Expert Advisory Committee

Query No. 43

Subject: (i)

Timing of recognition of revenue on material supplied

under a contract along with works contract and 1

(ii) treatment of agency fee in relation to a contract.

A. Facts of the Case

1. A government company, under the administrative control of Ministry of Communications, undertakes turnkey telecommunication projects in India and abroad. The scope of work under the contracts is mainly ducting, cable laying from telephone exchanges to subscribers’ end including supply of material.

2. For revenue recognition, the company follows the percentage of completion method as envisaged in Accounting Standard (AS) 7, ‘Accounting for Construction Contracts’, issued by the Institute of Chartered Accountants of India and the company’s accounting policy in this regard is as under:

“By taking proportion that costs to date bear to the latest estimated total cost through work in progress including total attributable profits.

In evaluating work-in-progress, head office expenses, which include bonus, productivity linked reward and local income tax abroad, are not considered for the purpose of costs incurred and total estimated costs.

Notes:

(a) Revenue is not recognised where the work performed is less than 25% of the value of job in a contract.

(b) For the purpose of works performed, material billed to the party but remaining in trust with company is considered as part of the costs.”

3. Under the contract with a client, normally the item rates for material and works are given separately and progress payments are released for the material supplied/works done at the unit rates given in the contract. The company procures material in accordance with the Bill of Quantity (BOQ) given in the contract and the consignee is the client who pays the customs duty, etc., in accordance with the terms of the contract. In case it is a third country import, the prices for the material are generally FOB (port of despatch)/CIF (port of destination).

4. Under percentage of completion method the company prepares the cost estimates at the time of the award of the contract and these estimates are reviewed periodically and finally at the end of the financial year. The materials procured specifically for the contract, on customs clearance by the client, are handed over to the company for installation and spare parts, if any, are kept by the client in its own godown. The materials which are given in the BOQ and for which the unit rates are given in the contract, are considered as supply items by the company and the materials which are of consumable nature for which no unit rates are given, are considered as the inventory items of the company. The supply items, when billed in accordance with the terms of the contract with the client, are also included in the costs for the purpose of revenue recognition while the inventory items, till these are installed, are not considered as costs incurred.

5. The querist has also given an example to make the position clear.

A contract is of US$ 1.5 Mn and cost estimates are as under:

I. Supply items as per BOQ in the contract US$ 500,000 II. Works:

(a) Consumable items US$ 1,00,000

(b) Contractors’ payments US$ 2,00,000

Profit US$ 5,00,000

US$ 15,00,000

As per the terms of the contract, the client releases the payment for supply items as per BOQ on proof of despatch while for works, payments are released on respective installation of civil and telecom works.

At the end of financial year, on review of latest cost estimates, it is noticed that the cost estimates prepared are in order and accumulated costs worked out are as under:

Material supplied and billed US$ 300,000

Consumable items installed US$ 50,000

Consumable items in inventory US$ 50,000

Contractors’ payments US$ 100,000

Other expenses US$ 50,000

For recognition of income, the company considers the costs incurred as under:

Material supplied US$ 300,000

Consumable items US$ 50,000

Contractors’ payments US$ 100,000

Other expenses US$ 50,000

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                                                                                       US$ 500,000

Consumables of US$ 50,000 being inventory and not installed are not considered as costs. As such, the total cost incurred will be taken as US$ 500,000 and the income recognised would be computed in the following manner:

Costs incurred to date X contract value

Latest Total Cost Estimate

i.e. 500,000 X 15,00,000
10,00,000

As such, the turnover recognised would be US$ 750,000 with a profit of US$ 250,000 recognised for the year.

6. According to the querist, the above practice is being consistently followed by the company for the last several years. However, at the time of audit for the year 1999-2000, the auditors pointed out that material though billed to client but lying in transit, pending installation should be excluded from the cost incurred for the purpose of revenue recognition.

7. In response to audit objection, the querist has pointed out that the material has been procured specifically for the contract and in accordance with the BOQ given in the contract with the client and even if there is a short closure of contract, the client is supposed to pay for the work already performed and material supplied in accordance with the unit rates given in the agreement.

8. According to the querist, keeping in view the consistency, auditors agreed to the company’s view point but advised that the opinion of the Expert Advisory Committee of the Institute of Chartered Accountants of India be taken on the subject keeping in view the fact that AS 7, in paragraph 9.4, specifically mentions as under:

“9.4 If the percentage of completion method is applied by calculating the proportion that costs to date bear to the latest estimated total costs of the contract, adjustments are made to include only those costs that reflect work performed. Examples of items which may need adjustment include:

(i) the costs of material that have been purchased for the contract but have not been installed or used during contract performance; and

(ii) payments to subcontractors to the extent that they do not reflect the amount of work performed under the subcontract.”

As per the querist, the item under (i) above is for consumable/general purpose items which are not part of the BOQ but are paid on the basis of works performed.

9. The auditors have also reservation on another item, i.e., the agency fee which is not considered as a part of the construction cost by the company. The facts in this regard are given hereinafter.

10. The company appoints agents for countries abroad to provide assistance for its marketing promotion efforts. The agents work in a territory and assist the company in identifying the potential contract(s). The company, however, pays the fee to the agents when a contract is awarded and it is generally fixed as percentage of the contract awarded to the company. As the scope of work under the agency agreement is general and includes all potential business, the company does not consider the fees paid to the agents as cost incurred and treats it as overheads. The same is also not taken in sanctioned cost estimates of the project. The auditors were of the view that fee is in percentage and is related to a specific contract. Accordingly, it should be taken as a part of costs incurred.

B. Queries

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

(i) Whether the present practice of the company to include in ‘cost incurred’, the material specifically procured in accordance with the Bill of Quantity for a contract and billed to the client, is in order.

(ii) Whether the agency fee paid to the agents is to be taken as cost incurred keeping in view the fact that though the agency is for a particular territory, the fee payable is as a percentage of the contract awarded.

C. Points Considered by the Committee

12. The Committee restricts itself to the particular issues raised by the querist in paragraph 11 above and has not touched upon any other aspect of accounting that may be contained in the query.

13. The Committee notes paragraph 9.4 of AS 7, as reproduced in paragraph 8 above. The Committee also notes that paragraph 9.3 of AS 7 provides as under:

“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.”

14. The Committee is of the view that in case the whole contract is considered as a unit, i.e., the supply of material, in itself, is not considered performance of the contract or a part thereof under the percentage of completion method, revenue should not be considered to be earned just on supply of the material even though the amount is billed to the client. In other words, it is necessary that the material should be actually installed or used in the performance of contract. The fact of the progress payments being received on billing or on supply of the material is not relevant because progress payments may not necessarily reflect the stage of completion. Thus, according to the Committee, the total cost of material supplied should be reduced by the cost of material that has been purchased for the contract but has not been installed or used during contract performance. However, in case the contract for supply of material and for works is not considered as a unit, revenue for both material and works should be recognised taking into account the requirements of relevant Accounting Standards, i.e., Accounting Standard (AS) 9, ‘Revenue Recognition’, in case of material supplied (at the time when risks and rewards of ownership are transferred) and AS 7 in case of construction work.

15. The Committee also notes paragraph 8.2 of AS 7 which states as below:

“8.2 Costs not specifically attributable to any contract incurred by the contractor before a contract is secured are usually treated as expenses of the period in which they are incurred. However, if costs attributable to securing the contract can be separately identified and either the contract has been secured or there is clear indication that the contract will be obtained, the costs are sometimes treated as applicable to the contract and are deferred. As a practical measure, costs directly identifiable with a contract are sometimes deferred until it is clear whether the contract has been secured or not.”

16. The Committee is of the view that in this particular case, agency fee is directly attributable to the procurement of contract, and, accordingly, it should be accounted for as a cost directly related to the specific contract.

D. Opinion

17. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 11:

(i) Please refer to paragraph 14 above.

(ii) Agency fee paid to agents should be treated as cost directly attributed to specific contract and should be accounted for accordingly.

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1Opinion finalised by the Committee on 17.1.2001.