Are you aware about accounting treatment of forfeiture of bank guarantees of contractors?

A. Facts of the Case

A Government Company in the business of electricity distribution, and was responsible for all activities associated with distribution of power within its territory. Under a government scheme, The Company would award certain capital contracts to contractors based on tenders submitted.

Under the contract tender process, the contractor had to submit two types of securities namely the Earnest money deposit, which shall be forfeited by the company if the contractor fails to accept the allotted work or failure of the bidder to furnish performance security.

Performance security for satisfactory execution of work. This security shall be forfeited by the company on the breach of condition of contract during the execution.

One such tender was awarded to M/s A Infra Power for execution of some capital work, but they did not provide the requisite performance guarantee to the company. Accordingly, the company forfeited the bank guarantee (BG) submitted by the firm as earnest money deposit (EMD) and accounted it as income.

In another tender to M/s B for some other capital work, the company availed some mobilisation advance from the company and later on expressed inability to execute the contracted work, and therefore the Bank Guarantee was forfeited and accounted as Income. In this case also, there was no work executed by the contractor.

The Government Auditors did not agree with Company’s accounting treatment and stated that the Income realised should be adjusted against the cost of assets as the Capital Work in Progress is not stated appropriately.

B. Issue

The company has sought the opinion on the following issues arising from the above:

• Accounting treatment of forfeiture of bank guarantees of contractors.
• The amount of bank guarantee is Rs. 21.24 crore as against the total turnover of the company Rs. 6956 crore. Therefore, in the light of principle of materiality, whether the treatment given by the company in its books of account is correct or not.

C. Opinion

On the basis of the above, the opinion in respect of the issues raised by the company:

• On the basis of AS 5, income arising from forfeited bank guarantees cannot be adjusted against the cost of the asset rather, the same should be recognised in the statement of profit and loss. The treatment made by the company is correct.
• However, considerations of materiality should be applied based on the specific facts and circumstances in the given case, i.e., as to whether income arising out of bank guarantees forfeited, can influence the decisions of the users of the financial statements and it is a matter of judgement.

The above opinion was affirmed by the ICAI-Expert Advisory Committee.

Deepak Kumar, Audit Associate, SW India