1.9 - Query

Treatment of escalation claims


1. A public sector company is manufacturing long and varying production-cycle items such as hydro and thermal sets, boilers and boiler auxiliaries, compressors, industrial turbo-sets, oil rigs etc.

2. The valuation policy related to long production-cycle items consistently followed by the company in the past is as below:

(i) Since all long production-cycle items involve piecemeal despatches, these piecemeal despatches are assigned values on technical estimates (policy No 2Ai).

(ii) When the aggregate value of despatches including despatches with customers represents 30% or more of the realisable value, they are valued at 97.5% of the realisable value, or in its absence quoted price. Otherwise, they are valued at actual/estimated factory cost or 97.5% of the realisable value, whichever is lower (Policy No. 2A i).

(iii) Finished goods in plant and work-in-progress are valued at actual/estimated factory cost or 97.5% of the realisable value whichever is lower(Policy No. 2A i).

(iv) The balance of 2.5% is reckoned as income on completion of the supplies under the contract. (Policy No. 2A i)

(v) Piecemeal despatches are billed in terms of the contract primarily to recover the dues against the contract price and billing does not represent the value of despatches. This is adjusted to equal intrinsic value on the basis adopted for valuation as stated in policy 2 (A) (i) and 2(A) (ii) above shown as “despatches made to customers” to form part of the turnover (Policy No. 5(i).

(vi) In case of price escalations on sale contracts, where the basis of price escalations has been agreed, income is taken on billing otherwise it is reckoned on acceptance/receipt [Policy No. 10 (i)].

3. The company has now been advised that the policy on price escalations has not been followed correctly in some cases. It has been pointed out that in “one division, escalation in sale price of contract in few cases has been worked out on the basis of bills raised to customers and have not been restricted to the intrinsic value of the goods despatched to customers in accordance with the Accounting Policy No. 5 (i) of the Accounting Policies. This has resulted in turnover being taken in excess by Rs. 243.44 lakhs with a consequential effect on the profit for the year. In respect of the other divisions figures could not be ascertained”. A similar view has been expressed by another authority which is as follows:
“The escalation in the sale price of contracts has been work out by the Company on the basis of bills raised to customers without relating the same to the intrinsic value of despatches to the customers in accordance with the Accounting Policy No. 5 (i) of the Company. This has resulted in turnover, being taken in excess in accounts and thus in over-statement of current year’s profit. In respect of ‘X’ Division the turnover was taken in excess by Rs. 745.41 lakhs with the result that the profit of the unit for the year was overstated by Rs.118.99 lakhs. In respect of other units also there would be similar excess credit to the turnover and consequential increase in the profit of the Company.”

4. The company has therefore been advised that the escalation claims should also be adjusted to intrinsic value as is being done for the valuation of the despatches.

5. The management of the company however does not agree with the above view on the following grounds:

(i) Unlike in the case of despatches where the ‘bills’ are to be ‘valued’ as per company’s policy and adjusted upward or downward to equal intrinsic value there is no question of ‘valuation’ of price variation claims which are in the nature of ‘receipts’. The other ‘claims’ like export subsidy, duty drawback, refund of customs etc. also dealt with in the accounting policy no. 10 are all of the nature of ‘receipts’ where no ‘valuation’ is called for.

(ii) Escalation claims are in the nature of reimbursement of additional expenses incurred by the company on the basis of predetermined and agreed formulae. They become due to the company because of anticipated changes in cost after entering into the contract.

(iii) Escalation charges are claimed based on a specific percentage of the amount billed, as it will be impossible to link discrete elements of the formulae with the actual physical quantities billed.

6. The opinion of the Expert Advisory Committee has been sought whether in the circumstances mentioned in the query, price escalation claims should be ‘valued’ and restricted to the intrinsic value of supplies, or they should be taken into account on billing or on their acceptance/receipt, as the case may be, like export subsidy, duty drawback, refund of customs duty etc. which are also recognised on their acceptance/receipt as per the accounting policy followed by the company in this regard.




Opinion

1st April, 1985

The Committee notes that the company is following the percentage of completion method as the bills of despatches to customers are adjusted to their intrinsic value to form part of the turnover. From the facts of the case it is not clear to the Committee whether all conditions necessary in following the percentage of completion method, in particular the one related to making allowance for future unforseeable factors, as laid down in Accounting Standard 7(AS-7) on ‘Accounting for Construction Contracts’ issued by the Institute of Chartered Accountants of India, have been met and that the policy in this regard is consistently followed in all the divisions of the company. In any case, presuming that all such conditions inherent in following the percentage of completion method have been met, the Committee is of the opinion that the revenue on accounting of the price escalations should also be recognised to the extent of their intrinsic value at the time of billing provided the company has evidence of the final acceptability of the amount of the claim.1
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1 Para 14.1 of AS-7