Query No. 18

Subject:     

Accounting treatment of deduction allowed from invoiced amount.^[1]

A. Facts of the Case

1. A public sector undertaking is engaged in the business of ship building and ship repair.

2. For ship repair jobs, the company submits quotation based on the work package sent to the company by the ship owner.  The work is awarded to the company on the basis of the quotation submitted.  As the work progresses, some additional work, not covered by the quotation, may also be required to be done on the ship.

3. On completion of the repair work, a ‘work completion certificate’ is prepared which is counter-signed by the representative of the ship owner.  Subsequently, invoice is prepared based on the work completion certificate, describing the nature of the work done together with the rate and the amount.  The rate charged in the invoice for additional work would not have been quoted earlier.

4. The ship owner scrutinises the invoice vis-a-vis the work completion certificate and the rates quoted.  The variations in rates and quantities noticed by the ship owner are intimated to the company seeking clarification and adjustments in the invoice.  The main areas where objections are generally raised are:

(a) Variations in the quantities between the work completion certificate and the invoice.

 

(b) Other errors in billing.

 

(c) Disagreement with rates charged for additional work.

 

(d) Cost of components invoiced on cost-plus basis not agreeable to the ship owner on account of non-production of satisfactory proof.

 

(e) Any sub-contract work done through outside specialists invoiced on cost-plus basis, of which the cost is not fully acceptable to the ship owner.

5. The scrutiny details forwarded to the company by the ship owner are examined and the company’s comments communicated to the ship owner.  Finally, negotiations take place between the ship owner and the company on the basis of the scrutiny details.  The negotiations may result in a deduction being allowed from the invoiced amount either as a lump sum or as a percentage of the invoiced amount, as the case may be.  The deduction is treated by the company as trade discount.

6. The accounting treatment followed by the company is as follows:

(a) For repair work, the company receives progress payments which are treated as advances till the final invoice is raised and adjusted against the final invoice.

 

(b) When the invoice is raised, the ship owner’s account is debited and ‘Ship Repair Income’ account is credited with the invoiced amount.

 

(c) Discount, if any, arrived at as explained in paragraph 5 above is treated as ‘trade discount’ in the normal course of business and the ship repair income is reduced to the extent of discount allowed by debiting the ‘Ship Repair Income’ account and crediting the ship owner’s account.

 

(d) At the close of the year, the process of scrutiny by the ship owners and negotiations between the ship owners and the company in respect of certain invoices raised by the company may not be over.  In such cases, based on the past experience, a ‘provision for anticipated losses and expenditure’ is created by debiting the profit and loss account.  The provision is disclosed under the head “provisions” in the balance sheet.

B. Queries

7. The opinion of the Expert Advisory Committee has been sought on the following issues:

(a) Whether the accounting treatment of the deduction from the invoiced amount followed by the company, as explained in paragraph 6(c), is in order, or whether the deduction should be shown distinctly as a separate item of expenditure in the profit and loss account after showing the ship repair income at the gross invoice amount.

 

(b) Whether the disclosure of the ‘provision for anticipated losses and expenditure’ in the balance sheet as explained in paragraph 6(d) is in order, or whether the provision should be shown as a deduction from the ‘sundry debtors’ along with provision for doubtful debts.

 

(c) Whether there is any other alternative method of accounting in respect of the above items.

C. Points Considered by the Committee

8. The Committee notes that the difference between the invoiced amount and the amount finally settled between the ship owner and the company arises mainly on account of factors listed in paragraph 4 above.  These factors can be classified into two categories:

(a) Errors in billing (arising on account of variations between the quantities as per the work completion certificate and the invoice, and other clerical errors in preparing the invoice).

 

(b) Disagreement between the company and the ship owner about rates/costs on which prior agreement has not been reached between them.

9. As far as the difference attributable to (a) above is concerned, it is in the nature of an error.  As far as the difference attributable to (b) above is concerned, it arises because of absence of prior agreement between the parties on certain rates/costs.  Thus, in respect of these rates/costs, the rates/costs charged in the invoice are provisional in nature and the difference on this account represents a price adjustment.

10. The company is treating the difference between the invoiced amount and the amount finally settled as trade discount.  In this regard, the following definition of the term ‘trade discount’ as given in the ‘Guidance Note on Terms Used in Financial Statements’ issued by the Institute of Chartered Accountants of India is noteworthy:

“Trade discount

A reduction granted by a supplier from the list price of goods or services on business considerations other than for prompt payment.”

11. The Committee is of the view that considering the nature of the difference between the invoiced amount and the amount finally settled (as discussed in paragraph 9 above), it cannot be said to be trade discount.  As such, its description as trade discount is not appropriate.

12. In view of the nature of factors giving rise to the difference between the invoiced amount and the amount finally settled, the Committee is of the view that it is the finally settled amount (and not the invoiced amount) that properly reflects the revenue of the company from ship repair operations.  If the amount that is finally settled between the parties were known at the time of raising of the invoice, the invoice itself would have been raised for such amount.

13. The Committee takes note of paragraph 13 of Accounting Standard (AS) 4, ‘Contingencies and Events Occurring after the Balance Sheet Date’ which requires that “assets and liabilities should be adjusted for events occurring after the balance sheet date that provide additional evidence to assist the estimation of amounts relating to conditions existing at the balance sheet date .........”.  The expression ‘events occurring after the balance sheet date’ has been defined as “those significant events, both favourable and unfavourable, that occur between the balance sheet date and the date on which the financial statements are approved by the Board of Directors in the case of a company, and, by the corresponding approving authority in the case of any other entity.”

14. Based on the observations made in paragraph 12 and considering the requirements of AS 4 referred to in paragraph 13, the Committee is of the view that in respect of the invoices raised during an accounting period for which the final amount is settled by the date of approval of accounts by the board of directors, the difference between the invoiced amount and the finally settled amount should be adjusted in the ‘ship repair income’ account.  The Committee notes that the treatment followed by the company has the same effect (though the difference is being termed as ‘trade discount’ which, in the opinion of the Committee, is not correct).

15. The Committee notes that in respect of the invoices raised during the year for which final amount is not settled by the close of the year, the company is following the policy of making a provision on the basis of the past experience and disclosing it in the profit and loss account under the head ‘provision for anticipated losses and expenditure’.  Based on the observations made in the previous paragraph, the Committee is of the view that the said amount should instead be adjusted in the ‘ship repair income’ account by a corresponding credit to the ship owner’s account.  The Committee is also of the view that the aforesaid provision should be made after taking into consideration the developments up to the date of approval of accounts by the board of directors, as required by AS 4.

D. Opinion

16. Based on the above, the Committee is of the following opinion on the issues raised in paragraph 7 above:

(a) The adjustment of the difference between the invoiced amount and the amount finally settled against ‘ship repair income’ account is in order.  Events occurring up to the date of approval of the accounts by the board of directors should be taken into consideration in determining the amount of the adjustment to be made in this regard.  The description of the difference as ‘trade discount’ is not appropriate. 

 

(b)  In respect of ship repair jobs for which negotiations between the ship owners and the company are not over, the accounting treatment and manner of disclosure followed by the company, as described in paragraph 6(d) are not appropriate. Instead, the amount of difference between the invoiced amount and the amount likely to be finally settled (as estimated on the basis of past experience) should be adjusted in the ‘ship repair income’ by a corresponding credit to the accounts of the respective ship owners.  Consequently, the figure of sundry debtors included in the balance sheet would be net of adjustment for such difference.  In other words, the amount of the difference would be neither shown under the head ‘provisions’ nor shown as a deduction from the sundry debtors in the balance sheet.

 

(c) See (a) & (b) above.

_______  

^[1] Opinion finalised by the Committee on 28.5.1999.