Query No. 13                                                                  

Subject:           Determination of stage of completion in foreign currency contracts executed by foreign branches.[1]

A.        Facts of the Case  

1.         A government company (hereinafter referred to as the ‘company’) incorporated under the Companies Act, 1956, is a leading turnkey construction company having widespread operations in several parts of India and other countries like Malaysia, Nepal, Bangladesh, Mozambique, Algeria and Sri Lanka. The query is for recognition of revenue in its foreign projects and accordingly the facts below pertain to foreign projects.

2.         The company secures contracts through bidding or negotiations and pricing of contracts is decided at the level of the Chairman and Managing Director (CMD) of the company at corporate office. The projects are executed on item rate, cost plus or lump sum turnkey basis.

3.         The company on behalf of projects, because of its financial strength, arranges various types of bank guarantees (bid bond, advance payment guarantee, performance guarantee, guarantee for release of retention money, etc.) at a very competitive cost to the clients as per the contract conditions. The company has also provided a corporate guarantee towards its design obligations in a foreign contract.

4.         At times, the company avails the services of consultants who provide various services in connection with securing the contracts as well as for smooth operation during execution stage. The appointment of these consultants is done at corporate level only.

5.         The expenditure incurred upto the stage of securing the contract in all cases and on services of consultants referred above is generally borne by the corporate office and is not passed on to projects even if the project is secured. The project may earn profit or incur losses. The project duration is normally 2-3 years but may be longer for high value projects.

6.         The project operates as a foreign branch of the company and is treated as Permanent Establishment (PE) in the country of operations. The manpower for executing the contract is deputed by the company to the projects on temporary posting basis. The salary of employees, in US$, is processed at corporate office and credited to their accounts but the actual expenditure is charged to the project. The project is executed by deploying machinery/plant which is procured specifically for the project or diverted from other projects and/or by sub-contracting of certain portion of the work. On completion of the project, the plant & machinery is transferred to other projects in other countries or brought to India or disposed-off in the foreign country and all activities are wound up. Similarly, employees are posted back to India. Pending and unsettled issues like disputes, taxation issues of the country etc. are dealt with from the corporate office which takes a long time.

7.         The company also posts project heads who, besides a power of attorney, are delegated certain financial and administrative powers by the CMD. The projects can float tenders; appoint sub-contractors within the limits laid down as per the delegated powers as aforesaid beyond which they have to approach the corporate office. In such cases, either the proposals are finalised at corporate office or approval from higher management at corporate office is obtained. Progress of the projects is monitored from the corporate office on regular basis and the officers/ concerned director incharge of the project from the corporate office also visit the projects for supervision from time to time. The projects are also subject to internal audit conducted by officers deputed by corporate office and proprietary & supplementary audit by the office of Comptroller and Auditor General (C&AG). In nutshell, the projects are given functional freedom so that project execution is carried out efficiently but they have to operate under the control and supervision of the corporate office and are required to follow the rules and regulations laid down by the company in all matters.

8.         The contract payments are received in various currencies like Euro, US$ and the local currency of the project country. The percentage of payments in different currencies varies from contract to contract. Expenditure on executing the contracts is also in different currencies and varies from contract to contract. Efforts are made to enter into contracts such that the company pays in the currency in which it receives the payment. However, in case of projects where funds are provided by the Government of India (Indian lines of credit) to the foreign Government, large portion of expenditure is/may be in INR although the contract with the foreign Government provides for payment in foreign currency. Payment in such cases is released to the company by Export-Import Bank of India (EXIM bank) in foreign currency or equivalent INR.

9.         Temporary surplus funds with the projects are generally invested at corporate level in short-term bank deposits to be made available to projects when required. Surplus funds which are considered no longer required are repatriated to India keeping in view the Foreign Exchange Management Act (FEMA) provisions. Similarly, if the projects require funds, the same are provided by the company’s corporate office. The transfer of funds from/to the projects is not based on profit earned/loss incurred but on the needs of the projects. The projects are not permitted to borrow.

10.       Separate books of account are maintained for each contract. The statutory audit of these projects is carried out either by the local auditors appointed by the board of the company with the approval of C&AG or the central statutory auditors are deputed for the audit after taking approval of C&AG. For meeting local tax requirements and payment of local taxes, accounts are also prepared in local currency.

11.       Consolidated accounts incorporating the figures of foreign projects are prepared at corporate level and incremental tax as per the Indian Income-tax Act is paid by the company. The querist has stated that based on the above facts, the company is treating all foreign projects as integral foreign operations under the Indian Generally Accepted Accounting Practices (GAAPs).

12.       Upto 31.03.2011, the books of account of the projects were prepared in different currencies and INR figures were worked out by converting different currencies figures into INR using yearly/ monthly average exchange rates. Since 01.04.2011, the books of account are prepared in single currency in Indian Rupees by converting foreign currency transactions into INR at the exchange rate prevailing on the date of transaction. Monetary items are restated at the prevailing closing exchange rate at each balance sheet date.  Net exchange gains on restatement of monetary items are accounted for in the statement of profit and loss for the year. During January 2011, the company had obtained an opinion from a renowned firm regarding determination of functional currency as per which the functional currency of foreign jointly controlled operations would be INR.

13.       Since more realistic estimate can be prepared in the currency in which substantial payments are to be received (say MYR), project cost estimate/revised cost estimates are prepared in that currency. For this purpose, back up records in MYR are maintained and transactions in currencies other than in MYR are also converted into MYR. Percentage of completion of the project and profitability is calculated based on actual audited figures in INR for the expenditure incurred to date and the estimated remaining costs (in different currencies) which is arrived at in INR by applying the exchange rates for different currencies on the balance sheet date (sample calculations have been provided by the querist as Annexure ‘A’ for the perusal of the Committee).

14.       The querist has stated that major projects in hand are either complete or in advanced stage of completion. In the past few years, the turnover from foreign projects has been varying between 30% to 50% of the total turnover. 

15.       The relevant provisions of the Accounting Standards referred to by the company for the above treatment have been reproduced by the querist as follows:

Accounting Standard (AS) 11, ‘The Effects of Changes in Foreign Exchange Rates’

“7.6          Foreign currency is a currency other than the reporting currency of an enterprise.”

“Foreign Currency transactions

Initial Recognition
...

9.        A foreign currency transaction should be recorded, on initial recognition in the reporting currency, by applying to the foreign currency amount the exchange rate between the reporting currency and the foreign currency at the date of the transaction.”

“Reporting at Subsequent Balance Sheet Dates

11.      At each balance sheet date:

(a)  foreign currency monetary items should be reported using the closing rate.  However, in certain circumstances, the closing rate may not reflect with reasonable accuracy the amount in reporting currency that is likely to be realised from, or required to disburse, a foreign currency monetary item at the balance sheet date, e.g., where there are restrictions on remittances or where the closing rate is unrealistic and it is not possible to effect an exchange of currencies at that rate at the balance sheet date.  In such circumstances, the relevant monetary item should be reported in the reporting currency at the amount which is likely to be realised from, or required to disburse, such item at the balance sheet date;

(b)  non-monetary items which are carried in terms of historical cost denominated in a foreign currency should be reported using the exchange rate at the date of the transactions; and

(c)  non-monetary items which are carried at fair value or other similar valuation denominated in a foreign currency should be reported using the exchange rates that existed when the values were determined.”

“Recognition of Exchange Differences

13.      Exchange differences arising on the settlement of monetary items or on reporting an enterprise’s monetary items at rates different from those at which they were initially recorded during the period, or reported in previous financial statements, should be recognised as income or as expenses in the period in which they arise, with exception of exchange differences dealt with in accordance with paragraph 15.”

“Net Investment in a Non-integral Foreign Operation

15.      Exchange differences arising on a monetary item that, in substance, forms part of an enterprise’s net investment in a non-integral foreign operation should be accumulated in a foreign currency translation reserve in the enterprise’s financial statements until the disposal of the net investment, at which time they should be recognised as income or as expenses in accordance with paragraph 31.”

“Financial Statements of Foreign Operations

Classification of Foreign Operations

17.      The method used to translate the financial statements of a foreign operation depends on the way in which it is financed and operates in relation to the reporting enterprise.  For this purpose, foreign operations are classified as either “integral foreign operations” or “non-integral foreign operations”.”

“20.    The following are indications that a foreign operation is a non-integral foreign operation rather than an integral foreign operation:

(a)        while the reporting enterprise may control the foreign operation, the activities of the foreign operation are carried out with a significant degree of autonomy from those or the reporting enterprise;

(b)        transactions with the reporting enterprise are not a high proportion of the foreign operation’s activities;

(c)        the activities of the foreign operation are financed mainly from its own operations or local borrowings rather than from the reporting enterprise;

(d)       costs of labour, material and other components of the foreign operation’s products or services are primarily paid or settled in the local currency rather than in the reporting currency;

(e)        the foreign operation’s sales are mainly in currencies other than the reporting currency;

(f)        cash flows of the reporting enterprise are insulated from the day-to-day activities of the foreign operation rather than being directly affected by the activities of the foreign operation;

(g)        sales prices for the foreign operation’s products are not primarily responsive on a short-term basis to changes in exchange rates but are determined more by local competition or local government regulation; and

(h)        there is an active local sales market for the foreign operation’s products, although there also might be significant amounts of exports.

The appropriate classification for each operation can, in principle, be established from factual information related to the indicators listed above.  In some cases, the classification of a foreign operation as either a non-integral foreign operation or an integral foreign operation of the reporting enterprise may not be clear, and judgement is necessary to determine the appropriate classification.”

“Non-integral Foreign Operations

24.    In translating the financial statements of a non-integral foreign operation for incorporation in its financial statements, the reporting enterprise should use the following procedures:

(a)   the assets and liabilities, both monetary and non-monetary, of the non-integral foreign operation should be translated at the closing rate;

(b)   income and expense items of the non-integral foreign operation should be translated at exchange rates at the dates of the transactions; and

(c)   all resulting exchange differences should be accumulated in a foreign currency translation reserve until the disposal of the net investment.”                  

“Disposal of a Non-integral Foreign Operation

31.    On the disposal of a non-integral foreign operation, the cumulative amount of the exchange differences which have been deferred and which relate to that operation should be recognised as income or as expenses in the same period in which the gain or loss on disposal is recognised.”

Accounting Standard (AS) 7, ‘Construction Contracts’

“Recognition of Contract Revenue and Expenses

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.”

“24.  The recognition of revenue and expenses by reference to the stage of completion of a contract is often referred to as the percentage of completion method.  Under this method, contract revenue is matched with the contract costs incurred in reaching the stage of completion, resulting in the reporting of revenue, expenses and profit which can be attributed to the proportion of work completed.  This method provides useful information on the extent of contract activity and performance during a period.

25.    Under the percentage of completion method, contract revenue is recognised as revenue in the statement of profit and loss in the accounting periods in which the work is performed.  Contract costs are usually recognised as an expense in the statement of profit and loss in the accounting periods in which the work to which they relate is performed.  However, any expected excess of total contract costs over total contract revenue for the contract is recognised as an expense immediately in accordance with paragraph 35.”

“29.  The stage of completion of a contract may be determined in a variety of ways.  The enterprise uses the method that measures reliably the work performed.  Depending on the nature of the contracts, the methods may include:

(a)   the proportion that contract costs incurred for work performed upto the reporting date bear to the estimated total contract costs; or

(b)   surveys of work performed; or

(c)   completion of a physical proportion of the contract work.

Progress payments and advances received from customers may not necessarily reflect the work performed.

30.    When the stage of completion is determined by reference to the contract costs incurred upto the reporting date, only those contract costs that reflect work performed are included in costs incurred upto the reporting date.  Examples of contract costs which are excluded are:

(a)   contract costs that relate to future activity on the contract, such as costs of materials that have been delivered to a contract site or set aside for use in a contract but not yet installed, used or applied during contract performance, unless the materials have been made specially for the contract; and

(b)   payments made to subcontractors in advance of work performed under the subcontract.”

“Changes in Estimates

37.    The percentage of completion method is applied on a cumulative basis in each accounting period to the current estimates of contract revenue and contract costs.  Therefore, the effect of a change in the estimate of contract revenue or contract costs, or the effect of a change in the estimate of the outcome of a contract, is accounted for as a change in accounting estimate (see Accounting Standard (AS) 5, Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies). The changed estimates are used in determination of the amount of revenue and expenses recognised in the statement of profit and loss in the period in which the change is made and in subsequent periods.”

16.       While discussing the results of foreign operations of one particular project where substantial portion of receipts and expenditure is in local currency, one view was as to why not the percentage of completion and/or profitability be worked out in the local currency. Analysis of this reveals that this method will result in showing higher turnover and profitability in the initial years of the project. The counter view was that since the reporting currency of the company is INR and audited accounts are also in INR which incorporate the effect of exchange differences, adoption of local currency as the basis will distort the results unless reporting currency is changed to the local one since start of the project and necessary adjustments are made for the past period. Moreover, the percentage of expenditure to receipts in a particular currency may substantially vary not only at the initial stage of a contract but later on also when the expenditure is actually being incurred. Such an approach may also result in following different methods of revenue recognition in different projects. It was therefore decided to refer the matter for an expert opinion.

B.        Query

17.       Opinion of the Expert Advisory Committee of the Institute of Chartered Accountants of India (ICAI) is sought on the following issues:

(i) Whether the functional currency of different foreign projects should be different or INR for all projects or currency of country of the project?

(ii) Whether the project cost estimate/revised cost estimate being prepared as above is correct? If not, in which currency the project cost estimate should be prepared?

(iii) Whether percentage of completion and profitability as being worked out is correct? If not, how it should be worked out?

(iv) If any other method is suggested, how to account for the past transactions may also be advised.

C. Points considered by the Committee

18.       The Committee notes that the basic issues raised by the querist relate to whether the functional currency of different foreign projects should be different or INR for all projects or currency of country of the project, and in which currency the project cost estimate/revised cost estimate and cost incurred should be computed to determine the stage of completion of the project. The Committee has, therefore, considered only these issues and has not examined any other issue that may arise from Facts of the Case, such as, allocation of various elements of cost to the project, determination of actual and estimated project cost,  translation of various items of foreign operations in the financial statements of the company, whether determination of stage of completion by reference to the contract cost incurred upto the reporting date reliably measures the work performed, etc. For this purpose, the Committee has presumed that foreign operations are in respect of construction contracts which fall within the scope of AS 7 and the outcome of the contract of foreign operations can be estimated reliably. The Committee, while expressing its opinion, has dealt only with the method of determination of stage of completion of the project and has not gone into determination of amounts to be reported in the financial statements related to construction contracts.

19.       With regard to foreign currency transactions, the Committee notes the following paragraphs of AS 11:

“7.6 Foreign currency is a currency other than the reporting currency of an enterprise.”

“7.15 Reporting currency is the currency used in presenting the financial statements.”

“Initial Recognition

9.     A foreign currency transaction should be recorded, on initial recognition in the reporting currency, by applying to the foreign currency amount the exchange rate between the reporting currency and the foreign currency at the date of the transaction.”

“Reporting at Subsequent Balance Sheet Dates

11. At each balance sheet date:

(a)     foreign currency monetary items should be reported using the closing rate.  However, in certain circumstances, the closing rate may not reflect with reasonable accuracy the amount in reporting currency that is likely to be realised from, or required to disburse, a foreign currency monetary item at the balance sheet date, e.g., where there are restrictions on remittances or where the closing rate is unrealistic and it is not possible to effect an exchange of currencies at that rate at the balance sheet date.  In such circumstances, the relevant monetary item should be reported in the reporting currency at the amount which is likely to be realised from, or required to disburse, such item at the balance sheet date;

(b)     non-monetary items which are carried in terms of historical cost denominated in a foreign currency should be reported using the exchange rate at the date of the transactions; and

(c)     non-monetary items which are carried at fair value or other similar valuation denominated in a foreign currency should be reported using the exchange rates that existed when the values were determined.”

 

20.       On the basis of the above, the Committee notes that AS 11 prescribes that the reporting currency should be used in recording foreign currency transactions and for presenting financial statements. Accordingly, the Committee notes that AS 11 does not follow the ‘functional currency’ concept. However, the Committee notes that as per AS 11, the methodology used to translate the financial statements of a foreign operation depends on the classification of the foreign operations as integral or non-integral.  In this regard, the Committee notes the following paragraphs of AS 11:

“7.10   Integral foreign operation is a foreign operation, the activities of which are an integral part of those of the reporting enterprise.”

“7.13   Non-integral foreign operation is a foreign operation that is not an integral foreign operation.”

“18. A foreign operation that is integral to the operations of the reporting enterprise carries on its business as if it were an extension of the reporting enterprise’s operations. For example, such a foreign operation might only sell goods imported from the reporting enterprise and remit the proceeds to the reporting enterprise. In such cases, a change in the exchange rate between the reporting currency and the currency in the country of foreign operation has an almost immediate effect on the reporting enterprise’s cash flow from operations. Therefore, the change in the exchange rate affects the individual monetary items held by the foreign operation rather than the reporting enterprise’s net investment in that operation.

19. In contrast, a non-integral foreign operation accumulates cash and other monetary items, incurs expenses, generates income and perhaps arranges borrowings, all substantially in its local currency. It may also enter into transactions in foreign currencies, including transactions in the reporting currency. When there is a change in the exchange rate between the reporting currency and the local currency, there is little or no direct effect on the present and future cash flows from operations of either the non-integral foreign operation or the reporting enterprise. The change in the exchange rate affects the reporting enterprise’s net investment in the non-integral foreign operation rather than the individual monetary and non-monetary items held by the non-integral foreign operation.

20. The following are indications that a foreign operation is a non-integral foreign operation rather than an integral foreign operation:

 (a) while the reporting enterprise may control the foreign operation, the activities of the foreign operation are carried out with a significant degree of autonomy from those of the reporting enterprise;

(b) transactions with the reporting enterprise are not a high proportion of the foreign operation’s activities; 

(c) the activities of the foreign operation are financed mainly from its own operations or local borrowings rather than from the reporting enterprise;

(d) costs of labour, material and other components of the foreign operation’s products or services are primarily paid or settled in the local currency rather than in the reporting currency;

(e) the foreign operation’s sales are mainly in currencies other than the reporting currency;

(f) cash flows of the reporting enterprise are insulated from the day-to-day activities of the foreign operation rather than being directly affected by the activities of the foreign operation;

(g) sales prices for the foreign operation’s products are not primarily responsive on a short-term basis to changes in exchange rates but are determined more by local competition or local government regulation; and

 (h) there is an active local sales market for the foreign operation’s products, although there also might be significant amounts of exports.

 

The appropriate classification for each operation can, in principle, be established from factual information related to the indicators listed above. In some cases, the classification of a foreign operation as either a non-integral foreign operation or an integral foreign operation of the reporting enterprise may not be clear, and judgement is necessary to determine the appropriate classification.”

On the basis of the above, the Committee is of the view that since determination of appropriate classification of foreign operations into integral and non-integral is a matter of judgement, the company should apply the criteria specified in the above paragraphs considering its own facts and circumstances.

21.       With regard to the determination of stage of completion, the Committee notes that the objective is to determine the extent of contract work completed/performed so as to provide information on contract activity and performance during a period. Thus, the purpose is to determine reliably the stage of completion and not reporting per se. Therefore, AS 11 which prescribes reporting requirements for foreign operations would not govern the determination of stage of completion. In this regard, the Committee notes that AS 7 also does not provide explicit guidance as to which currency should be used for computing project cost estimates/revised cost estimates and actual cost incurred to determine the stage of completion of the project when costs and revenues are denominated in different foreign currencies. However, AS 7 prescribes various methods for determining stage of completion including survey of work performed and completion of a physical proportion of the contract work and requires to use that method which measures the stage of physical completion of work reliably. The Committee further notes that where stage of completion is determined by reference to contract costs incurred upto the reporting date, only those costs are included which reflect the work performed. Accordingly, the Committee is of the view that since the effect of foreign exchange fluctuations in themselves do not reflect the performance of contract activity, i.e., the work performed, as a matter of principle, the same should be ignored while determining the stage of completion.

22.       With regard to the currency to be used while determining the stage of completion, the Committee is of the view that in order to ignore the effect of foreign exchange fluctuations and to reflect only the level/extent of work performed, only one currency and one fixed exchange rate(s) should be used for computing the actual cost incurred and the total estimated costs in the determination of the stage of completion of a contract in a particular country. The effect of foreign exchange fluctuation on the stage of completion can be explained with the help of following illustration:

It is presumed for the sake of convenience that salary is the only component of cost, which is expected to be incurred on the foreign project at USD 10, when the exchange rate was USD 1= Rs. 40/-

The actual cost (salary) incurred as on the reporting date is USD 5

Exchange rate on the date of transaction is Rs. 50 per USD

Exchange rate at the end of reporting year is Rs. 60 per USD

Thus, it can be seen from the above that if the effect of exchange rate is ignored, the stage of completion would be 50% whereas, if the effect of foreign exchange fluctuations is included, the stage of completion would be determined as follows:

Actual cost incurred = Rs. 50*5 = Rs. 250

Total estimated cost = Actual cost incurred + Remaining expected cost at the end of reporting year = Rs. 250 + Rs. (5*60) = Rs. 550

Thus, %age of completion = 250/550 *100 = 45.45%

The above illustrates how the inclusion of or ignoring the effects of foreign exchange fluctuations affect the stage of completion. Accordingly, the Committee is of the view that the present practice being followed by the company would be correct only if it approximates the stage of completion reliably, as discussed above.

23.       With regard to the accounting for past transactions, the Committee is of the view that if the practice of the company to determine the stage of completion is not correct as discussed in paragraphs 21 and 22 above, this would result into reporting of incorrect figures of revenue and profits in the financial statements of earlier years. Accordingly, in that case, the same should be rectified and disclosed in the current year as a ‘prior period item’ in accordance with the requirements of Accounting Standard (AS) 5, ‘Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies’. In this regard, the Committee notes the definition of prior period item and paragraph 15 of AS 5 as follows:

“4.3. Prior period items are income or expenses which arise in the current period as a result of errors or omissions in the preparation of the financial statements of one or more prior periods.”

“15. The nature and amount of prior period items should be separately disclosed in the statement of profit and loss in a manner that their impact on the current profit or loss can be perceived.”

D. Opinion

24. On the basis of the above, the Committee is of the following opinion on the issues raised by the querist in paragraph 16 above:

 (i) AS 11 does not follow the ‘functional currency’ concept. Therefore, the question of using functional currencies of different foreign projects does not arise, as discussed in paragraph 20 above.

(ii) & (iii) Since the effect of foreign exchange fluctuations does not reflect the performance of contract activity, i.e., the work performed, the same should be ignored for the purpose of determination of stage of completion. Regarding the currency to be used for computation of cost estimates/revised cost estimates and costs incurred while determining the stage of completion, the Committee is of the view that in order to ignore the effect of foreign exchange fluctuations and to reflect only the extent of work performed, one currency and one fixed exchange rate(s) should be used for computing the afore-mentioned amounts, as discussed in paragraph 22 above. Accordingly, the Committee is of the opinion that the present practice being followed by the company would be correct only if it approximates the stage of completion reliably, as discussed in paragraphs 21 and 22 above.

(iv) The Committee is of the opinion that if the practice of the company does not determine the stage of completion reliably, as discussed in paragraphs 21 and 22 above, the same should be treated as prior period item. In that case, the same should be rectified and disclosed separately in the current year as a ‘prior period item’ in accordance with the requirements of AS 5, as discussed in paragraph 23 above.

Annexure – A

Project: ABC

Calculation of Percentage of completion and Percentage of Profitability

Note -   * Finalised figures are subject to audit

  ** Based on back up records

__________________________

[1]Opinion finalised by the Committee on 1.5.2014.