Query No. 23

Subject:          

  Accounting treatment of construction work-in-progress.1

A. Facts of the Case

1. A public sector company is engaged in the business of construction of  ships  and  ship  repair  activities  on  contract  basis.  The  ship  building contracts are generally fixed price contracts and the construction period of a ship is generally 3 to 4 years. The payment terms of the contract are linked  with  the  events  achieved  like  signing  of  contract,  keel  laying, launching, sea trials, delivery, etc. Keel laying event is the first physical progress event of the vessel under construction. As per the querist, the company starts recognition of revenue only after the first physical event, i.e.,  keel  laying,  according  to  the  percentage  of  completion  method prescribed  under  Accounting  Standard  (AS)  7,  ‘Accounting  for Construction Contracts’2, issued by the Institute of Chartered Accountants of India .

2. The company has followed the following accounting policies for the purpose of revenue recognition:

The  Accounting  Standard  (AS)  7,  ‘Accounting  for  Construction  Contracts’  has  since been revised. The revised standard comes into effect in respect of all contracts entered into during accounting periods commencing on or after 1-4-2003 and is mandatory in nature.

I. Work-in-progress

Work-in-progress  in  respect  of  ship  construction  and  retrofit contract is valued on the following basis:

(i)         Where the estimated total cost of completion exceeds the total price including subsidy:

At lower of the cost or estimated realisable value; derating such  costs  in  the  same  proportion  as  the  total  price including  subsidy  bears  to  the  current  estimated completion cost of the ships under construction.

 

(ii)        Where  the  total  price  including  subsidy  exceeds  the estimated total cost of completion:

At  estimated  realisable  value;  in  the  proportion  as  the price including subsidy bears to the current completion cost of the related ships under construction.

  II. Income/Turnover

Income is considered in the accounts:

(i)         In respect of ships and retrofit works under construction: At  lower  of  accretion  in  the  value  of  work-in-progress vide  paragraph  I  above  and  in  the  aggregate  value  of  instalments  of  price/government  assistance  that  have fallen due.

(ii)        In respect of ships delivered and retrofit works completed during the year:

 

At the total price including extras and escalation realisable from owners deducting therefrom income accounted for in earlier years in accordance with clause (i) above.

 

(iii)   Profit is not recognised until the contract is complete at least 20 percent. For this purpose, weightage is given to the following three factors:

(a)   The  proportion  that  costs  incurred  to  date  bear  to the estimated total costs of the contract;  

 

(b)   stage of completion; and

 

(c)   revenue received.

The  stage  payments  received  from  the  customers  (owners)  as  per  the contractual terms are credited to the ‘Advance Payments from Customers Account’ and grouped under Current Liabilities. The income arrived at as  per  the  above  accounting  policy  is  transferred  to  the  current  year’s income from ‘Advance Payments from Customers Account’. In case the income so arrived at is more than the stage payments received/receivable from the owners, the balance is shown under work-in-progress as per the accounting policy.

3. During  the  year  1999-2000,  the  company  secured  orders  for construction of ten passenger vessels for a total contract price of Rs.71.45 crore. The vessels are under different stages of construction and the keel laying  event  for  all  the  ten  vessels  has  already  been  completed.  The physical  progress  of  the  vessels  ranges  from  1%  to  15%.  As  per  the terms  of  the  contract,  the  company  had  received  Rs.39  crore  towards stage payments on the above vessels and spent Rs.13.36 crore towards construction. It is estimated that the total cost of completion of the vessels is Rs.116.59 crore against revenue of Rs.71.45 crore and the percentage of realisation works out to 61.28%. Hence, the equivalent realisable value for the amount spent (Rs.13.36 crore) would be Rs.8.19 crore, i.e., Rs. 13.36 crore x 61.28%.

4. During  the  finalisation  of  accounts  for  the  year  1999-2000,  the company  recognised  Rs.8.19  crore  as  income/turnover  based  on  the proportionate value of the contract in relation to cost incurred with regard to  the  above  vessels  as  per  the  accounting  policy  of  the  company.  No profit  was  recognised. However,  the  statutory auditors  of  the  company observed that the above amount of Rs.8.19 crore should not be considered as income and opined that it should be shown in work-in-progress since there is no reasonable progress in the construction of the vessel.

5. The company is of the view that the amount of Rs.8.19 crore (i.e., net realisable value, based on cost of the vessels under construction) is to be recognised as income/turnover instead of work-in-progress since the company is following the percentage of completion method and all the vessels are of loss making nature.

B. Queries

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

(a)        Whether the amount of Rs.8.19 crore should be considered as  income  (turnover)  or  work-in-progress  in  respect  of the vessels under construction.

 

(b)        Whether the accounting policy followed by the company in  respect  of  revenue/profit  recognition  is  in  line  with AS  7.  If  not,  whether  any  change  is  required  in  the accounting policy of the company.

 

(c)        Whether AS 7 restricts recognition of income on realisable cost basis (i.e., without recognising profit) on a contract till percentage of physical completion is more than 25%.

C. Points considered by the Committee

7. The  Committee  restricts  itself  to  the  particular  issues  raised  in paragraph 6 above, and has not examined any other accounting issue that may be contained in the facts of the case.

8. The Committee notes that the company is engaged in the business of  construction  of  ships  on  contract  basis  at  a  fixed  price  and  that construction of ships usually takes 3 to 4 years. The company is following the  percentage  of  completion  method  for  recognition  of  revenue.  The Committee presumes that all the conditions for following the percentage of completion method are satisfied. The value of work-in-progress to be considered  for  recognition  of  revenue  in  respect  of  the  contract  at  the year-end is estimated in proportion to the total contract price, e.g., if 45% of  the  cost  has  been  incurred  till  date,  45%  of  contract  price  will  be assumed  to  be  the  value  of  the  work-in-progress.  The  Committee  also notes  that  the  company  does  not  recognise  profit  arising on  a  contract unless at least 20% work on the contract has been completed.

9. The Committee also notes that paragraphs 7.2, 9.8, 17.2 and 19 of AS 7 provide 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.”

“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.”

 

“17.2Profit in the case of fixed price contracts normally should not be recognised unless the work on a contract has progressed to a reasonable extent.”

 

“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.”

10. The Committee is of the view that as per the percentage of completion method, the revenue, namely, the accretion in the value of work-in-progress during the year should be determined based on the contract price keeping in view the stage of completion reached. The Committee, however, notes that the company is recognising revenue at the lower of accretion in the value of work-in-progress at the year-end and the accretion in the aggregate value of instalments/government assistance fallen due. The Committee is of  the  view  that  value  of  instalments/government  assistance  fallen  due does  not  necessarily  represent  the  value  of  work  completed  based  on stage of completion reached. Therefore, it may not be proper to recognise the latter amount as revenue. The Committee also notes that paragraphs 9.8  and  17.2  of  AS  7  restrict  the  recognition  of  profit  rather  than  the recognition of revenue. Thus, revenue can be recognised during a period, without  recognising  any  profit.  The  Committee  is  of  the  view  that  the amount of Rs.8.19 crore recognised by the company as revenue (turnover) for the year 1999-2000 appears to represent the accretion in the value of work completed during the period since the opening balance of the value of work completed was nil as all the contracts undertaken during the year were  new.  It  appears  that  this  amount  was  lower  than  the  instalments/ aggregate amount of government assistance fallen due, since the company has considered that amount as the revenue. Thus the recognition of the amount of Rs.8.19 crore as revenue appears to be correct as a matter of coincidence, rather than as a matter of policy.

11. The Committee is of the view that paragraph 17.2 read with paragraph 9.8  of  AS  7  provides  that  profit  arising  on  fixed  price  contracts,  by application of percentage of completion method, should not be recognised unless the contract has progressed to a reasonable extent. The progress to a  reasonable  extent  depends  upon  facts  and  circumstances  of  the  case and  normally  contract  is  assumed  to  have  progressed  to  a  reasonable extent only on completion of 20 to 25% work. However, if, depending on facts  and  circumstances  of  the  case,  it  can  be  satisfactorily  concluded that  a  contract  has  progressed  to  a  reasonable  extent,  profit  may  be recognised  on  the  contract  though  work  completed  on  contract  is  less than the aforesaid percentages. The Committee notes that, in the present case, the company has not recognised profit during the year on contracts which are not complete at least 20 per cent.

12. In this context, the Committee notes its earlier opinion on a similar subject (published in Compendium of Opinions, Volume XX, page 100, Query No. 29) whereby it is opined that no profit should be recognised unless  the  contract  has  progressed  to  a  reasonable  extent,  say  20%  to 25%. It has also been opined that in that particular case since the contract had not progressed to a reasonable extent revenue should not be recognised and the work-in-progress should be valued at cost. The Committee is of the view that in the aforesaid opinion since it was a profitable situation, it was decided to value work-in-progress at cost so that no profit could be recognised  as  the  contract  had  not  progressed  to  a  reasonable  extent. Since in the aforesaid opinion, the value of work-in-progress was advised to be taken at cost, it was decided not to term it as ‘revenue’ or ‘turnover’, although in this opinion, the Committee recognises that revenue (turnover) can  be  at  cost  and,  therefore,  can  be  termed  as  such.  The  Committee, however,  notes  that  this  difference  in  terminology  does  not  alter  the overall result of the contract.

13. The Committee is also of the view that as per paragraph 19 of AS 7, the company is required to provide full amount of foreseeable losses on all the contracts in the financial statements for the period irrespective of the amount of work done.

D.  Opinion

14. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 6:

(a)        As  stated  in  paragraph  10  above,  Rs.  8.19  crore  should  be recognised as turnover.

 

(b)        The accounting policy followed by the company in respect of revenue/profit recognition is not appropriate. The accounting policy should be modified so as to indicate clearly that revenue is  the  accretion  in  the  value  of  work-in progress  determined on the basis of stage of completion reached. The accretion in the  value  of  work-in-progress  should  not  be  compared  with the value of instalments/government assistance fallen due for the purpose of recognition of revenue. Also, the company is required to provide full amount of foreseeable losses on all the contracts in the financial statements for the period irrespective of the amount of work done.

 

(c)        AS 7 restricts recognition of profits, and not revenue, in the case  of  fixed  price  contracts  till  a  reasonable  progress  has been  made  under  the  contract.  The  progress  to  a  reasonable extent depends upon the facts and circumstances of the case and  normally  contract  is  assumed  to  have  progressed  to  a reasonable  extent  only  on  completion  of  20  to  25%  work. Thus, if a reasonable progress has not been made in a contract which is profitable  on an overall basis,  the revenue/turnover should be recognised at cost; and in case the contract is expected to result into loss on overall basis, the revenue/turnover should be  recognised  by  derating  the  relevant  cost  to  its  estimated realisable value.

1Opinion finalised by the Committee on 5.7.2001