Query No. 17
Subject: Revenue recognition in case of project managers.[1]
A. Facts of the Case

1. A public sector company (hereinafter referred to as ‘the company’) registered under the Companies Act, 1956, is engaged in construction and operation of Hydro Electric Power Projects. In addition to construction and operation of Hydro Electric Power Projects, being a central public sector undertaking, the company is also engaged in project management/consultancy and other construction contracts on behalf of other agencies on deposit work basis generally not on profit and loss basis. These assignments are either related to own projects of the company or work has been entrusted to the company by the Government of India (GoI). None of the assignments as aforesaid is taken up by the company by bidding like a contractor (emphasis provided by the querist). For carrying out these assignments, the company acts as an agent of the agency on whose behalf said deposit work is done and there is no principal to principal relation between the company and the said agency. One of such assignments is for formulation and implementation of Rajiv Gandhi Gramin Vidyutikaran Yojna (hereinafter referred to as the ‘RGGVY’). The company is carrying out these assignments in a number of states on behalf of respective states. The brief background as well as the modus operandi for carrying out these assignments are as under:

“Clause 4: Role of the company:
4.1
(a) The company 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) The company shall be responsible for formulation, development and implementation of the projects in the identified area involving system planning, design, engineering (in accordance with the GoI’s guidelines, specifications and construction standards, wherever applicable) and procurement in accordance with agreed competitive bidding procedures.
(c) The projects shall be implemented by the company in a time bound manner as scheduled in the approved projects and projects so implemented by the company 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, the company 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 the company 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 the company under this agreement shall be funded by the GoI from the funds sanctioned to the 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 the GoI directly to the company, 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 GoI funded projects shall be maintained by the company.
(d) the company 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 the company shall also be reimbursed.

5.2 Service charges payable to the company 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 project’s cost. Further, additional statutory taxes payable by the company shall be reimbursed. …”

Relevant extracts of Agreement between the funding company, State Government, SPU and the company entered separately for each state have been provided by the querist as under:

“3.0 Construction / Implementation
3.1 The company 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 the GoI.
3.2 The company shall specify quarterly milestones, and progress shall be reviewed with reference to these milestones jointly by the GoI, authorised representative of State Government, State Electricity Board and the company in quarterly Performance Review Meetings.
3.3 The company 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 the company 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 the company under this provision, shall be suitably adjusted in the project cost.
3.4 (a) The company 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 the company during implementation through appropriate management and control systems.
(c) On behalf of the project authority (State Government and SEB), the company shall ensure that the equipment & material specifications and construction practices & standards are as those approved/stipulated by the Funding Company. …”

2. Accounting treatment being followed by the company in respect of the above type of work is described as under:

(*** stands for ‘the company’, ** stands for ‘name of SPU’ and * stands for ‘the State Government’.)

3. The querist has stated that the above accounting treatment is in conformity to the recent opinion of Expert Advisory Committee (EAC) (published as Query No. 19 of Volume XXXI of the Compendium of Opinions) given in respect of one of the subsidiaries of a power sector company executing the rural electrification work under RGGVY. The querist has also provided the relevant extracts of the opinion referred to by it.

4. Significant accounting policy of the company in respect of accounting of aforesaid assignment is reproduced below:

“10.2 In respect of Project Management/Consultancy Contracts/Cost plus Contract, revenue is recognised based on the terms of agreement and the quantum of work done under the contract.”

5. For such assignments, revenue recognition principle i.e., proportionate completion method as enunciated in AS 9 / AS 7 is being followed for the computation of revenue only. However, other disclosures warranted by AS 7 were not given in the financial statements in view of the explanation given in paragraph 2 above read with the EAC opinion referred in paragraph 3 above (emphasis supplied by the querist).

6. During the audit of accounts for the financial year (F.Y.) 2011-12 of the company, the Government auditor had raised an observation on the accounting treatment being followed by the company in respect of aforesaid assignment. The observation of the audit is reproduced below:

“In terms of the Accounting Policy No. 10.2 in respect of revenue, the Company has recognized the revenue in respect of Project Management / Consultancy / Construction Contracts on the basis of Contract Agreement and quantum of work done under the contract. During review of the Profit & Loss Account, it has been observed that the company has recognized the revenue of Rs. 131.42 crore on account of Rural Electrification / Construction Contracts and other different works assigned by different agencies having long terms cycle contracts falling under the category of Accounting Standard 7 in terms of different opinions of Expert Advisory Committee of the ICAI. As such, the provisions of the Accounting Standard 7, i.e., Construction Contracts should have been followed and accordingly, an accounting policy with other treatment as required in compliance of AS 7 should have been followed with following disclosures at the reporting date:
1. the amount of contract revenue recognised as revenue in the period;
2. the methods used to determine the contract revenue recognised in the period;
3. the method used to determine the stage of completion of contract in progress;
4. the aggregate amount of cost incurred and recognised profits (less recognised losses) upto the reporting date;
5. the amount of advances received and
6. the amount of retentions.

As such, accounts are deficient to that extent and needs to revisit the treatment given in the Profit and Loss Account and Balance Sheet.”

However, after referring to the aforesaid opinion of EAC, the auditors did not press further the observation as far as recognition of revenue is concerned. But they insisted on the following disclosures in the accounts:

B. Query

7. On the basis of the above, it is contended by the company that AS 7 is not applicable in case of such assignments, though the revenue is being recognised on proportionate completion method. The company is of the view that the recent EAC opinion referred to above is quite clear and supports the accounting treatment of the company in respect of such assignments. However, since the above referred EAC opinion is silent on the issue of disclosure requirements as per AS 7, which has been pointed out by the Government auditors at paragraph 6 above, opinion of EAC has been sought by the querist on the following issues:

.

C. Points considered by the Committee

8. The Committee notes that the basic issues raised by the querist are related to applicability of AS 7 in the extant case in relation to recognition of revenue in the context of RGGVY assignment undertaken by the company and its disclosure requirements. 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, revenue recognition policy to be followed for other projects viz., owned projects and other construction contracts, accounting policy to be followed for operation and maintenance of the project after its implementation, 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 or MoUs entered into with the State Government or State Power Utilities, or sub-contractors or funding company, treatment of establishment and administrative expenses incurred by the company as direct or indirect cost in the books of the company, etc. Further, the Committee wishes to point out that its opinion is expressed purely from the accounting point of view. The Committee notes that while various sub-clauses of clause 4 of MoU between the funding company and the company indicate that SPU is one of the project authority, clauses 3.2 and 3.4 (c) of the Agreement between funding company, State Government, SPUs and the company indicate SEB to be the project authority. Accordingly, the Committee presumes that SPUs and/or SEBs are project authorities along with the State Government.

9. With regard to recognition of revenue, the Committee notes paragraph 17(b) of Accounting Standard (AS) 1, ‘Disclosure of Accounting Policies’, notified under the Companies (Accounting Standards) Rules, 2006 (hereinafter referred to as the ‘Rules’), 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 is responsible for formulation 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/SPU/ SEB as significant risks and rewards related to the project vest with the State Government/SPU/SEB which is clear from the following facts:

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 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/ SPUs 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 ‘Rules’, 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. As regards application of AS 7 in the extract case, 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, AS 7 is applicable in the extant case. In this connection, the Committee notes paragraph 4 of AS 7, notified under the ‘Rules’, which is reproduced below:

Accordingly, the Committee is of the view that the principles of AS 7 should be applied while recognising revenue (viz., service charges) from the services rendered as well as while considering disclosures as per AS 7. The Committee is further of the view that since, in the extant case, contract revenue is the service charges, same should be considered while providing disclosures as per AS 7. Similarly, contract cost would be restricted to the cost incurred in relation to its service contract, as per the principles of AS 7.

D. Opinion

12. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 7 above:

_________

[1]Opinion finalised by the Committee on 16.7.2013.