Facts:
A public sector company (‘company’), listed in the stock exchanges, is engaged in the field of engineering, manufacture of equipments, erection & commissioning of power projects. In power project business, the contracts received by the company are either Engineering, Procurement and Construction (EPC) contracts or Boiler, Turbine and Generator (BTG) Packages, where civil works and Balance of Plant (BOP) package items are not in the scope. The normal execution period of a contract ranges between 3 to 5 years. The scope of the contract includes supply of equipments, erection, commissioning, ensuring guarantee output from the machines, completing the trial operation and synchronising the plant to the grid.
The company has stated that long-term construction contracts are obtained by the company’s marketing wing which allocates the scope and value to various manufacturing units and regions/ sites for execution. The units/regions bill the customers based on Billing Break Up (BBU) agreed with the customers.
The accounting policy of the company for revenue recognition in respect of construction contracts is on percentage completion method based on percentage of actual cost incurred up to the reporting date to the total estimated cost of the contracts. Actual cost incurred up to reporting period is worked out on actual cost incurred for each contract in respect of items manufactured and physically dispatched to the project site. Further, in power sector regions/sites, actual cost incurred towards engineering, commissioning, etc. by region/site is considered for working out percentage of completion for revenue recognition. Items like steel, cement and bought-outs directly supplied from supplier to project site and billed to the customer are also considered as part of actual cost incurred for working out percentage of completion for revenue recognition.
Query
On the above facts, the company has sought the opinion of the EAC: (a) whether the practice of cost of manufactured items dispatched to project site alone being considered as ‘cost incurred’ without considering the cost of raw material in stocks, works in progress at the plant, finished goods at stores as cost incurred is in line with the revenue recognition principle as per AS-7?, (b) In case of erection sites, whether the cost of cement and steel procured and delivered at the project site, specific to the project, in respect of which billing has been done as per the BBU agreed with the customer can be considered as ‘cost incurred’ in working out the percentage of completion as per AS-7 and whether the same is in line with the revenue recognition principle as per AS-7?, and (c) Whether change in estimated revenue and estimated cost in respect of long-term contracts executed over a longer period needs to be disclosed as ‘change in estimate’ as per AS-5?
Opinion:
After considering paragraphs 21, 29 and 30 of AS-7, the Committee is of the view that determination of contract costs incurred for calculating stage of completion depends upon the performance of contract activity rather than mere incurrence of cost. Costs that relate to future activity are to be recognised as ‘work in progress’. Accordingly a judgment is to be exercised by the management while determining the contract costs incurred considering various factors, such as terms and specifications of the contract, identifiability with the contact, achievement of milestone in relation to the contract, etc.
In view of the above, the practice of the company to consider the cost of manufactured items dispatched to the project site alone as ‘cost incurred’ is not correct, since mere event of dispatch can not be considered as a completion of a stage and may not trigger revenue recognition.
As regards steel and cement procured and delivered at the contract site and billed to the customer cannot trigger considering a cost as ‘contract cost incurred’. These items are general in nature for a construction activity and cannot be said to be specific for a project even though supplied directly to the contract site. Accordingly, this should be considered for determining ‘contract cost incurred’ only when these have been used/ applied for performance of contract activity. Till that time, these should be considered as ‘work in progress’.
Change in estimate on account of changes in estimated contract revenue and costs should be disclosed in accordance with AS-5 read with AS-7. Accordingly, the effect of change in estimated contract revenue and cost which has or is expected to have a material effect in the current period or subsequent periods needs to be disclosed. However, if it is impracticable to quantify the amount of change, the fact should be disclosed. [Please refer pages 1825 to 1830 of C.A. Journal, June, 2012]
