1.15 - Query
Accounting treatment of liquidated damages recoverable/recovered as per terms of the contract/purchase order.1. A company is engaged in the manufacture of nitrogenous fertilizers. It awards contracts for jobs of capital/revenue nature incorporating therein a clause for recovery of liquidated damages in the event of delay in execution of the contract. Similarly, in the purchase orders made for procurement of stores and spares, packing material, incidental goods etc., a similar clause is incorporated for recovery of liquidated damages/penalty in the event of delay in supply of ordered material.
2. The accounting treatment in respect of liquidated damages/penalty recoverable/recovered followed by the company is as follows:
(a) In the case of a work contract, whether of capital or revenue nature, the liquidated damages/penalty deducted as per provisions of the contract is kept under the account-head ‘provisional liability’ until final decision in the matter is taken. In case the work/job is completed during the year but a final decision regarding levy of penalty/liquidated damages is not taken by the competent authority, no further adjustment is done and the amount of penalty/liquidated damages continue to be shown under the head ‘Provisional liability’. However, if the matter regarding levy of penalty is finally decided by the competent authority for recovery from the contractor, during the year, the amount lying under the account-head ‘Provisional liability’ is debited and asset account is credited in the case of capital jobs. In the case of jobs of revenue nature, the credit is given to the account-head ‘Repairs & Maintenance’. However, in case the competent authority decides to refund the penalty/liquidated damages amount recovered, the provisional liability account is debited by making payment to the contractor.
(b) In case of delay in supplying the materials etc., the amount of penalty/ liquidated damages is credited to the cost of materials. However, if the competent authority finally decides to refund the liquidated damages earlier recovered, the amount of liquidated damages is debited to the cost of materials in the year in which such final decision is taken by the competent authority.
Thus, in case the competent authority decides to levy penalty/liquidated damages, the cost of asset/materials/repairs & maintenance, as the case may be, is reduced with the amount of penalty/liquidated damages. As per the querist, this accounting practice is being followed by the company with a view to reflect a true and fair view of the asset/material accounts etc., in the books of account in the event of recovery of liquidated damages/penalty from the contractor. However, as per the querist, there is another view, that is, to treat the amount of liquidated damages/penalty recovered from the contractor as “Misc.Income”.
3. The querist has sought the opinion of the Expert Advisory Committee as to whether the accounting practice being followed by the company with respect to the liquidated damages/penalties, is correct, or the amount of such damages/penalties should be credited to miscellaneous income in the year in which the component authority finally decides to levy it.
February 3, 1994
1. The Committee notes that the query seeks opinion of the Committee on treatment of liquidated damages in respect of (a) capital works contract, (b) revenue works contract, and (c) supply of materials.
2. As far as capital works contracts are concerned the Committee notes para 9.1 of Accounting Standard (AS) 10 on Accounting for Fixed Assets, issued by the Institute of Chartered Accountants of India, which provides as follows:
“9.1 The cost of an item of fixed asset comprises its purchase price, including import duties and other non-refundable taxes or levies and any directly attributable cost of bringing the asset to its working condition for its intended use; any trade discounts and rebates are deducted in arriving at the purchase price. Examples of directly attributable costs are:
(i) Site preparation;
(ii) Initial delivery and handling costs;
(iii) Installation cost, such as special foundations for plant; and
(iv) Professional fees, for example, fees of architects and engineers.
The cost of a fixed asset may undergo changes subsequent to its acquisition or construction on account of exchange fluctuations, price adjustments, changes in duties or similar factors.”
3. The Committee also notes the underlying principle of the cost to be capitalised as is evident from para 9.8 of the Guidance Note on Treatment of Expenditure During Construction Period, which provides as below:
“9.8 During the course of construction of a big project, some losses are bound to occur. To an extent the losses may be treated as normal and added to the cost of the project. For instance, a wall may have to be pulled down and rebuilt. The total cost then can be capitalised. However, to the extent the loss is avoidable and results from inefficiency, mischief or an accident it should not be treated as part of the cost of the project. The amount of such a loss should be segregated and written off when production commences, over a period of three to five years.”
4. With regard to materials the Committee notes para 6.3 of Accounting Standard (AS) 2 on ‘Valuation of Inventories’, issued by the Institute of Chartered Accountants of India, which defines the ‘cost of purchase’ of inventories as follows:
“6.3 ‘Cost of Purchase’ consists of the purchase price including duties and taxes, freight inwards and other expenditure directly attributable to acquisition, less trade discounts, rebates, duty drawbacks and subsidies, in the year in which they are accounted, whether immediate or deferred, in respect of such purchase.”
5. The Committee is of the view, on the basis of the above, that the liquidated damages/penalties received/receivable from the contractors or suppliers, are not directly attributable, like rebates and trade discounts, to acquisition of capital equipments or raw material, stores etc. They can also not be regarded as price adjustments. Such damages result from inefficiency on the part of the contractor/supplier, i.e., delay in completion of works contracts and supply of materials, as the case may be. Therefore, the liquidated damages received from the contractors/suppliers cannot be adjusted in the cost of purchase of materials or cost of the assets. The Committee is of the view that similar considerations apply to the revenue works contracts and, therefore, the same cannot be adjusted to the cost of repairs and maintenance.
6. On the basis of the above, the Committee is of the opinion that the accounting policy of the company with regard to the liquidated damages/penalties recovered/recoverable from the contractors or suppliers, as stated at para 2 of the query, is not correct. Such damages/penalties should be shown as income separately, in the profit and loss account, and not be adjusted in the cost of the relevant asset or repairs and maintenance or raw materials account. However, if the amount of such damages/penalties is not material, it can be shown as a part of miscellaneous income. Insofar as the timing of the recognition of such damages/penalties in accounts is concerned, these should be recognised when the following conditions are satisfied, namely-
(i) The amount of such damages/penalties, is reasonably measurable; and
(ii) It is not unreasonable to expect its ultimate collection.
The above treatment would apply even if the award of the liquidated damages/penalty is made by the competent authority in the same year in which the relevant materials/equipments are acquired.