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A. Facts of the Case
1. A company is engaged in the business of construction contracts. The contracts are mainly awarded by the Government bodies or autonomous companies controlled by the Central or State Government(s). In order to execute the contract(s), the terms thereof provide for granting of mobilisation advance to the awardee of the contract (‘the company’ in the present case). The querist has provided the following clause as extracted from the document for proper understanding of the transaction:
“(i) Plant, Machinery and Shuttering Material Advance
An advance for plant, machinery and shuttering material required for the work and brought to site by the contractor may be given if requested by the contractor in writing within one month of bringing such plant and machinery to site. Such advance shall be given on such plant and machinery, which in the opinion of the Engineer-in-Charge will add to the expeditious execution of work and improve the quality of work. The amount of advance shall be restricted to 5% of the tender value. In case of new plant and equipment to be purchased for the work, the advance shall be restricted to 90% of the price of such new plant and equipment paid by the contractor for which the contractor shall produce evidence satisfactory to the Engineer-in-Charge. In the case of second hand and used plants and equipments, the amount of such advance shall be limited to 50% of the depreciated value of plant and equipment as may be decided by the Engineer-in-Charge. The contractor shall, if so required by the Engineer-in-Charge, submit the statement of value of such old plant and equipment duly approved by a Registered Valuer recognised by the Central Board of Direct Taxes under the Income-tax Act, 1961. No such advance shall be paid on any plant and equipment of perishable nature and on any plant and equipment of a value less than Rs. 50,000/-, seventy five per cent of such amount of advance shall be paid after the plant & equipment is brought to site and balance twenty five percent on successful commissioning of the same.
Leasing of equipment shall be considered at par with purchase of equipment and shall be covered by tripartite agreement with the following:
1. Leasing company which gives certificate of agreeing to lease equipment to the contractor.
2. Engineer-in-Charge, and
3. The contractor.
This advance shall further be subject to the condition that such plant and equipment (a) are considered by the Engineer-in-Charge to be necessary for the works; (b) are in and are maintained in working order; (c) and are hypothecated to the Government as specified by the Engineer-in-Charge before the payment of advance is released. The contractor shall not be permitted to remove from the site, such hypothecated plant and equipment without the prior written permission of the Engineer-in-Charge. The contractor shall be responsible for maintaining such plant and equipment in good working order during the entire period of hypothecation failing which such advance shall be entirely recovered in lump sum. For this purpose, steel scaffolding and form work shall be treated as plant and equipment. The contractor shall insure the plant and machinery for which mobilisation advance is sought and given, for a sum sufficient to provide for their replacement at site. Any amounts not recovered from the insurer will be borne by the contractor.
(ii) Interest and Recovery
The mobilisation advance and plant and machinery advance in (ii) and (iii) above bear simple interest at the rate of 10 per cent per annum and shall be calculated from the date of payment to the date of recovery, both days inclusive, on the outstanding amount of advance. Recovery of such sums advanced shall be made by deduction from the contractor’s bills commencing after first ten per cent of the gross value of the work is executed and paid on pro-rata percentage basis to the gross value of the work billed beyond 10% in such a way that the entire advance is recovered by the time eighty per cent of the gross value of the contract is executed and paid, together with interest due. The contractor shall at his risk and cost submit the samples of materials to be tested or analysed and shall not make use of or incorporate in the work any materials represented by the samples until the required tests or analysis have been made and materials finally accepted by the Engineer-in-Charge. The contractor shall not be eligible for any claim or compensation either arising out of any delay in the work or due to any corrective measures required to be taken on account of and as a result of testing of materials.
The contractor shall, at his risk and cost, make all arrangements and shall provide all facilities as the Engineer-in-Charge may require for collecting, and preparing the required number of samples for such tests at such time and to such place or places as may be directed by the Engineer-in-Charge and bear all charges and cost of test unless specifically provided for otherwise elsewhere in the contract or specifications. The Engineer-in-Charge or his authorised representative shall at all times have access to the works and to all workshops and places where work is being prepared or from where materials, manufactured articles or machinery are being obtained for the works and the contractor shall afford every facility and every assistance in obtaining the right to such access.
The Engineer-in-Charge shall have full powers to require the removal from the premises of all materials which in his opinion are not in accordance with the specifications and in case of default, the Engineer-in-Charge shall be at liberty to employ at the expense of the contractor, other persons to remove the same without being answerable or accountable for any loss or damage that may happen or arise to such materials. The Engineer-in-Charge shall also have full powers to require other proper materials to be substituted in place thereof and in case of default, the Engineer-in-Charge may cause the same to be supplied and all costs which may be incurred for such removal and substitution shall be borne by the Contractor.”
2. The querist has drawn the attention of the Committee to paragraph 15 of Accounting Standard (AS) 7 (revised 2002), ‘Construction Contracts’, which is reproduced below:
“15. Contract costs should comprise:
(a) costs that relate directly to the specific contract;
(b) costs that are attributable to contract activity in general and can be allocated to the contract, and
(c) such other costs as are specifically chargeable to the customer under the terms of contract.”
3. The querist has stated that a cost that may be attributable to contract activity and can be allocated to specific contracts includes borrowing costs. As per the querist, in the present scenario, there appears to be a contradiction when AS 7 (revised 2002) is read with Accounting Standard (AS) 16, ‘Borrowing Costs’, which states that borrowing costs include interest and commitment charges on bank borrowings and other short-term and long-term borrowings.
4. As per the querist, since the advances received from the contractee for the purpose of performance of contract are a part of short-term or long-term borrowings, the company is justified in treating interest paid on advances received from the contractee as a part of contract cost rather to treat it as a part of finance cost.
5. The querist has also drawn attention to paragraph 20 of AS 7 (revised 2002) which, inter alia, states that costs that relate directly to a contract and which are incurred in securing the contract are also included as part of the contract costs if they can be separately identified and measured reliably and it is probable that the contract will be obtained. Since, according to the querist, the interest expenses are exclusively incurred for the performance of the contract, it can be said that it is a part of contract cost.
B. Query
6. The querist has sought the opinion of the Expert Advisory Committee as to whether by treating the borrowing cost as cost of construction in accordance with AS 7 (revised 2002), the querist is properly adhering to the provisions of AS 7 (revised 2002) without violating the relevant provisions of AS 16 and the requirements of Schedule VI2 to the Companies Act, 1956.
C. Points considered by the Committee
7. The Committee notes that the basic issue raised by the querist relates to treatment of interest expenditure on mobilisation advance for equipment to be used for the purposes of construction received from the customer for a specific contract as contract cost. 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. Further, the Committee wishes to point out that its opinion is expressed purely from accounting point of view, and is therefore, not meant for any other purpose, such as, determination of contract price in case of ‘cost plus’ contracts, in which case ‘cost’ for the purpose of determination of contract price should be determined as per the terms of the contract. Also, the Committee’s opinion is restricted to the situation mentioned in the Facts of the Case and does not contemplate other possible situations. Incidentally, the Committee notes that it is not clear as to whether mobilisation advance and advance for plant, machinery and shuttering material are one and the same. The Committee presumes that the mobilisation advance is for plant and machinery and shuttering material and that shuttering material is also a type of plant and machinery. It is also not clear as to what appears to be the ‘contradiction’ mentioned by the querist in paragraph 3 above. Further, while clauses (i) and (ii) of a document are reproduced by the querist in paragraph 1 above, in clause (ii), there is reference to clauses (ii) and (iii). The lack of clarity in the reference to the clauses of the document, however, does not affect the issue raised by the querist and the Committee’s opinion thereon.
8. The Committee notes that the company incurs interest expenditure on mobilisation advance received from the customer which is recoverable by the customer along with the amount of the advance by deduction from the company’s bills. Accordingly, the Committee is of the view that the mobilisation advance received by the company is of the nature of ‘borrowing of funds’. This is because advance received from the customer is akin to a loan obtained which, in the ordinary commercial parlance, amounts to borrowing of funds. The nomenclature, viz., ‘advance’ and mode of repayment (i.e., adjustment against future billing in the manner stated in paragraph 1 above) do not alter the position. In this case, the borrowing has been made from the customer. Consequently, the Committee is of the view that interest expenditure on mobilisation advance is of the nature of ‘borrowing cost’ as AS 16 defines the term ‘borrowing costs’ as “interest and other costs incurred by an enterprise in connection with borrowing of funds.” However, the Committee is of the view that the objective of AS 16 is to deal with capitalisation or expensing of borrowing costs incurred in connection with assets. The Committee is of the view that in the present case the output of the contracts undertaken by the company are not its assets. In fact, the company is a contractor and the output of the contract does not belong to the company. Accordingly, the provisions of AS 16 do not apply in the present case. With respect to inclusion of the interest in the contract cost, the discussion is contained in the following paragraphs.
9. The Committee notes paragraph 15 of AS 7 (revised 2002) reproduced in paragraph 2 above. The Committee also notes paragraph 17 of the Standard, which is reproduced below:
“17. Costs that may be attributable to contract activity in general and can be allocated to specific contracts include:
(a) insurance;
(b) costs of design and technical assistance that is not directly related to a specific contract; and
(c) construction overheads.
Such costs are allocated using methods that are systematic and rational and are applied consistently to all costs having similar characteristics. The allocation is based on the normal level of construction activity. Construction overheads include costs such as the preparation and processing of construction personnel payroll. Costs that may be attributable to contract activity in general and can be allocated to specific contracts also include borrowing costs as per Accounting Standard (AS) 16, Borrowing Costs.”
10. The Committee notes that in the present case, the purpose of mobilisation advance is to finance the purchase/taking on lease of plant and machinery required for the work and brought to the site. The Committee is of the view that if the plant and machinery are exclusively dedicated to the specific contract (with or without eventual disposal), the interest on mobilisation advance in respect of the same should be treated as a contract cost under paragraph 15(a) of AS 7 (revised 2002). If this is not the case and the company can use the plant and machinery for other contracts also, either before or after the completion of the specific contract, then, the interest cannot be treated as contract cost. This is because in that case the purpose of borrowing will be to finance acquisition of plant and machinery which is capable of being used in several contracts and there is no nexus between interest expenditure and the construction activities. Accordingly, in such a case, treating interest on mobilisation advance as contract cost under paragraph 15(b) of AS 7 (revised 2002) is not appropriate as it cannot be considered that such interest is attributable to the contract activity in general. Further, since the Facts of the Case do not indicate that interest is chargeable under the terms of contract to individual customers, it is not covered under paragraph 15(c) of AS 7 (revised 2002).
11. The Committee notes that Schedule VI to the Companies Act, 1956 does not address the issue raised by the querist as it contains no specific requirement with respect to elements of ‘contract cost’. However, the Committee is of the view that the disclosure requirements of Schedule VI should be complied with.
D. Opinion
12. On the basis of the above, the Committee is of the opinion that by treating the borrowing cost (representing interest on mobilisation advance) as cost of construction (i.e., contract cost) in accordance with AS 7 (revised 2002), the querist will be properly adhering to the provisions of AS 7 (revised 2002) without violating the relevant provisions of AS 16 only if the relevant plant and machinery is exclusively dedicated to the specific contract (with or without eventual disposal) as discussed in paragraph 10 above. Schedule VI to the Companies Act, 1956 does not address the issue raised by the querist as it contains no specific requirement with respect to elements of ‘contract cost’. However, the disclosure requirements of Schedule VI should be complied with.
1Opinion finalised by the Committee on 24.08.2009
2Schedule VI has since been revised. Revised Schedule VI came into force for the Balance Sheet and Profit and Loss Account for the financial year commencing on or after 01.04.2011.
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