not recognising the revenue, since there are many other factors which are considered for deciding the stage of completion for recognising revenue in respect of a particular construction contract. Thus, in case the company is following the percentage of completion method for recognising revenue on construction contracts, it should recognise revenue, subject to conditions laid down in Accounting Standard (AS) 7, in particular those specified in paras 17.4 and 19.
4. On the basis of the above, the Committee is of the opinion that the company could have recognised the revenue in accordance with Accounting Standard (AS) 7, after fulfilling its requirements, in particular those specified in the above paragraphs, in respect of proportion of work completed in last year, in the profit and loss account of the last year itself. ______________________________ |