Query No. 13

Subject:          

Revenue recognition under FOR destination contracts.¹

A. Facts of the Case

1. A  company  is  engaged  in  manufacturing  and  marketing  of pharmaceutical preparation and veterinary products. The company effects sales from the head office and marketing units/C&F service points to its customers who are dealers, stockists, hospitals (largely government), etc. The customers are spread across respective states some of which are in remote places.

2. The  despatches  are  generally  in  small  parcels/partial  truck  loads. The transporters collect the stock, store them in their godown and despatch the same on getting sufficient load to a particular destination. In view of this,  consignments  take  about  3  or  4  days  time  to  reach  even  nearby destinations. The total number of invoices during 1999-2000 were 19,439 on all-India basis from all the marketing units.

3. In the case of a government order, a single invoice covers despatches to  multiple  locations.  The  company  does  not  obtain  proof  of  delivery from the transporters since most of the consignments are small parcels and the transporters do not have the practice of providing proof of delivery to  the  company. The  transporters  provide/issue  ‘certificate  of  delivery’ only on specific request. Till date, there have been no complaints of non- delivery against any transporter. The despatch/sale is evidenced by receipt of the sale consideration.

4. The company’s significant accounting policy with respect to revenue recognition is as under:

“6. Revenue Recognition

6.1 Revenue  from sales  is  recognised  on  transfer  of  property  in the goods to the customer in terms of sales contract and in the case of loan licence conversion contracts, on completed service contract method.

(i) Accordingly,  in  the  case  of  ‘FOR  Destination’  sale contracts  where  acknowledgement  from  customers  are not on hand, the sale is set up based on the probable date of consignment reaching the destination.

 

(ii) In  case  of  sales  where  documents  against  payment/ acceptance  are  sent  through  bank,  the  sales  are  set  up based  on  the  date  of  receipt  of  payment/notice  of acceptance by the company.

6.2 Sales returns are accounted for in the year of return.”

5. The above accounting policy is consistently being followed by the company  since  the  year  1988.  Till  the  year  1987,  the  company  was recognising revenue from sales on delivery of goods to the transporter. The  government  auditors had,  in  the  supplementary report for  the  said year, opined that the property in the goods on FOR Destination contracts had not been transferred to the buyer till delivery took place and, therefore, sales were overstated. In the light of the observation of the government auditors, the company had changed its accounting policy and accordingly,it  is  deferring FOR  Destination  sales,  already invoiced  and  accounting for them in the ensuing financial year if the consignment is not expected to reach the destination in the relevant financial year. The company does not  have  any  document  in  majority  of  the  cases  evidencing  the  actual date of delivery for either recognising a despatch as sales in the current year or for deferring the same to the subsequent financial year for reasons stated in paragraph 3 above. The decision to recognise or defer is based on the estimate of the management.

6. According to the querist, the company has a difficulty in obtaining proof of delivery in all sales transactions in view of the following:

(i) Number of despatches are very high and despatches are made to peripheries and interior locations.

 

(ii)        Additional  avoidable  costs  involved  in  obtaining  proof  of delivery for all the despatches.

 

(iii)   If acknowledgement would be the basis for setting up of sales/ deferral  obtaining  the  same  would  delay  the  finalisation  of accounts and audit thereof. It may not be possible to obtain all acknowledgements before finalisation still leaving an element of uncertainty.

 

(iv)   Problems faced with multiple deliveries under a single invoice.

7.  According to the querist, the statement of deferrals submitted by the management, therefore, cannot be verified by the auditors against proof of  actual  delivery.  The  auditors,  therefore,  hitherto  were  auditing  the estimate of the management in the same manner as other estimates, viz., obtaining the basis of preparation, inquiring into apparent inconsistencies and thereafter accepting the same if found not unreasonable.

8. The  government  auditors  have  in  recent  years  been  asking  the company  for  more  tangible  evidence.  Failing  to  obtain  the  same  the government auditors have now issued a comment u/s 619(4), the text of which is reproduced as under:

“Profit and Loss Account

Sales and Operating Income Rs.5,803.16 lakh read with Accounting Policy No.6.1(i):

This does not include deferred sales of Rs.58.58 lakh by Bangalore Branch due to alleged non delivery of goods on or before 31st  March,2000. In the absence of proof of actual dates of delivery, correctness of deferred sales and resultantly sales booked could not be vouchsafed in audit.

The Accounting Policy No.6.1(i) also needs to be modified to account for  ‘FOR  Destination’  sales  only  on  receipt  of  goods  at  the destination.”

B. Queries

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

(a)  Whether  in  the  light  of  the  difficulties  expressed  by  the management in ascertaining actual date of delivery, the present practice of estimating the actual date of delivery would be an appropriate basis for recognising ‘FOR destination’ despatches as  sales  in  terms  of  the  accounting  policy  followed  by  the company.

 

(b)  If answer to (a) above is in the negative, how should the date of actual delivery be determined as it is the basis for recognising an FOR destination despatch as a sale in terms of the company’s accounting  policy,  in  the  light  of  difficulties  experienced  by the management in obtaining proof of delivery in respect of all sales transactions and in the interest of expeditious finalisation of accounts?

 

(c) Whether it is incumbent upon the auditor to insist upon proof of delivery as the only sufficient and appropriate audit evidence and  qualify  the  accounts/disclaim  the  figure  of  sales  and deferred sales if the management does not obtain and furnish the  same  before  issuing  his  audit  report,  despite  other corroboratory evidences such as receipt of payment, etc.

 

(d) Whether  there  is  a  need  to  modify  the  said  significant accounting policy No.  6(1)(i) as  directed  by the  government auditors. If so, in what manner.

C. Points considered by the Committee

10.   The  Committee  notes  that  paragraphs  10  and  11  of  Accounting Standard  (AS)  9,  ‘Revenue  Recognition’,  issued  by  the  Institute  of Chartered Accountants of India, state as below:

“10.  Revenue from sales or service transactions should be recognised when the requirements as to performance set out in paragraphs 11 and 12 are satisfied, provided that at the time of performance it is not  unreasonable  to  expect  ultimate  collection.  If  at  the  time  of raising of any claim it is unreasonable to expect ultimate collection, revenue recognition should be postponed.

11. In a transaction involving the sale of goods, performance should be regarded as being achieved when the following conditions have been fulfilled:

(i)   the seller of goods 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; and

 

(ii)  no significant uncertainty exists regarding the amount of the consideration that will be derived from the sale of the goods.”

 11. The  Committee  is  of  the  view  that  the  time  of  transfer  of  all significant  risks  and  rewards  of  ownership  may  be  different  from  the time of transfer of legal ownership. The question whether 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, is a question of facts and circumstances of each case. For this purpose, factors such as who will bear the loss in case  the  goods  are  destroyed,  risk  of  loss  in  transit,  the  rights  of  the unpaid seller, etc., will have to be considered in each case of sale. The Committee is of the view that in an FOR destination contract, normally significant risks and rewards incidental to the ownership of the goods are transferred on delivery of the goods at destination, unless  the terms of the contract stipulate otherwise. Thus, where keeping in view the facts and circumstances of each case, it is established that the risks and rewards in  the  goods  are  transferred  only  on  goods  reaching  the  destination, revenue in respect thereof should be booked at that time.

12.   In view of the above, efforts should be made to obtain certificate of delivery  so  as  to  establish  whether  delivery  to  the  destination  of  the clients took place within the relevant accounting year. In case, however,it is not feasible to obtain certificate of delivery, the estimates of average time taken to deliver the goods to the respective clients should be made. Such estimates of the average time taken to deliver goods to the respective clients should be based on past experience and other relevant factors. In order to ensure that the average arrived at is a representative figure, there should be a fairly large number of orders on which the average is based. The  auditor  should  apply  the  principles  and  procedures  stated  in  the Statement on Standard Auditing Practices (SAP) 18, ‘Audit of Accounting Estimates’, while auditing this item.

D. Opinion

13. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 9:

(a) The practice of recognising ‘FOR Destination’ despatches as sales on the basis of estimated date of delivery is appropriate provided  such  estimates  have  been  arrived  at  in  accordance with paragraph 12 above. Otherwise, efforts should be made to obtain certificate of delivery so as to establish whether delivery to the clients took place within the relevant accounting year.

 

(b)  Please see (a) above.

 

(c)  The  auditor  should  normally  obtain  sufficient  appropriate evidence of goods having reached their destination as stated in paragraph 11 above. However, where estimated average time taken is used as the basis, the auditor may apply the principles and  procedures  stated  in  SAP  18,  ‘Audit  of  Accounting Estimates’.

 

(d)  Yes,  the  accounting  policy  in  respect  of  ‘FOR  Destination’ contracts should be modified to state that the sale is recognised on goods having reached the destination or on the basis of the estimated  average  time  taken  to  reach  the  destination  of  the respective clients.

¹ Opinion finalised by the Committee on 14.4.2001.