A. Facts of the Case
1. A company (hereinafter referred to as ‘ABC’) is a wholly owned subsidiary of a listed Central Public Sector Undertaking (CPSU). ABC was incorporated in the year 2002 under the Companies Act, 1956. The main objective of the company is to acquire, establish and operate electrical systems etc. for distribution and supply of electrical energy, to undertake works on behalf of others, and to act as engineers/consultants amongst others.
2. Under the Bharat Nirman programme of the Government of India, the Ministry of Power (MoP) has been entrusted with the formulation and implementation of the Rajiv Gandhi Gramin Vidyutikaran Yojana (RGGVY). The RGGVY aimed at electrifying all villages and habitations and providing access to electricity to all rural households of the country through Central Public Sector Undertakings (CPSU), with M/s XYZ as the nodal agency, since the CPSUs have the technical and professional competence and expertise to implement such a scheme on a massive scale. The scheme was launched in April 2005 under which 90% grant is provided by Government of India and 10% as loan by the State Governments.
3. A MOU was signed on 16th August, 2004 between XYZ and ABC with the objective to be associated in the formulation and implementation of projects under the programme in association with the concerned State Government/power utility. In accordance with the said MOU, ABC entered into agreements with XYZ, State Governments and State Power Utilities (SPUs) for implementation of projects in those states on behalf of the State Governments/SPU. Under the said MOU, the funds required for the execution of the project are released directly to ABC by XYZ including 12% service charges. ABC is responsible for selecting executing agencies (contractors) through open tenders. Project-wise separate contracts namely “Supply Contract” and “Erection Contract” are entered into between ABC and the selected contracting companies, for execution of the work. At no point of time, XYZ, State Government or SPU enters into any kind of contract with the executing agency, i.e., the contractors. The executing agency furnishes a performance bank guarantee in favour of ABC only for executing the work. Further, the responsibility of levying and collecting the liquidated damages, if any, from the executing agency is that of ABC and, the amount so recovered will be adjusted in the project cost. Relevant extracts of the various documents are given hereinbelow for ready reference:
MOU between XYZ and ABC dated 16.08.2004:
“Clause 4. Role of ABC
4.1
(a) ABC shall undertake these projects on deposit work basis (in suitable installments) on behalf of the borrower/ owner of the project after a separate multilateral agreement is entered into as stated hereinabove.
(b) ABC shall be responsible for formulation, development and implementation of the projects in the identified area involving system planning, design, engineering (in accordance with XYZ’s guidelines, specifications and construction standards, wherever applicable) and procurement in accordance with agreed competitive bidding procedures.
(c) The projects shall be implemented by ABC in a time bound manner as scheduled in the approved projects and projects so implemented by ABC will be taken over immediately after their completion by the concerned State Government / State Power Utility, who will be responsible for proper operation and maintenance thereafter.
(d) If the State Government / State Power Utility so desires, ABC may consider taking up operation and maintenance of the completed projects on mutually agreed terms and conditions under a separate agreement with that State Government / State Power Utility.
4.2 If the State Government / State Power Utility so desires, the role of ABC may be limited to:-
(a) Project monitoring and supervision of quality of works during construction,
or
(b) Formulation and preparation of project reports based on the details provided by the concerned State Government / State Power Utility, arranging project approvals, providing advisory support during procurement, if required, and project monitoring and supervision of quality of works during construction. …”
“Clause 5. Project Execution and Development Expenditure
5.1
(a) The projects to be implemented by ABC under this agreement shall be funded by XYZ from the funds sanctioned to State Government/ State Power Utility under Accelerated Electrification of Villages and Households Programme.
(b) The funds for the execution of the projects shall be released by XYZ directly to ABC, including service charges as per agreement to be executed with the borrower/ owner of the project under suitable multilateral arrangements, which shall be legally enforceable.
(c) Separate accounts for development and implementation of such XYZ funded projects shall be maintained by ABC.
(d) ABC shall be entitled to service charges of 12% of project cost on pro-rata basis and the same may be included in the project cost. Further, additional statutory taxes payable by ABC shall also be reimbursed.
5.2 Service charges payable to ABC shall be 2% and 5% of the project cost on pro-rata basis for the scope of services as defined against clauses 4.2 (a) and 4.2 (b) respectively and the same may be included in the projects cost. Further, additional statutory taxes payable by ABC shall be reimbursed. …”
“Clause 7. Representation and Warranties
Neither Party shall have the right or power to bind the other party(ies) to any agreement without the prior written consent of the party(ies) concerned. Unless specifically agreed in writing, no Party is authorised to make commitments, representations, warranties or agreements on behalf of the other parties and each party agrees that it will not hold itself out as having such authority. If any Party acts in violation of the foregoing the said Party agrees to indemnify, defend and hold the other parties harmless from and against any and all claims, demands, losses, damages, liabilities, law suits and other proceedings judgments and awards, the reasonable cost and expenses (including, but not limited to, reasonable attorneys’ fee) arising directly or indirectly, in whole or in part, out of the breach of this article by such party, whether committed by the indemnifying party, its employees, agents, successors or assigns.”
“Clause 8. Limitation of Liability
Neither party shall be liable to each other for any financial liability or any consequential loss incurred by the party individually in respect of any of the project(s), so identified herein above as per provision of Clause 5 under these present. The MOU is subject to the detailed terms and conditions of the Accelerated Electrification of Villages and Households Programme, as may be agreed / desired / decided by the Government of India / XYZ.”
Agreement between XYZ, State Government, SPU and ABC entered separately for each state
“3.0 Construction / Implementation
3.1 ABC shall make all possible efforts to complete the project(s) within the approved time frame starting from the date of release of the first installment of funds by XYZ.
3.2 ABC shall specify quarterly milestones, and progress shall be reviewed with reference to these milestones jointly by XYZ, authorised representative of State Government, State Electricity Board and ABC in quarterly Performance Review Meetings.
3.3 ABC shall suitably incorporate the provisions towards levy of liquidated damages in their agreements with contractors for delay in completion of the project(s) and also other relevant contractual provisions pertaining to the procurement of goods and works. Declaration in this regard shall be furnished by ABC before setting the actual expenditure on the project in line with the provisions under clause 1.3(g) of this agreement. All amounts towards Liquidated Damages, if any, as may be recovered by ABC under this provision, shall be suitably adjusted in the project cost.
3.4 (a) ABC shall ensure that its own quality control systems and inspection are adopted in the implementation of these projects.
(b) the best cost control measures shall be enforced by ABC during implementation through appropriate management and control systems.
(c) On behalf of the project authority (State Government and SEB), ABC shall ensure that the equipment & material specifications and construction practices & standards are as those approved/ stipulated by XYZ…”
General Terms & Conditions of Contract between ABC and Executing agencies
“1.0 Definition of Terms
1.1 ‘Contract’ means the agreement entered into between the Employer and the Contractor as per the Contract Agreement signed by the parties including all attachments and appendices thereto and all documents incorporated by reference therein.
1.2 ‘Employer’ shall mean_____ (entrusted by the_______ with the concurrence of Government of ________) and shall include its legal representatives, successors and assigns.
1.3 Contractor or Manufacturer shall mean the Bidder whose bid will be accepted by the Employer for the award of the Works and shall include such successful Bidder’s legal representatives, successors and permitted assigns.
1.4 Sub-Contractor shall mean the person named in the Contract for any part of the Works or any person to whom any part of the Contract has been sublet by the Contractor with the consent in writing of the Engineer and will include the legal representatives, successors and permitted assigns of such person. ...”
“Special Conditions of Contract
Volume – IA
All the conditions stipulated in Special Conditions of Contract (SCC) shall supplement the General Conditions of Contract (GCC), Erection Condition of Contract (ECC), Instructions to Bidders (INB) and Technical Specification Vol. IIA & IIB. Wherever there is a conflict, the provisions herein shall prevail over those in the GCC, ECC, INB and Technical Specification Vol. IIA & IIB. (Emphasis supplied by the querist.)
1.0 General Information
1.1 ABC incorporated under the Companies Act, 1956, having its Registered Office at … (hereinafter called the Employer) has been contracted by the State Electricity Board (hereinafter called the Owner) with the concurrence of State Government for execution of Rural Electrification Works for electrification of villages and rural households in one of the district of the State.
1.2 ABC, therefore, invites sealed bids for the following packages of Rural Electrification Works in District on domestic competitive bidding basis:
Rural Electrification Work in the District under RGGVY Scheme of GOI on turnkey basis.
1.3 The project shall be executed by ABC on deposit work basis with funds made available out of the proceeds of the financial assistance received by the State Government from XYZ and the ownership of the aforesaid package shall remain vested with the State Electricity Board. All eligible payments against this work shall be made by ABC under suitable arrangement with the State Government.
1.4 “Owner” shall mean the State Electricity Board.
For the purpose of execution of the Contract, the contractual activities on the part of the ‘Owner’, wherever context requires so, shall be performed by ABC (the Agency appointed by the State Electricity Board) for and on behalf of the State Electricity Board, except in case where the State Electricity Board itself is statutorily required to do so.
1.5 Wherever reference to ABC is made in the bidding documents, Contract/Notification/Letter of Award (in the event of Award of Contract) or any related papers/documents, it shall be deemed to be for and on behalf of the State Electricity Board. …”
“14.0 Liquidated Damages
14.1 For Equipment Portion
14.1.1 If the Contractor fails to successfully complete the commissioning within the time fixed under the Contract, the Contractor shall pay to the Employer as liquidated damages and not as penalty a sum specified for each specified period of delay. The details of such liquidated damages are brought out in the accompanying Special Conditions of Contract.
14.1.2 Equipment and materials shall be deemed to have been delivered only when all its components, parts are also delivered. If certain components are not delivered in time the equipment and materials will be considered as delayed until such time the missing parts are also delivered.
14.1.3 The Contractor shall pay to ABC as liquidated damages and not as penalty, a sum of half percent (0.5%) of the contract price for each calendar week of delay or part.
14.2 Total amount of liquidated damages for delay under the Contract will be subject to a maximum of 5% of the Contract price.
14.3 Liquidated damages for not meeting performance guarantee during the performance and guarantee tests shall be assessed and recovered from the Contractor as detailed in Technical Specifications / Special Conditions of Contract. Such liquidated damages shall be without any limit whatsoever and shall be in addition to damages, if any, payable under any other clause of conditions of Contract. ...”
4. The querist has stated that the accounting policy of the company on revenue recognition provides as follows:
“Income from consultancy services is accounted for on the basis of actual progress/ technical assessment of work executed, in line with the terms of respective consultancy contract.”
According to the querist, in accordance with this accounting policy, at present, the company is recognising only the service charges (professional fee) as its revenue/ turnover. In other words, gross amount of cost of project is neither reflected in revenue nor in expenses as they are offset. Further, the amount received as advance for deposit works is shown under ‘Current Liabilities’ as ‘Amount received against deposit works’. Any amount received from XYZ is being credited to this account and all the payments made to agencies are debited to this account.
Company’s justification for this accounting policy
5. As per the MOU, it is clear that the ownership of the entire work shall vest with the various State Governments/State Power Utilities. ABC works only as an agent on their behalf and the funds are provided by the Government of India under a fiduciary relationship of principal and agent. ABC is to utilse the funds as per the terms and conditions of the MOU. After meeting the actual expenses on the work, the balance is to be refunded. This definition of ownership is contained in clause 1.0 of ‘XYZ Guidelines for procurement of goods and services’ under the chapter ‘Invitation to Bids’. Further, as per clause 6.2 of the said guidelines, the statutory deduction of taxes and duties at source related to these works shall be done by ABC on behalf of the State Power Utilities and TDS so deducted shall be deposited with the relevant tax authorities on their behalf. TDS certificates shall also be issued on their behalf by utilising their PAN/TAN/TIN. Also as per clause 8.7.2, all invoices under the construction contracts, awarded by ABC, shall be raised by the contractor on “State Power Utilities acting through ABC” and all payments shall be made to the contractor by ABC on behalf of State Power Utilities. The waybills/road-permits are also being issued by the owner, i.e., the State Power Utilities. Therefore, ABC is performing these services as an implementing agency on nomination basis, and not as a contractor as ownership of the assets vests with the State Power Utilities. Therefore, Accounting Standard (AS) 7, ‘Construction Contracts’, is not applicable.
Contentions of the Auditor (querist)
6. It is apparent from the clauses 4 and 5 of the MOU with XYZ and also in the multi-lateral agreement amongst ABC and separate State Governments (relevant extracts reproduced above) that ABC is acting as project managers. ABC is given the turnkey responsibility to execute the project under a ‘cost plus’ basis. According to paragraph 4 of AS 7, contracts for rendering of services, which are directly related to the construction of assets, for example, services of project managers and architects, fall within the scope of a construction contract that is required to follow an accounting policy in accordance with AS 7. Paragraph 5 of AS 7 classifies two types of contracts, fixed price and cost plus. The contracts engaged into by ABC are cost plus 12% contracts, according to substance of the agreement. The querist has also provided the following arguments in his support:
• Modus operandi described in the arrangement for compliance of TDS provisions etc. are no criterion for deciding the applicability of AS 7.
• ABC is not acting as an agent of the State Government or SPU because ABC is solely responsible for the completion of the project, through the contractors. All the agreements entered into by ABC are on ‘Principal to Principal’ basis. XYZ or the SPU are nowhere held responsible for the acts of ABC. In fact, all the guarantees given by the executing agencies are also in favour of ABC and not the SPU. Had it been a case of an agency, then these guarantees should have been given directly in favour of the State Government /SPU.
• Contention of the company’s management that ownership of the asset vests with Government and hence, it is not a ‘construction contract’ holds no water as in all cases of construction contracts too, the ownership of assets built vest with the principal and not with project manager. Ownership of asset is not a criterion for the applicability of AS 7.
• Expert Advisory Committee in the context of Query No. 19 of Volume XXVIII of the Compendium of Opinions on the subject, ‘Accounting treatment of receipt and utilization of project-specific funds’, had opined in paragraph 13 as follows:
“13. As regards the situation where the company is not acting as an agent and the economic benefits or service potential of the assets created will not flow to the company, the Committee is of the view that the company should recognise both project-related expenses and turnover in respect of its own scope of work executed directly and/or through other agencies in accordance with the applicable accounting standards (for example, Accounting Standard (AS) 7, ‘Construction Contracts’) in the income and expenditure account. …”
• The accounting policy followed by the company facilitates understatement from its profit and loss account, of thousands of crores in the form of revenue or expenses, which is spent by the national exchequer towards nation building, through the responsibility and the accounts of the government company ABC, thus, undermining ‘substance accounting’ as laid in the Framework for the Preparation and Presentation of Financial Statements’, issued by the Institute of Chartered Accountants of India (ICAI).
• In this background, the querist believes that the accounting policy to be followed by ABC should be ‘proportionate completion method’, for a cost plus contract under AS 7.
B. Query
7. On the basis of the above, the querist has sought the opinion of the Expert Advisory Committee on the following issues:
(i) Whether or not the company is required to follow proportionate completion method prescribed for a ‘cost plus contract’ method, in accordance with AS 7.
(ii) Whether the existing accounting treatment followed by the company of recognising only the service charges, i.e., professional fee, as its revenue is in order.
C. Points considered by the Committee
8. The Committee notes that the basic issues raised by the querist are related to (i) applicability of AS 7 in the extant case, and (ii) propriety of accounting treatment followed by the company of recognising only service charges as its revenue. Therefore, the Committee has examined only these issues and has not examined any other issue that may arise from the Facts of the Case, such as, propriety of arrangement for compliance of provisions of income-tax/deduction of TDS on payments as per the provisions of Income-tax Act, 1961, or interpretation of the terms of the agreements entered into with the State Government or State Power Utilities, or sub-contractors or XYZ, etc. Further, the Committee wishes to point out that its opinion is expressed purely from the accounting point of view.
9. For the sake of convenience, the Committee deals firstly with the second issue relating to recognition of revenue. The Committee notes paragraph 17(b) of Accounting Standard (AS) 1, ‘Disclosure of Accounting Policies’, which is reproduced below:
“b. Substance over Form
The accounting treatment and presentation in financial statements of transactions and events should be governed by their substance and not merely by the legal form.”
In view of the above, the transactions and events are accounted for and presented in accordance with their substance, i.e., the economic reality of events and transactions, and not merely in accordance with their legal form. In other words, it is the ‘economic reality’ that is important in accounting and not only the ‘legal reality’. In the extant case, the Committee notes from the Facts of the Case that while the company (ABC) is responsible for formulation, development and implementation of the projects in accordance with the agreed procedures, the actual execution is being done through other agencies/parties. Further, the Committee notes that while the legal form is that all the documents, such as, bidding documents, notification to executing agencies, contract and letter of award or even the guarantees given by the executing agencies etc., are in the name of the company, the substance of the transaction is that the company is acting only as an agent of the State Government/State Power Utility/State Electricity Board as significant risks and rewards related to the project vest with the State Government/State Power Utility/State Electricity Board which is clear from the following facts:
(a) It has been specifically stated in clause 4.1 (a) of MOU between XYZ and ABC that the company shall undertake these projects on behalf of the borrower/ owner of the project.
(b) Clause 3.4 of Agreement between XYZ, State Government, SPU and ABC clearly reflects that the company is just acting under the instructions/ specifications of the XYZ, the nodal agency appointed by the Government of India.
(c) It is clearly stated that the State Electricity Board would be the owner of the project and the company is an agency appointed by the State Electricity Board (refer clause 1.4 of Special Conditions of contract between ABC and executing agencies).
(d) The company is getting only a fixed percentage of income as service charges depending on the nature of contract awarded to it.
(e) Although the company has the right to recover liquidated damages from the executing agencies but the same is adjustable against the project cost. Thus, neither such cost is borne by the company nor such recovery benefits the company. In other words, all significant risks and rewards related to the business are assumed either by the owner (State Government/State Power Utility/State Electricity Board) or executing agencies.
10. On the basis of the above, the Committee is of the view that since the significant risks and rewards related to the ownership of project do not vest with the company, the costs and revenues related to the construction of the project and the procurement of the products as per the project should not be recognised in the books of account of the company. The Committee is further of the view that as the company is merely providing services in relation to construction/procurement to the State Governments/ State Power Utilities for which it is receiving fixed service charges, keeping in view the consideration of substance over form as explained above, the company should recognise only the service charges received in consideration of its services as its revenue. In this regard, the Committee also notes paragraphs 10 and 11 of Accounting Standard (AS) 7, ‘Construction Contracts’, notified under the Companies (Accounting Standards) Rules, 2006, which provide as follows:
“10. Contract revenue should comprise:
(a) the initial amount of revenue agreed in the contract; and
…”
“11. Contract revenue is measured at the consideration received or receivable. …”
On the basis of the above, the Committee is of the view that since the consideration being received by the company out of its contract for rendering of services is a fixed percentage of the project cost, the same should be considered as contract revenue of the company in the extant case.
11. The Committee is also of the view that the project assets and liabilities of the said business should also not be recorded in the books of account of the company. In this regard, the Committee notes that the terms ‘Asset’ and ‘Liability’ are defined in paragraphs 49(a) and 49(b) respectively of the ‘Framework for the Preparation and Presentation of Financial Statements’, issued by the Institute of Chartered Accountants of India, as follows:
“(a) An asset is a resource controlled by the enterprise as a result of past events from which future economic benefits are expected to flow to the enterprise.”
“(b) A liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.”
Accordingly, the Committee is of the view that insofar as the company is concerned, the project assets and project liabilities do not meet the definitions of ‘Asset’ and ‘Liability’ respectively. This is because the future economic benefits from the project assets are not expected to flow to the company. On completion of the project, the assets are taken over by the respective State Governments or State Power Utilities. The project assets are not funded by the company. In substance, they are funded by the State Government /Government. Accordingly, the liabilities which arise during the transactions are those of the Government and not that of the company.
12. As regards the recognition of contract revenue in the extant case as per AS 7, the Committee notes that for execution of the projects, the company enters into ‘supply’ and ‘erection’ contracts with the selected contracting companies (sub-contractors/executing agencies). Thus, the company is rendering services directly related to the construction as in case of project managers and accordingly, the principles of AS 7 should be applied while recognising revenue (viz., service charges) from such services. In this connection, the Committee notes paragraph 4 of AS 7, notified under the Companies (Accounting Standards) Rules, 2006, which is reproduced below:
“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) …”
Accordingly, the company should recognise the service charges on the proportionate completion basis as per the principles of AS 7.
13. As regards the contention of the auditor that the contracts entered into by the company are cost plus contracts, the Committee does not agree with it. The Committee is of the view that under a cost plus contract, the contractor is paid cost plus fixed percentage (the entire sum being recognised as contract revenue) whereas in this extant case, the company is being paid only a fixed percentage of project cost as service charges in relation to its rendering of services. Accordingly, the question of treating the project in the extant case as ‘cost plus contract’ does not arise.
D. Opinion
14. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 7 above:
(i) The company should follow proportionate completion method in accordance with AS 7 as discussed in paragraph 12 above and apply this for recognition of only the service charges as revenue. However, the contracts in the extant case cannot be called as cost plus contracts as discussed in paragraph 13 above.
(ii) The company should recognise only the service charges as discussed in paragraph 10 above.
1Opinion finalised by the Committee on 21.12.2011.
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