1.6       Query

Revenue recognition in case of construction contracts

1. A heavy engineering equipment manufacturing company sells the equipment on turnkey basis. Field erected large-sized storage spheres for storing LPG, naphtha, ethylane, propelyene etc., tonnage oxygen plants of 550 Tonnes per day, huge columns, towers, ammonia/urea reactor etc. are some of the products of the company. Delivery period of such products ranges between one and three years. In almost all turnkey projects, usual payment terms are as under:

(a)        Supply portion

(i)         10% advance alongwith letter of Intent against submission of proforma invoice and bank guarantee for a like amount.

(ii)        15% on submission of P & I Drawings and approval of the same.

(iii)       15% advance against placement of major imported raw materials/bought-out components such as air compressors, expansion turbines etc. and/or establishment of foreign letters of credit.

(iv)       50% against proof of despatch documents such as LR/RR, packing list, excise duty gate passes, EIL Release Note or Inspection Certificate.

(v)        5% on completion of preliminary acceptance/hydraulic test.

(vi)       5% on successful commissioning and acceptance by the customer, or submission of bank guarantee for performance.

(b)        Erection portion

(i)         10% advance on opening of erection site at customer’s place and against bank guarantee.

(ii)        80% on progress of erection work on monthly progress bills.

(iii)       5% on completion of erection and preliminary acceptance.

(iv)       5% on commissioning and final acceptance by the customer and against bank guarantee covering guarantee period.

2. The entire sale value is broken down into various equipment supplies and price breakup is prepared enabling the company to prefer pro-rata payments on supply of each and every equipment reflected in the price breakup.

3.The company is recognising sales at 100% contract value for that item for the purpose of turnover as and when the equipment is despatched from the company for further erection work at site. Sales accounting is done as follow: -

           (i) When stage-wise advances are received from customer: Bank A/C Dr.

To Advance from customers

(ii) When a particular equipment covered in the price breakup is despatched for further erection work at site:

4. In view of the above, sales is taken 100% though last 10%, becomes due after 36 months, i.e., on commissioning. Because of this reason, the company is not able to realise the last 10% till the commissioning of the project but is compelled to pay income tax @ 50% on the portion of 10% taken as income during each year.

5.The querist is of the view that though the practice followed by the company is in accordance with the accepted accounting principles in this regard, it is disadvantageous to the company from the taxation angle. The querist is further of the view that inclusion of the “Balance payment not due”, i.e., 10% of the contract price, in the ‘Sundry Debtors’, gives a misleading ratio of ‘Sundry Debtors’ to ‘Sales’.

6.The querist has sought the opinion of the Expert Advisory Committee as to whether the said 10% of the contract price which is not due can be recognised as revenue in the year in which it falls due, i.e., after completion of the project, thereby deferring the tax liability, and linked with cash inflow.

                                                                                 Opinion                                 April 27, 1987

1. The Committee notes that the principles of revenue recognition on construction/service contracts are laid down in Accounting Standard 7 (AS-7) ‘Accounting for Construction Contracts’ and Accounting Standard 9 (AS-9) on ‘Revenue Recognition’, issued by the Institute of Chartered Accountants of India.

2. According to AS-7, ‘under the percentage of completion method, the amount of revenue recognised is determined by reference to stage of completion of the contract activity at the end of each accounting period (para 9.1)……. 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 physical proportion of the contract work (para 9.2)…….. progress payments and advances received from customers may not necessarily reflect the stage of completion….. (para 9.3)”.

3. According to AS-9; “In a transaction involving the rendering of services, performance should be measured either under the completed service contract method or under the proportionate completion method, whichever relates the revenue to the work accomplished. Such performance should be regarded as being achieved when no significant uncertainty exists regarding the amount of the consideration that will be derived from rendering the service.”

4. From the facts of the query, the Committee notes that the query relates to the revenue recognition in respect of 10 percent of the contract price of the equipments which is payable after completion of erection, performance of certain tests and commissioning of the equipment and that the company is evidently following the percentage of completion method for revenue recognition. The Committee presumes that the company has fulfilled conditions specified in AS-7, in addition to the ones stated in the above paragraphs for the adoption of percentage of completion method.

5.The Committee is therefore of the opinion that the company should, after giving due consideration to the factors specified in paras 8 and 9 above, recognise 100 percent contract price as revenue in the year in which the entire equipment is despatched and the contract is performed to a substantial extent. The Committee further wishes to point out that the estimated liability may be provided in the accounts for fulfilling possible claims. However the liability to be provided for possible claims is to be reasonably estimated. The question of admissibility of the provision for possible claims, in computation of taxable income, is a separate question which has to be resolved keeping in view the facts and circumstances of each case.

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