Expert Advisory Committee

Query No. 3

Subject: Accounting for additional costs expected due to pay scale revision

under a cost plus contract and revenue recognition in respect thereof.^[1]

A. Facts of the Case

1. A public sector consultancy and engineering services organisation engaged in design, procurement and project management activities in the petroleum sector also provides consultancy services in the areas of petrochemicals, oil and gas processing, pipelines, ocean engineering services, ports and harbours, metallurgy, cement, paper and power etc.

2. As per the querist, the principles on which the company recognises revenue are stated in the company’s accounting policy reproduced below :

“Income for 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 after adjusting the obligation towards guarantees, warranties and penalties etc., provided/under negotiation in the respective contracts. However, in regard to contracts where guarantees, warranties, penalties, etc. is to the extent of 100% of the contract value, the same is restricted to the exposure of the company towards such contracts by way of performance bond/guarantees etc.”

3. The querist has stated that the company comes under the Ministry of Petroleum and Natural Gas. The employees of the company are covered with two types of pay-scales: (a) employees under Industrial DA pattern, and (b) employees under Central DA pattern. The government has set up a Commission to decide about the pay package for employees on Industrial DA pattern. The pay-scales will be revised w.e.f. 1.1.1997 based on the recommendations of the Commission. Accordingly, in the year 1996-97, the company provided for wage revision for its employees on Industrial DA pattern w.e.f. 1.1.1997.

4. According to the querist, normally revision of wages takes considerable time. In the accounts for the year 1996-97, the company provided on an ad hoc basis, Rs.679 lakh towards pay and allowances, for 3 months, of officers working in the company on Industrial DA pattern. The provision so made included provision for salaries and allowances payable to persons working on jobs to be billed on lumpsum basis and also on jobs to be billed on cost plus basis.

5. The querist has informed that the government auditors were of the view that, income in respect of cost plus jobs should also have been recognised considering the provision made, in accordance with the provisions of Accounting Standard (AS) 9, ‘Revenue Recognition’ and accrual concept of accounting. They did not agree to the company’s argument that the revenue should not be recognised because of the reasonable risk associated with the actual realisation of the income in subsequent years. As per the querist, the auditors perhaps assumed that there was no uncertainty in the ultimate collection of the corresponding revenue.

6. According to the querist, as per the contracts with the clients, on cost plus jobs, the billing is done based on the actual payment made to employees and allocated to jobs on the basis of hours booked by those employees on each job. Normally, pay revision takes 3 to 4 years’ time. During this period, work on quite a number of jobs gets completed and in practice it is very difficult to recover the amount of remuneration on account of pay revision arrears billable on such jobs which have already been finished. The querist has stated that as per paragraphs 9.4 and 9.5 of AS 9, revenue should not be recognised under such circumstances. The aforesaid paragraphs are reproduced as below :

“9.4 An essential criterion for the recognition of revenue is that the consideration receivable for the sale of goods, the rendering of services or from the use by others of enterprise resources is reasonably determinable. When such consideration is not determinable within reasonable limits, the recognition of revenue is postponed.

9.5 When recognition of revenue is postponed due to the effect of uncertainties, it is considered as revenue of the period in which it is properly recognised.”

7. As per the querist, since the amount billable on cost plus jobs on account of pay revision to be recommended by the Commission cannot be determined accurately at the time of providing for the anticipated expenditure, it is not proper to recognise revenue on account thereof. Paragraphs 9.4 and 9.5 of AS 9 categorically state that where consideration is not determinable within reasonable limits, the recognition of revenue is postponed. The querist has also contended that in view of uncertainties involved in the process, the matching concept with respect to such provisions is not called for, though the provision for expenses has been made on the principle of prudence.

8. The company included the following note in the Notes to Accounts:

“Salaries and benefits include provision of Rs.1176.55 lakh (Rs.3740.78 lakh) in respect of pay revision to officers and staff for IDA employees. The amount chargeable from reimbursable jobs will be billed as per the contract when the actual payment is made.”

The querist has stated that the company has been consistently following the above policy since its inception keeping in view the concept of prudence which states that provision is made for all known liabilities and losses even though the amount cannot be determined with certainty and represents only a best estimate. According to the queriest, the principle of prudence makes it amply clear that matching concept may not be applicable in all situations where the element of uncertainty exists/is attached to future events. Keeping in view the principles of prudence and substance over form, the company has given an explanatory note to accounts (reproduced above).

9. According to the querist, the government auditors have commented on the above as under :

“Profit & Loss Account

Income (Schedule H)

Income from services rendered - Rs.27,452.40 lakh

In violation of the matching concept and the company’s accounting policy, the company has not accounted for income of Rs.679.02 lakh billable by it in respect of cost plus jobs on account of revision of pay scales with effect from 1st January, 1997 during this year even though proportionate expenditure of Rs. 515.04 lakh on these jobs has been provided in the accounts. This resulted in the understatement of income and profit by Rs.679.02 lakh.”

B. Queries

10. In view of the government auditors’ comments, the querist has sought the opinion of the Expert Advisory Committee on the following issues:

(a) Whether the accounting treatment adopted by the company i.e., providing for the anticipated expenditure but not recognising the revenue, is in line with AS 9 in view of the uncertainty attached to the recovery of the income because of:

(i) apprehended closure of the contracts before the submission of the Pay Revision Report; and.

(ii) undeterminable quantum of the revenue recognisable.

(b) If the treatment is correct, whether any further disclosure is called for.

C. Points Considered by the Committee

11. The concept of prudence as described in Accounting Standard (AS) 1, ‘Disclosure of Accounting Policies’, is as under:

“Prudence

In view of the uncertainty attached to future events, profits are not anticipated but recognised only when realised though not necessarily in cash. Provision is made for all known liabilities and losses even though the amount cannot be determined with certainty and represents only a best estimate in the light of available information.”

12. As per Accounting Standard (AS) 9, ‘Revenue Recognition’, revenue from service transactions is usually recognised as the service is performed, either by the proportionate completion method or by the completed service contract method. Paragraph 7.1(i) of the Standard states as below:

“7.1 (i) Proportionate completion method - Performance consists of the execution of more than one act. Revenue is recognised proportionately by reference to the performance of each act. The revenue recognised under this method would be determined on the basis of contract value, associated costs, number of acts or other suitable basis........”

13. Paragraph 10 of AS 9 states as below:

“10. 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.”

Paragraph 12 of the same Standard reads as below:

“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 the consideration that will be derived from rendering the service.”

14. Accounting Standard (AS) 4, ‘Contingencies and Events Occurring After the Balance Sheet Date’ states as below (paragraph 16):

“16. If disclosure of contingencies is required by paragraph 11 of this Statement, the following information should be provided:

(a) the nature of the contingency;

(b) the uncertainties which may affect the future outcome;

15. Paragraph 4 of Accounting Standard (AS) 7, ‘Accounting for Construction Contracts’, 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.”

Paragraph 7.2 of AS 7 states as below:

“7.2 Under the percentage of completion method, revenue is recognised as the contract activity progresses based on the stage of completion reached. The costs incurred in reaching the stage of completion are matched with this revenue, resulting in the reporting of results which can be attributed to the proportion of work completed. Although (as per the principle of ‘prudence’) revenue is recognised only when realised, under this method, the revenue is recognised as the activity progresses even though in certain circumstances it may not be realised.”

16. The concept of prudence thus provides that a provision for a known liability should be made even if the amount cannot be determined with accuracy. A reasonable estimate of the expenditure should be made on the basis of available information. Under the facts of the query, a provision for additional costs should be made in the books of account upon the setting up of the Commission for pay revision if the following two conditions are satisfied:

(a) It is probable that future events will confirm that a liability has been incurred at the balance sheet date; and

(b) a reasonable estimate of the amount of the resulting loss can be made.

In case either of the above conditions is not met, appropriate disclosures as required by paragraph 16 of AS 4 (reproduced above) will need to be made. It may also be noted that the provision/disclosure, as appropriate, would be required to be made in respect of the employees of the entire organisation who are covered under the proposed pay revision irrespective of the fact whether such costs would be recoverable from clients or not.

17. As per paragraphs 10 and 12 of AS 9 (reproduced above), revenue from services rendered can be recognised only if (a) at the time of rendering the services, it is not unreasonable to expect ultimate collection, and (b) no significant uncertainty exists regarding the amount of the consideration that will be derived from rendering the services. In the present case, the querist has stated that the terms of the contract provide that the actual payment made to employees is billable. Thus, the additional cost, if any, incurred on account of retrospective revision of pay scales will also be billable. It follows that if a reasonable estimate of the amount of the additional cost can be made (see paragraph 16 above), there would be no significant uncertainty in determining the amount to be recovered from the clients. In these circumstances, if it is not unreasonable to expect ultimate collection, the related revenue should be recognised.

18. The querist has indicated that a reasonable risk is associated with the actual realisation of the additional cost billed on the client after closure of jobs, thus leading to an uncertainty of realising revenue from the client. In accordance with paragraph 10 of AS 9 as reproduced in paragraph 13 above, in the case of those projects where it is unreasonable to expect the recovery of additional costs, the recognition of revenue should be postponed. However, in such a situation, disclosure as per paragraph 14 of AS 9 should be made in such a case. The aforesaid paragraph 14 reads as follows:

“14. In addition to the disclosures required by Accounting Standard 1 on ‘Disclosure of Accounting Policies’ (AS 1), an enterprise should also disclose the circumstances in which revenue recognition has been postponed pending the resolution of significant uncertainties.”

D. Opinion

19. Based on the above, the Committee is of the following opinion on the issues raised in paragraph 10:

(a) As the terms of the contract provide that the actual payment made to employees is billable, the additional cost, if any, incurred on account of retrospective revision of pay scales will also be billable. Therefore, if a reasonable estimate of the amount of the additional cost can be made as stated in paragraph 16 above, there would also be no significant uncertainty in determining the amount to be recovered from the clients. In these circumstances, if it is not unreasonable to expect ultimate collection, the related revenue should be recognised.

(b) Please see paragraph 18 above.

[1]Opinion finalised by the Committee on 13.8.1998.