Expert Advisory Committee

1.25 Query:

Revenue recognition of amounts receivable on

completion of performance guarantees.

1. An engineering consultancy company is engaged mainly in design, engineering and project management activities in the petroleum sector. In addition to petroleum refining, it has started consultancy services in the areas of petrochemicals, oil and gas processing, pipelines, ocean engineering, ports and harbour, metallurgy, fertilizer, cement, paper etc. The company only gives consultancy and does not undertake construction contracts (emphasis supplied by the querist).

2. During the comprehensive appraisal of the accounts of the company, the office of the Member, Audit Board and Ex-officio Director of Commercial Audit, New Delhi, have expressed their reservation with regard to the treatment adopted by the company in the accounts in respect of the following mentioned items and have suggested that expert opinion of the Institute may be obtained. The treatment adopted by the company in the accounts and the remarks of the Member, Audit Board are given below: -

(1) The company is following a policy of recognising income as per the accounting policy which is reproduced below:

(a) 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 latest estimated total direct cost 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 obligation towards guarantees/ warranties and penalties etc., provided under negotiation in the respective contracts.

3. The company is following the above accounting policy consistently right from its inception which is based on Para 10 of Accounting Standard (AS) 9 on ‘Revenue Recognition’ issued by the Institute of Chartered Accountants of India, which is reproduced below:

“Revenue from sales or service transactions should be recognised when the requirements as to performance set out in paragraphs 11 and 12 are satisfied, provided that at the time of performance it is not unreasonable to expect ultimate collection. If at the time of raising of any claim it is unreasonable to expect ultimate collection, revenue recognition should be postponed.”

4. In the view of the querist, the above para clearly states that revenue from sales or service transactions should be recognised when the requirements as to the performance as given in paras 11 and 12 are satisfied. It may be mentioned that para 11 relates to the sale of goods and, therefore, is inappropriate to the company’s situation in question. Accordingly, para 12 which reads as under, is applicable to the company being a consultancy organisation:

“12. In a transaction involving the rendering of services, performance should be measured either under the completed service contract method or under the proportionate completion method, whichever relates the revenue to the work accomplished. Such performance should be regarded as being achieved when no significant uncertainty exists regarding the amount of consideration that will be derived from rendering the services.”

5. From the above para it is very clear, in the view of the querist, that revenue should be recognised only when no uncertainty exists regarding the amount of consideration that will be derived from rendering the service (emphasis supplied by the querist). The querist has clarified that the amount of guarantees is in respect of the guarantees issued by banks on behalf of the company against counter indemnity every year in case the client agrees to pay the money for performance guarantee entered into with the client.

6. The querist has informed separately that in case of a lumpsum contract a specified percentage is payable on mechanical completion of plant and associated facilities and on submission of bank guarantee for an equivalent amount valid for a period of 12 months. The payment received against the bank guarantees issued is taken as advance payment received and treated in books of account accordingly. The company is, thus, recognising income as regards the amount payable against performance guarantee on completion of the performance guarantee period as entered with the client and is accounted for as income in that year which falls in line with Paras 10 and 12 of AS 9.

7. The company being a consultancy organisation is also reflecting the amount of liabilities towards guarantee/warranty in Schedule-J which is required as per S.No.3 (ix) of Part II of Schedule VI to the Companies Act, 1956. From the above it can be seen that all the provisions that relate to the Companies Act, 1956, and Accounting Standard 9, which are applicable to the company, are being followed consistently.

8. The Government Auditors have commented as under:

S. No.3 (ix) of Part II of Schedule VI of the Companies Act, 1956, provides that aggregate of the amounts set aside to the provisions made for meeting specific liabilities or contingencies or commitments should be disclosed in the Profit and Loss Account. Therefore, it would not be justifiable if amount of performance guarantee withheld on completed contracts is not taken as revenue in the Profit and Loss Account and amounts of contingent liability are mentioned only in Schedule ‘J’.

Para 17.4 of Accounting Standard (AS) 7 on ‘Accounting for Construction Contracts’, issued by the Institute of Chartered Accountants of India, requires that an appropriate allowance for future unforeseeable factors should be made on either a specific or a percentage basis. The unforeseeable factors include fulfillment of performance guarantee or warranty or penalty on completed contracts. Para 18 lays down that the costs of a contract should comprise costs which relate directly to a specific contract and are attributable to the contract activity in general. Therefore, it would not be appropriate not to bring to account full revenue on completed contract. Further, AS 9 (Para 10) lays down that revenue from service transactions should be recognised when the requirements of performance set out in para 12 are, inter alia, satisfied. Para 12 provides that performance should be measured to the work accomplished and such performance should be regarded as being achieved when no significant uncertainty exists regarding the amount of the consideration that would be derived from rendering the service.

9. In view of the above, the querist has sought the opinion of the Expert Advisory Committee on the following issues: -

(i) Whether AS 7 for recognising income net of guarantee/warranty is applicable to the company.

(ii) Whether the treatment adopted by the company in framing company’s policy which is followed consistently in line with Paras 10 and 12 of AS 9 is correct.

(iii) The disclosure of the information with regard to guarantee/warranty as mentioned in Schedule J is in line with S. No. 3 (ix) of Part II of Schedule VI to the Companies Act, 1956.

Opinion February 2, 1996

1. The Committee notes that Para 4 of Accounting Standard (AS) 7 on ‘Accounting for Construction Contracts’, issued by the Institute of Chartered Accountants of India, states as below:

“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.”

2. The Committee notes from the facts of the query as stated by the querist in para 1 of the query that the company is engaged mainly in design, engineering and project management activities in the petroleum sector. Since these consultancy services are related to construction of assets, the Committee is of the view that AS 7 is applicable to such services. The view of the Committee is further strengthened from the fact that the company is giving performance guarantees in respect of the assets so constructed.

3. The Committee notes from para 2(1) of the query that the company is following a policy of recognising income, net of guarantees/warranties in a situation where the company is giving performance guarantees in respect of the assets so constructed. The Committee further notes that where the company receives amounts in respect of performance guarantee against bank guarantees, the same is treated as advance. The Committee is of the view that recognition of revenue pertaining to guarantees/warranties would depend upon uncertainty of collectability which, in turn, would depend upon the facts and circumstances of each case. Thus, in case it is estimated based on factors such as the past experience involved etc., that it is not unreasonable to expect ultimate collection, the revenue pertaining to the performance guarantee may be recognised on receipt of the relevant amount. However, in case the uncertainty relating to collectability arises subsequently, it would be appropriate to make a separate provision in this regard.

4. The Committee also notes from para 5 of the query as stated by the querist that the amount of guarantees is in respect of the guarantees issued by banks on behalf of the company against counter indemnity every year.

5. The Committee notes Clause 3(ix) of Part II of Schedule VI to the Companies Act, 1956, which is reproduced below:

“3. The profit and loss account shall set out the various items relating to the income and expenditure of the company arranged under the most convenient heads, and in particular, shall disclose the following information in respect of the period covered by the account.

(ix) (a) The aggregate, if material, of the amounts to set aside to provisions made for meeting specified liabilities, contingencies or commitments.

(b) he aggregate, if material, of the amounts withdrawn from such provisions, as no longer required.”

6. The Committee further notes from Note 4 to Schedule VI, Part I to the Companies Act, 1956, which is reproduced below:

“4. A foot-note to the balance sheet may be added to show separately contingent liabilities.”

7. The Committee notes that the term ‘Contingency’ has been defined in para 3.1 of Accounting Standard (AS) 4 on ‘Contingency and Events Occurring After the Balance Sheet Date’, issued by the Institute of Chartered Accountants of India, as below:

“A contingency is a condition or situation the ultimate outcome of which, gain or loss, will be known or determined only on the occurrence, or non-occurrence of one or more uncertain future events.”

8. The Committee further notes para 5.5. of AS 4, reproduced as below:

“5.5 The existence and amount of guarantees, obligations arising from discounted bills of exchange and similar obligations undertaken by an enterprise are generally disclosed in financial statements by way of note, even though the possibility that a loss to the enterprise will occur, is remote.”

9. The Committee is of the view, that it is not the requirement under clause 3(ix) of Part II of Schedule VI to the Companies Act, 1956, as stated by the querist in para 7 of the query, to disclose contingent liabilities. However, the disclosure made by the company in Schedule J regarding guarantees issued by banks on behalf of the company against counter-indemnity is in accordance with the requirement of Note 4 of Part I of Schedule VI to the Companies Act, 1956.

10.On the basis of the above, the opinion of the Committee on issues raised in para 9 of the query is as below:

(i) In the facts and circumstances of the query, AS 7 is applicable in respect of consultancy contracts related to construction of assets.

(ii) See para 3 above.

(iii) Amount of guarantees issued by banks on behalf of the company against counter-indemnity should be disclosed as contingent liabilities.

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