1.34 Query: Provision for losses on contracts.
1. A government of India company undertakes turnkey projects in India and abroad in all the fields of telecommunications. The company follows the percentage of completion method for recognition of revenue, on the basis of the ratio of cost incurred to latest revised estimated total cost. However, no revenue is recognised where the work performed is less than 25% of the value of the contract.
2. Till 1987-88, the company used to make a provision for project performance for unforeseeable losses at 5% of the value of the contracts, for which the performance period/ guarantee period is not over. The provision was being reviewed every year at the year-end. For those projects for which the guarantee period was over, the provision for project performance used to be withdrawn and disclosed in the profit and loss account, after showing the profit for the year, and provision to be created for the year was being shown above the line as a charge to the profit for the year. Subsequently, the office of Member Audit Board advised the company to review this practice and stated that only the net provision to be created should be shown as expense for the year. However, if in a year there is net withdrawal, this may be shown after the profit for the year. Accordingly, from the accounting year 1988-89, the company started this practice of “topping up principle”, i.e., showing only net provision created in the profit and loss account and if any net withdrawal is there, showing it after the profit for the year.
3. In the accounts of 1991-92, this matter again came up for discussion with the statutory auditor as well as government auditors. The view expressed by one of the auditors was that the company should resort to the practice which was being followed till 1987-88, i.e., provision created for the year should be shown as a charge to the profit and withdrawal be shown after the profit for the year. At present, the provision for project performance is being maintained at 2% of the accumulated turnover for which guarantee period is not yet over. However, the querist feels that the provision for project performance is for unforeseen circumstances and it should not be linked up with any one project and it should be on the accumulated turnover of the company. As such, the company should maintain provision on total accumulated turnover at the requisite percentage only and if the provision already created is more, this should be withdrawn and shown after the profit for the year and if some more provision is required to be created this should be shown as a charge to the profit for the year.
4. The querist has sought the opinion of the Expert Advisory Committee as to whether the company should continue its present practice of showing the net provision to be created as a charge to the profit for the year, and if net amount is to be withdrawn it should be shown after the profit for the year. The querist has explained the problem by way of the following illustration:
“The amount carried forward in provision for project performance is Rs. 6 crores as on 1.4.91. During the year 1991-92, there are ten projects, for which provision included in Rs. 6 crores is Rs. 1.5 crores, are completed and guarantee period is also over and as such this provision is required to be written back. Further, ten projects have been added, and on accumulated turnover of these projects and continuing projects a further provision of Rs. 4 crore is needed and, therefore, net provision required as on 31.3.92 is Rs. 8.5 crores. Will it be in order if the company creates a net provision of Rs. 2.5 crores or it will be required to show Rs. 4 crores as charge to profit and loss account and then Rs. 1.5 crores after the profit for the year?”
Opinion January 20, 1993
1. The Committee notes para 17.4 of Accounting Standard (AS) 7 on ‘Accounting for Construction Contracts’, issued by the Institute of Chartered Accountants of India, which reads as follows:
“17.4 While recognising the profit under percentage of completion method, and appropriate allowance for future unforeseeable factors should be made on either a specific or a percentage basis.”
2. The Committee is of the view that the provision for unforeseeable losses, in respect of various contracts of similar nature undertaken by an enterprise, on percentage basis, may be made either on individual contract basis or collective basis. Under the latter method, the provision may be maintained at amount equivalent to a certain percentage of the value of all the incomplete contracts or whose guarantee period is not yet expired. In such a case, if the provision made in earlier periods being brought forward, is found short or in excess of the requirements, an additional provision equivalent to the short fall is made, or, as the case may be, the excess provision is written back. Thus, at a particular point of time, there can be either withdrawal from or addition to such provision. Therefore, the question of the netting of provision made and provision written back at the same time cannot arise in such cases.
3. On the basis of the above, the Committee is of the opinion that since the provision is made on percentage basis collectively on all contracts, i.e., it does not relate to any particular contract, any withdrawal from such provision, in case the provision brought forward is found in excess of the requirement, should be taken as income for the period during which such withdrawal is made. However, where the provision so made in the past was not representative of the estimated liability that may arise in this regard, i.e., the amount was in excess of the provision reasonably necessary for the purpose, such excess is of the nature of a reserve. Any withdrawal of such excess should be shown in the profit and loss account, below the line. __________________________________ |