1.17 Query: Disclosure of bills discounted in financial statements.
1. A Public limited company is engaged in manufacturing and export of synthetic cotton and blended yarn. The company has been sanctioned credit limits by a consortium of banks for financing of its export receivables, etc. As all the exports bills of the company are covered by irrevocable letters of credit, it gets 100% finance on negotiation of its export documents. As per the querist, the export bills so negotiated are disclosed in the accounts under the head ‘contingent liability’. Therefore, neither the export receivables are included in the current assets, nor the corresponding bank finance is considered in current liabilities. The querist has stated that the statutory auditors of the company have certified the above disclosure as true and fair, and the Expert Advisory Committee of the Institute of Chartered Accountants of India, in some of their earlier opinions* had also recommended this practice.
2. The querist has further stated that notes to the balance sheet of the company for the year ended as on June 30, 1993, disclosed the following as contingent liability:
“Export Bills negotiated under irrevocable letter of credits amounting to Rs. 18,00,40,000 (previous year Rs. 11,36,78,000)”
The export bills disclosed as above, were not considered for working out the current ratio for the company, which in the view of the querist, is generally calculated without taking into account any contingent liability. As per the querist, although there is no direct liability of the company, the purpose of showing the negotiated export bills under the head ‘contingent liability’ is that the company may be held liable in case the foreign party fails to pay the amount of the bills to the bank. Moreover, since all such bills are backed by irrevocable letters of credit by the foreign parties’ bankers, in some cases it could be allowed not to be shown even as contingent liability.
3. The querist has stated that while discussing the issue of issuance of commercial papers with the Reserve Bank of India (RBI), RBI raised the point that such export receivables and corresponding bank finance should be included in the current assets and current liabilities of the company respectively, for working out the current ratio for the company. However, the querist feels that the very purpose of issue of commercial papers is to meet the working capital requirements of the company. The bankers’ borrowing limits are earmarked to that extent, to ensure that there is no double financing for the same current assets. As per the querist, RBI has also clarified in their format for calculating the maximum permissible bank finance (MPBF) by the second method of lending by banks, that in case of export oriented companies, the current ratio of 1.33, for the purposes of issuing commercial papers, can be computed excluding export bills. RBI, as per the querist, in a specific reply sent to the company, has also confirmed the calculations of the current ratio without export bills. (The querist has supplied a copy of the relevant papers for perusal of the Committee). The querist also feels that since the purpose of raising funds either from banks, or by issuing commercial papers is same, i.e., meeting the working capital requirements, there should not be any change in the parameters used for working out the current ratio for the two purposes.
4. The querist has sought the opinion of the Expert Advisory Committee on the following issues:
(a) Whether disclosure of export bills, covered by irrevocable letters of credit negotiated to banks, as contingent liability, is in accordance with the generally accepted accounting principles.
(b) Whether such bills, shown as contingent liability, should be considered for working out the current ratio for the company, for the purposes of issuance of commercial papers.
Opinion February 3, 1994
1. The opinion of the Committee expressed herein is restricted to the accounting aspects of the query. The Committee has not considered any legal issue or an issue relating to banking practice that may arise in this regard.
2. The Committee notes that Accounting Standard (AS) 4 on ‘Contingencies and Events Occurring After the Balance Sheet Date’, issued by the Institute of Chartered Accountants of India, defines a contingency as “a condition or situation, the ultimate outcome of which, gain or loss, will be known or determined only on the occurrence, or non-occurrence of one or more uncertain future events”. The Committee also notes that according to Eric L. Kohler, a contingent liability is “An obligation, relating to a past transaction or other event or condition, that may arise in consequence, as a future event now deemed possible but not probable…..”*.
3. On the basis of the above, the Committee is of the view that export bills covered by irrevocable letters of credit of the foreign parties’ bankers, negotiated to the banks, constitute/contingent liability for the company. The Committee is also of the view that purely from accounting point of view, current ratio for an enterprise, notwithstanding anything to the contrary specified by any authority, is proportion of its current assets and current liabilities. It indicates the liquidity position of the enterprise at a given point of time. Therefore, in this view of the Committee, the export receivables represented by the bills negotiated with banks should not be considered for working out the current ratio for the company. More so, because, the said bills are covered by irrevocable letters of credit. Therefore, even in case of default by the foreign parties, the company would normally be able to recover the amount of bills from their bankers, i.e., the liquidity position of the company would not be affected by the said bills.
4. On the basis of the above, subject to para 1 above, the Committee is of the following opinion, in respects of the issues raised by the querist in para 4 of the query:
(a) Yes.
(b) Purely from the accounting point of view, the export bills backed by irrevocable letters of credit, negotiated with banks and shown as contingent liability in the accounts, should not be considered for working out the current ratio for the company. ___________________________ * Vide Query No. 1.5 of Volume II and query No. 1.2 of Volume III of Compendium of Opinions respectively. * A Dictionary for Accountants, Eric L. Kohler, Fifth Edition. |