1.5 Query:

Accounting treatment on unconsumed material at the end

of financial year in case of cost plus contracts

(i)            Item-rate contracts

(ii)            Lumpsum contracts

(iii)            Cost-plus contracts

(iv)            Turnkey projects.

2.The querist has stated that the company has been maintaining its financial accounts in respect of these contracts under ‘Percentage of Completion Method’ as per Accounting Standard (AS) 7 on ‘ Accounting for Construction Contracts’, issued by the Institute Chartered Accountants of India, except in case of cost plus contracts where the total cost incurred towards work is reimbursed by the clients and is thus charged to profit and loss account. Since the total cost of material procured is fully reimbursed by the clients, the company is not showing any inventory of the unconsumed material lying at site at the close of the financial year. The querist has further clarified that in case of cost-plus contracts, revenue is recognised by raising bills on the clients which include all materials procured and lying unconsumed. Accordingly, client has been charged for all the direct cost of material/stores purchased which are booked under value of work done irrespective of whether material has been consumed in the works or not. As per the terms and conditions of the contract, the payments are normally released by clients on procurement of the materials and such payments are not linked with the execution of project. As such, on supply of material and procurement thereof, according to the querist, the right of property is also passed on to the client. The unused material thus becomes the property of the client and the company loses its right to transfer the same anywhere. As such, the closing stock at the end of accounting year is not shown as unconsumed material. However, it is mentioned by the querist that the company remains liable for the timely completion of the project for which the contract is made.

3. According to the querist, the non-exhibition of inventory of unconsumed material at the close of the financial year has been adversely commented by the statutory auditors and the Member, Audit Board. 

4. The querist has mentioned that in response to the observation of the Member, Audit Board, it was clarified to them that such contracts are awarded on cost-plus basis with the following stipulations:

(i)         Actual cost will be inclusive of cost of all materials purchased directly or indirectly for use on work with or without value.

(ii)        Cost of direct labour engaged, inclusive of fringe benefits like bonus, compensation and insurance premium, also forms part of the actual cost.

(iii)       Maintenance/Running/Repair of plant and machinery and hire charges of plant and machinery and all incidental expenses incurred in connection with execution of work are allocated to work.

(iv)       The owner’s representative is associated with all major purchases of material.

(v)        Monthly R.A. bills of actual cost comprising cost incurred on work based on different vouchers are raised and payment realised within the period stipulated in the agreement.

(vi)       The material remaining unconsumed at the close of the year is not shown in the inventory as such material is the property of the clients because of reimbursement of full cost of the material by them.

(vii)      All materials which are unconsumed after the completion of the project will be handed over to clients within one month of the date of handling over of the project. As a matter of fact, as the right of ownership/material gets passed on to the client at the time of its reimbursement, the closing stock is not being exhibited in the ‘Inventory Schedule’ and is included in sales.

5. The querist has further informed the revenue recognition policy of the company as follows:

“The Value of Work Done for Cost Plus/Deposit/Project Management works includes besides other expenses, material procured & lying unconsumed and secured advances to sub-contractors.”

6. The revenue is being recognised strictly as per the above accounting policy. Under the cost-plus contracts, clients are reimbursing all the costs incurred by the company including the percentage of margin thereon. If any material is left unused at the end of the accounting year, the same is not shown as inventory but as per the existing practice such procured/issued material is charged in the value of the contract.

7. The statutory auditors of the company have qualified their report in this regard as follows:

“Value of Work Done (VWD) in respect of Cost Plus/ Deposit/Project Management works includes stock of unconsumed material amounting to Rs. 2,00,24 thousand as on close of the year and profit thereon as applicable. Effect on loss for the year in unascertained.”

8. The querist has informed the Committee that another public sector company has also been following the same accounting policy in this regard.

9. The querist has sought the opinion of the Expert Advisory Committee as to whether the accounting treatment of the unconsumed material at the close of the financial year in case of cost plus construction contracts executed by the company for the client is proper.

                                                                      Opinion                                           May 16, 1997

1. The Committee notes from the facts of the case that in case of cost-plus contracts the company is not following the percentage of completion method. The Committee further notes that in respect of the materials purchased for use in the cost-plus contracts, the company is recognising revenue by including the same in the value of work done inclusive of the profit margin thereon. Thus, obviously, the company is not following the completed contract method in respect of its cost-plus contracts. The Committee notes that Accounting Standard (AS) 7 on ‘Accounting for Construction Contracts’, issued by the Institute of Chartered Accountants of India, requires in para 16 that “either the percentage of completion method or the completed contract method may be used”.

2. On the basis of the above, the Committee is of the view that even in case of a cost-plus contract which inherently involves reimbursement of all expenses plus a profit margin, the revenue in respect thereof shall only be recognised as the contract progresses, only by adopting the percentage of completion method as per AS 7. Thus, in the view of the Committee, recognition of revenue only on the acquisition of material by the contractor would be appropriate, inter alia, if the acquisition of material constitutes in itself the relevant stage of completion, without actually performing the physical construction work, as per para 9.2 of AS 7 reproduced below:

“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 contracts, by surveys which measure work performed and completion of a physical proportion of the contract work.”

3. The Committee is, however, of the view that in case of construction contracts, generally, the physical completion of the contract is of paramount importance in determining the stage of completion for the purpose of revenue recognition. Accordingly, acquisition of material only may not be an appropriate stage of completion of the project.

4. The Committee is further of the view that it is the inherent nature of a cost-plus contract that all the expenditure incurred by the contractor is reimbursed plus a profit margin thereon as per the terms of the contract. Thus, the fact that on completion of the contract, the balance of material remaining unconsumed will be returned to the client, does not change the inherent nature of the cost-plus contract. A typical cost-plus contract submitted by the querist does not seem to convey a different nature of a cost-plus contract. The Committee is, accordingly, of the view that non-disclosure of the unconsumed material by way of a closing stock at the end of the year would result in over-stating the amount of the value of material consumed for the purposes of disclosure in the profit and loss account. It will also over-state the figure of turnover of the company by including the value of unconsumed material inclusive of profit element thereon. The Committee is, accordingly, of the view that the unconsumed material should be disclosed as closing stock in the financial statements of the company at the end of a financial year, even though the cost in respect thereof is to be reimbursed by the company and the same is lying with the company to be returned to the client on completion of the contract. However, on completion of the project, the value of the material to be returned to the client may be disclosed after netting off the corresponding liability in this regard.

5. On the basis of the above, the Committee is of the opinion that the accounting policy followed by the company in respect of the unconsumed material in case of cost-plus construction contracts is not proper.

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