1.36 Query: Revenue recognition in service contracts, applicability of Accounting Standard (AS) 7.
1. A consultancy organisation is engaged in providing design consultancy, procurement consultancy, project management and technical consultancy services for petroleum projects, refineries, oil fields, gas pipelines, off-shore engineering, petrochemical complexes etc. The company basically provides the technocrats and the time devoted by them is the basic stock-in-trade which, in view of the querists, is much different than the normal construction contracts, where materials and supply of equipments are also an integral part of the contract. The company, therefore, as per the querists, is a service company providing manpower for consultancy business only. The company normally takes jobs either on cost-plus basis or on fixed-price basis.
2. As per the qerists, the disclosed accounting policies of the company for the relative determination of the turnover/work –in- progress are as follows:
“1. Turnover:
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 estimate total direct costs of the work, or in proportion to work estimated to have been executed, whichever is less; and
(c) In the case of contracts providing for a percentage fee on equipment/ project cost, on the basis of physical progress as certified;
And after adjusting the obligations towards guarantees, warranties and penalties etc., provided/under negotiation in the respective contracts.
2. Turnover/ Work-in-Progress:
(I) No income has been taken into account on jobs, where-
(a) The terms of remuneration receivable by the company are not settled and/or the 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 going to be profit or loss on such jobs. However, in cases where undisputed terms have been agreed to by the client, income is being accounted for on the basis of such agreed terms though the final terms are pending and the contract is yet to be executed.
(b) The terms have been agreed to on lumpsum basis but the progress as defied in 1(b) above is less than 25% as certified by the project manager.
Costs of jobs as above have been carried forward as work-in-progress.
(II) While determining the work-in-progress, the company has adopted the following method:
(a) Physical progress of work is certified by the project manager based on certain criteria which differs from job to job and are reported to be beyond comprehensive physical explanation depending on the complexities of the contracts. It is reported to be based on actual experience of the project manager.”
3. However, as per the querists, this estimation of physical progress has resulted in the following anomalies:
(i) In many jobs, physical progress percentage as certified by the project manager is substantially different when compared to cost progress percentage actually incurred, and the originally estimated cost.
(ii) In many jobs, physical progress as certified by the project manager is substantially high as compared to cost of work-in-progress incurred and originally estimated cost.
(iii) In some cases the company has raised bills for substantial amounts and clients have also made payments but either substantial or the total remittance of client has been taken to “unearned income account” shown in the balance sheet, or adjustments on account of short billing are made without corresponding adjustments in the profit and loss account.
(iv) In many jobs, which have been taken to work-in-progress, income has not been estimated because either the percentage of physical progress, as certified by the project manager is less than 25%, or the actual cost progress has been found to be lower than 25%, even if one of the two criteria is more than 50% and in few cases even exceeds 95%.
[The querists have supplied detailed calculations in support of the above arguments, for the perusal of the Committee.]
4. The company prepares detailed estimates of cost for individual jobs at the time of making quotations and negotiations with the clients. This ‘estimated cost’ remains the basis for determining the income, i.e., the company does not revise the original estimated cost even when actual costs incurred exceed the originally estimated cost unless the client agrees for extra payments over and above the lumpsum contract price agreed between the two. Therefore, no revised estimates of the cost are worked out on the reporting date each year during the execution period of the contract which may be required for determining the stage of completion of the project/job. The company also does not prepare any estimates of costs to be incurred till completion of the contract and, therefore, does not mention or compile the overall profit or loss on the reporting date each year during the execution of the project.
5. The querists have further stated that in cases of lumpsum service contracts, mostly the company starts execution of the contract on the basis of Memorandum of Understanding (MOU) or a letter indicating the intentions of the client pending final decision, broadly stating the mode and quantum of payments to be released to the company. Time gap between starting execution of the contract and actual date of execution of the contract as per the querists, varies from 2 to 5 years. In some exceptional cases, reportedly, actual contracts have been singed after the completion of the project. The company raises bills on the basis of the terms which are decided either in the MOU or through other correspondence, and are generally of equal instalments spreading over the scheduled period of the contract, except where stated otherwise in the MOU.
6. The querists have informed that it has also been observed by the government auditors that the system of accounting for income on the fixed-price contracts does not appear to be proper. The querists have stated that para 9 of Accounting Standard (AS) 7, issued by the Institute of Chartered Accountants of India, states that where the company is accounting for income as per the percentage of completion method, 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 physical proportion of the contract work. If the percentage of completion method is to be applied by calculating the proportion that cost to date bear to the latest estimated total cost of the contract after making adjustments to include those costs that reflect work performed, the application of the percentage of the completion method is subject to a risk of error in making estimates. For this reasons, profit is not recognised in the financial statements unless the outcome of the contract can be reliably estimated. If the outcome can not be reliably estimated, the percentage of completion method is not used. In the case of fixed-price lumpsum contracts the conditions which will usually provide this degree of reliability are:
(i) Total contract revenue remaining 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.
(iii) The costs attributable to the contract can be clearly defined so that the actual experience can be compared with the prior estimates.
As per the querists, normally, the profit is not recognised in fixed price contracts unless the work of contract has progressed to a reasonable extent.
7. The querists have reproduced the requirements of SSAP-9 issued by the Accounting Standard Board, U.K., regarding assessment of profits on incompleted contracts as follows:
“…The overriding principle being that there can be no attributable profit until the outcome of a contract can reasonably be foreseen. Of the profit which in the light of all the circumstances can be foreseen with a reasonable degree of certainty to arise on completion of the contract there should be regarded as earned to date only that part which prudently reflects the amount of work performed to date. The method used for taking up such profits need to be consistently applied.”
“In calculating the total estimated profit on the contract, it is necessary to take into account not only the total costs to-date and the total estimated further costs to completion (calculated by reference to the same principles as were applied to cost to-date) but also the estimated future costs of rectification and guarantee work, and any other future work to be undertaken under the terms of the contract. These are then compared to the total sales value of the contract. In considering future costs it is necessary to have regard to likely increase in wages and salaries, to likely increases in the prices of raw materials and to rises in general overheads so far as these items are not recoverable from the customer under the terms of the contract.”
“The amount to be reflected in the year’s profit and loss account will be the appropriate proportion of this total profit by reference to the work done to-date, less any profit already taken in previous year.”
8. As per the querists, the Expert Advisory Committee in one of its earlier opinions*, had opined that “amount billed to the clients’ account” and the “clients account” will not appear anywhere on the “Liabilities” and “Assets” side of the balance sheet. However, in case of this company, in the fixed-price contracts, the company raises bills on clients and receives payments against those bills during the year, but at the close of the financial year, the entries are adjusted and the remaining part of the bills raised to the clients is credited to “Unearned income account”. This unearned income is made up of two components, (i) amount of bill raised by the company as reduced by the income recognised in case of those jobs where income has been recognised as per the two criteria being followed by the company, and (ii) in case of those jobs where the company has raised the bills and has received payment thereof but either the physical progress of the work is less than 25% as certified by the project manager or the cost progress percentage to originally estimated cost is less than 25% and the job has, therefore, been included in the schedule of work-in-progress or where the final contract with the client has not been executed even if the physical progress has exceeded 25% and so also the cost progress.
9. The querists have further stated that the billing to the client in respect of fixed-price jobs is done as per the terms of MOU or contract. The typical terms provide for the payment based on time or based on milestones. Since the billing to the client is done as per the contract terms, the amount billed to the client is debited to the sundry debtors account and credited to the income during the course of the year. Payments received from the clients are credited to the sundry debtors account. At the year-end, in respect of each job which is considered in work-in-progress due to non-execution of a formal contract, the amount received from the client as at the date of balance sheet is treated as advance from the client. Jobs in respect of which the lower percentage as stated above is more than 25%, the following entries are passed:
1. In case of excess billing:
Income Account - Debit
Unearned Income billed to Client - Credit
2. In case of short billing:
Unbilled Income - Debit
Income Account - Credit
Unearned income billed to clients is reflected on the liabilities side under the head current liabilities. Similarly, the income due but not billed is reflected on the assets side under the head other current assets.
10. The querists are of the view that Accounting Standard (AS) 7 issued by the Institute of Chartered Accountants of India, relates basically to accounting for construction contracts. However, some of the recommendations of the standard are applicable to the type of service contracts being undertaken by the company on lumpsum basis. To the extent possible, the company has made an attempt to follow AS 7 both in the accounting policies as well as in the actual practice considering the nature of the business of the company consistently over a number of years.
11. The querist have sought the opinion of the Expert Advisory Committee in respect of the following:
(i) Considering the nature of the business of the company, being purely a service rendering organisation, whether following of Accounting Standard (AS) 7, issued by the Institute of Chartered Accountants of India is appropriate for income recognition or not? If not then what policy of income recognition should be followed in the aforesaid circumstances. Also, since the company is following the above method consistently for the last many years, any change in the method of accounting, if needed, may be enumerated with reasons thereof.
(ii) If the present accounting policy being followed by the company is appropriate than how the income escaping recognition on the reporting date each year as detailed above can be properly reflected in the final accounts of the company.
Opinion February 8, 1994
1. The Committee notes paras 4, 9.2 and 17 of Accounting Standard (AS) 7 on ‘Accounting for Construction Contracts’, issued by the Institute of Chartered Accountants of India, which read as follows:
“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.”
“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.”
“17. The percentage of completion method can be used if the outcome of the contract can be reliably estimated.
17.1 In the case of fixed price contracts, this 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 actual experience can be compared with prior estimates.
17.2 Profit in the case of fixed price contracts, normally should not be recognised unless the work on a contract has progressed to a reasonable extent.
17.3 In the case of cost plus contracts, this degree of reliability would be provided only if both the following 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 percentage of completion method, an appropriate allowance for future unforeseeable factors should be made on either a specific or a percentage basis.”
2. On the basis of the above, and subject to para 1 above, the Committee is of the following opinion in respect of the issues raised in the query:
(a) Accounting Standard (AS) 7, issued by the Institute of Chartered Accountants of India is applicable in respect of the service contracts for project management, and technical and consultancy services relating to construction of an asset or a combination of assets, undertaken by the company. In case of other service contract not covered by the above, the company should recognise revenue as per Accounting Standard (AS) 9 on ‘Revenue Recognition’, issued by the Institute of Chartered Accountants of India.
(b) (i) Where no formal contract has been signed, the company should recognise revenue if it can reliably be measured on the basis of the memorandum of understanding or otherwise, provided there is no significant uncertainty as to its ultimate collection.
(ii) The policy to recognise revenue in the case of lumpsum service contracts, in proportion of actual costs of the work performed to latest estimated total costs of the work, or in proportion to work estimated to have been executed, whichever is less, may be proper if the said costs and the physical progress are more or less in tandem. Where they are not in tandem, the matter requires special consideration and therefore in such cases the manner of revenue recognition should be arrived at after proper investigation of the extent of work accomplished. However, no profit should be recognised unless the work has progressed to a reasonable extent, e.g., profit should be recognised only if 20 to 25% of the work is completed. Thus in the present case, if physical progress is 25% or above, profit should be recognised as a proportion based on the latest estimates of the total cost and total revenue.
*Vide Query no. 1.19, Compendium of Opinions, Vol. VII, published by the Institute of Chartered Accountants of India
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