1.11  Query:  

  Accounting for costs and recognition of income in a service organisation.

1. A limited company is providing consultancy in project management, designing and computers etc. The fee charged to the clients is either a percentage on the executed cost of the contracts or on lumpsum basis/man month basis.

2. The querist has stated that as per the existing policy/procedures followed by the company, income is recognised on technical evaluation based on percentage of completion method after keeping safety margins. The company is having a turnover of six to seven crores annually. The main jobs, where elaborate costing system is required, are project management consultancy and design assignments. For carrying out inhouse design assignments, the designers book their time (engineer days) for each project on their assessment and for project management the booking of earnings is based on the completion of milestone/bills raised etc. The statutory auditor felt that this costing system does not reflect the cost of each project in totality. In essence, total engineer days (mandays) possible in a year by utilising the regular technical manpower and the total engineer days (mandays) booked in various assignments are compared. This process takes into account/avoids overbooking or underbooking of engineer days (mandays) for projects as the work involved is also taken into account. Further, all direct expenses attributable to particular consultants are duly recorded and charged to the projects. This practice has been followed for more than ten years and this accounting policy has also been approved by the Board of Directors. The cost of engineer days (mandays) is always being reviewed and revised by the management periodically to avoid major discrepancies. The illustrative computations related to an engineer-day cost submitted by the querist are given in Annexure I.

3. As mentioned above, the system of recognising and booking of consultancy income is followed by the company for a number of years consistently and also being relied upon by the auditors. This year, however, the company’s statutory auditors have objected to the above prevalent practice of recognising income by commenting that the system is not scientific/satisfactory and, hence, could not be fully relied upon. According to the statutory auditors, deficiencies, inter-alia, included accounting of income based on technical evaluation only and is without considering cost incurred/cost to be incurred as no such accounting is undertaken. The aspects as mentioned above in para 2 were also explained to them. Moreover, it was also explained that the company deals in various types of projects like feasibility studies, wherein lumpsum fee is agreed upon with the clients and the mode of payment involves 50% along with the order and the balance on submission of draft and final report. Such contracts are usually spread over a number of years. On such projects, income is recognised on the reporting date based on the amount of efforts put in on the project and the advance fee, if any, is shown under “Advances from customers”. In the case of other contracts where the fee is linked with the stage of completion of the contracts, the revenue is recognised based on the billable stage and the balance upto the stage of reporting is shown as Sundry Debtors (Accrued Consultancy Fee). Auditors not being satisfied with the above explanation have qualified their report.

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

      (i) (a) Does the existing system followed by the company require review/modification, keeping in view the size of operations of the company? Further, whether to have a detailed costing system in contract accounting to match the revenue with the cost incurred/cost to be incurred without any exception or the cost can also be matched with revenue through the booking of engineer days (mandays) cost on projects for consultancy organisations.

            (b) Is it required to follow the system of recognising income as per Accounting Standard (AS) 7 on Accounting for Construction Contracts, issued by the Institute of Chartered Accountants of India or whether it can be applied to the extent as applicable to a service company and matching cost with revenue without detailed and exhaustive costing system.

      (ii) (a) How to determine and provide for the foreseeable losses, i.e., whether 100% earnings on the project should be booked on completion and then provide for, on ad hoc basis, for defects, rectifications etc., during defect liability period or it can/be shown net of earnings.

            (b) In the case of a consultancy, usually 5 to 10% of the amount is retained by the clients towards satisfactory adoption of the reports; whether it is a must to account for 100% income irrespective of the fact that the money has been retained by the client and chances of its realisation being remote.

            (c) How to quantify and provide for the losses due to future unforeseeable factors?

            (d) Whether amount billed to clients, having significant uncertainties and dispute of recovery, can be shown by reducing from sundry debtors without taking into income.

(iii) Ac                   (iii) Accrued consultancy income being the difference of income on reporting date and last billable stage contains the profit element when income                               is recognised on technical evaluation basis which has been objected to by the auditors. Does the objection hold good? If yes, can the                               profit element be unloaded to bring this at cost and correspondingly income to that extent be reduced?

                                                                                      Opinion                                 September 24, 1996

1. The Committee notes para 4 of Accounting Standard (AS) 7 on Accounting for Construction Contracts, issued by the Institute of Chartered Accountants of India, 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. On the basis of the above, the Committee is of the view that AS 7 would be applicable in respect of consultancy contracts in project management, designing, computers, etc., undertaken by the company where such contracts are related to the construction of an asset. The Committee is further of the view that the accounting principles enunciated in AS 7 would broadly be applicable in case of those long term contracts also which do not relate to construction of an asset.

3. The Committee notes that the company in question is following a rough and ready method of arriving at the cost of a project. The Committee is of the view that the method of costing followed by the company needs to be developed further. The company should relate actual costs to individual projects. In this context, the Committee wishes to draw the attention of the querist to the manner of accumulation of cost for construction contracts as laid down in para 8 of AS 7 as reproduced below:

“8. Costs to be accumulated for Construction Contracts

          8.1 Costs attributable to a contract are identified with reference to the period that commences with the securing of the contract and closes when the           contract is completed.

          8.2 Costs not specifically attributable to any contract incurred by the contractor before a contract is secured are usually treated as expenses of the           period in which they are incurred. However, if costs attributable to securing the contract can be separately identified and either the contract has been           secured or there is a clear indication that the contract will be obtained, the costs are sometimes treated as applicable to the contract and are deferred.           As a practical measure, costs directly identifiable with a contract are sometimes deferred until it is clear whether the contract has been secured or not.

          8.3 Costs attributable to a contract include expected warranty costs. Warranty costs are provided for when such costs can be reasonably estimated.

          8.4 Costs incurred by a contractor can be divided into:

        (i) Costs that relate directly to a specific contract;

        (ii) Costs that can be attributed to the contract activity in general and can be allocated to specific contract;

        (iii) Costs that relate to the activities of the contractor generally, or that relate to contract activity but cannot be related to specific contracts.

            8.5 Examples of costs that relate directly to a specific contract include:

                    (i)  site labour costs, including supervision;

        (ii)  materials used for project construction;

                    (iii) depreciation of plant and equipment required for a contract;

        (iv) costs of moving plant and equipment to and from a site.

          8.6 Examples of costs that can be attributed to the contract activity in general and can be allocated to specific contracts include:

        (i) insurance;

         (ii) design and technical assistance;

         (iii) construction overheads.

          8.7 Examples of costs that relate to the activities of the contractor generally, or that relate to contract activity but cannot be related to specific           contracts, include:

           (i) general administration and selling costs;

           (ii) finance costs;

           (iii) research and development costs;

           (iv) depreciation of plant and equipment that cannot be allocated to a particular contract.

          8.8 Costs referred to in paragraph 8.7 are usually excluded from the accumulated contract costs because they do not relate to reaching the present           stage of completion of a specific contract. However, in some circumstances general administrative expenses, development costs and finance costs are           specifically attributable to a particular contract and are sometimes included as part of accumulated contract costs.”

4. In the view of the Committee, the cost of the project should not include a profit element.

5. With regard to revenue recognition on the contract, the Committee is of the view that the company can follow the percentage of completion method only if it is in accordance with the requirements as laid down in para 17 of AS 7 reproduced below:

“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 cost 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.”

6. With regard to determination of stage of completion for the purpose of recognition of revenue, the Committee notes that para 9.2 of AS 7 states as below:

“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.”

7. With regard to the consideration of uncertainties, the Committee is of the view that if the uncertainties are so significant that the conditions specified in para 17.1 of AS 7 reproduced in para 4 above are not met, the company should not follow the percentage of completion method but should follow the completed contract method.

8. With regard to the provisions for the foreseeable losses, the Committee notes that para 19 of AS 7 states as below:

“19. A foreseeable loss on the entire contract should be provided for in the financial statements irrespective of the amount of work done and the method of accounting followed.”

The Committee is, therefore, of the view that the entire foreseeable losses should be booked irrespective of the booking of the revenue on the contract. The provision for foreseeable losses should not be netted off from the revenue recognised.

9. The provision for losses due to future unforeseeable factors can be either on a specific or a percentage basis. Where it is decided not to recognise revenue in respect of the amount billed to client in view of the significant uncertainties, neither the revenue should be booked nor the amount be shown as sundry debtors in the first instance. In view of this, the question of reducing the same from sundry debtors will not arise.

10. On the basis of the above, the Committee is of the following opinion in respect of the issues raised in para 4 of the query:

(i) (a) The existing system followed by the company requires review/modification. Insofar as the determination of the cost of individual project is concerned, it should be accumulated in accordance with the principles laid down in para 8 of AS 7 which is reproduced in para 3 above.

            (i) (b) Please see para 2 above.

(ii) (a) Provision for foreseeable losses should be made in respect of the entire contract irrespective of the amount of work done and the method of accounting followed. Such a provision should be made in the period in which the foreseeable losses are assessed to arise and not on the completion of the project. However, in no situation, revenue booked during the period should be net of the provision.

                 (b) The question is whether revenue in respect of retention money should be recognised when the chances of realisation thereof are remote. The Committee is of the opinion that in such a situation the said revenue should not be recognised.

                 (c) While recognising the profit under percentage of completion method, an appropriate allowance for future unforeseeable factors should be quantified on either a specific or a percentage basis.

                 (d) Sundry debtors cannot be directly reduced in respect of amounts billed to clients having significant uncertainties and dispute of recovery. A provision in this regard has to be created if the amount has already been recognised as revenue.

(iii) Stage of completion of the contract should be decided keeping in view the factors as stated in para 5 above and not only on the basis of bills raised. Accordingly, revenue and the profit should be recognised, also taking in account the other principles laid down in AS 7 discussed above.

ANNEXURE I

Hypothetical case involving calculation for working

out an Engineer-day cost

Direct Cost of an Engineer (Manager Level)

                                                                                                                        Rs.      

Assumptions

1.         Calculation of direct cost has been based on the salaries at Engineer Level (Manager). For other categories weightage is given and calculated on the basis of their salary structure as below:

2.The Engineer-day cost is reviewed periodically on the basis of actuals.

3.         Man days are being booked on the basis of time sheets filled in by the respective engineers.

Calculation of Overheads

(Rs.in lakhs)

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