Query No. 2

Subject:     

Inclusion of indirect costs in the total contract cost.^[1]

A. Facts of the Case

1. Aconsultancy and engineering company engaged in design and project management activities in the petroleum sector undertakes work in the areas of petrochemicals, oil and natural gas, pipelines, ocean engineering, ports and harbours, power, metallurgy, cement, paper, etc.

2. According to the querist, during the course of audit of accounts for the year 1996-97, government auditors have expressed certain reservations with regard to non-provision of foreseeable losses and commented that the treatment adopted by the company is not in line with paragraph 13 of Accounting Standard (AS) 7, ‘Accounting for Construction Contracts’, read with paragraph 19 of the same Standard.

3. The accounting policy of the company for recognition of revenue is as below:

“I. 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 costs 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.  However, in regard to contracts where guarantees, warranties, penalties etc. are 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.

        II. Turnover/Work-in-Progress

(1)  No income is taken into account in respect of jobs for which:

         (a) the terms of remuneration receivable by the company have not been settled and/or scope of work has not been clearly defined and, therefore, it is not possible in the absence of settled terms to determine whether there is a profit or loss on such jobs.  However, in cases where minimum undisputed terms have been agreed to by the clients, income has been accounted for on the basis of such undisputed terms though the final terms are still to be settled.

               (b)  the terms have been agreed to at lumpsum basis but:

                (i) the physical progress is less than 25%;

                 (ii) supply of equipment is not complete in case of works contracts.

     Costs of jobs as above are carried forward as work-in progress.

(2)  While determining the work-in-progress overheads incurred at head office and other offices are not considered.”

4. According to the querist, as regards cost-plus jobs, the company recognises revenue as and when the expenditure is incurred.  The invoices to the clients are raised broadly under the following heads:

      (i)  payroll cost;

 

      (ii)  out-of-pocket expenses; and

 

      (iii)  fee.

The overheads of the company are billed to the clients at a fixed percentage of the payroll cost.  This percentage is worked out on the basis of previous year’s data and applied in the following year.  As the payroll cost, out-of-pocket expenses, fee and overheads are recovered, there is no question of having any direct losses on these jobs since these are cost-plus jobs.

5. In respect of lumpsum contracts, the company raises its invoices on the clients on the basis of milestones stated in the contract.  It recognises income on lumpsum jobs in the following manner:

      (i)  No income is recognised when the progress of job is less than 25%. While determining the work-in-progress, overheads incurred at head office and other offices are not included in work-in-progress and are charged to the profit and loss account in the respective years.

 

      (ii)  Income is recognised in the same proportion which the actual direct cost of the work done bears to the latest estimated total direct cost of the work, or in proportion to the work estimated to have been executed, whichever is less.

For this purpose, the company draws revised cost estimates at the end of each financial year.

6. According to the querist, the government auditors have pointed out three cases in which, according to them, the company has not provided for the foreseeable losses to the extent of Rs. 267.39 lakhs.  As per the querist, the auditors, in their report, have stated that paragraph 13 of AS 7, read with paragraph 19 of the same Standard, requires that the foreseeable losses on the entire contract should be provided for in the financial statements irrespective of the amount of work done and method of accounting followed.

7. According to the querist, the government auditors, while working out the losses, have taken into account the indirect costs also besides direct costs.  This, according to the querist, is not correct in the context of the accounting policy followed by the company in respect of indirect costs, viz., to charge them off to the profit and loss account in the year of incurrence.  The querist’s contention is that there are no foreseeable direct losses on the jobs based on revised direct cost estimates.

B. Queries

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

(a) Whether the treatment adopted by the company in respect of exclusion of indirect costs in computing the total contract cost as explained above is as per the generally accepted accounting principles.

 

(b)  If the treatment adopted by the company is correct, whether any further disclosure in the accounting policy of the company is called for.

 

(c) If the treatment adopted by the company is not correct, what is the correct manner of accounting for foreseeable losses or disclosure thereof.

C. Points Considered by the Committee

9. The Committee observes that the basic issue in the query is that whether indirect costs form part of the cost of the contract or whether they should be expensed in the year in which they are incurred.

10. The Committee notes paragraphs 8.4, 8.6, 8.7 and 8.8 of Accounting Standard (AS) 7, ‘Accounting for Construction Contracts’ which state as below:

“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 contracts;

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

“8.6 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.”

11. From the above, the Committee notes that whether indirect costs should be included in the cost of construction or not, would depend on their nature.  Indirect costs of the nature described in paragraph 8.6 of AS 7 should be included in the cost of construction.   On the other hand, indirect costs of the nature described in paragraph 8.7 of AS 7 should not generally be included in the cost of construction.

12. The Committee notes that from the facts furnished by the querist, the exact nature of indirect costs that the auditors have included in the contract cost is not clear.  Therefore, the Committee is unable to state whether those indirect costs should be included in the contract cost or not.  This issue will have to be decided on the basis of the principles enunciated in paragraph 11 above.

13. The Committee notes paragraph 19 of AS 7 which 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.”

Accordingly, where the estimates of total contract cost (inclusive of indirect costs of the nature referred in paragraph 8.6 of AS 7) and revenue indicate a loss, a provision for the entire loss on the contract will need to be made as required by paragraph 19 of AS 7.

D. Opinion

14. Based on the above, the Expert Advisory Committee is of the following opinion on queries raised in paragraph 8 above:

(a) If the indirect costs under reference are of the nature described in paragraph 8.6 of AS 7, their non-inclusion in contract cost is not appropriate.  On the other hand, if these costs are of the nature described in paragraph 8.7 of AS 7, they should not be included in contract cost (unless they are specifically attributable to a contract).

 

(b) See (a) above.

 

(c) The foreseeable losses should be provided for on the basis of the estimate of total contract cost including the indirect costs of the nature described in paragraph 8.6 of AS 7.

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^[1] Opinion finalised by the Committee on 4.3.1999.