1.55 Query:   

  Matters arising out of introduction of accrual basis of accounting through

amendment in section 209(3) of the Companies Act, 1956.

1. The querist has raised certain issues in the context of amendment in section 209(3) of the Companies Act which became operative in 1988, making it obligatory upon a company to keep books of account on accrual basis and on the double entry system of accounting. The querist has mentioned that section 209(5) places heavy responsibility on those responsible for compliance with the relevant provisions as above. He has informed that the query is in the reference to the need of such persons who have obligation to ensure compliance with section 209 (3)(b).

2.The querist has drawn the attention of the Committee to the Guidance Note on Accrual Basis of Accounting, issued by the Research Committee of the Institute of Chartered Accountants of India, which has been published in the September 1988 issue of ‘The Chartered Accountant’. In para 7 of the Guidance Note, under the title “Change in the basis of accounting”, guidance has been provided on switching over from cash basis of accounting to accrual basi s of accounting. The querist has sought opinion with regard to para 7 of the Guidance Note, as read with section 209(3) (b), in respect of matters raised in the subsequent paragraphs.

3.At the beginning of the year, prior to section 209 (3)(b) becoming operative, a company may have certain items being accounted for on cash basis. Some of these items could be: -

a) Gratuity payable to employees.

b) Export incentives.

c) Warranties on goods sold which may run beyond a period of 12 months after close of the accounting year.

d) Leave due to the employees which may be availed of by them in the following years and possibly, upon termination of the employment, may become partly or wholly encashable.

  4.  While, in regard to gratuity being accounted on cash basis, the Institute’s directive is for the auditors to qualify the accounts, the opinion herein is being sought by the querist, on the following issues, in relationship to section 209 (3)(b) read with section 209(5), assuming that the payments during the current year in respect of liability accrued for the previous years are not material:

a) In respect of open items in existence on the date of the first day of the year when section 209(3) became operative, does a company have legal option to provide for such items either by way of a liability or an asset during the year? If so, what would be the corresponding account to which such income or costs be charged? In other words, can such an amount be chargeable in the profit and loss account as prior period item or by way of a direct charge to the reserves, if any?

b) In case of unprovided liability for gratuity at the beginning of year which was being considered in past on cash basis, shall entire amount of gratuity liability for all employees on payroll be provided in the accounts of the year?

c) If such liability is to be provided in respect of items existing at the beginning of the year, in respect of the warranty obligations which may be for a period of time, say 5 years, can the company determine the estimated present value of such liabilities and provide the same on net of tax basis.

d) In respect of leave that may be due to employees at the beginning of the year in respect of past service, is it obligatory to accrue the estimated cost of leave even though such costs may be worked off by the employees by proceeding on leave in the current and future years.

                                                      Opinion                  May 1990

1. The Committee notes that para 7.1 of the Guidance Note on Accrual Basis of Accounting, issued by the Research Committee of the Institute of Chartered Accountants of India, recommends as below:

“7.1 When an enterprise which was earlier following cash basis of accounting for all or any of its transactions, changes over to accrual basis of accounting, the effect of such change should be ascertained with reference to the transactions of the previous accounting periods also, to the extent such transactions have an impact on the current financial position of the enterprise. The fact of such change should be disclosed in the financial statements. The impact of, and the adjustments resulting from such change, if material, should be shown in the financial statements of the period in which such change is made to reflect the effect of such change. Where the effect of the change is not ascertainable, wholly or in part, the fact should be indicated. If the change has no material effect on the financial statements for the current period but is reasonably expected to have a material effect in later periods, the fact of such change should be appropriately disclosed in the period in which the change is adopted.”

2.On the basis of the above, the opinion of the Committee, on the issues raised by the querist in para 4 of the query, is as below:

a) The past unprovided expenses and past unaccrued incomes should be provided for/accrued by debiting/crediting the profit and loss account of the period in which the company changes over from cash basis of accounting to accrual basis. The said adjustments should not be disclosed as ‘prior period items’* as they arise as a result of change in the accounting policy, and, therefore, should be disclosed as recommended in para 7.1 of the abovementioned Guidance Note. The Committee is, however, of the opinion that it is permissible to transfer to profit and loss account, below the line, an amount, from General Reserve, equivalent to past net unprovided expenses, i.e., excess of past unprovided expenses over past unaccrued incomes.

b) As mentioned in (a) above, the entire amount of past unprovided liability in respect of gratuity will have to be provided for in the financial statements of the period in which the change in the basis of accounting is effected.

c) Provision for past unprovided warranty obligation still outstanding at the balance sheet date should be made to the extent such transactions have an impact on the current financial position of the company. The provision should be made on gross-of-tax basis and not net-of-tax basis. However, it is clarified that nothing aforesaid precludes a company from adopting a comprehensive inter-period tax allocation method, e.g., recommended by IAS 12 on “Accounting for Taxes on Income”.

d) Where, as per the terms and conditions of employment, employees are entitled to leave encashment benefit on retirement, provision for past unprovided leave encashment entitlements should be made for the liability at an amount estimated on rational basis keeping in view factors like past experience about the benefit actually availed of, possibility of availing the past leave in future etc.

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______ *“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 financial statements of one or more prior periods.” [Accounting Standard (AS) 5 on ‘Prior Period and Extraordinary Items and Changes in Accounting Policies.]