Query No. 3

Subject:     

Treatment of loan arranged by a contractor through

a tripartite agreement for financing a project.^[1]

A. Facts of the Case

1. A public sector company (hereinafter referred to as ‘the company’) is engaged in construction of projects on turnkey basis.  The company signed a Memorandum of Understanding (MOU) with a State Road Development Corporation (SRDC), fully owned by a state government, for constructing a number of Rail Over Bridges (ROBs) on land belonging to the state government.

2.  As per the MOU, the responsibility for arranging finance for the project devolved on the company.  The finance could be arranged even in foreign currency through ECB on the explicit understanding that the exchange fluctuation will be borne by SRDC.  Subsequent to signing of the MOU, SRDC agreed to pay a certain percentage of the loan amount to the company as one-time fee for arranging finance.

3. The cost of the project as also the interest during the construction period was to be financed out of the arranged loan.  The interest during the construction period was required to be added to the principal amount of the loan and this amount, along with interest till final repayment, was to be paid in equated monthly/quarterly instalments comprising both principal and interest.

4. As per the contract, SRDC shall repay to the company the expenditure incurred for the construction (as defined in the MOU), turnover tax and sales tax on works contract, and also pay a fixed percentage towards overheads and profit.  The contract is, thus, in the nature of a cost-plus contract.

5. With due approval of SRDC, the company negotiated the loan with a bank.  Under the arrangement, the bank agreed to extend the loan based on a tripartite agreement.  Accordingly, a tripartite agreement was entered into between the bank, the company and SRDC for a borrowing facility of Rs. 60 crore for five ROBs.

6. Some of the features of the tripartite agreement to which the querist has specifically drawn the attention of the Committee are as follows:

(a) The company and SRDC will be co-obligants and will be jointly and severally liable as principal borrowers for repayment of the entire loan along with interest.

 

(b)  Loan is guaranteed by the concerned state government.  Also, the bank is a joint beneficiary to whatever bank guarantees are given by the fabricators/sub-contractors against money/materials advanced to them by the company during the course of execution of the project.

 

(c) The agreement provides the bank a pari-passu hypothecation charge (along with the holders of bonds already issued by SRDC) over the receivables and inward revenue towards toll taxes, advertising charges etc. from the ROBs.

 

(d) The charge of hypothecation is to be created directly by SRDC in favour of the bank.

 

(e) The drawal and utilisation of the loan is to be made by the company. However, for the first drawal of the loan, approval of SRDC is obligatory.  Subsequent drawals do not require any approval from SRDC and can be made directly by the company.

(f) Loan instalments are to be released by crediting the term loan account (which is in the name of the company) and transferring the same to the current account of the company.

 

(g) One of the clauses of the tripartite agreement provides that SRDC “binds itself” and the company “agrees to the same” that whatever payments/monies are to be released/paid by SRDC in favour of the company would be paid directly to the bank “in adjustment of their liability” to the bank against the term loan.  The bank also has a lien on all such payments till the loan is fully paid.  As per the querist, the use of words “their liability” in the aforesaid clause shows that the intention of the parties or the substance of the transaction is that the primary liability for the loan is that of SRDC.  The querist has furnished a legal opinion in support of this contention.

 

(h) In case SRDC and/or the company fails to pay the instalments on due dates or SRDC fails to deposit the revenues ollected from ROBs, the bank is entitled to invoke the guarantee given by the state government.

7.The MOU provides that the company will be the legal owner of the ROBs and all other works constructed under the MOU till the last equated monthly/quarterly instalment is paid by SRDC to the company; however, from the date the construction is completed, the physical possession will be with SRDC “to use with all liabilities therein and maintain the assets”.  After the last equated monthly/quarterly instalment is received by the company, the assets will be handed over to SRDC and the company’s ownership will conclude on all assets.

8. According to the querist, the company has accounted for the above transactions as follows:

(a) The amount transferred to the current account of the company is shown as bank balance by showing the corresponding amount as ‘advances from client’.  The ‘advances from client’ account is adjusted based on billing/booking of turnover.

 

(b) The expenditure on the project calculated on accrual basis together with the related profit margin is shown as turnover.

 

(c) The billing/turnover which cannot be got reimbursed from the loan is shown as debtors (i.e. SRDC A/c).

 

(d) The company’s liability as co-obligant for the term loan is disclosed by way of the following note to the accounts:

 

“The company is co-obligant in respect of a bank loan in its name (including interest accrued thereon) of Rs. xxx million (Rs. xxx) which is being utilised for financing the cost of certain projects being executed by the company for a client.  The loan is to be secured by hypothecation charge over the revenue to be earned by the client against these projects and is to be guaranteed by state government and is to be paid back by the client alongwith interest.  The loan drawn (net of amount to be billed to the client) has been shown as advance from the client and the full amount of loan alongwith interest accrued thereon has been shown as contingent liability.”

(e) In the company’s books of account, no accounting entry is made for interest accrued on the loan.

9. According to the querist, the fact that SRDC has agreed to pay a one-time financing charge to the company for arranging the finance is one of the factors in determining as to whose liability the loan is.  The querist has contended that if the loan were to be primarily the liability of the company, there was no question of SRDC paying fee to the company for arranging finance and no tripartite agreement was required to be executed.

10. The querist has further advanced the following arguments in favour of treating the loan as a contingent liability in the books of company:

(a) Under the tripartite agreement, the bank is expected to receive the payments for the term loan, when due, directly from SRDC.  The disbursement of the loan to the company cannot start until SRDC gives its approval.  Disbursement of subsequent instalments of the loan to the company by the bank is for operational convenience and does not alter the nature of the loan.

 

(b) The company is debarred from receiving any payments from SRDC directly and is obliged to transmit the same to the bank in the eventuality of their receipt by it.  This shows the neutrality of the company in the lending between the bank and SRDC.

 

(c) Although the company is mentioned as a co-obligant in the tripartite agreement, the loan amount cannot be the primary liability of two parties; it would be the primary liability of one party and contingent liability of the other party

 

(d) The end-use of the loan, the direct mechanism of its repayment and guarantee of the loan by the state government show that the beneficiary and availee of the loan is SRDC.

 

(e) The receivables and inward revenues of SRDC are hypothecated to the bank.  No party will agree to create a charge on its revenues unless it was primarily liable for payment of the loan.

 

(f) Every borrower may not fail in discharging its committed repayments.  Hence, the liability for the payment will devolve on the second party in the rare eventuality of failure of the borrower to repay the amount.  The liability of the second party, i.e. company in this case, shall be limited to the unrecovered amount and not the full loan.  Hence, the full loan cannot be a liability of the company.

11. During the audit of annual accounts of the company, there was a difference of opinion as to whether the above loan transaction should be shown as a contingent liability or as loan.  The company’s contention was that it was a contingent liability that might crystallise if:

(a) SRDC failed to repay the loan on due date; and

 

(b) the state government also failed to honour its commitment under the government guarantee for the loan; and

 

(c) the company was pressed for the payment by the bank.

According to the querist, while the branch auditors of the company, another firm of chartered accountants and a firm of advocates concurred with the company’s contention, the statutory auditors made the following qualification in their audit report:

“In our opinion and to the best of our information and according to the explanations given to us, the said accounts subject to:

xxxxxxxxxxxxxxxx

Note No. (xx): Re: Treatment of the loan taken from the bank in which the company is co-obligant, for which legal opinion has been obtained by the company.

xxxxxxxxxx

give a true and fair view .....”

B. Queries

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

(a) Whether the accounting treatment followed and disclosures made by the company, as described in paragraph 8 above, are correct.

 

(b) If not, what would be the correct treatment.

C. Points Considered by the Committee

13. Accounting Standard (AS) 1, ‘Disclosure of Accounting Policies’, provides (paragraph 16) that “the primary consideration in the selection of accounting policies by an enterprise is that the financial statements prepared and presented on the basis of such accounting policies should represent a true and fair view of the state of affairs of the enterprise as at the balance sheet date and of the profit or loss for the period ended on that date.”  Thus, AS 1 requires that the accounting policies should be such as would result in the financial statements presenting a true and fair view.

14. According to AS 1, in selecting and applying accounting policies that would result in the financial statements presenting a true and fair view, one of the major considerations is the substance of the transactions.  According to the Standard, “the accounting treatment and presentation in financial statements of transactions and events should be governed by their substance and not merely by the legal form”.

15. The Committee notes that in the instant case, under the terms of the tripartite agreement, both the company and SRDC are co-obligants and are jointly and severally liable as principal borrowers to the bank for repayment of the loan amount and payment of the interest.  Further, the company will be the legal owner of the ROBs and all other works constructed under the MOU till the last equated monthly/quarterly instalment is paid by SRDC to the company, though from the date the construction is completed, the physical possession of the assets will be with SRDC which will use and maintain the assets.  After the receipt of the last instalment, the company’s ownership will conclude on all assets.  Thus, legally, the ROBs constructed by the company will remain the property of the company till the receipt of the last instalment and the company will be jointly and severally liable to the bank for repayment of loan and payment of interest.

16. Based on the facts of the case, the Committee is of the view that the above legal position does not truly represent the economic substance and reality of the underlying transaction due to the following reasons:

(a) Though, under the MOU, the legal ownership of the ROBs will remain with the company till it receives the last instalment, the toll for use of the ROBs as well as any advertisement revenue and other revenue from commercial exploitation of the ROBs is to be collected by SRDC.  The responsibility for maintenance of the ROBs after their construction is also that of SRDC.  Thus, even though the legal ownership would vest in the company till the receipt of the last instalment, the risks and rewards incident to ownership are intended to vest in SRDC.

 

(b) Though, legally, the company is a co-obligant along with SRDC for repayment of loan and payment of interest, the tripartite agreement envisages that the payments/monies to be released/paid by SRDC in favour of the company would be paid directly to the bank in adjustment of the liability to the bank against the term loan.  Thus, the economic substance and reality of the tripartite agreement is that the repayment of principal and payment of interest are to be effected by SRDC.

The Committee also notes that SRDC agreed to pay to the company a certain percentage of loan amount as one-time fee for arranging finance.

17. Based on the above, the Committee is of the view that notwithstanding the legal form of the transaction, in terms of economic substance and reality, it involves -

      (i)  construction of ROBs by the company for SRDC, and

      (ii)  discharge of obligation towards the bank by SRDC.

18. The Committee is of the view that as far as the company is concerned, its interest in the transaction is restricted to charges for services rendered by it.  Even though it is a co-obligant under the tripartite agreement, in real terms, the company would be liable to the bank only in the event of the failure of SRDC (or the state government) to meet its obligations under the tripartite agreement.  The Committee is also of the view that the temporary legal ownership of the company over the ROBs till the payment of the last instalment by SRDC is intended only to safeguard the company in the event of failure of SRDC to pay the dues to the company; the intention of the parties is not to vest the risk and rewards of ownership of ROBs in the company.

19. The Committee is of the view that the accounting treatment followed by the company in respect of the transactions dealt with by the query properly reflects their nature as discussed above.  However, in view of what has been stated in paragraph 18 above, the company needs to assess the possibility that SRDC or the state government will not meet its obligation towards the bank.  In this regard, the Committee notes paragraphs 10, 11 and 16 of Accounting Standard (AS) 4, ‘Contingencies and Events Occurring after the Balance Sheet Date’, which state as under:

“10. The amount of a contingent loss should be provided for by a charge in the statement of profit and loss if:

(a) it is probable that future events will confirm that, after taking into account any related probable recovery, an asset has been impaired or a liability has been incurred as at the balance sheet date, and

 

(b) a reasonable estimate of the amount of the resulting loss can be made.”

“11. The existence of a contingent loss should be disclosed in the financial statements if either of the conditions in paragraph 10 is not met, unless the possibility of a loss is remote.”

“16. If disclosure of contingencies is required by paragraph 11 of this Statement, the following information should be provided:

(a) the nature of the contingency;

 

(b) the uncertainties which may affect the future outcome;

 

(c) an estimate of the financial effect, or a statement that such an estimate cannot be made.”

It follows that where, in the assessment of the company, it is probable that SRDC or the state government will fail to meet its obligation and therefore a loss on this account is likely to devolve on the company, it would have to make a provision therefor.  On the other hand, if the above situation is possible but not probable, the company would have to make the disclosures required by paragraph 16 of AS 4, unless the possibility of a loss is remote.  In this regard, the Committee notes that the company has disclosed the facts relating to the loan in sufficient detail in a note to the accounts (implying thereby that the company considers that no provision is required under the circumstances).

D. Opinion

20. Based on the above, the Committee is of the following opinion on the issues raised in paragraph 12 above:

(a) The accounting treatment and disclosures referred to in paragraph 8 above are appropriate.

 

(b) See (a) above.

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