Query No. 44

Subject:   

Accounting for contracts for supply of materials.[1]

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. The company secured a contract from a foreign country for supply and supervision for installation and testing of SDH Digital Microwave Trunk Transmission System.  The detailed break-up is as under:

(i)  Goods:

 

         Battery, Charger, Solar Power System, Tower, Antenna System and Test Equipments.

 

(ii)  Services:

 

         Supervision of installation, testing and training.

 

The unit price has been given separately.  However, the total contract value is US$ 3.2 million which includes US$ 0.02 million for item

 

(ii). Other relevant clauses of the agreement are as under:

 

(iii)   Acceptance:

 

         (a)  Provisional acceptance:

 

Provisional acceptance certificate shall be issued by the purchaser within 45 days after the following requirements are met:

-  When full installation of the SDH Digital Microwave Trunk Transmission System (the entire contract) is completed and the result of the test and performance measurement fully satisfy the requirement provided in the specification.

-  Any defective components which affect the normal operation of the equipment and occurred during shipment, installation, adjustment or during testing, etc., have been replaced immediately by satisfactory units by the supplier.

         (b)  Final acceptance:

Final acceptance and certificate by the purchaser shall be made only after the following requirements are met:

-  Satisfactory operation of the system for a period of 18 months from the date of provisional acceptance certification.

-  All defective components that may have been observed for any reason which is not the fault of the purchaser have been replaced by satisfactory units and any defective construction shall also be repaired at the expense of the supplier within a reasonable time limit.

3.  The company has considered the contract as a turnkey contract and recognised the income under percentage of completion method as provided under Accounting Standard (AS) 7, ‘Accounting for Construction Contracts’.

4.  As per the querist, the auditors were of the view that these types of contracts are not covered under AS 7 as these are mainly supply contracts and the company should recognise the income for material and services separately, i.e., when supply is made the same should be recognised as trading income and when the services are completed, the same should be taken as income from project services.

5. The company had taken the plea that in such type of contracts, there is a strategic tendering and at times whole of the profit is either taken in services or in material keeping in view the competition, factors such as likely increase in quantity of a particular item, etc., and as such true positions will not be reflected in case material and services are treated separately.  Further, in such type of works, the company has consistently been following percentage of completion method under

AS 7.

6. It was agreed by the company to take the views of Expert Advisory Committee of the Institute of Chartered Accountants of India in this regard.

B. Queries

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

(a)  Whether the practice of the company to follow percentage of completion method in respect of contracts where company is to provide material and services is in order.

 

(b)  If not, whether income for material can be booked immediately on despatch of material and for services as and when the services are completed.

 

(c)  Any other method which can be advised by the Expert Advisory Committee for such type of contracts.

C.  Points Considered by the Committee

8. The Committee notes from the facts of the case (paragraph 2 above) that the contract is for the supply of certain goods and supervision for installation and testing of the transmission system.  The Committee also notes that the break-up of the contract value for supply of goods and supervision work is US $3.18 million and US $0.02 million respectively. The Committee noted that the value attached to the supervision work is not significant in relation to the overall contract value.  The Committee is of the view that the contract is mainly for the supply of materials and may not be construed as a construction contract.

9. From the above, the Committee is of the view that the contract, under the facts and circumstances explained in paragraph 2 above, is not covered by Accounting Standard (AS) 7, ‘Accounting for Construction Contracts’.  Accordingly, the Committee is of the view that the contract is for the supply of materials and the principles of revenue recognition applicable in case of sale of goods as prescribed in paragraphs 10 and 11 of Accounting Standard (AS) 9, ‘Revenue Recognition’, would be applicable in this case.  As far as the service aspect is concerned, the same would be governed by paragraph 12 of AS 9.  The aforesaid paragraphs are reproduced 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.

 

11. In a transaction involving the sale of goods, performance should be regarded as being achieved when the following conditions have been fulfilled:

(i)  the seller of goods has transferred to the buyer the property in the goods for a price or all significant risks and rewards of ownership have been transferred to the buyer and the seller retains no effective control of the goods transferred to a degree usually associated with ownership; and

 

(ii)   no significant uncertainty exists regarding the amount of the consideration that will be derived from the sale of the goods.

 

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.”

D.   Opinion

10. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 7:

(a)   The practice of the company to follow percentage of completion method in respect of contracts of the nature stated in paragraph 2 above is not in order.

 

(b)   The revenue in respect of supply of materials should be booked in accordance with paragraphs 10 and 11 of AS 9, and in respect of services in accordance with paragraph 12 of AS 9, as reproduced in paragraph 9 above.

 

(c)  The method to be adopted for accounting for the contracts of the nature stated in paragraph 2 above should be as per (b) above.

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