1.4 Query: Accounting for construction contracts in foreign countries. 1.A Government of India company, under the administrative control of Department of Telecommunications, Ministry of Communications, undertakes telecommunications related projects in India and abroad. The company gets the contracts in foreign countries mainly through international competitive bidding. In the contracts, unit rates are given for different type of works and the company gets payment against these works done, as per the payment terms given in the contracts. Such contracts are turnkey jobs which are broadly of the nature of ducting, cable laying (including supply of materials) from telephone exchanges to the subscriber’s end. The outcome of the said contracts, as per the querist, can be estimated reliably.
2.Since inception of the company in 1978, till the year 1990-91, it was recognising the income at the rates given in the contract on completion of the respective jobs. For the incomplete jobs, the proportionate expenditure was taken as work-in-progress at cost. This method of income recognition as per the company management was on the basis of the percentage of completion method and in accordance with Accounting Standard (AS) 7, issued by the Institute of Chartered Accountants of India. This method, as per the querist, was accepted by the statutory auditors as well as the government auditors. However, in the year 1991-92, statutory auditors of the company had raised a point that this method of income recognition is not correct, and is not in conformity with AS 7. As per the querist, the statutory auditors of the company were of the view that the item-rates given in the contract do not truly represent/reflect the profitability of the respective items completed in a contract, because in case of such contracts, there is strategic tendering, i.e., some items in the contract are over-loaded and in case of some other items profit elements are less, to get benefit of tender evaluation. Therefore, if the company follows the income recognition as per the existing system, this shall not be in accordance with AS 7. The statutory auditors, accordingly, proposed that the company should follow the method of percentage completion by taking the ratio of the cost incurred till the year-end to latest sanctioned cost estimates, and the income should be recognised through the work-in-progress as is done in case of construction works. The company, as per the querist, agreed to the suggestion of the auditors and changed its policy accordingly for the contracts commenced since 1991-92.
3.The querist has stated that this matter came up for discussion again, during the course of audit for 1992-93 accounts. The points for the discussion were as follows: a) valuation of work-in-progress for recognising income on foreign projects; and b) depiction of the same in the schedule relating to turnover. As per the querist, (a) the company maintains the accounts for foreign projects in three currencies (i) in local currency of the country, (ii) in US Dollars, and (iii) in Indian rupees. The transactions are recorded in the books, in the currency in which they are done and at the year-end, these are converted into Indian rupees as per the accounting policy of the company. (The querist has sent the relevant extracts of the statement of accounting policy for the perusal of the Committee). (b)Accumulated costs are taken in the foreign currency, mainly in the local currency, and transactions done in other currencies are converted into local currency/the currency in which the contract is denominated. The income is recognised as per the following formula:
Accumulated cost upto 31st March
Latest sanctioned cost estimate The above formula, as per the querist, gives the income for the period since the start of the contract. From this the income recognised till 31st March of the previous year is deducted to derive the figure of income for the relevant year. (c) In the books of account of foreign projects the following entry is passed: Closing work-in-progress Debit To Opening work-in-progress To Turnover (income recognised for the year) For conversion of foreign currency in Indian rupees, in the above method, the closing work-in-progress for the purpose of balance sheet is translated at the closing rate while the turnover, i.e., income recognised for the year is translated at the average rate as per the policy of the company. 4.The querist has explained the abovesaid policy of the company by way of the following example:
Example:The contract value for a contract started as on 1.4.1991 is US $ 50,000. Sanctioned cost estimates for the project are US $ 40,000, i.e., in US $ 40,000 the contract shall be executed. As on 31st March, 1992, the expenditure actually incurred is US $ 20,000 and the accumulated expenditure as on 31.3.1993 is US $ 30,000. In this case, the company would recognise the income as under: -
1991-92
20,000
40,000
i.e., closing work-in-progress as on 31.3.92 US $ 25,000 Less: Opening work-in-progress NIL Turnover for the year 1991-92 US $ 25,000 Expenses US $ 20,000 Profit US $ 5,000
1992-93
30,000
40,000
i.e., Closing work in Progress as on 31.3.93 US $ 37,500 Less: Opening work-in-progress US $ 25,000 Turnover for the year 1992-93 US $ 12,500
The above would then be translated into Indian rupees as explained at para 6 below. The journal entry would be as under for 1992-93:
Closing work-in-progress Debit 37,500 To Opening work-in-progress 25,000 To income recognised (turnover) 12,500
5. The querist has mentioned that the auditors of the company had stated that the company should prepare the cost estimates in Indian rupees and the expenditure should also be accumulated in Indian rupees, and not in US $, as per the practice adopted by the company. The auditors were of the view, that uptil last year, i.e., 1991-92 the average rate of 1 US $ was Rs.22/-. As such, the expenditure upto 31.3.92 should be taken as Rs.4,40,000 and the expenditure incurred for the year 1992-93, US $ 10,000 should be taken at the average rate of 1992-93, i.e., Rs. 28 per US $. The accumulated expenditure therefore would be Rs.7,20,000. As such, the cost estimates should be revised for the balance work. However, the management of the company is of the view that it will complicate the matters unnecessarily. The contracts are denominated in foreign currency and the execution expenses shall be mainly in foreign currency. The company has, therefore, prepared the cost estimates to execute the work in foreign currency. Accounts of the projects are also kept in foreign currency, as such, in the view of the company’s management it will be simple to first recognise income in US $ and then convert it into Indian rupees. Moreover, there may be some cases, where contract may continue for more than three years. In such cases the company would have to link up the currency translation rates of earlier years which will increase the clerical work unnecessarily.
6.As per the querist, the relevant exchange rates in the year 1991-92 and 1992-93 were as follows:
1991-92 Opening rate Rs. 19 = 1 US $ Closing rate Rs. 25 = 1 US $ Average rate Rs.22 = 1 US $ 1992-93 Opening rate Rs.25 = 1 US $ Closing rate Rs.31 = 1 US $ Average Rate Rs.28 = 1 US $
In the example given at para 4 above, the company would depict the turnover in 1992-93 by translating it at the average rate, as follows:
Closing work-in-progress (Rs.5,50,000 as 9,00.000 recognised last year(i.e. US $ 25,000 X 22) plus US $ 12,500 X 28, the average rate of 1992-93) Less: Opening work-in-progress 5,50,000 Turnover for the year 3,50,000
7.The querist has sought the opinion of the Expert Advisory Committee on the following issues:
(a) Whether the existing system followed in 1992-93 for income recognition, in respect of the foreign projects of the company, on the basis of the expenditure in foreign currency and cost estimates in foreign currency, using the following formula is correct:
Cost incurred till close of the year
Latest cost estimates
Or, it should revert to its earlier practice of recognising income for the items completed at the item rates given in the contract and for incomplete jobs, account the same as work-in-progress at cost.
(b) Is the existing system of depiction of income in the turnover schedule of the profit and loss account is in order or it needs to be changed? If so, the appropriate method may be suggested.
Opinion* November 25, 1994
1. The Committee notes that as per the Exposure Draft of revised Accounting Standard (AS) 11 on ‘Accounting for the Effects of Changes in Foreign Exchange Rates’, issued by the Institute of Chartered Accountants of India- “foreign operations of an enterprise refer to either its branch or its investments in a subsidiary, associate or joint venture etc., the activities of which are based or conducted in a country other than the country of the reporting enterprise.” The Committee thus notes that the said exposure draft envisages two types of foreign operations: (i) Foreign operations carried on as a separate entity, distinct from the reporting enterprise, e.g., a subsidiary or joint venture, etc., and (ii) foreign operations which are merely an extension of the activities of the reporting enterprise, e.g., foreign branch etc. The Committee is of the view that for the purposes of foreign currency translation, the foreign projects of the company should be treated as foreign branches, even though for the Companies Act purposes they may not be treated so.
2.The Committee notes paras 17 and 18 of Exposure Draft of revised Accounting Standard (AS) 11, which read as follows:
“17.The financial statements of a foreign branch should be translated using the procedures in paragraphs 18 to 23 of this Statement.
18. Revenue items, except opening and closing inventories and depreciation, should be translated into reporting currency of the reporting enterprise at average rate. In appropriate circumstances, weighted average rate may be applied, e.g., where the income or expenses are not earned or incurred evenly during the accounting period (such as in the case of seasonal businesses) or where there are exceptionally wide fluctuations in exchange rates during the accounting period. Opening and closing inventories should be translated at the rates prevalent at the commencement and close respectively of the accounting period. Depreciation should be translated at the rates used for the translation of the values of the assets on which depreciation is calculated.”
3.The Committee notes paras 9.2, 9.4, 9.8 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:
“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 wightage 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.”
“9.4 If the percentage of completion method is applied by calculating the proportion that costs to date bear to the latest estimated total costs of the contract, adjustments are made to include only those costs that reflect work performed. Examples of items which may need adjustment include:
(i) the costs of materials that have been purchased for the contract but have not been installed or used during contract performance; and
(ii) payments of subcontractors to the extent that they do not reflect the amount of work performed under the subcontract.”
“9.8 Normally, the profit is not recognised in fixed price contracts unless the work on a contract has progressed to a reasonable extent. Ordinarily this test is not considered as having been satisfied unless 20 to 25% of the work is completed.”
“17. The percentage of completion method can be used if the outcome of the contract can be reliable estimated.
17.1In 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 reliable 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) cost 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.”
4. The Committee notes from the above that under the percentage of completion method, turnover in respect of the uncompleted contracts is recognised by reference to the stage of completion of the relevant contract at the reporting date. In case the turnover is calculated by reference to the proportion of costs incurred to the total estimated cost, only such costs should be considered for calculating such proportion, which reflect the work performed. The turnover achieved during a particular period on a contract in this case would be equal to the value of the work completed during that period.
5. On the basis of the above, the Committee is of the following opinion in respect of the issues raised at para 7 of the query:
(a) The company may continue to recognise revenue in respect of its construction contracts by reference to the proportion that costs incurred till the reporting date bear to the latest estimates of the total cost, subject to compliance with the conditions laid down in Accounting Standard (AS) 7 issued by the Institute of Chartered Accountants of India.
(b) The company should disclose the amount of turnover recognised, opening work-in-progress, and closing work-in-progress as follows:
Value of closing work-in-progress _____________ (at the closing exchange rate) Less: Value of opening work-in-progress _____________ (at the opening exchange rate)
Turnover (value of _____________ Work completed during the year) _____________
__________________________
* The Committee wishes to draw the attention of the querist to the fact that this opinion is based on Exposure Draft of Revised Accounting Standard (AS) 11, issued by the Accounting Standard Board of the Institute of Chartered Accountants of India, published in ‘The Chartered Account’, August, 1993. It is, therefore, possible that this opinion may change upon issuance of revised Accounting Standard (AS) 11. |
