Inclusion of interest as an element of cost in the valuation of cost

of construction contracts.

1.‘X’ Limited is a large public limited company, engaged in the business of manufacturing high value capital equipment against specific work orders. The company manufactures, supplies and erects complete sugar, cement, chemical, fertilizer plants etc. The company is also engaged in high-tech fabrication and machining/jobbing as per the customers-supplied designs.

2. Majority of the company’s projects are spread over a period of 1-3 years. Same is the case for the high-tech jobbings. However, as per the practice followed by the industry, the sale billing is done and booked in the books of account in stages and for the part of the equipment supplied based on the agreement between the company and its customers. The accounting of stagewise billing includes the relevant profits.

3.Since the projects are spread over period(s) of more than a year and of high value capital equipments, the company receives advances against orders from its customers in various stages, such as, at the time of entering into an agreement, after completing identified activity etc. The advances against orders are received due to the reasons that the company has to pay advances to its suppliers due to long delivery period involved and the advances ensure commitment towards the capital equipment project of high value.

4.The company also receives advances against orders from its customers for the high-tech jobbing with or without material. In short, the company receives advances from the contracts against specific work done. The company advances to its sub-contractors and the suppliers also extend credit facilities to the company.

5.The company obtains non-specific working capital loans for financing its net current assets, at various rates of interest from financial institutions, banks, company fixed deposits, inter-corporate deposits etc. as and when required.

6.The company has incurred cash losses for the past few years and, therefore, according to the querists, internal accruals are, by and large, not available for working capital.

7.The raw materials stock is valued at the actual purchase cost and the finished goods and work-in-process are valued at lower of cost of conversion and net realisable value. The cost of conversion includes direct labour, direct expenses and production overheads on the basis of absorption costing method. At present, the interest is not treated as a part of cost of conversion.

8.The querists have drawn the attention of the Committee to Accounting Standard 2 (AS-2), issued by the Council of the Institute of Chartered Accountants of India, on ‘Valuation of Inventories’, which states that the costs other than production overheads are sometimes incurred in bringing inventories to their present location and condition, for example, expenditure incurred in designing products for specific customers. On the other hand, selling and distribution expenses, general administration overheads, research and development costs and interest are usually considered not to relate to putting the inventories in their present location and condition. They are, therefore, excluded from determining the valuation of inventories. The Standard also states that the Accounting Standard 2 (AS-2), as a special consideration, would not apply to work-in-progress under long term contracts such as engineering, real estate development and construction projects. The company feels, that the Accounting Standard 2 (AS-2) does not apply to its valuation of work-in-progress and finished goods since its products come under long term engineering contracts.

9.The querists have submitted a statement outlining the suggested methods for calculation of such interest for the purpose of apportionment to inventories.

10.The company feels that since the working capital has been financed mainly by loans and it could not have continued operations without them, the interest thereon is definitely an element of cost forming part of its cost of conversion and, therefore, calls for inclusion in the historical cost of inventory for the purpose of inventory valuation. In fact, the company contends that the true cost of production can not be arrived at without considering the interest element.

11.The querists have sought the opinion of the Expert Advisory Committee on the following issues arising from the above:

(I) (i) Whether the inclusion of interest as part of the cost is acceptable in principle?

(ii) Can the principle will continue to apply even during profit making years?

(II) Whether the Accounting Standard 2 (AS-2) applies to the company considering the company’s argument that its products come under long-term engineering contracts.

(III) If the interest is to be included as part of the cost for its apportionment to the inventories, which of the method suggested as per the statement mentioned in para 9 above should be followed? Whether interest cost can also be allocated to raw material and stores values a cost of storage. Whether any amendment is required to the method of interest cost allocation during the profit making periods.

Opinion March 13, 1989

1.The Committee notes that paras 2 and 3 of Accounting Standard 7 (AS-7) on ‘Accounting for Construction Contracts’, state as below:

“2. The feature which characterizes a construction contract dealt with in this Statement is the fact that the date at which the contract is secured and the date when the contract activity is completed fall into different accounting periods. The specific duration of the contract performance is not used as a distinguishing feature of a construction contract. Accounting for such contracts is essentially a process of measuring the results of relatively long-term events and allocating those results to relatively short-term accounting periods.

3. For the purposes of this Statement a construction contract is a contract for the construction of an asset or of a combination of assets which together constitute a single project. Examples of activity covered by such contracts include the construction of bridges, dams, ships, buildings and complex pieces of equipment.”

2.The Committee also notes that para 5 of Accounting Standard 2 (AS-2) on ‘Valuation of Inventories’, issued by the Institute of Chartered Accountants of India, excludes application of that Standard to valuation of “work-in-progress under long-term contracts, such as engineering, real estate development and construction contracts”.

3.On the basis of the above, the Committee is of the view that for the purpose of determination of cost of work-in-progress and finished products, accumulated by the company in question, AS-7 would be applicable. For valuation of raw materials inventories, AS 2 would be applicable.

4.The Committee further notes that para 8 of AS-7 deals with ‘Costs to be Accumulated for Construction Contracts’, which is reproduced below:

“Costs to be Accumulated for Construction Contracts

8.1 Costs attributable to a contract are identified with reference to the period that commences with the securing of the contract and closes when the contract is completed.

8.2 Costs not specifically attributable to any contract incurred by the contractor before a contract is secured are usually treated as expenses of the period in which they are incurred. However, if costs attributable to securing the contract can be separately identified and either the contract has been secured or there is a clear indication that the contract will be obtained, the costs are sometimes treated as applicable to the contract and are deferred. As a practical measure, costs directly identificable with a contract are sometimes deferred until it is clear whether the contract has been secured or not.

8.3 Costs attributable to a contract include expected warranty costs. Warranty costs are provided for when such costs can be reasonably estimated.

8.4 Costs incurred by a contractor can be divided into:

(i) Costs that relate directly to a specific contract;

(ii) Costs that can be attributed to the contract activity in general and can be allocated to specific contracts;

(iii) Costs that relate to the activities of the contractor generally, or that relate to contract activity but cannot be related to specific contracts.

8.5 Examples of costs that relate directly to a specific contract, include:

(i) site labour costs, including supervision;

(ii) materials used for project construction;

(iii) depreciation of plant and equipment required for a contract;

(iv) costs of moving plant and equipment to and from a site.

8.6 Examples of costs that can be attributed to the contract activity in general and can be allocated to specific contracts, include:

(i) insurance;

(ii) design and technical assistance;

(iii) construction overheads.

8.7 Examples of costs that relate to the activities of the contractor generally, or that relate to contract activity but cannot be related to specific contracts, include;

(i) general administration and selling costs;

(ii) finance costs;

(iii) research and development costs;

(iv) depreciation of plant and equipment that cannot be allocated to a particular contract.

8.8 Costs referred to in paragraph 8.7 are usually excluding from the accumulated contract costs because they do not relate to reaching the present stage of completion of a specific contract. However, in some circumstances general administrative expenses, development costs and finance costs are specifically attributable to a particular contract and are sometimes included as part of accumulated contract costs.”

5.The Committee notes from the facts of the query as stated in para 5 above that the company has obtained “non-specific working capital loans for financing its current assets”. Thus, the consequent interest costs are not ‘specifically attributable to a particular contract’, as stipulated in para 8.8 of AS-7, reproduced in para 4 above.

6.On the basis of the above, the opinion of the Expert Advisory Committee, on the issues raised by the querist in para 11 of the query, is as below:

(I) (i) As a matter of principle, inclusion of interest as a part of the cost of work-in-progress and finished jobs is acceptable only if it is specifically attributable to particular contracts. In the facts and circumstances of the query, since interest cost is not specifically attributable to particular contracts inclusion thereof as part of the cost is not acceptable.

(ii) Since answer to (i) is in the negative, this question does not arise.

(II) AS-2 does not apply to the company insofar as work-in-progress and finished goods are concerned. It will however apply to the company, in respect of raw materials inventories.

(III) In the present case, in view of I (i) above, since interest is not specifically attributable to particular contracts, the question does not arise.

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