1.16 Query: Revenue recognition of fees for rendering portfolio management services
1.A company was incorporated on 18th May, 1989, under the Companies Act, 1956, as a wholly owned subsidiary of a scheduled bank and carries on the business of merchant banking, portfolio management and leasing operations.
2.The company has been rendering portfolio management services to the clients as one of its activities. The portfolio management is done in accordance with the guidelines prescribed by the Reserve Bank of India (RBI). The guidelines, inter alia, provide for the lock-in period of at least one year.
3.For the period ended 31.3.90, the company rendered the portfolio management services to various clients on an understanding that the clients would get a minimum return of about 12% per annum on funds deployed and there was no mention about the percentage of management fees to be received by the company. But there was an understanding that the management fees of the company will be about 2% per annum if the clients got return (after paying management fees) of at least 12% per annum. On this basis, the following accounting policy was determined and followed:
“Management Fees-Portfolio Management
The portfolio management fees are recognised on accrual basis on expiry of the tenure or one year form the date of acceptance of funds, whichever is earlier.”
4.The company finalised its accounts for the period ended 31st March, 1990, in accordance with the abovementioned accounting policy and did not take any credit for portfolio management fees as the accounts were made up only for the period from 18.5.1989 to 31.3.1990 (less than one full year) and the tenure of any of the portfolio management contracts was not complete.
5.The Comptroller & Auditor General of India objected to the above accounting policy as the same does not comply with section 209(3)(b) of the Companies Act, 1956, i.e., the portfolio management fees are not accounted for on day to day accrual basis.
6. The company submitted its reply as under:
A. In accordance with the accounting policy of the company, income does not accrue till the period of fund management or one year (whichever is earlier) expires. Therefore, the question of calculation of income from the date on which funds were entrusted to 31st March, 1990, did not arise as no income accrued till one year was over from the date of receipt of funds.
B. Further, RBI directive provided that portfolio funds should not be accepted for management for a period shorter than one year. Since this is the first accounting period of the company which itself is shorter than one year, no income has accrued to the company.
C. The portfolio management fees were not fixed with the owners of funds or portfolio clients. The percentage of management fees was largely dependent on the return which the portfolio clients would get. The management fees may be lower than even two percent in case the return to portfolio clients is less than the minimum expected.
Therefore, according to the querist, management fees in this case do not accrue from day to day, as there is an element of uncertainty about the amount of management fees which will be receivable. 7.The C & AG had agreed to the company’s contentions as mentioned above on the understanding that for the future, the company should seek the opinion of the Expert Advisory Committee of the Institute of Chartered Accountants of India and finalise the accounts in accordance with the said advice.
8.The letters obtained by the company from the clients at the time of placement of funds during 1990-91, have been modified and specify portfolio management fees @ 2% p.a. on funds deployed. The letter also mentioned that they expected return on their investment of about_______% p.a. (the percentage is not being fixed as there is a prohibition by RBI for such commitment about return on investment). The querist has submitted a copy of this letter for the perusal of the Committee. The querist has also submitted a copy of the circular issued by RBI for the perusal of the Committee.
9.The querist has also stated that even after receipt of this type of letter, the company may not be able to get the portfolio management fees @ 2% p.a. in case the income generated falls short of the minimum return expected by the clients, even though, as per RBI’s directives, the company is not bound to guarantee return at any particular rate but the clients generally expect certain return at the time of placement of funds and inform their expectation to the company. If, for any reason, the return is less than expected by the client, the company may not get portfolio management fees at 2% p.a.
10.Accounting Standard (AS) 9 on ‘Revenue Recognition’, provides that if it is unreasonable to expect ultimate collection, revenue recognition should be postponed. It further provides that in a transaction involving the rendering of service, performance should be measured either under the completed service method or under the proportionate completion method, whichever relates the revenue to the work accomplished. Such performance should be regarded as being achieved when no significant uncertainty exists regarding the amount of the consideration that will be derived from rendering the service.
11.The querist has sought the opinion of the Expert Advisory Committee on the following issues:
(a) Whether the accounting policy followed by the company is correct and in accordance with section 209(3)(b) of the Companies Act, 1956.
(b) At what point of time the credit for portfolio management fees by the company should be taken; whether
(i) at the end of the contracted period; or
(ii) on day to day basis, i.e., from the date of acceptance of the funds to the date of closing the accounts.
Opinion September 4, 1991
1.The Committee notes that the circular issued by Reserve Bank of India states, inter alia:
“Portfolio management services (PMS) should be in the nature of investment consultancy/management, for a fee, entirely at the customer’s risk, without guaranteeing, either directly or indirectly, a predetermined return. The bank should charge a definite fee for the services rendered independent of the return to the client. PMS should be provided by banks/ their subsidiaries to their clients in respect of the latter’s long term investible funds for enabling them to build up a portfolio of securities; in any case the funds should not be accepted for portfolio management for a period less than one year.”
2. The Committee also notes that the letter received from the clients by the company at the time of the placement of funds states, inter alia:
“Our expectation of the return being about ______ % p.a. (subject to T.D.S) after all your costs, expenses including portfolio management fees (2% p.a.)……. We are agreeable to pay 2% of the amount given to you for portfolio management as charges/management fees”.
3.The Committee notes that as per the circular issued by Reserve Bank of India and the letter issued by the client to the company at the time of placement of funds, the portfolio management fees can not be lower than the stipulated rate (i.e., 2%). In other words, the management fees shall not be lower than the stipulated rate even if the return on funds is lower than the expected rate.
4. The Committee, however, also notes from the facts of the query that there is an understanding between the company and its clients, though not written, that the company may not get the portfolio management fees at the rate of 2% if it is not able to get the expected return for the clients. Whether the company can do so keeping in view the RBI’s circular and client’s letter referred to in paragraphs 1 and 2 above, is a matter not free from doubt. In view of the Committee, in case it is permissible for the company to lower the management fess in the event of lower return on funds than expected, then there is an element of uncertainty in the amount of management fees receivable by the company. The effect of such uncertainty on revenue recognition is dealt with in Accounting Standard (AS) 9 on ‘Revenue Recognition’ issued by the Institute of Chartered Accountants of India, the relevant paragraphs, viz, paragraphs 9 and 12 are reproduced below:
“9. Effect of Uncertainties on Revenue Recognition
9.1 Recognition of revenue requires that revenue is measurable and that at the time of sale or the rendering of the service it would not be unreasonable to expect ultimate collection.
9.2 Where the ability to asses the ultimate collection with reasonable certainty is lacking at the time of raising any claim, e.g., for escalation of price, export incentives, interest etc. revenue recognition is postponed to the extent of uncertainty involved. In such cases, it may be appropriate to recognise revenue only when it is reasonably certain that the ultimate collection will be made. Where there is no uncertainty as to ultimate collection, revenue is recognised at the time of sale or rendering of service even though payments are made by instalments.
9.3 When the uncertainty relating to collectability arises subsequent to the time of sale or the rendering of the service, it is more appropriate to make a separate provision to reflect the uncertainty rather than to adjust the amount of revenue originally recorded.
9.4 An essential criterion for the recognition of revenue is that the consideration receivable for the sale of goods, the rendering of services or from the use by others of enterprise resources is reasonably determined. When such consideration is not determinable within reasonable limits, the recognition of revenue is postponed.
9.5 When recognition of revenue is postponed due to the effect of uncertainties, it is considered as revenue of the period in which it is properly recognised.
12. In a transaction involving the rendering of services, performance should be measured either under the completed service contract method or under the proportionate completion method, whichever relates the revenue to the work accomplished. Such performance should be regarded as being achieved when no significant uncertainty exist regarding the amount of the consideration that will be derived form rendering the service.”
5.The Committee is, therefore, of the following opinion:
(i) On the basis of the circular and the letter (referred to in paras 1 and 2 above) the company is legally entitled to the management fees at the rate of 2% irrespective of the return on the funds. Therefore, the portfolio management fees should be accounted for on time basis.
(ii) In case, however, the company is permitted to charge lower portfolio management fees in the event of lower return on funds than expected as indicated in para 4 above, the fees should be accounted for as under:
(a) If there is a minimum fees payable to the company irrespective of the return to the clients, such minimum fees should be recognised on a time basis.
(b) The difference between the fees at the rate of 2% and the minimum fees should also be recognised on a time basis if the facts and circumstances prevailing makes it reasonably certain that the company will be able to generate the expected return on the funds of the clients. The Committee is of the view that since accounts are finalised after the balance sheet date, the return generated after the balance sheet date but before the finalisation of accounts may also be one of the factors to determine whether it would be reasonably certain for the company to generate the expected rate of return. ___________________________ |