Query No. 9

Subject: 

A. Facts of the Case

1. A wholly owned government company has the main objective of setting up and running agricultural farms primarily for the production of seeds of good grains, fibre crops, plantation crops, oil seeds, vegetables and fruits, etc.

2. The employees of the company can encash unavailed leave during the period of service.  Upto the year 1997-98, the company had been following the policy of accounting for leave encashment on cash basis. In the opinion of the querist, Accounting Standard (AS) 15, ‘Accounting for Retirement Benefits in the Financial Statements of Employers’, issued by the Institute of Chartered Accountants of India, does not apply to leave encashment during the period of service.

3. During the year 1998-99, the company changed its policy of accounting for leave encashment.  The new policy reads as under:

“Provision for future liability in respect of leave encashment is made on an estimated basis by the company as on the date of balance sheet.  The said provision is being treated as deferred revenue expenditure to be written off in ten financial years commencing from the year 1998-99.  Further provision/adjustment for leave encashment will be made at the year end on actuarial valuation.”

4. As per the querist, the above accounting policy was based on the view that the cost of leave encashment is on account of past services rendered by the employees to the company, though the payments will be made in future.  Therefore, the cost should be allocated over the periods in future.  The provision for leave encashment required to be made on account of past services of the employees worked out to Rs. 4.75 crore.  A provision for this amount was created under the head ‘other provisions’. The management decided to treat this expenditure as deferred revenue expenditure to be written off in ten years starting from the year 1998-99.  A note to this effect was also given in the accounts.

5. According to the querist, the government auditors commented on the new accounting policy as under:

“According to AS 15, provision is required to be made only for liability accruing for the current year in respect of retirement benefits payable to the employees.  In the event of change in the nature and extent of retirement benefits or the basis of their accounting, such liability in respect of past retirement cost benefits is also to be provided and a suitable disclosure made.  While the former would be directly chargeable to the profit and loss account, the latter would be adjusted through ‘prior period account’.

Accounting policy V(4) of the company refers to future liability on account of leave encashment and provides for treatment of such liability as ‘deferred revenue expenditure’. To that extent, the accounting policy as well as Note III(4) below the accounts is not in alignment with AS 15 and is also misleading.  In consequence, the company has treated liability of leave encashment in respect of retirement benefit cost relating to past years as deferred revenue expenditure resulting in over-statement of miscellaneous expenditure (to the extent not written off or adjusted) by Rs. 427.50 lac and under-statement of loss by an equal amount.  Since AS 15 has not been fully complied with, the statement of the statutory auditors to the effect that the balance sheet and profit and loss account dealt with by their report are in compliance with the Accounting Standards insofar as they are applicable to the company, is also incorrect”.

6.  The management is of the view that the policy adopted by the company meets the requirements of AS 15 as the total provision has been made and the same is to be written off in the next ten years.  This system has been adopted because the total provision did not pertain to the current year and charging off the same would have adversely affected the performance of the year 1998-99.

7.  The statutory auditors have made the following observation in their audit report:

“Due to change in the accounting policy relating to provision for future liability in respect of leave encashment as referred to in accounting policy V(4), forming part of accounts, a provision of Rs. 4.75 crore under the head ‘other provisions’ has been made on the basis of estimated liability as on the date of balance sheet and the same is treated as deferred revenue expenditure to be written off over a period of ten financial years commencing from financial year 1998-99.  Consequently, loss for the year is higher by Rs. 47.5 lac”.

B. Query

8.  The querist has sought the opinion of the Expert Advisory Committee on the issue whether the treatment of the amount of Rs. 4.75 crore as deferred revenue expenditure is correct.

C.  Points Considered by the Committee

9.  The Committee notes that the query relates only to encashment of leave during service period.  The Committee, therefore, restricts itself to this issue and does not express any opinion on treatment of leave encashment to which an employee is entitled at the time of retirement.

10. The 'Guidance Note on Audit of Miscellaneous Expenditure Shown in Balance Sheet', issued by the Institute of Chartered Accountants of India, states that "unless some benefit from the expenditure can reasonably be expected to be received in future and unless the amount of such benefit is reasonably determinable, there is no justification for carrying forward the expenditure for being written-off in subsequent periods".  The Committee is of the view that this principle should be applied in determining whether the provision made by the company in respect of encashable leave of past years can be deferred or not.

11. The Committee is of the view that the encashable leave of earlier years to which employees are entitled arose on account of services rendered by the employees during those years.  Thus, the accumulated encashable leave of earlier years would not result in any future benefits to the company.  Accordingly, the Committee is of the view that the provision on the account cannot be deferred and should be fully expensed in the year 1998-99.

12.  Paragraph 12 of Accounting Standard (AS) 5, ‘Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies’, requires that “when items of income and expense within profit or loss from ordinary activities are of such size, nature or incidence that their disclosure is relevant to explain the performance of the enterprise for the period, the nature and amount of such items should be disclosed separately”.

13. The Committee is of the view that if the amount of provision in respect of encashable leave of earlier years is material, the disclosure thereof in the profit and loss account should be made in accordance with paragraph 12 of AS 5.

D. Opinion

14. On the basis of the above, the Committee is of the opinion that the accounting treatment adopted by the company is not correct.  The provision to be made in respect of encashable leave of earlier years should be created by way of a charge to the profit and loss account for the year 1998-99.  The amount of provision, if material, should be disclosed in accordance with paragraph 12 of AS 5.

1Opinion finalised by the Committee on 22.4.2000.