Treatment of losses in valuation of work-in-progress

1.A public sector company is manufacturing on contract basis thermal sets and other heavy electricals. A contract may comprise manufacturing of more than one unit of equipment. The company is following the accounting policy of valuing work-in-progress in plant “at actual/estimated factory cost or realisable value, whichever is less.”

2.The auditor of one of its divisions qualified his report, on its accounts for the year 1983-84, with regard to valuation of work-in-progress in respect of loss making products, as below:

“Over valuation of work-in-progress by Rs. 819.19 lakhs, as estimated by management in respect of loss making products where the cost incurred is less than the sales value. In these cases the realisable value is being determined by writing down the cost of work-in-progress by the anticipated loss proportionate to cost incurred. In accordance with the declared accounting policy, work-in-progress is to be valued at cost or realisable value, whichever is lower. Realisable value, according to accepted accounting practices, should be determined by reducing from selling price the cost of completion and the cost necessarily to be incurred in order to make the sale. The full anticipated loss ought to have been reduced from the cost of work-in-progress rather than a proportionate amount. Consequently, profits are overstated by Rs.819.18 lakhs.

3.The statutory auditors of the company included the above comments in their report as below:

“As per Company’s practice, for the purpose of comparing historical cost with net realisable value each item of work-in-progress is dealt with separately. In one division, jobs where costs exceed realisable value, full anticipated loss is accounted for in the current period by suitably writing down the work-in-progress. However, in the case of jobs where costs do not exceed the realisable value, only proportionate loss in relation to cost incurred is accounted for. This treatment is not in accordance with the accepted practice that inventories should not be carried in the financial statements in excess of the amounts expected to be realised in the ordinary course of business and that the full anticipated loss should be recognised in the current period. As such, the work-in-progress at the year end stands over valued by Rs. 819.19 lakhs as estimated by the management. As the Company has been consistently following the method of valuing work-in-progress, as explained above, the opening work-in-progress is also containing an element of over valuation, which has not been quantified. In view of this, the impact on profit of the year by not following the accepted practice cannot be given.”

4.The querist has explained the policy on valuation of work-in-progress followed by the company as below:

“As a going concern, the realisable value relatable to part completion in a work order is determined with reference to the trend observed in completed orders as represented by the ratio of actual factory cost to sales value in the previous year. The cost so determined is deducted from the cumulative booking of the factory cost against the related work-order. In cases, where the work-in-progress so worked out is more than the balance sale value, the work-in-progress is restricted to balance sale value. This applies to loss making product also.”

5. The querist has argued in favour of the above policy followed by the company as follows:

(i) It would appear that in an ongoing concern with a large number of contracts, each with a number of units, a policy of consistently providing for the proportionate loss will be quite in order as the total losses will get provided proportionately over the period the contract runs and the units get manufactured.

(ii) Provision of the total loss in the current period will mean provision for future fixed costs like depreciation etc. which are period costs. This appears illogical as not only will the current year’s operating results be vitiated but also those of succeeding years. Any estimate of fixed cost apportionment which will depend upon capacity utilisation of the relevant period is bound to be rough and ready.

6. In the above context, the following issues have been raised for the opinion of the Expert Advisory Committee:

(i) Is total anticipated loss on the whole contract to be provided, even if costs have been incurred only in respect of one or two of the many units in the contract or is the provision of loss to be confined to only those units in respect of which costs have been incurred?

(ii) Even in respect of those units where costs have been incurred, is the total loss to be provided for in the current period or only proportionate loss?

Opinion February 19, 1985

1.The Committee notes that, Accounting Standard-7 on ‘Accounting For Construction Contracts, issued by the Institute of Chartered Accountants of India, which covers accounting treatment of contracts involving manufacture of ‘complex pieces of equipment;1 recommends the following treatment of foreseeable losses;

“13.1 When current estimates of total contract costs and revenues indicate a loss, provision is made for the entire loss on the contract irrespective of the amount of work done and the method of accounting followed. In some circumstances, the foreseeable losses may exceed the costs of work done to date. Provision is nevertheless made for the entire loss on the contract.

13.3 If a provision for loss is required, the amount of such provision is usually determined irrespective of:

(i) whether or not work has commenced on the contract; and

(ii) the stage of completion of contract activity; and

(iii) the amount of profits expected to arise on other unrelated contracts.

13.4 The determination of a future loss on a contract may be subject to a high degree of uncertainty. In some of these cases, it is possible to provide for the future loss and in other cases only the existence of a contingent loss is disclosed.”

2.On the basis of the above, the opinion of the Expert Advisory Committee on the issues raised by the querist in para 6 of the query is as below:

(i) Total anticipated loss on the whole contract should be provided even if costs have been incurred only in respect of one or two of the units in the contract. Thus provision of loss should not be confined only to those units in respect of which costs have been incurred.

(ii)From the above, it follows that total loss and not proportionate loss should be provided in respect of those units in respect of which costs have been incurred.

In those cases, however, where the determination of a future loss on a contract is subject to a high degree of uncertainty, the existence of the loss should be disclosed in the financial statements unless the possibility of a loss is remote.[1]

1 Para 3, Page 3

[1] para 11 of AS—4 on “Contingencies and Events Occurring After the Balance Sheet Date” issued by the Institute of Chartered Accountants of India.