Query No. 29

Subject:   

A.  Facts of the Case.

1.  A company has been undertaking civil engineering contracts for the last three decades.  According to the querist, the company recognises income based on percentage completion method as per Accounting Standard (AS) 7, ‘Accounting for Construction Contracts’.  The maximum tenure of the company’s projects is about 3 years and it is in a position to determine the profit/loss of a project with reasonable certainty even at the time of receiving the order itself.  All the company’s contracts are fixed price contracts, some of which have escalation clauses.

2.  The company recognises income (turnover) as and when the bills are certified by its clients irrespective of the fact whether the payment is received or not.  Similarly, the expenses are accounted for as and when the liability is incurred irrespective of the fact whether the payment is made or not.  As per the querist, the company, in accordance with paragraph 9.8 of AS 7, has a policy not to recognise profit or loss from a project unless a minimum of 20% of the total project value is completed.

3. Thus, the company recognises profit only on completion of atleast 20% of the total value of the contract.  As per the querist, the profit or loss in respect of the whole project is determined after taking into account the following as specified in paragraph 9.6 of AS 7:

      (i)  The income in respect of work done for a project is accounted for based on the bills certified by the client.

      (ii)  The expenditure is accounted for as and when the liability is incurred.

      (iii)  Future estimated cost to complete the project.

     (iv)  Future estimated billing till the completion of the project.

The overall profit or loss of the project is estimated after taking into account the above factors.  The profit/loss is then arrived at as a percentage of the total value of the project.  The expected profit/loss percentage thus arrived at is applied to the overall work done upto the end of the financial year and the quantum so arrived at is shown as profit or loss as the case may be.

4.  As per the querist, by employing this method, the company not only recognises the profit/loss of a project uniformly over different financial years but also takes the advantage of percentage completion method by way of reflecting income to the extent of work actually executed as stated in AS 7.

5.  If the difference between the income and the expenditure for any financial year for a given project on a percentage basis is more than the overall expected profit percentage as calculated in the manner explained above, then that percentage of excess amount is transferred from the actual billing certified by the client to current liability and shown as advance payment received from the clients.  As per the querist, this entry is passed in accordance with paragraphs 15.2 and 9.3 of AS 7.

6.  However, where the difference between income and expenditure on a percentage basis as calculated above is less than that of overall profit percentage basis at the end of financial year, the difference is either adjusted from expenses which are in the nature of deferred revenue or shown as closing WIP depending on the project realities.

7.  As per the querist, progress payments and advances received from customers which are not in relation to work performed are shown as liability in accordance with paragraph 15.2 of AS 7.  Similarly, amount retained by customers towards satisfactory performance is shown as receivable in accordance with paragraph 15.3 of AS 7.

B.   Queries

8.  Keeping the above in view, the querist has sought the opinion of the Expert Advisory Committee on the following issues in reference to certain paragraphs of AS 7:

(i)   According to paragraph 9.1 of AS 7, the advantage of percentage completion method of accounting is that it reflects revenue in the accounting period during which activity is undertaken to earn such revenue.

(a)  Accordingly, whether in fixed price contracts, the actual value of work certified can be accounted for as income (turnover) irrespective of whether the work has progressed to a reasonable extent (i.e., 20% in the case of the company).

(b)  In order to give effect to the advantage as contemplated in paragraph 9.1 of AS 7, whether the work done but not certified as well as work done not billed can also be accounted for as income (turnover).

(ii) According to paragraph 9.2 of AS 7, in order to determine revenue, no special weightage should be given to any single factor; instead, all factors should be taken into consideration.  Further, according to paragraph 9.3, progress payments and advances received from customers cannot usually be treated as equivalent to revenue earned.

Thus, if progress payments are received in such a manner that they do not reflect the actual percentage of work done but such progress payments are made purely to honour contractual terms, then whether it would be appropriate to recognise the same as income (turnover) irrespective of the fact that such payments are based on the running bills raised by the company and certified by the client.

The querist has stated that the abovesaid situation does arise in certain cases where a higher ‘unit rate’ is bid for all items of initial work and a lower ‘unit rate’ is bid for later work and consequently cash inflow of the project in the initial period would be disproportionately higher and, similarly, the cash inflow at the final stages of the project would be disproportionately lower.

(iii)   According to paragraph 9.8 of AS 7, normally, the profit is not recognised under fixed price contracts unless the work on a contract has progressed to a reasonable extent.

(a)  Whether only the profit should not be recognised till the project has reasonably progressed or even the income (turnover) should not be recognised.

(b)  In case the income (turnover) is also not to be recognised, then what is the justification of stating in paragraph 9.1 of AS 7 that a contractor is allowed to take the advantage of reflecting the revenue of actual work performed.

(c)  In case the income (turnover) is allowed to be recognised and the expenditure in respect of the project upto the end of the year is either more or less than that of the income upto the end of the year, then how should the difference be treated?  In other words, if the income (turnover) is more than the expenditure, whether the excess amount can be treated as liability by transferring the excess amount from income to advance received from client and show a no-profit, no-loss situation.  Similarly, if the expenditure is more than the income then whether the difference can be treated as deferred expenditure or by way of increase in WIP to the extent of difference and still show a no-profit, no-loss situation.

C.  Points Considered by the Committee

9.   The Committee notes the following paragraphs of Accounting Standard (AS) 7, ‘Accounting for Construction Contracts’:

“9.  Percentage of Completion Method

9.1 Under the percentage of completion method, the amount of revenue recognised is determined by reference to the stage of completion of the contract activity at the end of each accounting period. The advantage of this method of accounting for contract revenue is that it reflects revenue in the accounting period during which activity is undertaken to earn such revenue.

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.

9.3 Progress payments and advances received from customers may not necessarily reflect the stage of completion and therefore cannot usually be treated as equivalent to revenue earned.”

“9.5 The application of the percentage of completion method is subject to a risk of error in making estimates. For this reason, profit is not recognised in the financial statements unless the outcome of the contract can be reliably estimated. If the outcome cannot be reliably estimated, the percentage of completion method is not used.

9.6 While recognising the profit under this method, an appropriate allowance for future unforeseeable factors which may affect the ultimate quantum of profit is generally made on either a specific or a percentage basis.

9.7  In the case of fixed price contracts, the conditions which will usually provide this degree of reliability are:

(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.

9.8  Normally, the profit is not recognised in fixed price contracts unless the work on a contract has progressed to a reasonable extent. Ordinarily, this test is not considered as having been satisfied unless 20 to 25% of the work is completed.”

10. The Committee notes that as per paragraph 9.2 of AS 7, the revenue to be recognised is determined by reference to the stage of completion of the contract activity as determined on the basis of the relevant factors.

11. The Committee is of the view that AS 7 contemplates recognition of all expenditures pertaining to the stage of construction reached at the end of the financial year, and the recognition of revenue by applying the percentage of work completed to the total contract value.  Thus, the profit figure for the period is the difference between the revenue so recognised and the costs incurred for completing the project upto that stage, subject to allowance as per paragraph 9.6 of AS 7, as reproduced above.  In other words, it is the actual profit so arrived at which should be recognised rather than the profit figure based on the overall profit percentage as worked out by the company.  Further, the billing pattern would not have any effect on the revenue recognition unless it represents the actual work completed.  Any excess or short billing would be reflected as advance received or amounts receivable as the case may be.

12. From the above, the Committee is of the view that the company’s accounting system as stated in the facts is not in accordance with AS 7.

13.  The Committee is also of the view that the conditions stipulated in paragraph 9.7 of AS 7 for recognition of profit are usually not considered as having been satisfied unless 20% to 25% of the work has been completed.  This is so because it is normally considered too early for any project to say with reliability that the project will be profitable.  Since the major portion of the construction work is yet to be completed, keeping in view the contingencies that may arise in future, it is considered prudent not to recognise any profit at that early stage.  At the end of the financial year, the cost of such work completed which is less than 20-25%, should be carried over as work-in-progress.

D.   Opinion

14.  On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 8:

(i)  (a)  Ordinarily, in a fixed price contract, the profit is not recognised unless the work has progressed to a reasonable extent (i.e., 20% to 25%).  Therefore, revenue (turnover) is not recognised in the financial statements.  The cost of such work done is carried over to the next period as work-in-progress.

(b) No.  Please refer to paragraph 11 above.

(ii)   No.  Please refer to paragraph 11 above.

(iii)   (a)  The revenue (i.e. turnover) should also not be recognised in the financial statements.

(b)  Please refer to paragraph 13 above.

(c)  In view of what has been stated above, this issue does not arise.

1Opinion finalised by the Committee on 25.9.2000.