Expert Advisory Committee
ICAI-Expert Advisory Committee
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Query No. 19

Subject:   

MOU arrangements – whether a job work or

transactions of purchases and sales.1

A.  Facts of the Case

 

1. A pharmaceutical company entered into MOU agreements with certain parties (MOU parties). As per the terms of MOUs, the MOU parties provide bulk, raw material and other excipients required for the manufacture of products for supply of the finished goods to parties under instructions of the MOU parties.  The MOU agreements also state the charges that the company will get which are based on the quantity and value of the respective finished goods.

 

2.  For the bulk, raw material and other excipients received by the company, the bills are raised in favour of the company.  The company issues a purchase order on receipt of the materials as per the invoice of the concerned MOU party.  Material received under MOU is recorded as the company's purchases.  Wherever the supplies are made by third parties on behalf of the MOU parties, initially the account of the third party is credited and the purchases account is debited.  On receipt of documentary evidence about the payment having been made by the MOU party to the third party, the third party's account is debited and the credit is given to the concerned MOU party on whose behalf the material is received by the company.  Irrespective of the fact whether the bulk, raw material and other excipients are supplied by the MOU party under their bills or through the third party, the purchases are treated as the company's own purchases.  According to the querist, the ownership of the material rests with the company, the moment they enter the factory of the company.

 

3. During the course of manufacture of the finished goods, if the bulk, raw material and other excipients are found short, the same are arranged by the company.  The cost of such materials used is debited to the MOU party and the amount is recovered from them.

 

4.  The identity of the materials received from the respective MOU parties and the finished goods produced therefrom is maintained.  After completion of the manufacturing activities, the finished goods are transferred to the depots of the concerned MOU party.  As per the MOU agreement, the cost of transportation to the depot of the MOU party is borne by the company itself.  The goods are distributed from depot to the distributors or the actual users as per the instructions of the concerned MOU party.  The freight including the insurance charges from depot to the actual users is borne by the MOU party.  Under some of the MOU agreements, the loss on account of shortages/breakages in transit are borne by the company, whereas in others by the concerned MOU party.  The terms of MOU agreements with MOU parties also differ in respect of loss due to expiry of goods remaining unsold; in some cases such loss is borne by the company, whereas in others it is borne by the concerned MOU party.

 

5.  The sales invoices are raised in the name of the concerned MOU party.  As per the querist, since the bills are issued in the name of the MOU party, the property in the goods is transferred to MOU party only at the stage when the invoices are prepared and the goods are physically transferred to the concerned MOU party.  The sales made in this fashion are recorded as 'sales' in the profit and loss account of the company.

 

6. The company recovers the money from the distributors and actual users to whom the finished goods are distributed.  The terms of MOU provide that the money realised by the company shall be reimbursed to the MOU party after deducting charges in the form of fixed amounts based on quantity and value of the finished goods and also at a fixed percentage of sales value as agreed upon under the MOU.  This discharges the company's liability towards purchases made from the MOU party or the payment made by the MOU party to the third parties for supply of materials, if any.

 

7. The statutory auditors are of the view that the transactions of sales and purchases and manufacturing of the goods under the MOU arrangements is nothing but a job work.  They have proposed that the sales and purchases recorded in the company's books should not be shown in the profit and loss account of the company.  They are of the opinion that only the job charges, i.e., the conversion charges/service charges received by the company as per the MOU agreement should be recorded as income in the books of account of the company.  Stocks of materials and finished goods which are included in the inventory of the company should also not find any place in the books of account of the company as these are held by the company only on behalf of the respective MOU parties.

 

8. According to the querist, the receipts of materials by the company are reflected as its purchases in the sales-tax return filed by the company.  The purchase tax paid by the company wherever applicable, has been claimed as a set off by the company while filing the sales-tax return with the sales-tax authorities.  The sales tax on the sales also stands collected by the company.  Wherever possible, depending on the availability of funds, the sales-tax has been paid by the company to the sales-tax authorities. The MODVAT benefit is also availed of by the company.

 

9. The querist has argued that treating the transactions of sales and purchases under the MOU arrangement as job work is not at all desirable as MODVAT availed of by the company on the purchases made under the MOU arrangement would no longer be available to the company.  Sales tax collected by the company would be an unauthorised collection of sales tax.  Sales tax paid by the company on the sales would not be refunded to the company by the sales tax authorities.  This is an arrangement specifically agreed by the MOU parties.  The MOU parties have also passed entries accordingly in their books and have not booked the purchases as their own purchases, as the material was supplied by them to the company for getting the goods manufactured at an agreed pre-determined rate.  The excise duty paid by the company has been disclosed in the company’s profit and loss account.  Most of the MOU parties are traders and not manufacturers and they might not have registered themselves as manufacturers with the excise authorities and therefore for carrying out the manufacturing activities in the company’s premises, they might not have obtained any permission required under the relevant Excise Act.

 

10. According to the querist, keeping in view the above and the MOU agreements with the MOU parties, the company has treated all the purchases and sales as its own purchases and sales.  The conversion charges received by the company are shown separately in the profit and loss account of the company.

 

B.  Query

 

11. The querist has sought the opinion of the Expert Advisory Committee as to whether the company is right in showing the sales and purchases under the MOU arrangements as sales and purchases of the company or whether the MOU arrangement should be treated as a job work.

 

C. Points Considered by the Committee

 

12. Accounting Standard (AS) 1, ‘Disclosure of Accounting Policies’, states (paragraph 17) that one of the major considerations governing the selection and application of accounting policies is 'substance over form', i.e., "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".

 

13. Accounting Standard (AS) 9, ‘Revenue Recognition’, defines the term revenue as follows:

 

“Revenue is the gross inflow of cash, receivables or other consideration arising in the course of the ordinary activities of an enterprise from the sale of goods, from the rendering of services, and from the use by others of enterprise resources yielding interest, royalties and dividends. Revenue is measured by the charges made to customers or clients for goods supplied and services rendered to them and by the charges and rewards arising from the use of resources by them. In an agency relationship, the revenue is the amount of commission and not the gross inflow of cash, receivables or other consideration.”

 

14. AS 9 lays down certain conditions for recognition of revenue.  In respect of sale of goods, the Standard requires that revenue should be recognised when (apart from fulfillment of other conditions laid down in this behalf) the seller has transferred to the buyer the property in the goods for a price or all significant risks and rewards of ownership have been transferred to the buyer and the seller retains no effective control of the goods transferred to a degree usually associated with ownership.

 

15. The Committee is of the view that from the view point of the buyer also, a transaction of purchase of goods should be recognised when the property in the goods or all significant risks and rewards of ownership have been transferred to the buyer and the seller retains no effective control of the goods transferred to a degree usually associated with ownership.  In case the transfer of property in the goods and the transfer of all significant risks and rewards of ownership do not take place concurrently, the timing of recognition of the purchase should be determined considering the substance of the transaction, i.e., the purchase should be recognised when all significant risks and rewards of ownership are transferred to the buyer.

 

16. The point of time when all significant risks and rewards of ownership pass on from the seller to the buyer depends on the terms and conditions of the contract.  In this regard, the Committee takes note of the fact that the MOUs with different parties are not identical.  For example, in the case of some contracts, the loss on account of shortages/breakages of materials in transit is borne by the company while in others, such loss is to be borne by the MOU party.  Similarly, the loss due to expiry of unused materials is borne by the MOU party in the case of some contracts while in the case of the others it is borne by the company.  The Committee is of the view that the determination of the issue as to whether the transfer of materials by the MOU parties to the company and transfer of products manufactured to MOU parties or third parties should be recorded as purchases and sales respectively of the company or not should be based on the considerations set-forth in paragraphs 12 to 15 above.  In other words, where the significant risks and rewards of ownership in respect of materials transferred to it by the MOU parties vest with the company, the materials should be recorded as purchases of the company.  It is obvious that in such a case, the products manufactured using these materials would represent sales revenue of the company.  On the other hand, where the significant risks and rewards of ownership of materials transferred to the company continue to vest with the MOU parties concerned, the materials do not constitute purchases of the company.  In such a case, the revenue of the company would be limited to service charges receivable from the MOU party as per the terms of the contract.

 

17. The Committee observes that the treatment of transactions under MOU arrangements as purchases and sales of the company for the purposes of taxation can not be the criteria for determining the true nature of the transactions and their correct accounting treatment.

 

D.  Opinion

 

18. On the basis of the above, the Committee is of the opinion that the issues raised by the querist will have to be determined in the context of the facts and circumstances of each contract.  Where, as per the terms of the contract, the significant risks and rewards of ownership of materials pass on to the company, the transaction should be recorded by it as a purchase, and products manufactured using these materials and sold to MOU party/third parties would represent revenue of the company from the sale of the products.  On the other hand, where the significant risks and rewards of ownership of materials continue to vest in the MOU parties concerned, the revenue of the company would be limited to service charges receivable by it under the terms of the contract.

 

1 Opinion finalised by the Committee on 8.8.2000.