Query No. 15

Subject:     

Accounting for sale proceeds of a fixed asset in excess of its original cost.^[1]

A. Facts of the Case

1. A public sector company has adopted the following accounting policy regarding treatment of profit on sale of fixed assets:

“Proceeds from the sale of assets in excess of original cost are credited to Capital Reserve.”

2. In accordance with the above policy, to the extent that the proceeds from sale of fixed assets are in excess of their written down value but less than or equal to the original cost, the excess is credited to the profit and loss account as ‘Profit on Sale of Assets’; the amount which exceeds the original cost of the asset is treated as a capital receipt and credited to capital reserve in the balance sheet.  The company has been following this practice consistently from the year 1984-85.  According to the querist, the same has been accepted by auditors.

3. During the audit for the year 1997-98, government auditors have observed that crediting the amount realised in excess of the original cost of the asset directly to capital reserve is not correct and that the same should be credited to the profit and loss statement as required by paragraph 26 of Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’ which is reproduced below:

“Losses arising from the retirement or gains or losses arising from disposal of fixed asset which is carried at cost should be recognised in the profit and loss statement.”

4. The querist is of the view that the treatment suggested by the government auditors is not correct due to the following reasons:

(a) It is a fundamental accounting concept that any gain arising beyond the original cost of an asset is a capital receipt/profit and may not be treated as a revenue profit.

 

(b) The ‘Guidance Note on Terms Used in Financial Statements’ issued by the Institute of Chartered Accountants of India defines the term ‘Capital Profit’ as under:

         “Excess of the proceeds realised from the sale, transfer or exchange of the whole or a part of a capital asset over its cost.”

 

(c) The capital profits are not distributable profits.  This is supported by section 205 and Explanation of the term ‘Capital Reserve’ in section 293 of the Companies Act, 1956.

 

(d) In case the capital profits are credited to profit and loss account and appropriated to capital reserve subsequently, the book profit will be higher to that extent, thereby attracting Minimum Alternative Tax (MAT) even on capital profits.

B. Query

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

      (i) Whether the present policy of the company of crediting the profit arising from the sale of assets in excess of their original cost directly to capital reserve is in order or not.

      (ii)  If it is considered to be in order, whether any clarification or amplification/modification of AS 10 is needed.

      (iii)  If it is considered not to be in order, what treatment should be adopted by the company in future.

C. Points Considered by the Committee

6. The Committee notes paragraph 26 of AS 10 which requires that gains arising from disposal of fixed assets should be recognised in the profit and loss statement.  The Committee notes that the above requirement applies in all cases where a fixed asset (which is carried at cost) is disposed of, including those where the sale proceeds exceed the original cost of the asset concerned.  Thus, AS 10 does not prescribe a different treatment for gains representing the excess of sale proceeds over the original cost -- it requires the entire gain to be taken to the profit and loss account.

7. The Committee also notes that Part II of Schedule VI to the Companies Act, 1956, requires that the profit and loss account should clearly disclose the result of working of the company during the period and also disclose every material feature, including credits or receipts and debits or expenses in respect of non-recurring transactions or transactions of an exceptional nature.  It is noted that the above requirements do not make any distinction between what are often referred to as capital profits and other profits -- all credits relating to the working of the company during the period are required to be recognised in the profit and loss account.  The Committee also notes that Schedule VI specifically requires that profit on investments should be recognised in the profit and loss account (except to the extent the same has been adjusted against any previous provision or reserve) even if they have been held for long-term, as in the case of fixed assets.

8. On the basis of the above, the Committee is of the view that the entire amount of excess of sale proceeds over the net book value of the assets concerned should be recognised in the profit and loss account.

9. The Committee notes that section 293, to which a reference has been made by the querist, does not explain the term ‘capital reserve’.  This, however, does not have any bearing on the opinion of the Committee.

D. Opinion

10. Based on the above, the Committee is of the following opinion on the queries raised in paragraph 5 above:

      (i) The policy of the company of crediting the excess of sale proceeds of fixed assets over their original cost to capital reserve is not appropriate.

      (ii) This issue does not arise in view of what has been stated at (i) above.

      (iii) The appropriate treatment would be to credit the entire excess of sale proceeds over the net book value of the fixed assets concerned to the profit and loss account.

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^[1] Opinion finalised by the Committee on 4.3.1999.