Expert Advisory Committee
ICAI-Expert Advisory Committee
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1.8   Query:  

Accounting for sales and inventories under a construction contract.

 

1. The querist is engaged in the design and development, manufacture, repair and overhaul of aircraft, engines, related avionics and accessories and supply of parts mainly to Indian Air Force and other Defence Establishments.

 

2. The querist has stated that for major products, a contract is entered into with the IAF setting out the quantities on order, the description of the orders and the general conditions governing the transaction. The price and the actual delivery schedules are not determined at the contract stage itself but are agreed to by the parties generally on an annual basis sometime before the beginning of the year or even during the currency of the year in which the products are to be delivered. The cycle-time for manufacture of the aircraft is between 2-3 years and actual work on construction of the aircraft is undertaken in anticipation of the price and delivery schedule being decided at a later stage as stated above. Expenditure incurred in the construction work is also financed by IAF under an “On-Account Payment” system without waiting for finalisation of price and delivery schedules.

 

3. The querist has further stated that the prices for the various products to be delivered during a year are finalised under a system of ‘fixed cost quotations’ (FCQ). Under this system, a cost quotation per unit of products to be delivered in a financial year is prepared by estimating the various elements of cost, viz., material, labour and overheads and other direct charges. This quotation, with supporting details, is given to the customer and later, in discussions, each cost component constituting the basis for the price is settled. The quotation so agreed to is the ‘fixed cost quotation’ and profit on this is allowed at an agreed pre-determined percentage. The FCQs as stated above are finalised annually for deliveries during each year. As per the agreed financing pattern with the customer, the expenditure incurred towards procurement of materials is reimbursed by the customer on incurrence of expenditure. Thus, the material cost is paid in advance subject to adjustment later. Similarly, monthly ‘on account payment’ procedure exists for labour and overheads. Deferred Revenue Expenditure is reimbursed subject to ceiling for the project on incurrence with agreed percentage of profit as final payment. All advances and ‘on account’ payments are shown as advances received from the customer and are adjusted when final payments are made by the customer on delivery of aircraft/engine/equipment.

 

4. With regard to materials, an “Absorption Account” is maintained and submitted to paying authority by the company, showing the total value of materials procured for the project, value of materials consumed and balance, if any, carried in the inventory. The total value of materials procured will be compared with the total of advances given and the total consumption will be compared with the total material costs allowed in the approved quotation and final adjustments by way of recovery to be made by the customer. Left over material belongs to customer and will be disposed off to his best interests and proceeds credited to him.

 

5. The materials used for the projects are both of Soviet origin and non-Soviet origin. A substantial portion of the company’s inventory consists of materials procured for projects undertaken in collaboration with USSR under which materials are procured on ‘deferred credit’ basis (10/15 years credit based on inter-governmental agreement). The company undertakes the procurement of materials according to the specifications right from the inception, i.e., calling quotations, evaluation of offers, placement of purchase orders, follow-up with the suppliers, receipt and inspection of materials and storing them and issue of the same as and when required against each project. The company has been accounting material cost as part of sales and the appropriate consumption is shown under the expenditure head and hence balance material not yet consumed is shown as inventory in the books of account. ‘Deferred Liabilities’ are set up and reflected in the books for outstanding payments to USSR for materials procured on deferred credit basis. When sales are effected, the undischarged deferred credit relating to the cost of material incorporated in the sales is treated as deferred debt. The customer pays these deferred debts only at the time of discharging the related deferred liabilities by the company.

 

6. As stated earlier, ‘on-account’ advances are adjusted as and when sales are set up. Thus, the unadjusted advances from customer are being shown as liability at the year end. A copy of the Accounts for the period ended March 31, 1991, have been submitted by the querist for better appreciation.

 

7. The querist has also stated that with the amendment to the Sales Tax Act, wherever the production is treated as on “works contract”, a question arises as to whether the material financed by the customer should form part of the company’s books of account since the same belongs to the customer in pure legal terms from inception. The querist has explained that this question has arisen because of the fact that the Supreme Court, while deciding in favour of the company in civil appeal no. 1658 (NT) of 1982, against the State of Orissa for their demand for payment of sales tax, had categorically held that the materials imported under the license were always the property of the Government and that the company had no property in any part thereof and had no right to dispose of these materials. The Supreme Court held that the material belonged to the Government of India at all material times. In the light of this, a query was raised by Government auditors about the appropriateness of inclusion of materials not owned by the company in its balance sheet and profit and loss account. They suggested that disclosure is needed in the accounts quantifying the materials belonging to the customer. They also expressed the view that revenue may be recognised only to the extent of value added by the company. The querist contemplates that neither the accounting treatment in the books of the company nor financing arrangement by customer had any implication on the ownership of the property in the materials and that these are independent of the legal position of the work done by the company for Defence Services, whereas Government auditors took the stand that the accounting treatment should follow the legal position and should not exhibit a picture which is different from the legal position. They held that, since, ab-inito, the material belonged to the Ministry of Defence only, the accounting of this material by the company should be in its capacity of a bailee of the material.

 

8. The company replied to the objections raised by the Government auditors as follows:

 

(i) The materials required for production are ordered are by the company, invoiced on the company and payments thereof are made by the company. The materials are received, inspected, and claim action wherever necessary is initiated against insurers and suppliers, or else the materials are taken to stock, by the company. The customer finances the expenditure under an ‘On account’ payment procedure whereby reimbursement for procurement of materials (on cash, credit or deferred credit terms) is made by the customer to the company as and when claimed. Where the value of materials exceeds Rs. 25 lakhs, this ‘On Account ‘ payment is obtained in advance from IAF, subject to certain conditions.

 

(ii) These ‘On account’ payments are adjusted on rendering of invoice for work done/supplies made. Till then, advances, from IAF are shown as liability to Govt. of India in the books of the company.

 

(iii) In the above circumstances, the accounting of receipt of ‘On Account’ payments as liability to Govt. of India and of the materials procured as purchases, consumption, inventory, tooling etc., in the books of the company would seem to be logical and inescapable. The company is, therefore, not taking any steps to change the existing method of accounting of materials.

 

9. The querist has sought opinion of the Expert Advisory Committee on the following issues:

 

                        (a) Whether the company can continue with the existing practice? or

 

(b) Should the company disclose as a ‘note’ in notes to the accounts about the ownership of the material? or

 

(c) Should the company exclude completely the material in question from the regular accounts including deferred debts, deferred liabilities and advances relating to such material?

 

(d) Sales are set up by the company on the basis of finalised ‘fixed cost quotations’ which include materials content on an estimated basis. In the case of materials acquired from Soviet Union, the material cost will be adjusted on the basis of actual cost at the end of the project. However, Absorption Account is to be rendered as detailed at para 4 above in case of materials both of Soviet and non-Soviet origin for effecting suitable adjustment at the end of the project. The company appended a note to this effect in the 1990-91 accounts. The question is, whether the company is right in setting up sales based on prices indicated in approved FCQs pending final adjustment after rendition of Absorption Account at the end of the project.

                                                                        Opinion                                   October 7, 1992

 

1.  The Committee notes para 17(b) of Accounting Standard (AS) 1 on Disclosure of Accounting Policies, issued by the Institute of Chartered Accountants of India, which reads as follows:

 

“The accounting treatment and presentation in financial statements of transactions and events should be governed by their substance and not merely by the legal form”.

 

2.  The Committee feels that in the given circumstances, there can be two possibilities. The first possibility is that the company acts as the agent of the government. If it be so, the accounting treatment suggested by the government auditors, as stated in para 7 of the query, would be correct. The other possibility is that for all practical purposes the company is the owner in substance as it has the right, though a restricted one, to use the materials. The Committee’s opinion is based on the second possibility which is further strengthened by the other relevant facts furnished by the querist, i.e., the company itself orders the materials required for production, which are invoiced on the company and that the materials are received and inspected by the company, payments to the suppliers of materials is also made by the company and claim action against the insurers and suppliers are also made by the company. Moreover, the cost of materials is an integral part of the composite cost of contract entered into by the company with the IAF. Therefore, the fact that the cost of materials acquired by the company to manufacture aircrafts is financed by the contractee merely suggests that terms of the contract provide for a factor (e.g. materials, labour and overheads etc.) linked payments, by the contractee and in substance the materials acquired by the company belong to the company only, irrespective of the legal form of ownership.

 

3. The Committee also notes para 3 of Accounting Standard (AS) 7 on ‘Accounting for Construction Contracts’, as stated below, and on the basis of this, the Committee is of the view that an aircraft is a complex piece of equipment, and, therefore, the contract for construction thereof is within the scope of AS 7:

 

“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. The Committee further notes para 22 of the Statement on accounting policies followed by the company, as stated below, which clarifies that the company follows completed contract method for accounting for contracts entered into by the company.

 

“Sales are set up on completion of contracted work on the basis of signalling out/acceptance by the customer’s inspection of the product. Where sale prices are not established, sales are set up on provisional basis at prices likely to be realised. Research and development expenditure financed by the customer is billed and accounted as sales.”

 

5. The Committee further notes para 7.3 of Accounting Standard (AS) 7, which reads as follows:

 

“7.3 Under the completed contract method, revenue is recognised only when the contract is completed or substantially completed; that is, when only minor work is expected other than warranty obligation. Costs and progress payments received are accumulated during the course of the contract but revenue is not recognised until the contract activity is substantially completed.”

 

6. On the basis of the above, the Committee’s opinion, read with para 2 above, in respect of the issues raised by the querist in para 6 of the query, is as follows:

 

(a) Yes, the company can continue with the existing practice of accounting in respect of inventories, subject to (b) below.

 

(b) Yes, the company should disclose, in the notes to accounts, about the legal status of the ownership of materials.

 

                        (c) No.

 

(d) Under the completed contract method of accounting for construction contracts, revenue may be recognised or sales may be set up once the contract is completed wholly or substantially, as per para 7.3 of Accounting Standard (AS) 7, as reproduced above. Till that time, the costs incurred on the project should be carried forward as contract work-in-progress. Hence, if at the time of finalisation of fixed cost quotations (FCQs), the contract is completed wholly or substantially the company may book sales based on prices indicated in approved FCQ. But since such sales price is subject to adjustments at the end of the project appropriate provisions should be made for any loss which may arise on account of such adjustment.

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