Query No. 15

Subject:

Combining and segmenting of construction contracts.¹

A. Facts of the Case

1. A company, which is a Government of India undertaking, is a leading engineering and consultancy company in the field of petroleum refineries, pipelines, oil and gas processing, petrochemicals, offshore structures and platforms, ports and terminals, metallurgy, fertilisers, power, highway and bridges, airports and intelligent buildings and urban development.

2. A client in the process of setting up grass-root refinery invited the company to submit its offer for providing engineering consultancy services.

3. The company submitted its offer for carrying out consultancy services for setting up of refinery project under three proposals namely Proposal A (Process Design, Environmental Impact Assessment/ Rapid Risk Analysis, etc.), Proposal B (Project Management Consultancy Services), Proposal C (Engineering, Procurement, Construction Management Services) with price for each such proposal totaling to Rs. 665 crore plus service tax as applicable.

4. The client, vide its Letter of Acceptance (LOA) dated 22nd November, 2006, awarded the work (copy of LOA has been furnished by the querist for the perusal of the Committee) for consultancy services comprising the scope of work as above at a price of Rs. 606 crore plus service tax as under :

       -- The work shall be bifurcated into two contracts to cover the total scope of work.

      -- The first contract will be for Rs. 21 crore for the work of defined preparatory services to be rendered between 1st September, 2006 and 31st March, 2007.

      -- The balance price of Rs. 585 crore for the remaining scope of work will form part of the second contract which will be entered into at a later date. The first contract will be suitably referenced in the second contract.

5. The first contract for Rs. 21 crore was formally entered into, the work was executed and full payments were received. (Copy of the contract has been furnished by the querist for the perusal of the Committee.)

6. According to the querist, contract revenue for the year ending 31st March, 2007 was recognised as per the provisions of Accounting Standard (AS) 7, Construction Contracts , treating the above two contracts as a single construction contract for Rs. 606 crore in terms of paragraph 8 of AS 7. The total consideration for overall project was negotiated as a single package with total cost and overall profit margin for total price at Rs.606 crore. The bifurcation of fees in Part I and II was purely based on commercial considerations without any relevance to the corresponding cost of the each part. Since the nature of transactions satisfied all the conditions as mentioned in paragraph 8 of AS 7, the same was treated as a single contract for accounting purposes in the financial year 2006-07. Accounts for the year 2006-07 were approved by the Board on 30th May, 2007.

7. Pending finalisation and signing of the second contract, an interim agreement/ arrangement was entered into on 15th May, 2007 with effect from 1st April, 2007 to provide uninterrupted services within the scope of work forming part of the second contract, wherein a lump sum amount of Rs. 7 crore plus applicable taxes was paid to the company per month for a period of four months for the defined scope of work. The interim arrangement was for a period of 4 months or signing of the contract II, whichever earlier. (Copy of the interim arrangement agreement has been furnished by the querist for the perusal of the Committee.) As per the interim arrangement, the activities covered under the said arrangement shall be a part of contract II and the payments made under this interim arrangement shall be adjusted against the lump sum price of contract II, i.e., Rs. 585 crore.

8. The above interim arrangement was further extended for a month till 31st August, 2007, pending finalisation/ signing of the second contract. All payments under the interim arrangement, i.e., Rs. 35 crore (Rs. 7 crore * 5) and applicable taxes have since been received. This interim arrangement was neither extended beyond August, 2007 nor was contract II signed.

9. Meanwhile, in July/August, 2007 the client invited fresh proposal from various consultants including the company for providing consultancy services to execute the refinery project for prospective services with new methodology and terms. Accordingly, proposal dated 2nd August, 2007 and 6th August, 2007 were submitted to the client for providing the desired services, detailing the methodology of work execution, terms and conditions and remuneration for its services totalling to Rs. 970.53 crore. (Copies of proposals have been furnished by the querist for the perusal of the Committee.)

10. The company, after negotiations, submitted its final offer along with justification amounting to Rs. 773.50 crore vide its Term Sheet dated 25th October, 2007 (copy of the Term Sheet has been furnished by the querist for the perusal of the Committee)

The price of Rs.773.50 crore was arrived at as below:

     (a) Base price agreed : Rs.635.5 crore (i.e., midpoint between Rs.606 crore and Rs.665 crore)
     (b) Add: Escalation (as proposed by the company): Rs.128 crore
     (c) Less: Price paid by the client : Rs. 25 crore (although Rs.56 crore has been invoiced).
     (d) Add: extra price for changed terms : Rs.15 crore
     (e) Add: extra price for FEED package:Rs.20 crore
     Total price : Rs.773.50 crore

The querist has informed that though the company has received the total amount of Rs.56 crore as invoiced, only Rs.25 crore has been offered as reduction against the same (in the justification for increase in the fees) as some part of the work done earlier would need to be redone due to change in methodology for completing the balance work.

The escalation of Rs.128 crore was sought as increase in fees for the overall project due to delays on the part of the client in implementation of the project and the consequent increase in the cost to the company for the job. Thus, it was for increase in fees from the originally quoted/agreed consideration i.e., Rs.665 crore / Rs.606 crore respectively for the total execution of the project covering Part I/interim arrangement/balance work.

The changed terms for which Rs.15 crore was proposed mainly cover changes in the time schedule for the completion of the project and related bonus/penalties, additional terms of guaranteeing the estimated project cost, consequent penalty, etc.

11. The client accepted the company s final offer and issued LOA dated 14th November, 2007 specifying the scope of work and remuneration for prospective services to be rendered for the project with a project completion schedule of 42 months from the date of LOA. (Copy of the final offer and LOA dated 14th November, 2007 have been furnished by the querist for the perusal of the Committee.)

The aforesaid LOA contained the following clause:

     All other terms & conditions will be in line with the draft contract PRP/EPCM/001B dated March 23, 2007 except for amendments required in the contract which both parties shall mutually agree.

The draft contract mentioned above is intended for Part II of earlier LOA dated 22.11.2006 for Rs.606 crore.

12. The querist has informed that all other consultants had given their price and terms for the total project/jobs without considering the scope of the work completed by the company. However, depending on the acceptability of the portion of the engineering work already completed by the company upto the date of award of the work, other consultants could have given some discounts on the price which is not ascertainable. If at any stage, the client wants to discontinue the services of a consultant, balance portion could be contracted to other consultants and in that case the consultant may be required to redo the substantial work to make it compatible with their methodology of project execution and give their terms accordingly.

13. Further, the querist has informed that in the event a consultant s job is discontinued at the mid stage, the contract needs to be terminated. As per the querist, in the instant case though LOA dated 22nd November, 2006 was in place, since there was no formal contract with the company for the Part II of the job, probably the question of termination of contract would not apply and the company would have only received the payments for the first part and interim arrangement totaling Rs.56 crore.

14. As per the querist, cost has been estimated for the total job involved in execution of the project and proposal submitted to the client accordingly. As such no separate costing has been done for part I, II/balance work. As mentioned in paragraph 6 above, the bifurcation of the fees in the Part I and balance portion of work was purely on commercial consideration without estimating and considering the cost separately. However, estimated cost for the balance portion of the job can be ascertained taking into account the cost already incurred for completed portion of the job under Part I/interim arrangement.

15. The querist has given the following arguments for combining as well as segmenting contracts:

      Alternative I- For combining contracts

     New LOA dated 14.11.07 for prospective services is to be considered as group of contracts along with earlier contract/ arrangement in terms of paragraph 8 of AS 7 due to the under noted reasons:

      (a) The scope of services remained the same as were envisaged in the original LOA dated 22.11.2006 with some changes in the price due to escalation factor and some additional scope of work and changes in methodology of execution. As such, this should be construed as an extension of the original job which is also referred in the term-sheet dated 25.10.07 submitted by the company and forming part of LOA dated 14.11.07. Hence, LOA dated 14.11.07 should be construed as renegotiation of the price and terms due to temporary withholding of the job. [The querist has clarified that the additional scope and change in methodology of execution are not significantly different from what was originally contemplated.]

      (b) The scope of services pursuant to earlier LOA as well as new LOA pertains to construction of same asset and activities contemplated under the project are also primarily the same except for some modifications/ additions/deletions in the scope of work. The price of the services has been negotiated with reference to the original LOA terms and remuneration taking into account the services already rendered and as such all the contracts/arrangement are inter-related and are part of a single project with overall profit margin. Further, the term escalation used in the term-sheet dated 25.10.07 submitted by the company can be construed with reference to existing contract or an already negotiated consideration.

     (c) LOA dated 14.11.07 stipulates that All other terms & conditions will be in line with the draft contract PRP/ EPCM/001B dated March 23, 2007 except for amendments required in the contract which both parties shall mutually agree. [Emphasis supplied by the querist.]

      Alternative II-For segmenting contracts

     Work done pursuant to earlier LOA/Contract/interim arrangements against which the company had rendered services and received payment of Rs.56 crore should be treated as a separate construction contract in view of the following observations:

     (a) The services in accordance with earlier LOA/interim arrangement have been rendered and full payments received.

     (b) Client has obtained separate offer from various consultants including the company for prospective services of the project with certain modifications including additional scope and change in execution methodology. The company had submitted its offer against the same which has been accepted and LOA has been issued for prospective services only and fresh contract for such services should be entered into.

B. Query

16. The querist has sought the opinion of the Expert Advisory Committee as to whether the amount of Rs. 56 crore received from the client for the services rendered under the earlier contract/ interim arrangements (which have since been closed) can be recognised as revenue in the books of account of the company considering them as a separate construction contract, distinct and separate from scope of work under LOA dated 14th November, 2007 for Rs. 773.50 crore in compliance with the provisions of AS 7.

C. Points considered by the Committee

17. The Committee notes that the basic issue raised by the querist relates to the treatment of the receipt of Rs. 56 crore as revenue from a separate contract de hors the balance scope of work under the subsequent LOA dated 14th November, 2007. Therefore, the Committee has examined only this issue and has not examined any other issue that may be contained in the Facts of the Case. In particular, the Committee has not examined the issue whether the LOA dated 14th November, 2007 itself is to be segmented for scope change, since this issue has not been raised by the querist. The Committee notes from the copies of documents furnished by the querist that the amount of Rs. 773.50 crore includes, inter alia, (i) an amount of Rs. 52 crore towards services of the company in respect of crude oil receipt facilities at Mundra and cross country crude oil pipeline from Mundra to Bhatinda and in case the client excludes services related to these two items from the scope of work awarded to the company, then, a reduction of Rs. 52 crore will be made from the lump sum price of Rs. 773.50 crore and (ii) an amount of Rs. 20 crore towards FEED package. Though the item (i) consisting of the two facilities is also found in the original scope of work, it appears that no specific price is mentioned for it in the original scope of work. (Of course, the client has the right to request for any changes, modifications, deletions and/or deletions to the scope of work for which impact proposal should be submitted by the company, if the changes can be performed). The Committee has not addressed the issue of treatment of these elements of contract, since this issue has not been raised by the querist.

18. The Committee notes that Accounting Standard (AS) 7, Construction Contracts, issued by the Institute of Chartered Accountants of India has subsequently been notified by the Central Government under the Companies (Accounting Standards) Rules, 2006. The Committee notes the following paragraphs from AS 7:

      2.1 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.

      4. For the purposes of this Standard, construction contracts include:

        (a) contracts for the rendering of services which are directly related to the construction of the asset, for example, those for the services of project managers and architects; and

         (b) ..."

6. The requirements of this Standard are usually applied separately to each construction contract. However, in certain circumstances, it is necessary to apply the Standard to the separately identifiable components of a single contract or to a group of contracts together in order to reflect the substance of a contract or a group of contracts.

     7. When a contract covers a number of assets, the construction of each asset should be treated as a separate construction contract when:

         (a) separate proposals have been submitted for each asset;

         (b) each asset has been subject to separate negotiation and the contractor and customer have been able to accept or reject that part of the contract relating to each asset; and

         (c) the costs and revenues of each asset can be identified.

      8. A group of contracts, whether with a single customer or with several customers, should be treated as a single construction contract when:

         (a) the group of contracts is negotiated as a single package;

        (b) the contracts are so closely interrelated that they are, in effect, part of a single project with an overall profit margin; and

        (c) the contracts are performed concurrently or in a continuous sequence.

      9. A contract may provide for the construction of an additional asset at the option of the customer or may be amended to include the construction of an additional asset. The construction of the additional asset should be treated as a separate construction contract when:

         (a) the asset differs significantly in design, technology or function from the asset or assets covered by the original contract;or

        (b) the price of the asset is negotiated without regard to the original contract price.

         Contract Revenue

      10. Contract revenue should comprise:

        (a) the initial amount of revenue agreed in the contract; and

        (b) variations in contract work, claims and incentive payments:

              (i) to the extent that it is probable that they will result in revenue; and

              (ii) they are capable of being reliably measured.

     11. Contract revenue is measured at the consideration received or receivable. The measurement of contract revenue is affected by a variety of uncertainties that depend on the outcome of future events. The estimates often need to be revised as events occur and uncertainties are resolved. Therefore, the amount of contract revenue may increase or decrease from one period to the next. For example:

       (a) a contractor and a customer may agree to variations or claims that increase or decrease contract revenue in a period subsequent to that in which the contract was initially agreed;

       (b) the amount of revenue agreed in a fixed price contract may increase as a result of cost escalation clauses;

      (c) the amount of contract revenue may decrease as a result of penalties arising from delays caused by the contractor in the completion of the contract; or

       (d) ..."

19. From the above, the Committee notes that the principles related to accounting treatment for construction of an asset (including combining and segmenting of construction contracts) are equally applicable to services directly related to the construction of that asset. Hence, engineering consultancy services and other services which are directly related to the construction of the refinery will be accorded the same accounting treatment as the treatment for the construction contract of the refinery.

20. The Committee notes that for accounting purposes, initially the company combined the two contracts, viz., preparatory services (for which contract was signed) and the balance scope of work (which was supposed to be entered into later). There was an interim arrangement pending the signing of second contract. This interim arrangement makes appropriate reference to the second contract to be entered into in future. While the work under the interim arrangement was in progress, the client invited fresh proposal from various consultants including the company for providing consultancy services to execute the refinery project with new methodology and terms. After negotiation, the price for the balance scope of work (excluding for the work already completed) was arrived at by the company, which was accepted by the client. Invitation of fresh bids and separate LOA dated 14th November, 2007 with net price for balance scope of work may apparently suggest that the scope of the original contract has been reduced to the extent of work already done and that the balance scope of work is a separate contract, though the latter includes pending portion of original scope (which is substantial for the facts of the case) with some changes. However, for accounting purposes, whether the balance scope of work is to be treated as a separate contract or to be combined with earlier contract/interim arrangement with scope reduced to the extent of work already done depends on application of relevant provisions of AS 7 quoted above and not on legal aspects.

21. The Committee is of the view that in the present case, paragraph 7 of AS 7 is not applicable since it is not a case of single contract covering a number of assets with separate proposals for each asset. While paragraph 8 of AS 7 does not directly deal with a case where during the course of execution of a contract fresh bidding takes place resulting in a new contract for balance scope of work, the Committee is of the view that the principle enshrined in paragraph 8 of AS 7 can be applied as a guiding factor in such situations. The Committee is also of the view that a group of contracts should be combined if all the three conditions stipulated in paragraph 8 of AS 7 are met, and, should not be combined if any one or more of the three conditions stipulated therein are not met. This is because paragraph 8 of AS 7 uses the word and at the end of condition (b).

22. The Committee notes that basically the consultancy services are in respect of construction of a refinery. There is only change in the methodology of execution of the project with some scope change and not the asset being constructed. The asset is still refinery. All the bidders had based their price for the entire work and the successful bidder was expected to discount the price on the assessment of the work already done by the company. The company too started from the base price and made some adjustments to arrive at the price for the balance scope of work. Thus, the balance scope of work is not separately negotiated without regard to the original contract/interim arrangement. This is fully supported by the facts mentioned in paragraph 10 above. For example, the escalation element is not only for the balance scope of work but for the entire project. Though Rs. 56 crore was billed and accepted, only Rs.25 crore was reduced from the base price since the company has to redo some part of work done earlier due to change in methodology for completing the balance work. As mentioned in paragraph 14 above, no separate costing was done for original contract/interim arrangement/balance scope of work. Cost was estimated for the total job involved in the execution of the project. Price was allocated to each such part purely on commercial consideration without estimating and considering the cost separately. While estimation for balance work could have been done not separately but after considering cost already incurred, that has not been done. This indicates that only overall profit margin has been contemplated at all stages. The balance scope of work, when undertaken as a continuation of work already done, will complete the whole project. The LOA dated 14th November, 2007 also specifies that all other terms and conditions are as per draft of the originally contemplated second contract, except for mutually agreed amendments. The Committee is of the view that all these facts indicate compliance with conditions stipulated in paragraph 8 of AS 7.

23. From the above, the Committee is of the view that the original contract, the interim arrangement and the LOA dated 14th November, 2007 for balance scope of work are interconnected and should be treated as such for accounting purposes. The entire services are related to the construction of the refinery, though there is change in methodology of execution and there are some scope changes. Further, the Committee is of the view that the paragraph 10(b) of AS 7 is applicable whether it is a single contract or a group of contracts treated as a single contract for accounting purposes. Accordingly, the difference between (a) the price for balance scope of work as increased by Rs.25 crore offered as reduction in respect of work already done and (b) the original contract price should be viewed as contract revenue towards variations in the contract work, claims and incentive payments mentioned in paragraph 10(b) of AS 7 quoted above. Paragraph 11(a) of AS 7 quoted above acknowledges that a contractor and a customer may agree to variations or claims that increase or decrease contract revenue in a period subsequent to that in which the contract was initially agreed. The Committee is of the view that this variation can happen even in the case of fresh bidding process as has happened in the present case. In working out the aforesaid variations and claims, the point whether the LOA dated 14th November, 2007 itself is to be segmented for accounting purposes in respect of scope changes (such as additional scope of work relating to services of the company in respect of the items mentioned in paragraph 17 above) should also be considered. For the reasons stated in paragraph 17 above, the Committee is not expressing any view in this regard.

24. With respect to the part of the work done earlier in respect of which the amount of Rs. 56 crore has already been received, the Committee is of the view that Rs. 25 crore represents the work to be adjusted in the final offer and, therefore, the portion amounting to Rs. 31 crore {i.e., Rs. 56 crore received less: Rs. 25 crore} which is separated from the final offer, should be booked as revenue.

D. Opinion

25. On the basis of the above, the Committee is of the opinion that out of the amount of Rs.56 crore received from the client for the services rendered under the earlier contract/interim arrangements, Rs. 25 crore cannot be separately recognised as revenue considering them as a separate construction contract distinct and separate from the scope of work under LOA dated 14th November, 2007 for Rs. 773.50 crore. However, the balance portion of Rs. 31 crore should be recognised as revenue separately.

¹ Opinion finalised by the Committee on 30.5.2008