Query No. 40

Subject:   

   Accounting treatment of interest for period of default in payment

of instalments under a hire purchase scheme.[1]

A. Facts of the Case

1. A public sector company supplies machinery and equipment to small industrial units on hire purchase basis under its hire purchase scheme.

2. As per the terms and conditions of the hire purchase scheme, in case any instalment is not paid within one month of the due date, the hirer is liable to pay penal interest at the rate of 2 per cent per annum over and above the normal rate on the defaulted amount from the date of default to the date of actual payment.

3. The penal as well as normal interest for the defaulted period is recorded in the books of account as under:

        Hirer’s Account     Dr.

                 To Interest Suspense Account

When payment is received, the following entries are passed:

        (i)  Bank Account     Dr.

                         To Hirer’s Account

        (ii) Interest Suspense Account     Dr.

                         To Interest Earned Account

Penal interest and normal interest for the defaulted period are credited to the profit and loss account to the extent of the actual amount received during the year.  Thus, they are treated as income when they are actually realised.

4. In cases where the hirers’ accounts are frozen on account of legal action taken or for any other reason, no interest is charged from the date of issuance of the freezing order and the income, if any, is accounted for only on the settlement of cases, i.e., on cash basis.

5. In order to improve the realisation position, the management waives the penal interest in several cases.  The same is adjusted in the company’s books of account by making the following accounting entry:-

        Losses written off on account of

        Interest Suspense Account     Dr.

                 To Interest Suspense Account

                 (as per contra)

The above adjustment is reflected in the profit and loss account in the schedule on ‘Interest’, as a contra adjustment.

6. There have been a number of cases where interest for the period of default is not being recovered. According to the querist, in view of the uncertainty attached to its recovery, the credit balance lying in ‘Interest Suspense Account’ is shown as a reduction from the sundry debtors to avoid unnecessary inflation of sundry debtors and is reflected in the balance sheet in the schedule of ‘Current Assets’ as under:

        Sundry Debtors:

        Sundry Debtors: Accrued instalments      

        Less: Interest Suspense       

        Less:        Provision for doubtful debts           

                Sundry debtors            

The above presentation is based on the advice of the government auditors.

7. The statutory auditors for the year 1990 were of the opinion that ‘Interest Suspense Account’ was a liability and should not have been deducted from the sundry debtors. It was argued by them that once the corporation had charged the interest to sundry debtors individually, it should not reduce the accumulated balance from the sundry debtors as a whole.

8. According to the querist, in view of the observations of the statutory auditors, the matter was referred to the Expert Advisory Committee.  In its Opinion (No.1.27 published in Compendium of Opinions, Volume X), the Expert Advisory Committee had opined that the accounting treatment followed by the company was not in consonance with Accounting Standard (AS) 9, ‘Revenue Recognition’.

9. The querist has sought a reconsideration of the above opinion based on the following grounds:

(a) The aforesaid opinion was based on the parameters laid down in Accounting Standard (AS) 9, ‘Revenue Recognition’.  Paragraph 2 of AS 9 states that the standard does not deal with the aspects of revenue recognition in respect of hire purchase and leasing agreements to which special considerations apply.  According to the querist, therefore, the very basis on which the Committee had founded its opinion is not applicable in the instant case.

(b) According to the querist, it is in order to show a true and fair view that the company nets off the unrealised interest from sundry debtors in presenting the balance sheet.  By following this method, on the one hand, a complete control is maintained over interest/penal interest recoverable from each hirer and, on the other, in accordance with the generally accepted accounting principles, no revenue is recognised in respect of the interest for period of default until such interest is actually realised.  According to the querist, keeping a detailed record of such interest by debiting the same to the hirer’s account is also in order as, occasionally, the books of account are required to be produced before a court of law in connection with legal cases for recovery, etc.  The company’s case for charging of interest would become extremely weak in case the interest entries are not routed through individual hirers’ accounts.  It is, therefore, of paramount importance that interest is debited to hirer’s account unless the accounts are frozen on account of certain special circumstances like hirer’s death, insolvency, etc.

B. Query

10.The querist has sought the opinion of the Expert Advisory Committee on the issue whether the accounting treatment followed by the company in respect of interest for period of default is correct.

C. Points Considered by the Committee

11. The Committee notes that the issues involved in the query relate to recognition of normal and penal interest for period of default and not to recognition of revenue arising from a hire-purchase transaction per se.  The Committee is of the view that the principles enunciated in AS 9 regarding recognition of revenue in the form of interest are applicable to recognition of normal and penal interest for period of default.  As such, the Committee does not agree with the contention of the querist that the very basis of conclusions reached in the earlier opinion was inappropriate.

12. Paragraph 13 of AS 9 requires that “revenue arising from the use by others of enterprise resources yielding interest, royalities and dividends should only be recognised when no significant uncertainty as to measurability or collectability exists”.  Paragraph 9.2 of AS 9 states as below:

“9.2 Where the ability to assess the ultimate collection with reasonable certainty is lacking at the time of raising any claim, e.g., for escalation of price, export incentives, interest etc., revenue recognition is postponed to the extent of uncertainty involved. In such cases, it may be appropriate to recognise revenue only when it is reasonably certain that the ultimate collection will be made. Where there is no uncertainty as to ultimate collection, revenue is recognised at the time of sale or rendering of service even though payments are made by instalments.”

13. The Committee notes that the company is crediting the entire interest (both normal as well as penal) for the period of default to ‘Interest Suspense Account’ with a corresponding debit to the account of the hirers and is recognising interest income for the period of default only when it receives the payment thereof.  In this regard, AS 9 provides that in case of a significant uncertainty as to ultimate collection, revenue recognition should be postponed “to the extent of uncertainty involved”.  Thus, the accounting treatment being followed by the company would be appropriate only if significant uncertainty about the ultimate collection of interest exists in all the cases.  In this regard, the Committee specifically takes note of the observation of the querist that in a number of cases, interest for the period of default is not being recovered.  The Committee is of the view that the mere fact that such interest has not been recovered in some cases does not by itself justify the crediting of the entire amount of such interest to “Interest Suspense Account” and recognising interest income only when the payment is actually received.

14. The Committee notes that the company is crediting the ‘Interest Suspense Account’ to facilitate control and to strengthen its position in case of any subsequent litigation.  The Committee also notes that the company is following the practice of showing the entire unrealised interest as a deduction from the sundry debtors. The Committee does not agree with this practice. The Committee is of the view that if the company follows the practice of crediting ‘Interest Suspense Account’, in order to comply with the requirements of AS 9, it should assess the realisability of the balance standing to the credit of this account at the year end.  The amount in respect of which significant uncertainty about ultimate collection exists should continue to remain under the aforesaid account while the remaining amount should be recognised as income for the period.  In assessing the collectability as above, the company should consider the events occurring after the balance sheet date (including collection of interest subsequent to the balance sheet date). Reference may be made in this regard to Accounting Standard (AS) 4, ‘Contingencies and Events Occurring after the Balance Sheet Date’ issued by the Institute of Chartered Accountants of India.

15. The Committee notes the accounting treatment followed by the company in respect of waiver of penal interest as explained in paragraph 5 above.  The Committee is of the view that upon waiver of penal interest which has already been recorded in the books of account, the original entry made for recording the interest should be reversed.  Accordingly, the entry should be:

        Interest Suspense Account     Dr.

                 To Hirer’s Account

Thus, the entry being passed by the company is not correct.

D. Opinion

16.   On the basis of the above, the Committee is of the opinion that deducting the entire unrealised interest for period of default from sundry debtors, as is being done by the company, is not correct. The amount to be deducted on this account should be such in respect of which there is significant uncertainty of collection.  In assessing the collectability of interest, the events occurring after the balance sheet date should be duly considered.  Subject to the above, the manner of presenting the sundry debtors in the company’s balance sheet isappropriate.

[1] Opinion finalised by the Committee on 14.1.2000

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