Expert Advisory Committee

Query No. 24

Subject:

Revenue recognition for turnkey project/service contract.1

A. Facts of the Case

1. A company is a Government of India enterprise. It entered into an agreement in October 1998 with Ministry of External Affairs, Government of India, for setting up a plastic technology demonstration and common facility centre abroad on turnkey basis for a total value of Rs. 371.70 lakh comprising the following:

Summary of Project Cost Estimates

Sl. Description Indian Rs. Foreign Total Cost

No. Component in Lakhs Exchange (Rs. Lakh)

in US $

(a) (b) (c) (d) (e)

1. Plant and equipment for 157.90 — 157.90 (CIF)*

demonstration projects.

2. Plant and equipment for 161.80 — 161.80 (CIF)*

common facility centre

3. Technical assistance and

Expert fees (deputation of four

experts for a period of 12 months, i.e.,

48 man months and 4 experts

for a period of one month, i.e.,

4 man months). 6.00 85,000 40.00

4. Cost of consumable

(i.e., lubricating

oil, grease) and raw material. 8.40 9,000 12.00

______________________________________________________________________

Total 334.10 94,000 371.70

______________________________________________________________________

* Including 8% service charges on FOB value but excluding sales tax and excise duties where applicable.

(Foreign exchange component has been computed at the exchange rate of US$ 1=Rs.40)

2. According to the querist, as per the terms of the agreement, the company was to supply machinery and equipment costing Rs. 248.63 lakh (FOB) and charge service charges @ 8% thereon. The company agreed to depute experts and technicians for carrying out installation, trial and commissioning of machinery and equipment at the site, subject to availability of local infrastructure and also agreed to provide consumables and raw material for trial and commissioning period for which no service charges were to be received. The company had, upto 31.3.2000, supplied equipments costing Rs. 270.02 lakh and claimed Rs. 18.72 lakh as service charges.

3. According to the querist, the government auditors pointed out that the company has shown full amount under sales and service charges respectively even though the work was not completed as on 31.3.2000. Also, the company has not disclosed its policy for recognition of income from service contracts. As per the government auditors, according to paragraph 7.1 of Accounting Standard (AS) 9, ‘Revenue Recognition’, income from service contracts should be recognised either on percentage of completion method or on completed contract method and, therefore, in the absence of any policy for recognition of income, sales was overstated and work-in-progress was understated by Rs. 270.02 lakh and profit and service charges were overstated by Rs. 18.72 lakh.

4. The company argued that the company was to receive 8% service charges on the cost of machinery and equipment supplied for the project and no further service charges/other income were to be received by the company in respect of the other components of the project. All the machinery and equipments were supplied before 31.3.2000, and transfer of property in goods was made before 31.3.2000. As all the related invoices were raised on the Ministry of External Affairs, Government of India, before March 31, 2000, the service charges and sales were booked during 1999-2000.

B. Query

5. The querist has sought the opinion of the Expert Advisory Committee regarding accounting treatment and income recognition for the turnkey project.

C. Points considered by the Committee

6. The Committee notes paragraph 4 of Accounting Standard (AS) 7², ‘Accounting for Construction Contracts’ and paragraph 2 of AS 9 which are reproduced below:
AS 7
“4. Contracts for the provision of services come within the scope of this Statement to the extent that they are directly related to a contract for the construction of an asset. Examples of such service contracts are contracts for the services of project managers and architects and for technical engineering services related to the construction of an asset.”

AS 9
“2. This Statement does not deal with the following aspects of revenue recognition to which special considerations apply:

(i) Revenue arising from construction contracts;³

(ii) Revenue arising from hire-purchase, lease agreements;

(iii) Revenue arising from government grants and other similar subsidies;

(iv) Revenue of insurance companies arising from insurance contracts.”

7. The Committee is of the view that the contract appears to be of the nature of a construction contract as the company’s responsibility is not limited to only supply of machinery and equipment, but also to carry out installation, trial and commissioning of the machinery and equipment. Since the services to be rendered by the company directly relate to the construction of the plant, the Committee is of the view that in the facts and circumstances of the case, AS 7 would be applicable and not AS 9.

8. The Committee notes that the company is recognising revenue on supply of machinery and equipment and not on the completion of the contract. The Committee also notes that revenue can be recognised before the completion of the contract only if the enterprise follows percentage of completion method in accordance with the provisions of AS 7. With regard to this method, the Committee notes paragraphs 9.1 to 9.7 of AS 7 reproduced below:

“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.

9.4 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 materials 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.

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. The Committee is of the view that the service charges which the company is to receive on supply of machinery and equipment, should be recognised on the basis of the stage of completion reached on the balance sheet date, provided the conditions specified in AS 7 in relation to recognition of revenue under percentage of completion method, are fulfilled. The amount billed to the client may not necessarily represent the stage of completion reached. In arriving at the stage of completion reached, the factors stated in paragraphs 9.2 and 9.3 of AS 7 should be considered.

D. Opinion

10. On the basis of the above, the Committee is of the opinion that the company can decide to follow the percentage of completion method provided it meets the requirements of AS 7. According to this method, it can recognise revenue on the supply of machinery on the basis of this stage of completion reached in relation to the total contract.

1Opinion finalised by the Committee on 5.7.2001.

2The 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

3Refer to AS-7 on ‘Accounting for Construction Contracts’

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