1.23 Query
Provision for losses in case of construction contracts
1.A public limited company, wholly owned by a state government, undertakes construction works exclusively for government departments/undertakings. The Company was incorporated on 8.2.1980 and the accounts have been completed and got audited upto 31.3.1986. It undertakes contracts both on turnkey and non-turnkey basis and follows the mercantile system of accounting and values inventories on FIFO basis. Its construction activities are spread all over the state and it undertakes all kinds of contracts, i.e., bridge construction, building construction, road work etc.
2.The company is following the system of crediting the value of work done, measured by the company engineers upto 31st March every year at the rates approved by the clients and debits all works and other expenses to the profit and loss account, irrespective of whether a work is in the initial stage or nearing completion, since the rates for each item in the contract is quoted and accepted by the clients. For instance, the construction of a building work, the contract value of which is Rs. 50 Lakhs, consists of several items such as earth work, laying foundation, concrete work, bricks work, R.C.C. work, plastering and white washing etc. The company charges the client for doing each work on the basis of rate per metric cube of work done. Thus, the rate for each item of work quoted includes material, labour, overheads and profit as an integral part of the rate itself.
3.In the above context, the querist has drawn the attention of the Committee to Accounting Standard 7 (AS-7) on ‘Accounting for Construction Contracts’; para 7.3 and 7.4 of which mention that provision for losses should be made if the company anticipates that there is likelihood of losses in the remaining part of the contract. The querist has stated that if a contract extends for a period of three or four years, there is difficulty in quantifying the losses anticipated for the remaining portion of the contract as the reasons for possible losses like cost escalation in materials, labour etc. and losses due to floods, fire, drought etc. are unpredictable. Also contracts which are not profitable in the first year may earn profit in the next year. It is therefore felt by the querist that the present system of crediting the value of work done at the rates approved by the clients and debiting all works and other expenses to the profit and loss account will show a true and fair picture of the working of the company.
4.The Government Auditors commented on the last year’s accounts that the company should follow the procedure outlined in AS-7 and provide for anticipated losses and also should not take revenue in the contracts which are in progress.
5.On the contrary, the querist is of the view that above-mentioned contention is not in order as the procedure out-lined in para 7 of AS-7 is applicable under the completed contract method only and does not apply to the system followed by the company where a contract is made by quoting rates, item-wise and agreed to and paid by their clients as such. Thus, in the view of the querist, the company is right in taking credit for the value of work done measured time-wise upto 31st March each year and billed to the clients. This method of preparing the accounts is being followed by the company from the inception and audited by various statutory auditors. The present auditors also agree with the procedure followed by the company. According to the querist, other construction companies also follow more or less the same procedure.
6.In the circumstances of the query, the opinion of the Expert Advisory Committee has been sought on whether
(i) the procedure followed by the company is in order and will show true and fair picture of the working of the company, and
(ii) the system outlined in AS-7 is mandatory and should be followed in the preparation of final accounts.
Opinion August 21, 1987
1.The Committee notes from the facts of the query that the company is evidently following the ‘percentage of completion method’ and not ‘completed contract method’ for accounting for construction contracts. In this context, the Committee notes that para 9 of Accounting Standard 7, “Accounting for Construction Contracts”, issued by the Institute of Chartered Accountants of India, recommends basis for recognising revenue on construction contracts where percentage of completion method is followed. The said para 9 is reproduced below:
“9. Percentage of completion method
9.1 Under the percentage of completion method, the amount of revenue recognised is determined by reference to the stage of completion of the contract activity at the end of each accounting period. The advantage of this method of accounting for contract revenue is that it reflects revenue in the accounting period during which activity is undertaken to earn such revenue.
9.2 The stage of completion used to determine revenue to be recognised in the financial statements is measured in an appropriate manner. For this purpose no special weightage should be given to a single factor, instead, all relevant factors should be taken into consideration; for example, the proportion that costs incurred to date bear to the estimated total costs of the contract, by surveys which measure work performed and completion of a physical proportion of the contract work.
9.3 Progress payments and advances received from customers may not necessarily reflect the stage of completion and therefore cannot usually be treated as equivalent to revenue earned.
9.4 If the percentage of completion method is applied by calculating the proportion that costs to date bear to the latest estimated total costs of the contract, adjustments are made to include only those costs that reflect work performed. Examples of items which may need adjustment include:
(i) the costs of materials that have been purchased for the contract but have not been installed or used during contract performance; and
(ii) payments to subcontractors to the extent that they do not reflect the amount of work performed under the subcontract.
9.5 The application of the percentage of completion method is subject to a risk of error in making estimates. For this reason, profit is not recognised in the financial statements unless the outcome of the contract can be reliably estimated. If the outcome cannot be reliably estimated, the percentage of completion method is not used.
9.6 While recognising the profit under this method, an appropriate allowance for future unforeseeable factors which may affect the ultimate quantum of profit is generally made on either a specific or a percentage basis.
9.7 In the case of fixed price contracts, the condition which will usually provide this degree of reliability are:
(i) total contract revenues to be received can be reliably estimated,
(ii) both the costs to complete the contract and the stage of contract performance completed at the reporting date can be reasonably estimated, and
(iii) the costs attributable to the contract can be clearly identified so that actual experience can be compared with prior estimates.
9.8 Normally, the profit is not recognised in fixed price contracts unless the work on a contract has progressed to a reasonable extent. Ordinarily this test is not considered as having been satisfied unless 20 to 25% of the work is completed.
9.9 In the case of cost plus contracts, the conditions, which usually provide this degree of reliability are:
(i) costs attributable to the contract can be clearly identified; and
(ii) costs other than those that are specifically reimbursable under the contract can be reliably estimated.”
2.The Committee further notes from the facts of the query that the company is recognising revenue in respect of even those contracts which are at their inception stage, i.e., they may not have progressed to a reasonable extent. In the view of the Committee, this is apparently not in accordance with para 9.8 of AS-7, reproduced above. The Committee also notes that whether other conditions for following the percentage of completion method as recommended in para 9 of AS-7, are fulfilled, is not apparent from the facts of the query.
3.Regarding provision for losses, the Committee notes that para 7.4 of AS-7 states that “under both methods, provision is made for losses for the stage of completion reached on the contract. In addition, provision is usually made for losses on the remainder of the contract”. Thus, the querist’s contention that para 7.4 is relevant only where ‘completed contract method’ is followed, is not correct. In this context, the Committee also notes para 13 of AS-7, dealing with “Provision for Foreseeable Losses”, which recommends as below:
“13. Provision for 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 contracts.
13.2 When a contract is of such magnitude that it can be expected to absorb a considerable part of the capacity of the enterprise for a substantial period, indirect costs to be incurred during the period of the completion of the contract are sometimes considered to be directly attributable to the contract and included in the calculation of the provisions for 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; (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.”*
4.The Committee is therefore of the view that difficulty in quantifying the ‘anticipated’ losses mentioned by querist in para 3 of the query is not the ground for not making a provision, as an estimate can be made on the basis of the given factors in the normal course of business. However, where determination of future loss on a contract is subject to a high degree of uncertainty and it is not possible to provide for the future loss the existence of a contingent loss should be disclosed as recommended in AS-4 on “Contingencies and Events Occurring After the Balance Sheet Date”, issued by the Institute of Chartered Accountants of India.
5. On the basis of the above, the opinion of the Committee on the issues raised by the querist in para 6 of the query, is as follow:
(i) The procedure followed by the company is apparently not in order and will not give a true and fair view of the working of the company unless recommendations of AS-7 have been adhered to by the company.
(ii) At present AS-7 is not mandatory; it is recommendatory in nature. However, while discharging his attest function, the auditor should examine whether the recommendations in the accounting standard have been followed or not. If the same have not been followed, the auditor should consider whether keeping in view the circumstances of the case, a disclosure in his report is necessary.** _________________________________________________________________________________
* Refer to AS-4 on “Contingencies and Events Occurring After the Balance Sheet Date.” ** Clarification Regarding Authority Attached to the Documents Issued by the Institute, published in the December, 1985 issue of, ‘The Chartered Accountant’. |