1.25 Query
Classification and Definition of “Contingent Liability” – 2. You are aware that in accordance with the revised guidelines for bonus issue the Government has stipulated that contingent liabilities which have a bearing on the net profits of the company will also be taken into account whilst arriving at the 33-1/3rd residual reserves required to be maintained, of the proposed expanded capital. We enclose a copy of Schedule – G, Notes to the Accounts, in our 1972 Annual Report. You will please find that in this note there are two items viz., Item: 4- claims not acknowledged as debts, and Item: 6 – contingent liabilities. The insertion of these notes is as per the requirement of Schedule VI of the Companies Act, 1956. Briefly the amount referred to against Item: 4 represents the following: 1. Suits filed by an erstwhile Distributor of the Company for loss of discount and also loss of prestige and reputation which have been allegedly suffered by them on account of our Company having terminated the Distributorship agreement with them. Original suit was for Rs. 10.52 lakhs of which Rs. 5.52 lakhs were for alleged loss of discount and/or commission and Rs. 5.00 lakhs for loss of reputation. This suit was referred to Arbitration where the amount was raised to Rs. 20.52 lakhs to increase the alleged claim of loss of discount from Rs. 5.52 lakhs to Rs. 15.52 lakhs. The Distributorship Agreement was lawfully terminated in accordance with the provisions contained in the said agreement after giving notice on account of persistent default on the part of the said Distributor in the matter of honouring payment. On the contrary, we have certain genuine claims based on dishonoured Bills of Exchange which have not been paid by the said Distributor (for which we have filed suits), details of which are as follows:
(a) Amount is respect of 5 dishonoured Demand Drafts Rs. 1.81 lakhs (b) Amount in respect of 2 dishonoured cheques …Rs. 3.89 ,, Total Rs. 5.70 ,, 2.There is a second suit filed by an ex-employee of the Company whose services were terminated lawfully in accordance with the terms of appointment letter. He has claimed salary and other benefits which he would have been entitled to till the date of his retirement had he been in the service.Strictly speaking if such claims, which are not acknowledged as debts by the Company, are construed as contingent liabilities having a bearing on the net profits of the Company, it might take years for a company to be in a position to capitalise its reserves and issue Bonus shares after meeting the residual reserves requirement, since any aggrieved party can always file suits for any amount purely on frivolous and vexatious grounds. We shall be glad to have your opinion whether you consider the above claims as contingent liabilities having a bearing on the profits of the Company. We would also request you to let us know also what types of liabilities constitute contingent liabilities, which could have a bearing on the net profits of the Company.
SCHEDULE ‘G’ TO THE ACCOUNTS SCHEDULE FORMING PART OF THE BALANCE SHEET AND PROFIT AND LOSS ACCOUNT
1. Interim dividend for 1972 amounting to Rs. 11,76,000/- declared after the year end, has been paid out of General Reserve.
2. Managerial remuneration of Rs. 2,47,135/- (previous year Rs. 2,40,445/-) includes Rs. 2,125/- (previous year Rs. 9,925/-) being gratuity provided in the accounts for the year in excess of the amount approved by Government. In addition to this an amount of Rs. 12,750/- being excess provision to 31st December 1971, towards gratuity over the approved amount, requires approval from the Government.
3. Computation of net profit under Section 349 of the Companies Act, 1956 has not been shown as the Board has restricted the commission payable to the Managing Director to NIL.
4. Claims against the Company not acknowledged as debts Rs. 25,60,274/- (previous year Rs. 25,60,274/-).
5. Estimated amount of contracts remaining to be executed on capital account and not provided for Rs. 17,62,593/- (previous year Rs. 7,77,266/-).
6. Contingent Liabilities: (a) In respect of a guarantee given to A Bank against a loan of Rs. 43,745/- (previous year Rs. Nil) given by the Bank to the XYZ Employees’ Co-operative Credit Society; (b) On bills discounted Rs. 1,20,260/- (previous year Rs. Nil).
7. Previous year’s figures have been regrouped where necessary to make them comparable with those of the current year.
8. Of the employees, who were on the payroll of the Company as at 31st December 1972, 47 employees (previous year 41) were in receipt of or entitled to receive emoluments amounting in the aggregate to Rs. 2,000/- or more per mensem. For the purposes of this determination provision made in the accounts for gratuity has not been considered.
9. Sundry Debtors – others, include Rs. 8,316/- (previous year Rs. Nil) due from ABC (India) Ltd., a company under the same management.
Opinion April 14, 1974 The term “contingent liability” should be used in the accounting sense to designate a possible liability of presently determinable or indeterminable amount which arises from past circumstances or actions and may or may not become a legal obligation in the future. The uncertainty as to whether there will be any legal obligation differentiates the contingent liability from an actual liability. The claims mentioned in the published Balance Sheet of the Company as on 31st December, 1972, and referred to in your letter dated 27th November, 1973, may at a future date, have a bearing on the net profits of the Company if and when the relevant suits are decided against the Company. Before the relevant suits are decided against the Company and the contingent liabilities crystallise into actual liabilities, the contingent liabilities are not considered to have a bearing on the net profits of the Company according to generally accepted accounting principles. The concept of contingent liabilities having a bearing on the profits of the Company has been brought about by the Controller of Capital Issues (CCI) and so far as we are aware, the Government has indicated that the following contingent liabilities (the list being by no means exhaustive) are to be deducted from the reserves for the calculation of Residual Reserve Test: -
(i) Liability not provided for in respect of income tax appealed against.
(ii) Assam Road Tax appealed against.
(iii) Claims admitted by the Company.
(iv) Sales Tax under appeal.
(v) Claims against the companies in respect of Customs duty not admitted as debts (in respect of raw materials and not for capital goods).
(vi) Claims relating to bonus disputes.
According to the Government as these claims have a bearing on the Profit and Loss Account of the Company and can be identified on the basis of the footnotes given in the Balance Sheet, these will be deducted in the calculation of the residual reserves.
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