Expert Advisory Committee

1.7 Query:

Treatment of gratuity liability.

1. The accounting policy regarding treatment of gratuity liability of a large engineering company states as below:

“Due to losses in the past years provision for gratuity as per actual valuation is not made in the accounts. The payments are accounted on cash basis.”

2. The notes to accounts further reveal as under:

“Accrued estimated liability for gratuity to employees as per the actuarial valuation amounts to Rs. XYZ for which no provision has been made in the accounts, as the payments are accounted on cash basis.”

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

(1) Whether the accounts prepared under the aforesaid basis will give a true and fair view of the state of affairs of the company?

(2) Whether the auditors of the company are required to qualify their report and, if so, on what basis and what terms?

(3) Whether such unprovided liability should be deducted while computing net worth of the company for various statutory provisions such as:

(a) Section 58 A of the Companies Act, 1956.

(b) For the limits of investments under section 372 of the Companies Act, 1956.

(d) For working out net worth under the provisions of Sick Industrial Companies (Special Provision) Act, 1985.

Opinion May 19, 1997

1. The Committee notes sub-section (3) of section 209, which is as below:

“For the purposes of sub-sections (1) and (2) proper books of account shall not be deemed to be kept with respect to the matters specified therein-

(a) ………..

(b) If such books are not kept on accrual basis and according to the double entry systems of accounting.”

2. The Committee notes para 9 of the Guidance Note on Accrual Basis of Accounting, issued by the Institute of Chartered Accountants of India, which recommends as below:

“Where a company has maintained its books of account in a manner that all material transactions are accounted for on accrual basis as-discussed above, the auditor should state in his report that, as far as this aspect is concerned, the company has maintained proper books of account as required by law. Where a company has not maintained its books of account in a manner that all material transactions are accounted for on accrual basis as discussed above, the auditor will have to qualify his report or give a negative opinion with regard to the following assertions:

(a) Whether proper books of account as required by law have been kept by the company.

(b) Whether the accounts give the information required by this Act in the manner so required and give a true and fair view of:

(i) in the case of the balance sheet, of the state of the company’s affairs as at the end of its financial year; and

(ii) in the case of the profit and loss account, of the profit or loss for its financial year.”

3. The Committee notes from the ‘Definitions’ given in Accounting Standard (AS) 15 on ‘Accounting for Retirement Benefits in the Financial Statements of Employers’, issued by the Institute of Chartered Accountants of India that “pay-as-you-go is a method of recognising the cost of retirement benefit only at the time of payments are made to employees on or after their retirement.”

4. The Committee also notes para 12 of Accounting Standard (AS) 15 as below:

“The cost of retirement benefits to an employer results from receiving services from the employees who are entitled to receive such benefits. Consequently, the cost of retirement benefits is accounted for in the period during which these services are rendered. Accounting for retirement benefit cost only when employees retire or receive benefit payments (i.e., as per pay-as-you-go method) does not achieve the objective of allocation of those costs to the periods in which the services were rendered.”

5. Based on the above, the Committee is of the view that accounts will not give a true and fair view of the state of affairs if the provision for gratuity is not made on accrual basis and that the auditor should qualify his report.

6.The Committee notes that the Explanation to Rule 3 of Companies (Acceptance of Deposits) Rules, 1975, explains as below:

“For the purpose of this Rule, in arriving at the aggregate of the paid-up share capital and free reserves of a company, there shall be deducted from the aggregate of the paid-up share capital and free reserves as appearing in the latest audited balance sheet of the company, the amount of accumulated balance of losses, balance of deferred revenue expenditure and other intangible assets, if any, as disclosed in the said balance sheet.”

7. The Committee further notes sub-section (1) of section 370 of the Companies Act, 1956, which, inter alia, states as below:

“The aggregate of the loans made to all bodies corporate shall not exceed without the prior approval of the Central Government -

(a) such percentage of the aggregate of the subscribed capital of the lending companies and its free reserves as may be prescribed where all such other bodies corporate are not under the same management as the lending company;

(b) such percentage of the aggregate of the subscribed capital of the lending company and its free reserves as may be prescribed where all such other bodies corporate are under the same management as the lending company.”

8. The Committee also notes sub-section (2) of section 372 of the Companies Act, 1956, which, inter alia, states as below:

“The Board of Directors of the investing company shall be entitled to invest in any shares of any other body corporate upto such percentage of the subscribed equity share capital, or the aggregate of the paid up equity and preference share capital, of such other body corporate, whichever is less, as may be prescribed:

Provided that the aggregate of the investments so made by the Board in all other bodies corporate shall not exceed such percentage of the aggregate of the subscribed capital and free reserves of the investing company, as may be prescribed:

Provided further that the aggregate of the investments made in all other bodies corporate in the same group shall not exceed such percentage of the aggregate of the subscribed capital and free reserves of the investing company, as may be prescribed.”

9. The Committee also notes section 3 (ga) of the Sick Industrial Companies (Special Provisions) Act, 1985, which defines net worth as below:

“Net worth means the sum total of the paid-up capital and free reserves. For this purpose, free reserves means all reserves credited out of the profits and share premium account but does not include reserves credited out of the re-evaluation of assets, write back of depreciation provisions and amalgamation.”

10. The Committee notes that there is no specific provision in the Companies Act or in the SICA regarding whether an item of unprovided liability should be adjusted while calculating free reserves for the various purposes. One view can be that this need not be adjusted strictly from legal angle if it is not specifically required in law. However, if this view is accepted, there may be situations where though the company shows free reserves as per its books of account, it has in fact eroded its net worth very substantially. It is, therefore, desirable that logically and in terms of good accounting practice, any notes on unprovided liability should be adjusted in arriving at the figure of free reserve.

11. On the basis of the above, the Committee is of the following opinion:

(i) In case provision for gratuity is not made, the accounts will not give a true and fair view of the operating results and the state of affairs of the company.

(ii) The auditors of the company are required to qualify their report. The manner of qualification is given in para 2 above.

(iii) It is desirable that logically and in terms of good accounting practice, an unprovided liability is deducted while computing the free reserves of the company for the purposes of section 58A, section 372 and section 370 of the Companies Act, 1956, as well as for the purposes of the Sick Industrial Companies (Special Provisions) Act, 1985.

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