Query No. 12

Subject:

Recognition of revenue in respect of long production cycle items. ¹

A. Facts of the Case

1. A company is a leading engineering product company catering to the vital sectors of the economy such as infrastructure, surface transportation, mining and defence. The company is a public sector enterprise under the administrative control of the Ministry of Defence. With a turnover of Rs.1857 crore for the financial year 2004-05, the company is the market leader in earthmoving and mining products. The company is making profits consistently right from its inception. For the year 2004-05, the profit before tax of Rs. 272.80 crore registered a growth of 444% compared to the previous year. The shares of the company are listed on Mumbai and Bangalore Stock Exchanges and are actively traded scrips with a market price of Rs. 1473 per share (as on date) with face value of Rs. 10. The company is a fast growing engineering product company with export presence in as many as ten countries spanning over Asia, Africa and South American continents. For the year 2004-05, the export turnover of the company was Rs. 59 crore and according to the querist, it is expected to increase manifold in the future.

2. The company has three manufacturing units located at Kolar Gold Fields (KGF), Bangalore and Mysore. It has marketing and service centres spread all over India. The KGF unit manufactures dozers, excavators, loaders, walking draglines, rope shovels and sophisticated aggregates catering to the needs of the mining and defence sectors. The Bangalore unit manufactures rail coaches, EMU’s, wagons, overhead inspection vehicles for Indian Railways and also logistics vehicles (Tatra variants) for usage by the Ministry of Defence. In addition, Bangalore unit is manufacturing, for the first time in India, metro rail coaches under license from M/s Rotem of Korea. The Mysore unit manufactures highly sophisticated dumpers, graders, aircraft towing tractors, weapon loading systems and high powered internal combustion engines. All these products are highly technology intensive and call for an array of manufacturing technologies. Some of these products have a long production cycle time extending beyond one accounting year.

3. The querist has stated that the accounting policy of the company, as far as revenue recognition is concerned, is as under:

“(i) Sales set up for products, viz., equipments, aggregates, attachments and ancillary products is made when these are unconditionally appropriated to the valid sales contract after pre-despatch inspection by the specified authority.

(ii) Sales setup for long production cycle items, is reckoned based on technical estimates when the percentage of completion of each identifiable unit of contract including despatches with customers is 30% or more of the total realisable value of such contract or estimate. Such revenue recognition is restricted to 97.5% of the reckoned realisable value and the balance 2.5% is accounted on completion of the contract.”

According to the querist, these policies are being consistently followed by the company. Further, these policies have been validated by both the statutory auditors and the Comptroller and Auditor General of India (C&AG) (government auditors). However, during the meeting of the Audit Committee held on 06.01.06, the statutory auditors were of the opinion that the accounting policy propounded in paragraph 3 (ii) is not in line with Accounting Standard (AS) 9, ‘Revenue Recognition’, issued by the Institute of Chartered Accountants of India (ICAI). As per the querist, as the views of the statutory auditors are at variance with the stated policy of the company regarding revenue recognition, a need is felt to seek the opinion of the Expert Advisory Committee of the ICAI.

4. The querist has further stated that the marketing policy of the company is in line with the accounting policies being pursued. For instance, the revenue from sale of equipments, aggregates, components and attachments are recognised based on valid sales contracts. Further, the revenue is recognised in respect of these products only on the basis of pre-despatch inspection. This is applicable in the case of products and aggregates having a production cycle time of less than one year. Some of the products, like Walking Draglines are highly import intensive coupled with multiple manufacturing technologies. Further, the manufacturing of these equipments warrant fabrication and manufacture of heavy duty steel structures, integrating the multiple electrical and electronic assemblies, sub-assemblies and transporting them in dis- aggregated structures to customer site for erection and commissioning. All these activities, right from commencement of production to final erection take more than one year. Recognising the long production cycle time as well as assembling the structures at site, the company has evolved a specific marketing policy in respect of such products. The policy calls for production of these goods only on firm sale orders. Further, in case of these products, invariably advances are received from the customers before the commencement of production. In addition, the customer order provides for billing details, with respect to pre-identified and mutually agreed modules, assemblies and structures. Based on the billing details, invoices are raised as and when the modules, assemblies, structures, as the case may be, are despatched as per the terms of the sale order and payments are also received as agreed.

5. According to the querist, it may be seen from paragraph 4 above, that revenue is recognised based on reliable data regarding physical completion. Both the parties to the contract agree to the terms of sale and also payment in respect of modules despatched. Further, both the parties are clear in understanding the rights, obligations, risks and rewards as well as the terms of payment. In fact, in many of the transactions of this kind, the buyer pays not only advance but also to the extent of agreed percentage of value of invoices raised at the point of delivery at site or ex-works, as the case may be.

6. The querist has stated that considering the nature of business, the type of product and the long production cycle time involved, the method adopted by the company is in order. This also synchronizes the revenue recognition with occurrence of performance or event and is well within the realm of the principle of matching concept (emphasis supplied by the querist). According to the querist, US GAAPs also recognise revenue on the basis of percentage of completion method in respect of long production cycle items/products (the querist has referred to US GAAP 2002 by Siegel, Levine, Qureshi and Shim published by Prentice Hall). On the other hand, if revenue is recognised only after the final delivery of such equipment, it will lead to distortion of the financial performance and position of the company for earlier years.

7. The querist has further stated that AS 9 recognises revenue both from the sale of products and rendering of services. However, in the case of services, it reckons the applicability of percentage of completion method but not so in the case of sale of goods. The querist has further stated that in this regard, it may be worthwhile to note that revenue recognition irrespective of the fact whether it is revenue generation from rendering of service or from sale of goods, is well within the purview of the framework of matching concept of revenue with expenditure. Therefore, what is explicitly stated as applicable to rendering of services will be equally applicable for sale of goods. Further, as per the querist, in the case of goods having long production cycle time, as long as there is a valid contract and the parties to the contract agree regarding billing details, contractual obligations and payment terms, there is no need to apply the rule of explicit statement in the Standard. On the other hand, the strict interpretation of the Standard based on the literal meaning instead of the spirit behind it would adversely affect the financial performance of the companies having such products (emphasis supplied by the querist). This, in turn, according to the querist, would have significant impact on the perception of economic agencies, like stock exchanges, creditors, bankers, investors and other stakeholders.

8. The querist has also mentioned that an attempt was made by the company to find out the accounting policies pursued by other companies manufacturing engineering products having long production cycle time. The querist has observed that another company, having similar product profile as that of the company under construction in respect of products having long production cycle time, has similar accounting policy in respect of these items. It is requested by the querist that the Committee may also take cognizance of the other company’s accounting policy while expressing its considered opinion.

B. Query

9. The querist has sought the opinion of the Committee as to whether the accounting policy of the company, particularly, with regard to sale of products having long production cycle time is in line with AS 9. If not, what modifications, in the opinion of the Committee are desirable to conform to AS 9?

C. Points considered by the Committee

10. The Committee notes that the basic issue raised in the query relates to whether as per the provisions of AS 9, the revenue from sale of products having long production cycle time, produced under a contract with the customer, can be recognised following the principles of percentage of completion method. The Committee has, therefore, considered only this issue and has not touched upon any other issue arising from the Facts of the Case, such as accounting treatment of products having production cycle time less than a year, etc.

11. With regard to long production cycle items taking more than a year to complete, the Committee notes the ‘Objective’ paragraph, definition of the term ‘construction contract’, and paragraph 3 of Accounting Standard (AS) 7 (revised 2002), ‘Construction Contracts’, issued by the Institute of Chartered Accountants of India, which inter alia, state as follows:

        “Objective

The objective of this Statement is to prescribe the accounting treatment of revenue and costs associated with construction contracts. Because of the nature of the activity undertaken in construction contracts, the date at which the contract activity is entered into and the date when the activity is completed usually fall into different accounting periods.”

“A construction contract is a contract specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use.”

 

“3. A construction contract may be negotiated for the construction of a single asset such as a bridge, building, dam, pipeline, road, ship or tunnel. A construction contract may also deal with the construction of a number of assets which are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use; examples of such contracts include those for the construction of refineries and other complex pieces of plant or equipment.”

 

12. On the basis of the above, the Committee is of the view that in case of contracts of manufacture and supply of long production cycle items which are complex pieces of equipment and which are manufactured under a contract with the customer, AS 7 (revised 2002) is applicable because the date on which the contract is secured and the date when the contract activity is completed fall into different accounting periods. In view of this, the principles of recognition of revenue in respect of sale of goods, as enunciated in AS 9, as being argued by the statutory auditor, are not applicable in this case. In this regard, the Committee also notes paragraph 2 of AS 9, which, inter alia, states as follows:

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

                       (i) Revenue arising from construction contracts”.

13. With regard to method of recognition of revenue prescribed in AS 7, the Committee notes paragraph 21 of the Standard as reproduced below:

“21. When the outcome of a construction contract can be estimated reliably, contract revenue and contract costs associated with the construction contract should be recognised as revenue and expenses respectively by reference to the stage of completion of the contract activity at the reporting date. An expected loss on the construction contract should be recognised as an expense immediately in accordance with paragraph 35.”

14. On the basis of the above, the Committee is of the opinion that in the present case, the company should recognise revenue from sale of long production cycle items manufactured under a contract with the customer, on the basis of stage of completion of the product, i.e., percentage of completion method, provided other conditions and provisions of AS 7 (revised 2002) are also complied with.

D. Opinion

15. The Committee is of the opinion on the issues raised in paragraph 9 above that in the present case, AS 7 (revised 2002) is applicable rather than AS 9. Accordingly, the revenue of the company from sale of products having long production cycle time, i.e., more than a year, that are manufactured under a contract with the customer, should be recognised following the percentage of completion method as per the provisions of AS 7 (revised 2002).

¹ Opinion finalised by the Committee on 27.3.2006