1.10  Query:      

      Accounting for waiver of penal interest relating to prior years.

1. A techno-financial public sector company has the main business of granting loans to institutions like housing boards, companies and housing societies, etc. The project finance granted is governed by a loan agreement entered by the company with the borrower. The loan agreement regarding repayment of instalments and interest for the project finance disbursed includes a penalty clause in case of default in the payment of instalment and/or interest. An extract of the clause is reproduced below:

                        “In the event of default in the payment of the instalment of loan and/or interest in respect of the loan or different components of the loan on the due dates, the borrower without prejudice to the right of the company to recall the loan as provided in the general conditions shall pay (except as the company may otherwise agree in writing) to the company in addition to the  compound interest payable under the preceding proviso, additional interest at the penal rate of 2.5 (two and a half) per cent per annum on such overdue payments.”

2.The repayment of loan instalments and payment of interest are made quarterly, namely; June, September, December and March each year. At times, when the borrower has some liquidity problems, either the instalment for repayment or the interest are not received in time on the due dates. These payments are, however, made subsequently. As per the provision of the agreement mentioned above, once an agency defaults, it is liable to pay penal interest till the date of its actual payment. Sometimes, when the agency repays the loan after the due date and is subject to penal interest, the company waives the recovery of penal interest on merits, with the approval of the competent authority.

3.In line with the amendment in section 209 of the Companies Act, the penal interest charged against the agency is to be accounted for as income in the relevant year. Subsequently, if, after the close of the year and the adoption of accounts, it is noticed that the waiver of penal interest provided in the account is approved, the company considers this waiver as a prior period expenditure as the corresponding income had arisen in the previous year. However, the auditors have referred to Accounting Standard 5 issued by the Institute of Chartered Accountants of India and are of the view that this waiver of penal interest has to be accounted for as current year’s expenditure only and not as a prior period expenditure.

4.The querist has sought the opinion of the Expert Advisory Committee on the following issues:

a) Whether the waiver of interest can be continued to be booked as a prior period expenditure. 

b) Whether it should be treated as current year’s expenditure in the profit and loss account.

c) Whether it can be reduced from the current year’s income.

                                                           Opinion                                                      April 24, 1991

1.The Committee notes that as per para 13 of Accounting Standard (AS) 9 on ‘Revenue Recognition’, issued by the Institute of Chartered Accountants of India, the interest income should only be recognised when no significant uncertainty as to measurability or collectability exists. The Committee presumes that the company is accounting for the penal interest according to AS 9.

2. The Committee notes paragraph 3.1 of Accounting Standard (AS) 5 on ‘Prior Period and Extraordinary Items and Changes in Accounting Policies’, issued by the Institute of Chartered Accountants of India, which states as under:

“3.1 “Prior period items” are material charges or credits which arise in the current period as a result of errors or omissions in the preparation of the financial statements of one or more prior periods.”

3.The Committee is of the view that the waiver of penal interest relating to previous year in a subsequent year does not mean that there was an error or omission in the preparation of financial statements of such previous year. The Committee is, therefore, of the view that such write-off of the penal interest is not a ‘prior period item’.

4. The Committee is of the following opinion in respect of the issues raised in para 4 of the query:

a) The penal interest waived cannot be booked as a prior period expenditure.

b) The penal interest waived should be written of in the profit ad loss account of the current year.

c) The penal interest waived cannot be reduced from the current year’s income, subject to the concept of materiality.

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