Query No. 31

Subject:

Provision for incomplete assignments and disclosure

thereof in the financial statements.¹

A. Facts of the Case

1. A public sector undertaking, registered under the Companies Act, 1956, is under the administrative control of Ministry of Railways. The company provides services in all the facets of transportation engineering in India and abroad. The querist has informed that such consultancy projects do not involve construction of an asset. The company also exports rolling stocks and locomotives.

2. The accounts of the company are audited by statutory auditors appointed by the Comptroller and Auditor General of India (C&AG) and reviewed by the C&AG. During the course of audit of accounts for the financial year 2004-05, the statutory auditors expressed reservations on the presentation of ‘provision for incomplete assignments’.

3. The querist has stated that the company makes provision for incomplete assignments by deferment of income (for which associated costs are yet to be incurred) at specified rates, indicated in the accounting policy of the company, which, according to the querist, is in line with Accounting Standard (AS) 9, ‘Revenue Recognition’, issued by the Institute of Chartered Accountants of India. As per the querist, these rates are determined on the basis of the experience gained and perception developed by the company over a period of time. Provision is written back, as per the accounting policy of the company, on review by the management of the assignments on completion thereof and fulfillment of obligations. The said practice has been consistently followed by the company over the past two decades.

4. The querist has separately supplied the extracts from the relevant accounting policy as under:

“Consultancy fee is normally accounted for on the basis of bills raised/due for the year. It also includes supplies and expenses forming part of the contract which are recoverable from the customer.

In construction management/supervision contracts, fee is calculated as a fixed percentage on the value of work done/built-up cost of each contract as determined by the management, pending customer’s approval, if any.

Mobilisation advance is adjusted against running bills and mobilisation fee is recognised as income in the year of receipt/bills raised, if as per management’s review, certain activities against that contract have been carried out during the year.

In consultancy assignments including training which are spread over a number of years, the fee is arrived at after making provision for incomplete assignments and other obligations at the rate of five percent on supplies procured on behalf of customers and ten percent on services rendered. For determining such provision, fee excludes reimbursables, out of pocket expenses and local pay and allowances borne by the customer. Based on the management’s review of assignments on completion and fulfillment of the obligations, the provision is written back and treated as income in that year.”

The querist has also explained the above accounting policy by stating that provision of 5% is made on those consultancy projects where services are rendered for supplies procured on behalf of clients. Provision of 10% is made on those projects where consultancy services (technical and engineering) are provided to the clients. This includes consultancy management, supervision contracts and training projects. Such provisions are made on those projects which are spread over a number of years towards incomplete assignments and obligations. No provision is made on export sales, inspection and lease contracts. The amount of provision
is carried forward and added to the next year’s provision. This process is continuously followed until the project is completed in all respects and obligations are fulfilled.

5. The querist has stated that as the provision relates to deferment of income for the consultancy assignments, the income is adjusted as per the aforesaid rates from the fee bills raised to clients. The provisions written back on completion of assignments and fulfillment of obligations are treated as income of the year in which the write back is made. The revenue from consultancy fee is presented in the following manner in the Schedule of Income attached to the statement of profit and loss:

(Refer Note No. ________)             

                       :

Consultancy fee (net)                                                :   xxx.xx

The amount of consultancy fee (net) is shown on the revenue side of the profit and loss account. The amounts pertaining to provision made or provision written back on the completion of projects during the year are also shown by way of notes to accounts.

6. The querist has provided the following illustration to explain the manner of working out the provision:

(a) Total contract value of the assignment is Rs. 20,88,260/-(Rupees twenty lakh eighty eight thousand two hundred sixty only). The activities performed/to be performed are as under:
 

  (b) The work completed till 31st March 2005 is of Rs. 17,75,021/- (upto submission of final report stage).

(c) Amount of provision is Rs. 1,77,502/- i.e., 10% of the amount stated at (b) above.

(d) The company may have to incur an expenditure on costs associated to alteration/amendments desired by the clients and other related costs of printing and stationery, binding, travelling, meetings and presentation expenses, etc.

(e) On completion of the assignments and fulfillment of obligations, the provision is written back and treated as income of that year.

7. The querist has explained that paragraph 5 of AS 9, inter-alia, states that “when uncertainties exist regarding the determination of the amount,
or its associated costs, these uncertainties may influence the timing of revenue recognition”. The clients of the company, in relation to the project management contracts, often require alteration/changes in reports/designs before acceptance of the same and the company may incur expenses on dealing with arbitration, etc. As per the querist, the associated costs relating to such changes/arbitration and related costs on printing, stationery, travelling, presentation, legal expenses, etc. are difficult to determine and hence, recognition of revenue is deferred which is in line with AS 9. In addition, the clients retain 5% to 10%, as per the contracts, as retention money from each bill, which is paid on the successful completion of the contracts/projects and fulfillment of obligations or alternatively, the company has to provide performance guarantee(s) of equivalent percentage of the contract values. In a number of instances, clients also hold final payments until all the obligations are fulfilled and reports/designs are accepted by them. In view of the above, the querist considers that recognition of revenue is in accordance with AS 9.

8. The querist has stated that the company does not consider the provision made as above, as a provision covered by Accounting Standard
(AS) 29, ‘Provisions, Contingent Liabilities and Contingent Assets’, issued by the Institute of Chartered Accountants of India. According to the querist, AS 29 deals with the provision relating to expenditure.

9. As per the querist, the auditors are of the view that the company has arrived at its consultancy fee after deducting Rs.1,176.94 lakh and adding Rs.1,317.14 lakh being 5% /10% provision against incomplete consultancy assignments and being a sum determined to be reversed on completion of such assignments, respectively, in accordance with its principal accounting policy. As per the querist, the company, however, contends that it has no doubt about the realisability of the amounts billed and it retains the provision for the likely expenditure, which it may incur in future against the assignments which are still incomplete but presents the same as a deduction from gross receipts. The querist has stated that in the opinion of the auditors, such a provision for a liability created towards incomplete assignments should be considered as part of the expenditure instead of the same being shown as a deduction from the gross receipts of the company. As per the auditors, the said practice of the company results into incorrect statement of the gross receipts and gross expenditure of the company and, thus, does not comply with the provisions of Part II of Schedule VI to the Companies Act, 1956.

10. According to the querist, the C&AG has reviewed the audited accounts of the company for the year ended 31st March, 2005 as per section 617 of the Companies Act, 1956. The C&AG has confirmed the policy of the company and also the views of the management.

B. Query

11. The querist has sought the opinion of the Expert Advisory Committee as to whether the presentation of consultancy fee, net of income deferred,
in the manner brought out in paragraph 5 above, in any way contravenes the disclosure requirements of Part II of Schedule VI to the Companies Act, 1956, in respect of gross turnover or gross expenditure.

C. Points considered by the Committee

12. The Committee notes that the querist has sought its opinion on the issue whether it is appropriate to make a provision for costs yet to be incurred in respect of incomplete consultancy assignments as a percentage of the amount billed to the clients and whether the amount of the provision should be presented as a deduction from the revenue recognised in this regard. The Committee has, accordingly, considered only these issues and has not touched upon any other issue that may arise from the Facts of the Case, such as, whether it is appropriate to recognise revenue on the basis of the bills raised on the clients.

13. The Committee notes that the company under consideration is making a provision with regard to the expected expenditure in respect of alterations/amendments to the work performed by the company as desired by the client. The Committee is of the view that this provision is similar to the provision in respect of warranties in case of sale of goods. To the extent that such alterations/amendments relate to the work already performed, the Committee is of the view that such a provision is covered by AS 29, since these alternations/amendments relate to the past obligation, i.e., work done on a contract so far. The Committee is of the view that this provision is covered by the definition of the term ‘provision’ given in Part III of Schedule VI to the Companies Act, 1956, reproduced below, since it is a provision for a liability, the amount in respect of which cannot be determined with substantial accuracy:

“the expression “provision” shall, subject to sub-clause (2) of this clause, mean any amount written off or retained by way of providing for depreciation, renewals or diminution in value of assets, or retained by way of providing for any known liability of which the amount cannot be determined with substantial accuracy.”

14. On the basis of the above, the Committee is of the view that it is appropriate to make a provision in respect of the expected expenditure on alterations/amendments desired by the client, if these alterations/ amendments relate to the work already performed. Since, such a provision is a provision for a liability, it should not be deducted from the revenue as per the practice followed by the company under consideration, as given in paragraph 5 of the ‘Facts of the Case’. It should, instead, be reflected as a charge to the profit and loss account and under the head ‘provisions’ on the liability side of the balance sheet. The Committee is of the view that reflecting the provision as a charge to the profit and loss account is in accordance with the requirements of sub-clause (ix)(a) of Clause 3 of Part II of Schedule VI to the Companies Act, 1956, which provides that “the aggregate, if material, of the amounts set aside to provisions made for meeting specific liabilities, contingencies or commitments”, should be disclosed.

15. On the basis of the above, the Committee is of the view that in the present case, it would not be appropriate to make a provision in respect
of costs which are to be incurred in future, i.e., if such costs do not relate to the work performed by the company as on the balance sheet date because such costs are not in respect of present obligations from past events as envisaged in AS 29.

16. The Committee is further of the view that placing reliance on the requirements of paragraph 5 of AS 9, as reproduced below, to create a provision is not proper since the said paragraph provides for not recognising revenue at all rather than recognising the revenue first and then creating a provision:

“5. Revenue recognition is mainly concerned with the timing of recognition of revenue in the statement of profit and loss of an enterprise. The amount of revenue arising on a transaction is usually determined by agreement between the parties involved in the transaction. When uncertainties exist regarding the determination of the amount, or its associated costs, these uncertainties may influence the timing of revenue recognition.” (Emphasis supplied by the Committee.)

The Committee is of the view that not recognising the revenue to the extent of the work done so far, in view of the proportionate completion method followed by the company, on the ground that there would be some alterations/amendments in future, would not be appropriate. Instead, it would be appropriate to create a provision as suggested in paragraph 14 above. In the view of the Committee, the paragraph relates to the uncertainties of the associated costs of the performance of the work itself.

17. The Committee notes that the querist has also argued that making a provision is necessary in view of the amounts retained by the client for the purpose of the assignment. The Committee is of the view that retention of the money by a client does not necessarily give rise to uncertainties in relation to the determination of the amount of consideration or the associated costs. It only constitutes a kind of a security given to the client so that the company undertakes its commitments. In any case, as mentioned by the querist in paragraph 9 above, there are no uncertainties with regard to the realisability of the amount billed. Accordingly, making a provision in this regard is not warranted as there is no uncertainty about its collectability. In this context, the Committee notes paragraph 9.2 of AS 9, which provides as follows:

“9.2 Where the ability to assess the ultimate collection with reasonable certainty is lacking at the time of raising any claim, e.g., for escalation of price, export incentives, interest etc., revenue recognition is postponed to the extent of uncertainty involved. In such cases, it may be appropriate to recognise revenue only when it is reasonably certain that the ultimate collection will be made. Where there is no uncertainty as to ultimate collection, revenue is recognised at the time of sale or rendering of service even though payments are made by instalments.”

D. Opinion

18. On the basis of the above, the Committee is of the opinion that the company’s presentation of consultancy fee, net of income deferred, in the manner brought out in paragraph 5 above is not appropriate.

¹ Opinion finalised by the Committee on 25.1.2006