Expert Advisory Committee

1.8 Query:

Accounting for left-over materials.

1. A company is engaged in the manufacture of electronic products and systems. The company’s objectives as per Memorandum of Association are as follows:

The objectives of the company include to carry out all kinds of business relating to research, development, pilot production, manufacture, buying, selling, importing, exporting – items, equipment, apparatus, instruments, components, and systems for communication. The company shall also be entitled to carry on all or any of the following objects as being incidental or ancillary to the attainment of the above objectives.

To manufacture, buy, sell, exchange, install, work, alter, improve, manipulate, prepare for market, import or export and otherwise deal in all kinds of plant, machinery, apparatus, job substances, materials and things necessary or convenient for carrying on any of the business whom the company is authorised to carry on or usually dealt in by persons engaged in such business.

2.The company undertakes contracts of design, manufacture, assembly, inspection, testing, crafting and sales of electrical controls and later, erection, installation and commissioning of the items at sites specified by the customer.

3.The contracts are split into number of requisitions for the sake of speedier execution and to ensure that the final responsibility of various items ordered under the requisitions vests with the company. The method of operation of the contract is summarised, by the querist, as below:

(i) The customer would furnish, along with the requisition, information regarding specification, drawings, test requirements/procedures etc., required for the manufacture of the item for which requisitions are released.

(ii) The supplier would give information on engineering, manufacturing, testing, prototype requirements etc., for stores for which requisition has been raised by the customer.

(iii) There would be mutual discussions between the customer and supplier regarding the various parameters described in items (i) and (ii).

(iv) The supplier would furnish a quotation to the customer, containing particulars of (a) estimated material cost, and (b) estimated number of mandays required for execution of the requisition. These items would be mutually discussed and negotiated pricing formula for execution of these contracts is finalised. (Proforma for calculation of selling price has been submitted by the querist for the perusal of the Committee).

(v) The customer would place a formal purchase order, based on the agreed price.

(vi) The supplier company has to furnish technical information like drawings, bill of material, spares list, inspection plan, design basis report for new designs etc., which will be reviewed by the customer’s engineers and approved before execution of the contract. On completion of this stage, the supplier company can claim 25% of the conversion cost explained in the pricing formula.

(vii) Billing for the supplies effected is governed by the pricing formula, which inter alia, provides for the following:

(a) Actual material cost would be the value of direct materials actually purchased by the supplier company. The statements of the purchase of the actual materials are certified by the Internal Audit Department of the supplier company.

(b) Conversion cost as mutually agreed upon duly escalated as per the pricing formula.

(viii) The prices accepted are for supply, ex-works, inclusive of packing and forwarding to rail/road carriers, except insofar as these include the charges for erection, installation and commissioning as envisaged in the contracts. Taxes and duties are payable at actuals at the time of despatch within the stipulated delivery schedules.

(ix) Escalation will be applicable only for the conversion cost as the material cost will be paid on the basis of actuals and profit is a component of the selling price.

4. The scrutiny by the customer of the material content is done on a three tier basis, before fixation of the selling prices and during the execution of the contract. The three tiers are:

(a) Customer’s residential engineering cell stationed at supplier company’s premises;

(b) Customer’s system designers stationed at customer’s premises; and

5.The customer’s designers have the right to specify the source of supply of materials/specifications, test requirements etc., while approving the bill of materials (BOM) for the contract and modify the designs, test procedures and sources of procurement during the execution of the contract. The materials procured are subject to inspection and quality control by the customer’s quality inspectors stationed in the supplier’s premises. The discretion and freedom to purchase the actual materials by the supplier company is thus severely restricted.

6. Normally, extra materials to the extent of 10% are towards customer spares. Generally, the quantity procured would be higher than even these parameters due to stipulation like the minimum ordering quantity by material suppliers. The customer would also require that additional quantities of materials be procured in excess of the actual requirements, based on their site requirements at the time of installation and commissioning and also to take care of design modifications. All these additional quantities form part of the actual material cost to be billed by the company to the customer though the actual materials drawn/issued to jobs will be less than procured.

7. Hence, materials to the extent of 8% to 10% of the value of materials billed to the customer, are left over in the company after despatching the goods and meeting commitments towards spares. As the actual cost of materials procured are billed and realised, the customer had stipulated the following conditions in the contract:

“Since the material procured by the contractor is paid at actual, the contractor shall maintain a ‘kardex’ requisition/job-wise giving details of material, purchase order numbers, quantity used in the jobs including spares to control the material inventory. The contractor shall give a computerised list of all material procured against each requisition to purchaser. Also, the computerised left-over inventory list shall be issued to the purchaser once in a year for the requisitions which are declared jointly as completed in all respects during that year.”

Accounting treatment for materials by the company

8. All purchases are taken into inventory after receipt and inspection. The receipts are taken to Priced Stores Ledger (PSL) and the kardex and the issues are evaluated on the weighted average basis.

9. Job numbers are assigned requisition-wise and the issues are accounted for in the work-in-progress abstract, job-wise. The issues as explained earlier are accounted for in the kardex and PSL through valued material issue requisitions.

10.When the stores orders are ready for despatch after inspection by customer’s quality controllers, the project manager in-charge of the activity generates the list of purchase order issued against each requisition of the contract for materials procured and this is evaluated by the accounts department of supplier with reference to the purchase orders, payment particulars etc., upto landed cost. The evaluated list is verified by the Internal Audit Department of the company (i.e., supplier) and this list is the basis for billing of the direct material cost as per the pricing formula. Indirect materials like consumables etc., are not listed as they are covered by the factor of 10% added to the direct material. Thus, it may be seen that the actual direct material consumption has no nexus to the value of direct material cost billed to the customer against each requisition, though material booked to jobs is the value of materials actually utilised.

11.The stores are despatched as and when completed after obtaining the clearance of the customer’s resident quality inspectors. In several cases, the despatches get spread over to two or three financial years. Income is recognised based on bills raised for each batch of despatches. In this process, invoices are being raised for the actual values of materials procured, though actual utilisation of materials is less then the value of materials invoiced.

12.The project team executing the contract reviews the material left-over after execution of the jobs and furnishes material issue requisitions job-wise to charge-off the cost of materials left over and in custody of the company to consumption of raw materials, job-wise.

13.The review and charging of the cost of left-over inventory to consumption being a time consuming process, the time lag between the date of despatch of the finished goods and date of debiting the account of consumption of raw materials ranged between 3 to 6 months and at times falls beyond the financial year. The review of completed jobs was taken up only after the final batch of despatches took place, though the despatches might have been spread over more than one financial year. In this process, it is so happening that a portion/part of left-over materials on the jobs closed in a particular financial year at times are being charged-off in the next financial year. Thus, the income is on financial year basis whereas charging of consumption of left-over materials is on calendar year basis. This time gap was also not strictly observed in cases where the time lag between completion and despatch of the items manufactured and the dates of reviews at times may not fall within the same financial year.

14. As the billing for work done is as per a pre-determined formula, revenue is recognised as and when the conditions of contract are fulfilled. There is no stipulation in the contract to transfer the physical custody of the left-over raw material to the customer as explained in para 7 above. To assess the profitability of the contracts properly, truly and fairly, the company decided that the value of left-over materials which are in physical custody of the company be charged-off by way of debiting to the respective jobs. The items are stored separately and numerically, controlled by the Project Incharge, through a separate kardex and reflected in the books at a token value of Re. 1/- per unit of issue/measurement.

15.The customers, however, whenever require modifications at site by utilising the left-over raw materials, issue fresh requisitions called engineering change notes which indicate the value of work to be done covering only the labour charges and profit. The cost of materials is not being allowed or charged to the customers as they were available with them.

16.The querist has summarised the above facts as follows:

(i) Selling prices were arrived at based on negotiated pricing formula, which allowed pricing of an agreed BOM and conversion costs.

(ii) Customers had permitted procurement of materials more than requirements due to various reasons, and hence agreed to pay for the actual cost of materials procured against adequate documentation, verification and certification irrespective of their consumption.

(iii) The position of left-over materials was ill-defined. Recognition of revenue had to be made on despatch of the stores ordered and the pricing formula which permitted billing for materials procured but not fully utilised.

(iv) The value of left-over materials had perforce to be charged-off to consumption with a view to-

(a) matching costs with revenue;

(b) non-retaining of inventory at full value as the company feels that the left-over inventory paid by customers belongs to the customers and should not inflate the working capital of the company;

(c) contract was silent over charging-off of the left-over material and it appeared that the company was holding those stocks more in the nature of a bailee, as there was no compulsion to physically hand-over the materials to the customers, notwithstanding the fact that by the act of revenue recognition, transfer of title to the left-over materials had been made in an implied sense especially in the light of agreement to reimburse fully for the materials procured;

(d) customers had reserved his rights to utilise the left-over materials, only when need arose, and paid for the services rendered excluding the cost of materials utilised which had been paid for;

(e) the major contract governed by the pricing formula (operated on a requisition-wise basis) would be operated over a period of several years since the lead time of executing of the project was long and spread over several years;

(f) only numerical account had to be rendered to the customer for the left-over material once a year for the jobs completed during the year;

17.The values of left-over materials though in the custody of the company were reflected at a token value of Re.1/- per item in the books of account.

18. No work-in-progress was declared as the relevant ‘finished goods’ had already been despatched when the value of left-over materials were charged-off to consumption.

19. As per the querist, care was exercised to ensure that charge to revenue was almost uniform and did not drastically vary or alter the profitability of the company from year to year as only jobs closed during the last quarter of the financial year gets charged-off during the next financial year. Thus, each year, charging off values will consist of jobs closed during the major portion of the relevant year and a small portion of the jobs closed during the previous financial year.

20.The auditors feel that the left-over materials of even the jobs closed during the last quarter are to be charged-off during the same year, but not to be carried to the next financial year in order to match costs with revenue. The company’s argument is that major portion of left-over material is charged-off during the same financial year. Only a small portion is carried to the next year. Thus, each year’s charge consists of two portions – current year (major portion) and previous year (minor portion). Charge to revenue comprised partly of the jobs closed during the current year and partly during the previous year. This practice is unavoidable as the execution of jobs are spread over more than one financial year and review of completed jobs can be taken up only after completion of the work.

21.The querist has sought the opinion of the Expert Advisory Committee on the following issues arising form the above:

(a) Whether the accounting treatment given to the left-over materials of the contract is fair, equitable, just and reflect in spirit the conditions of contract in the books of account of the company?

(b) Can it be construed that the accounting method adopted by the company reflects a true and fair view of the accounts of the organisation, as the supplier in the contract?

Opinion May 17, 1994

1.The Committee notes that thequerist has sought opinion on the accounting treatment of left-over materials. Accordingly, the Committee has not considered the revenue recognition policy of the company in question or other accounting matters. Therefore, the opinion given hereafter deals only with the accounting treatment of left-over materials.

2.The Committee is of the view that the accounting treatment of left-over materials would depend upon whether in substance the risks and rewards of ownership of the materials vest with the supplier company or with the purchaser. The determination of vesting of risks and rewards of ownership of the left-over materials would depend upon various factors in addition to those mentioned in the query. Some of the important factors to be considered are as follows:

(i) Whether the purchaser at any point of time can recall those materials?

(ii) For how long the company is required to maintain the separate identity of the left-over material in the store?

(iii) Whether the supplier company can utilise these materials for some other jobs and in case the purchaser requires the material subsequently, the same could be replenished from some other materials.

3.The Committee, however, notes that it appears from the facts of the query, that the supplier company assumes the position of a bailee in respect of the left-over materials, from the day the relevant job is completed, i.e., accepted by the customer. Accordingly, the Committee is of the opinion that the accounting treatment being followed by the company in respect of the left-over materials is not proper. Since the company has already received payment for such materials and recognised such payment as revenue, it should fully charge off the left-over materials to the profit and loss account in the year when the job is completed, i.e., accepted by the customer. Such left-over materials should not be shown in the books of the company even at a notional figure of Re. one. However, for the purpose of control over such materials memorandum records may be maintained.

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