1.15 Query
Valuation of work in progress in long term contracts.
1.A public sector company, under Ministry of
Defence, is primarily engaged in construction of ships for Indian Navy, ONGC,
Port Trusts, etc. The construction period for each vessel extends to over more
than one financial year. As a result of this, the sales figures vary widely;
this fact is evidenced from the sales figures for the past 5 years.
3.In valuing the work-in-progress, the company
has consistently been including the net interest in calculating the overheads,
to be absorbed in the value of work-in-progress. Interest receipts of the
company are from call/term deposits from bank and from holding company. The net
interest is appropriated to the various vessels which were under construction
during the year.
4.Recently, the Director of Commercial Audit has requested to ensure that while valuing the work-in-progress, the element of interest be excluded from the overheads as recommended in Accounting Standard 2 on ‘Valuation of Inventories’, issued by the Institute of Chartered Accountants of India.
5.The company is of the view that if the above suggested procedure is adopted the profit and loss account will not give a true and fair view of the profit/loss of the company. The reason being that work-in-progress will be grossly undervalued/overvalued (depending on whether net interest is credit of debit respectively) if interest is excluded from the valuation of work-in-progress. In years when sales are ‘Nil’ the company will show a reduced profit or even a loss. On the contrary in the years when the sales are effected, a very high profit will be reflected. Thus, the profit and loss account will not show a true and fair view of the working of the company.
6.The company is further of the view that the reference to Accounting Standard 2 of the Institute of Chartered Accountants of India by the Director Commercial Audit to arrive at this conclusion is not correct, as the same Standard has stated, in para 5.3, that long term contracts are an exception to the norms stated in the said Accounting Standard.
7.The querist has sought the opinion of Expert
Advisory Committee as to whether the company is correct in including the
interest in calculation of overheads to be charged to the value of
work-in-progress at the close of the year.
Opinion September 13, 1989
1.The Committee notes clause (iii) of paragraph 5 of Accounting Standard 2 (AS 2) on ‘Valuation of Inventories’, which is as follows:
“This statement applies to valuation of all inventories except inventories of the following to which special considerations apply
………
(iii) work-in-progress under long term contracts, such as engineering real estate development and construction projects;”
2.The Committee also notes paragraph 3, 8.7 and 8.8 of Accounting Standard 7 (AS 7) on “Accounting for Construction Contracts”, which are reproduced below:
“3. For the purpose 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 includes the construction of bridges, dams, ships, buildings and complex pieces of equipment. 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 excluded 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.”
3.The Committee also notes that the company has been paying interest on long term loans taken for Capital Expansion Projects. Thus, the interest is not specifically attributable to a particular ship. The Committee is, therefore, of the opinion that the practice of considering the net interest in calculation of overheads to be charged to the value of work-in-progress at the close of the year, is not correct. _______________________
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