Query No. 15

Subject:           Recognition of revenue from contract for repairs and upgradation of submarine.[1]

A.        Facts of the Case

1.         A public sector company is engaged in construction of ships, repair of ships and repair / refit of submarines. In January 2006, the company secured the medium refit order of submarine INS Sindukirthi from Indian Navy with a contract value of Rs. 629 crore and to be completed in 36 months (3 years).

2.         In this regard, the following points are pertinent:

(a)           Indian Navy gets their submarines and other vessels repaired based on the respective operation-cum-refit (OCR) cycles as a part of their maintenance programme.

(b)           The repairs are carried out based on the item-wise defect lists and additional work requisitions.

(c)           The Indian Navy also modifies / reduces / enhances / deletes the scope of work during the execution of the contract based on their requirements.

(d)          Further, the necessity of repairs / renewals / replacements other than those included in the scope of work may also arise during the repairs. Such changes in the scope of work have cost and time implications as mutually agreed by the company and the Indian Navy.

(e)           The contract between the company and Indian Navy for the subject refit provides for additional work, growth of works and other changes in the scope of work as brought out above along with the corresponding cost and time implications.

(f)           Due to additional growth of work, the INS Sindukirthi contract value has been increased to Rs. 990 crore and the repair / refit work is scheduled to be completed in the year 2014.

3.         The querist has stated that revenue recognition on the said project has been accounted for as per the accounting policy disclosed in the notes forming part of the accounts as under:

“Income from other services including ship repair and submarine refit activities is   accounted for on accrual basis by adopting proportionate completion method.”

4.         The above said accounting treatment of revenue as per Accounting Standard (AS) 9, ‘Revenue Recognition’, for refit of INS Sindukirthi has been accepted by statutory auditors and Government auditors for the last six years (Financial Year (F.Y.) 2006-07 to 2011-12) without any objection and accordingly, this method of accounting is consistently followed over the years.

5.         This being the position, the Government audit had issued a sub-direction to the statutory auditors in the F.Y. 2012-13 to examine the adequacy and appropriateness of all the accounting policies of the company. The statutory auditors in their audit report on the accounts of the company for F.Y. 2012-13 had made a qualification that:

“The company has not recognised retrofit income as per AS 7 ‘Construction Contracts’ issued by the Institute of Chartered Accountants of India (ICAI) which constitutes a departure from the accounting standards referred to in sub-section 3(c) of section 211 of the Act. The company has recognised retrofit income in accordance with AS 9, ‘Revenue Recognition’, and in order to attain finality in this regard has decided to seek the views of the Expert Advisory Committee of the ICAI.

Had such income and provision for future loss been recognised as per AS 7 instead of AS 9, the loss of the company for the year ended 31st March, 2013 and the reserves (deficit) of the company as at 31st March, 2013 would have been higher by Rs. 1,301.34 lakhs; thereby resulting in net loss of Rs. 6,818.73 lakhs for the year.”

6.         The querist has stated that the company, on considering the salient features of the contract for repairs of Indian Navy submarine INS Sindukirthi, had adopted AS 9 for revenue recognition. The salient features of the said contract are as under:

(i)          Ownership of the submarine rests with Indian Navy only. The submarine has been only docked for repairs / refit at the company.

(ii)         The company has neither managerial involvement with ownership nor effective control over the submarine as it continues to be under the ownership of Navy.

(iii)        Revenue under this contract can be reliably measured as job-wise revenue based on the agreed defect list is indicated and identifiable in the contract. Therefore, economic benefits under the contract will flow to the company as per the progress of repairs work in terms of the agreed item-wise defect list.

(iv)        Costs of the item-wise defects agreed in the contract can be measured reliably with reference to corresponding revenue. The cost/revenue of additional/growth of work or deleted items is also identifiable reliably.

(v)         The medium repair cum upgradation of submarine INS Sindukirthi is neither a contract for construction of a new asset nor a contract for destruction / restoration of asset and the restoration of the environment following the demolition of assets. It is a contract for repairs and upgradation of submarine owned by Indian Navy and the activities do not result into creation of new asset.

7.         The querist has separately clarified that the repair activity under the scope of the contract includes medium repairs, modernisation work and upgrading the submarine by installing Club-s-system known as under missile firing system. The scope of work is being executed jointly by the company and a sub-contractor M/s XYZ, Russia. The querist has pointed out that majority of the materials for repairs of the submarine are being imported from the sub-contractor. The total contract price has been divided into Rupee and Dollar component. The details of the same are given hereunder:

With reference to the above table, the querist has explained that the scope of work of M/s XYZ includes supply of repair spares and modernisation of Club-s-system. Further, the querist has submitted that all the contracts with M/s XYZ including Club-s-system and modernisation works have been concluded as back to back contracts with M/s XYZ and these contracts include supply of material as well as their installation. The entire amount of US $ 76,827,664/- is payable towards various contracts with M/s XYZ. For the purpose of undertaking the repair works on this submarine, the company had imported RTD (Repair technical documents) from M/s XYZ for an amount of 12 million US Dollars.
8.         The querist has also stated that the revenue recognition on the INS Sindukirthi contract is in consonance with the conditions stipulated in AS 9 as furnished below:  

(i)         AS 9 deals with the recognition of revenue arising in the course of ordinary activities of the enterprise from the rendering of services. The subject contract for repairs of INS Sindukirthi is a service contract.

(ii)        The ‘Proportionate Completion method’ followed by the company for recognition of revenue on the said contract is in line with AS 9 (paragraph 7.1(i)).

(iii)       As per AS 9 (paragraph 7.1(i)), under ‘Proportionate Completion method’, revenue can be recognised proportionately by reference to the performance of each act. As brought out at paragraphs 6 (iii) & (iv) above, under the salient features of the contract, revenue and cost for each act / defect / job has been accounted for with reference to progress of work of each act / job.

(iv)       AS 9 does not prohibit revenue recognition for service contracts that span for more than one accounting period.

Thus, recognition of revenue on the contract for repairs of INS Sindukirthi of Indian Navy in line with AS 9 is in order as per the company.

B.        Query

9.         In view of the above facts, the querist has sought the opinion of the Expert Advisory Committee on the following issues:

(a)        Whether the recognition of revenue from repair/refit of the submarine as per AS 9 is correct.

(b)        If not so, whether any change is required in the accounting policy of the company to bring in line with AS 7 as observed by the statutory auditors.

C.        Points Considered by the Committee

10.       The Committee notes that the basic issue raised by the querist is whether revenue from repair / refit of the submarine should be recognised as per AS 9 or AS 7. Therefore, the Committee has examined only this issue and has not examined any other issue that may arise from the Facts of the Case, such as, accounting treatment of increase in contract value and time period, accounting in the books of contractee as to whether such repairs/refit would be capitalised or expensed off, accounting for any sub-contract or joint contract with M/s XYZ,   etc.
11.       The Committee notes the following paragraphs of AS 7, notified under the Companies (Accounting Standards) Rules, 2006 (hereinafter referred to as the ‘Rules’):

“Objective

The objective of this Standard is to prescribe the accounting treatment of revenue and costs associated with construction contracts. Because of the nature of the activity undertaken in construction contracts, the date at which the contract activity is entered into and the date when the activity is completed usually fall into different accounting periods. Therefore, the primary issue in accounting for construction contracts is the allocation of contract revenue and contract costs to the accounting periods in which construction work is performed. This Standard uses the recognition criteria established in the Framework for the Preparation and Presentation of Financial Statements to determine when contract revenue and contract costs should be recognised as revenue and expenses in the statement of profit and loss. It also provides practical guidance on the application of these criteria.”

“2.1     A construction contract is a contract specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use.”

“3.       A construction contract may be negotiated for the construction of a singleasset such as a bridge, building, dam, pipeline, road, ship or tunnel. A construction contract may also deal with the construction of a number of assets which are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use; examples of such contracts include those for the construction of refineries and other complex pieces of plant or equipment.

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

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

(b)        contracts for destruction or restoration of assets, and the restoration of the environment following the demolition of assets.” (Emphasis supplied by the Committee.)

The Committee notes from the above that the nature of activities covered under AS 7 involves or relates to construction of an asset, such as, construction of complex piece of equipment, as well as the contracts for restoration of assets. The Committee is of the view that restoration covered under AS 7 is the activity which would bring back the asset to its original condition. However, day-to-day repairs and maintenance activities, such as, AMC contracts, would fall outside the scope of AS 7. Further, the Committee notes that the objective of AS 7 is to cover those construction activities which, due to the nature of the activity being undertaken, fall into more than one accounting period. 

12.       The Committee notes that the contract in the extant case is that of refit of submarine based on its operation-cum-refit cycle as a part of its maintenance programme which involves upgradation of the submarine by installing Club-s-system known as under missile firing system, modernization work, medium repairs / renewals / replacements, etc.  Further, the Committee notes that the contract in the extant case was secured in January 2006 and was expected to be completed in 36 months, i.e., more than one accounting period. On the basis of the above, the Committee is of the view that the activities covered under the contract for refit of submarine are such that would bring back the submarine into its original condition after its prolonged use as a part of its operation-cum-refit cycle. Apart from this, there are certain activities, such as, modernization, upgrading the submarine by installing Club-s-system, etc. which would not only bring back the submarine into its original condition but may also enhance its operating efficiency and future benefits. Accordingly, the Committee is of the view that the contract in the extant case is of the nature of restoration contract although some of the activities covered in the contract may involve normal repairs and maintenance activities. Accordingly, considering that a single composite restoration contract has been undertaken by the company that also falls in more than one accounting period, it falls within the scope of AS 7. Accordingly, recognition of revenue in the extant case as per AS 9 is not correct. The Committee is further of the view that in the extant case, AS 7 would be applicable and, therefore, in accordance with the requirements of AS 7, the expected loss on the contract should be recognised as an expense immediately.

13.       In the context of application of AS 9, the Committee wishes to point out that both AS 7 and AS 9 contain similar requirements in terms of recognition of revenue under proportionate completion method. Further, in the context of recognition of provision for expected losses on the contract, it may be noted that where there is an expected loss on the contract covered within the scope of AS 9, provision should be recognised as per Accounting Standard (AS) 29, ‘Provisions, Contingent Liabilities and Contingent Assets’, notified under the Rules, considering its requirements in the context of ‘onerous contract’.

D.        Opinion

14.       On the basis of the above, the Committee is of the following opinion on the issues raised by the querist in paragraph 9 above:
(a) & (b)    Considering that a single composite restoration contract has been undertaken by the company that also falls in more than one accounting period, the contract in the extant case falls within the scope of AS 7, as discussed in paragraph 12 above. Accordingly, recognition of revenue in the extant case as per AS 9 is not correct. The Committee is further of the view that in the extant case, AS 7 would be applicable and, therefore, in accordance with the requirements of AS 7, the expected loss on the contract should be recognised as an expense immediately.

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[1]Opinion finalised by the Committee on 6.6.2014.