1.10 Query: 

   (i)   Revenue recognition from sale of goods before delivery there of.

(ii)  Revenue recognition in respect of long production cycle items.

1. A Government of India Undertaking, ABC Ltd., under the Ministry of Defence, registered under the Companies Act, 1956, manufactures a wide range of products like super alloys, titanium alloys, maraging steel, molybdenum etc., for strategic sectors like space, aeronautical, nuclear power and commercial sectors like lamp, furnace, instrumentation, electronics, communications, petroleum, petrol-chemicals, fertilisers etc. The metals are produced and sold in the form of ingots, forged billets, sheets, plates, strips, rods, wires, rings etc. To enable supply of the material in the form specified by the customers requiring special operations like machining, rolling, ring forming etc., for which facilities are not available inhouse, such jobs are off-loaded to the sub-contractors in India and abroad. The company’s sales turnover in 1995-96 was Rs.86 crores.

2. The querist has drawn the attention of the Expert Advisory Committee to the accounting policies with regard to sales and despatches to sub-contractors which are reproduced below:

(i)         Sales: Sales include excise duty. Sale is set up when the goods including serviceable scrap are unconditionally appropriated to the sale contract irrespective of delivery and location (emphasis added). Whenever the customer’s prior inspection at works is stipulated, sale is accounted only after acceptance.

          (ii)            Despatches to sub-contractors:

“In respect of the contracts for supply of items requiring long production cycle time which involve intermediary/final operations outside the company, income is considered as under (emphasis added):

3. The company has been setting up the sales/income as per the above accounting policy which is consistently being followed. The accounting policy as stated in para 2(i) above provides for setting up sale when the goods are unconditionally appropriated to the sale contract irrespective of delivery and location in case of ex-works sale orders. In respect of the contracts for supply of items which involve intermediary/final operations outside the company and the operations are spreading over more than one finanical year, the company is recognising the revenue as stated in para 2(ii) and passing all necessary accounting entries in the books of account.

4. For the year 1995-96, the company had accounted for an amount of Rs.5.18 crores as sales in respect of the goods covered as per the accounting policy stated at para 2(i), i.e., the items produced as per the firm orders received, inspected by the company’s quality control department and by the customer’s inspectors, in the cases where such a condition is stipulated by the customers, and unconditionally appropriated to the sale contract but the despatches took place after 31.3.1996. In these cases, though the invoices are raised, despatches did not take place by 31.3.1996 for various reasons like non-availability of the nominated transporters, non-availability of destination particulars from customers, retention of goods at the request of customer, and non-availability of road permits, Military Credit Notes (in case of despatches to military establishments) and Excise Exemption Certificates, Which are the responsibility of the customer. Further, for the year 1995-96, an amount of Rs. 3.78 crores was accounted as income towards despatches to sub-contractors in respect of the items sent to the sub-contractors as per the accounting policy stated at para 2(ii).

5. Statutory auditors of the company, while reporting on the accounts for the year 1995-96, qualified their report stating that the company’s accounting policies on revenue recognition, viz., sales and despatches to sub-contractors, are not in conformity with the mandatory Accounting Standard (AS) 9 on ‘Revenue Recognition’, issued by the Institute of Chartered Accountants of India.

6. In the view of the company, according to the querist, sales were set for the year 1995-96 as per the accounting policy which is consistently being followed. However, the statutory auditor qualified his report stating that the performance as contemplated in the accounting standard has not been fulfilled. The querist has submitted the extract of the audit report with the qualification on revenue recognition for the perusal of the Committee.

7. The querist has invited the attention of the Committee to the fact that the company is manufacturing certain critical and high value products and supplying the same to strategic sectors like space, aeronautics, armaments etc., involving production operations spreading over more than one financial year. Many a times, while manufacturing such critical products, the company is off-loading certain operations to its sub-contractors in India and abroad. In such cases, where major portion of the work by the company has been completed, as per the accounting policy of the company, the company is recognising income upto the stage of the completion of the jobs under the head ‘despatches to sub-contractors’ and necessary accounting entries are passed in the books of account. In these cases, as major values are involved and the major portion of the expenditure is also booked to the relevant expenditure heads, in case proportionate matching income is not booked in the respective year of the work done, there will be distortion in the operating results shown in the financial statements. The company has evolved the accounting policy at para 2(ii) and is following it consistently for the past several years without any objection from any agency to book the proportionate income. The company’s accounting policy on booking of income under despatches to sub-contractors ensures the concept of matching revenue with costs, and reflects revenue in the accounting period during which activity is undertaken to earn such revenue. The company’s accounting policy thus, matches the level of reported income to the level of reported activity in the view of the querist. He has further expressed his view that the company’s case is synonymous to that of construction contracts and the same treatment that is allowed to be followed for revenue recognition on construction contracts as per Accounting Standard (AS) 7 on ‘Accounting for Construction Contracts’, issued by the Institute of Chartered Accountants of India, is to be considered here also, though the products being manufactured are metals in different forms like sheets, rods, rings etc., and not complex pieces of equipment. The querist has further informed that there are no long production cycle items which are completely produced within the company.

8. The querist has illustrated the process of a long production cycle item as below:

An order was received by the company from M/s. PQR Ltd., for supply of Maraging Steel (MDN 250) Plates and Rings valuing Rs. 25 crores approximately. The order was received from the customer in March, 1996, and melting and forgoing operations commenced thereafter in ABC Ltd., for making ready the forged slabs stocks/forged ring stock which serves as the input material for conversion into Plates/Rings at the works of sub-contactors. With respect to conversion into Plates, a contract was concluded in October, 1996 with M/s. XYZ, for rolling and solution treatment of the Plates. Eleven Plates have been rolled and heat treated in February, 1997, and finishing operations such as sizing, levelling, DP test etc., are expected to be completed by April, 1997. Thereafter, the plates will be sent for sand blasting operation to another sub-contractor which is going to be done in a time frame of about 2 to 3 months minimum. The sand blasted plates which are likely to be ready by June 1997 will be sent to another sub-contractor for polishing and finishing operations which will take another 4-5 months. After final inspection, they are expected to be progressively delivered to the customer sometime around October/November, 1997. It may be noted that these various operations are not continuous and are to be carried out at different work centres and the above said production cycle time involved is subject to unforeseen delays in any of the work centers. Elaborate inspection procedures are called for at every stage of manufacture, both within company as well as at sub-contractor’s works by the company’s inspectors and the customers’ inspectors.

Similarly, for the supply of Rings to M/s. PQR against the above said contract, ABC has already made ready the forged stock for conversion into Rings at the works of a sub-contractor. A contract for conversion into Rings has been concluded with a foreign firm. After receipt of the foreign Government’s clearance, which has been sought by the company’s sub-contractor, the forged stock will be sent abroad for conversion. Considering the transit time by sea for sending the input stock, ring rolling at sub-contractors’ works, inspection prior to despatch and receipt in India will involve minimum 6 months time and part quantity of the rings are expected to be delivered to the customer around September, 1997. Joint inspections by representatives of ABC as well as PQR both at ABC’s works as well as at sub-contractors’ works are to be carried out involving elaborate inspection procedures which are very time consuming.

9. In consonance with the accounting policy at para 2(i) above, sales amounting to Rs. 5.18 crores, accounted for in 1995-96 as the sales contracts were on ex-works basis and the goods were unconditionally appropriated to the respective sale contracts. Further, there is no uncertainty with regard to the amount of the consideration that will be derived from the sale of the goods. Though the delivery of the goods has not taken place for the reasons given in para 4, such transactions are taken as sales on the strength of the legal position in case of ex-works contracts. A sale is defined under Section 4 of the Sale of Goods Act, 1930, as a contract whereby the seller transfers or agrees to transfer of the property in the goods to the buyer for a price. The expression of transfer of property as per the Transfer of Property Act essentially connotes the passing of rights or title in the property from one person to another. Accordingly, a sale as per the Sale of Goods Act, 1930, read with the Transfer of Property Act, envisages transfer of the property in goods to the buyer for a consideration along with various other stipulations like capacity of the parties, acceptance, mutual consent, competence of the parties, delivery etc. A contract of sale is completed where the transfer of the property in goods is effected irrespective of the actual transfer or removal of goods.

10. In view of the foregoing the querist has sought the opinion of the Expert Advisory Committee on the following issues:

(i)         Whether the accounting policy of the company with regard to setting up of sales irrespective of delivery and location is in line with Accounting Standard 9 on ‘Revenue Recognition’.

(ii)        Whether the accounting policy according to which the company is taking into books the value of despatches to sub-contractors upto the stage of completion as income where production operations are speared over more than one financial year is in accordance with the normally accepted commercial accounting principles.

                                                                     Opinion                                                          May 16,1997

1. The Committee notes that with regard to recognition of revenue in respect of sales of goods (hereinafter referred to as short production cycle items) paras 10 and 11 of Accounting Standard (AS) 9, on ‘Revenue Recognition’, issued by the institute of Chartered Accountants of India, prescribe as below:

“10. Revenue from sale 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.

11. In a transaction involving the sale of goods, performance should be regarded as being achieved when the following conditions have been fulfilled:

(i)         the seller of goods has transferred to the buyer the property in the goods for a price or all significant risks and rewards of ownership have been transferred to the buyer and the seller retains no effective control of the goods transferred to a degree usually associated with ownership; and

(ii)        no significant uncertainly exists regarding the amount of the consideration that will be derived from the sale of the goods.”

2. The Committee notes that Section 23(1) of the Sale of Goods Act, 1930, lays down as below:

“Where there is a contract for the sale of unascertained or future goods by description and goods of that description and in a deliverable state are unconditionally appropriated to the contract, either by the seller with the assent of the buyer or by the buyer with the assent of the seller, the property in the goods thereupon passes to the buyer. Such assent may be expressed or implied, and may be given either before or after the appropriation is made.”

Thus, if it is legally sustainable that property in the goods has been transferred as per the aforesaid provision of law, performance should be regarded as having been achieved for the purpose of compliance with AS 9.

3. The question whether all significant risks and rewards of ownership have been transferred to the buyer and the seller retains no effective control of the goods transferred to a degree usually associated with ownership, is a question of fact. For this purpose, factors such as who will bear the loss in case the goods are destroyed while they are in the custody of the seller, the risk of loss in transit, the rights of the unpaid seller etc., will have to be considered in each case of sale.

4. The Committee is, accordingly, of the view that in case of short production cycle items whether the transfer of property has actually taken place or significant risks and rewards of ownership in the goods have been transferred to the buyer are to be determined keeping in view the legal provisions and the actual facts and circumstances of the case; respectively, as discussed heretobefore.

5. With regard to long production cycle items taking more than a year to complete, in respect of which the company is recognising revenue before completion thereof, the Committee notes that Accounting Standard (AS) 7 on ‘Accounting for Construction Contracts’, issued by the Institute of Chartered Accountants of India, states about the applicability of the standard, inter alia, in paras 2 and 3 thereof, as below:

“2. The feature which characterises a construction contract dealt with in this Statement is the fact that the date at which the contract is secured and the date when the contract activity is completed fall into different accounting periods. The specified duration of the contract performance is not used as a distinguishing feature of a construction contract. Accounting for such contracts is essentially a process of measuring the results of relatively long-term events and allocating those results to relatively short- term accounting periods.

3. For the purposes of this Statement, a construction contract is a contract for the construction of an asset or of a combination of assets which together constitute a single project. Examples of activity covered by such contracts include the construction of bridges, dams, ships, buildings and complex pieces of equipment.”

6. From the above, the Committee notes that essentially AS 7 can be applied in situations where the accounting process involves measuring the results of relatively long-term events (often more than a year) and allocating those results to relatively short-term accounting period. The Committee is, therefore, of the view that in the present case, although the items produced by the company may not be strictly classifiable as complex pieces of equipment, yet, AS 7 can be applied in view of the aforesaid accounting process involved. However, the collection of costs and recognition of revenue in respect of such contracts should be in accordance with the terms and conditions laid down in the Standard. Accordingly, in case the company wishes to follow percentage of completion method to recognise revenue on the basis of stages of completion, it should be done as per AS 7.  For instance, the stage of completion should be determined as per para 9.2 of the Standard as below:

“9.2  The stage of completion used to determine revenue to be recognised in the financial statement 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.”

Similarly, as per AS 7, percentage of completion method can be followed if, inter alia, the following conditions are satisfied: 

“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 contract, 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.

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

(i)                 In respect of revenue recognition for short production cycle items, please see paras 2 to 4 above.

(ii)        In respect of long production cycle items, revenue can be recognised as the contract progresses only if such recognition is strictly in accordance with AS 7.

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