1.6  Query:      

Accounting for goods sent for customer’s approval.

1. A company is engaged in the manufacture of electronic products and systems. A project undertaken by the company includes supply and installation of ‘systems’ suitable to the customer’s requirements at various locations. For this purpose, a ‘prototype system’ is installed at one of the locations for ‘field trails’, to get customer’s acceptance of the performance of the system. Based on the successful completion of the field trails and acceptance of the system by the customer purchase order(s), orders for supply of such systems with additions/modifications as may be indicated by the customer at the required locations, are received.

2.As per the querist, a prototype system was installed at one of the customer’s locations in June 1988 for field trails. After the customer was satisfied with the performance, a purchase order was received from him for supply of a system, with capacity higher than that of the prototype. Accordingly, the capacity of the prototype system was suitably augmented by adding the required balancing materials. It was then despatched to the customer’s site and the sale proceeds were realised. Thereafter, another purchase order was received for supply of two more systems one of which has already been supplied. As per the querist, a purchase order for 2 or 3 more systems is expected shortly.

3. The querist has stated that as the ownership of the system installed for field trails was vested with the company, for accounting control purposes, the prototype system installed at customer’s location in 1988 was capitalised in the accounts for the year 1988-89 at its bought-out cost. Depreciation was provided thereon till September 1992. However, when the said prototype system was augmented to the capacity required by the customer by providing balancing items and sold to the customer as a complete system during the year 1992-93, the earlier capitalisation was reversed by writing back the full amount of depreciation provided till September 1992 thereby restoring the book value of the prototype system to its original cost. The cost of the system was then transferred to raw materials stock account which, together with that of the balancing materials used for augmenting its capacity and completing the system, was booked under ‘consumption of raw materials’. The amounts invoiced for the supply of the system and software and documentation were accounted under ‘Income from sales’ in line with the accounting for sale or regular merchandise.

4.The querist is of the view that the installation of the prototype system at customer’s location in 1988 is not to be viewed as and asset in true sense as it was installed for trial purposes and not for production purposes. In the normal course, such item, as and when bought, would have been taken to raw material stock account and booked to consumption of raw materials when used in the job. However, it had been capitalised as a means to retain accounting control over the item sent to customer’s site for field trials. Thus, the prototype system had become the raw material for the system sold as an item of regular merchandise notwithstanding its capitalisation in the books till acceptance and augmentation.

5.As per the querist, the auditors of the company are of the view that the capitalisation made in 1988-89 need not be reversed and its sale after augmentation to customer’s requirements in 1992-93 is to be treated as sale of asset in 1992-93. The excess of the sale value relatable to prototype system over its original cost is to be treated as capital gains and transferred to capital reserve for the reason that the system is held as an asset over the years for ‘trail purposes’ duly providing depreciation thereon. Mere addition of balancing items to augment its capacity to make a complete system over the years and selling it to the same customer may not alter its status till then as an asset.

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

(i)         Whether the accounting treatment adopted by the company as stated above is correct?

(ii)        If the answer to the above is in the negative, what else could be the acceptable alternative accounting treatment at the time of installation of the prototype system at the customer’s location?

(iii)       Should the abovesaid transaction be accounted for as sale of an asset as stated by the auditors?

(iv)       Whether there is any other acceptable way of accounting?

                                                                                       Opinion                            May 5, 1994

1. The Committee notes the following definitions of the terms ‘inventories’ and ‘fixed assets’, as given in para 6.1 of Accounting Standard (AS) 2, and para 6.1 of Accounting Standard (AS) 10, on ‘Valuation of Inventories’ and ‘Accounting, for Fixed Assets’, respectively issued by the Institute of Chartered Accountants of India:

“ ‘Inventories’ mean tangible property held

(i)         for sale in the ordinary course of business, or

(ii)        in the process of production for such sale, or

(iii)       for consumption in the production of goods or services for sale, including maintenance supplies and consumables other than machinery spares.”

“Fixed asset is an asset held with the intention of being used for the purpose of producing or providing goods or services and is not held for sale in the normal course of business.”

2.The Committee is of the view, on the basis of the above, that the system installed by the company at customer’s site for his acceptance, based on the field trails of the system, is an item of inventory, and is not a fixed asset. It should, therefore, be valued and disclosed as such, as per Accounting Standard (AS) 2 on ‘Valuation of Inventories’, issued by the Institute of Chartered Accountants of India.

3.The Committee is further of the view that installation of such systems at customers’ sites for their acceptance is akin to sale of goods on approval basis. The Committee is accordingly of the view that the company should recognise revenue on such sales as per paras 10 and 11 Accounting Standard (AS) 9 on ‘Revenue Recognition’, issued by the Institute of Chartered Accountants of India, which read as follows:

“10.      Revenue from sales or service transactions should be recognised when the requirements as to performance set out in paragraphs 11 and 12 are satisfied, provided that at the time of performance it is not unreasonbale to expect ultimate collection. If at the time of raising of any claim it is unreasonable to expect ultimate collection, revenue recognition should be postponed.

11.       In a transaction involving the sale of goods, performance should be regarded as being achieved when the following conditions have been fulfilled:

(i)         the seller of goods has transferred to the buyer the property in the goods for a price or all significant risks and rewards of ownership have been transferred to the buyer and the seller retains no effective control of the goods transferred to a degree usually associated with ownership; and

(ii)        no significant uncertainty exists regarding the amount of the consideration that will be derived from the sale of the goods.”

4.The Committee also notes para 12 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 read as follows:

“12.      Any change in an accounting policy which has a material effect should be disclosed. 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 such change is not ascertainable, wholly or in part, the fact should be indicated. If a change is made in the accounting policies which has no material effect on the financial statements for the current period but which 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.”

5.On the basis of the above, the Committee is of the following opinion in respect of the issues raised at para 5 of the query:

(i)         The accounting treatment with respect to the systems installed at customers’ site for their acceptance, adopted by the company, as stated at para 3 of the query is not correct.

(ii)        At the time of the installation of such systems at the customers’ site, value of the same should be transferred to a separate account such as ‘Goods sent on approval account’. If at the reporting date there are any such systems installed, for which no approval has been received from customers, the same should be valued as per Accounting Standard (AS) 2, issued by the Institute of Chartered Accountants of India and disclosed separately under the head ‘inventories’. The above change in the accounting policy of the company should be made as per para 12 of Accounting Standard (AS) 5, as reproduced at para 4 above.

(iii)       No. Please also refer to para 2 above.

(iv)       Please refer to (i) above.

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