Expert Advisory Committee
ICAI-Expert Advisory Committee
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Query No. 5

 

Subject:

Accounting treatment of commission to service agents and cash discount.1

 

A. Facts of the Case

 

1. A public sector company is basically engaged in the manufacture and supply of life saving drugs for meeting the requirements of Central/State Government institutions/hospitals. The company also caters to the requirements of retail market. Since its inception, the company is having significant business in the institutional sector. As per the industry practice, the company is marketing its products through the channels of distribution which involve either a stockist or a distributing service agent.

 

2. The responsibilities of the distributing service agents, inter alia, include the following:

(a) Assist the company in approaching institutions for generation of orders in favour of the company.

 

(b) After receipt of order, co-ordinate for distribution of the stocks from the company’s godown to the various peripheral institutions identified by the indenting institutions.

 

(c) Obtain acknowledgements from the institutions including peripheral institutions (like public health centres, etc.) to whom the stocks have been despatched.

 

(d) Furnish the acknowledgements so obtained to the respective paying authorities in the Government who are generally located in the district headquarters.

 

(e) Follow up for passing of the bills by the concerned approving authorities/paying authorities/treasuries, etc.

 

f) Collect appropriate forms from the institutions for charging concessional rate of tax/exemption from tax under the relevant sales tax laws.

 

(g) Ensure prompt realisation of the sale proceeds for the supplies made to the institutions by the company.

3. According to the querist, though the agent is expected to carry out all the above responsibilities, the most critical parameter of the performance of the service agent is collection of payments in time. Therefore, based on the above parameter, the commission structure has been designed by the company. The illustrative structure of payment of commission to service agents is as under:

Collection              Commission

Period (in days)                   %

1-15                                    10

16-30                                   9

31-45                                   8

46-60                                  6

61-75                                  5

76-90                                  4

91-120                                3

Beyond 120                         0

As may be seen from the above table, the percentage of commission keeps on decreasing as the number of days taken to realise the payment increases, and beyond a specific period the commission payable on realisation is nil. Hence, the receipt of sale proceeds is the most critical activity in the performance of the obligations of the service/distributing agents as per the terms of the contract and in its absence, performance is not considered to be complete.

 

4. As per the querist, the terms of the service agreement provide that for the purpose of determining the rate of remuneration/commission payable for realisation of sale proceeds, the payment is deemed to have been realised on the date on which the valid cheque/DD is received by the company subject to its encashment. The company does not recognise any obligation towards commission on procurement of the order by the agent. The obligation to pay commission arises only when the sale proceeds are realised, i.e., in the year of receipt of sale proceeds from the institutions as per the terms of the agreement.

 

5. On receipt of the sale proceeds, the company recognises the obligation and makes a provision for commission in the books of account pending receipt of formal claim from the service agent concerned. Accordingly, where the sale proceeds are not received as at the end of the year, no provision is made. The commission is accounted for in the subsequent financial year only if the sale proceeds are received within the stipulated period as per the terms of the agreement. If the sale proceeds are not realised or are realised beyond the specified period as shown in the table above, no commission is payable to the service agent.

 

6. The company similarly allows cash discount to other customers who purchase the goods and make payment within the specified period.

 

7. Keeping the above in view, the company, at present, recognises the accrual of the expenditure towards commission/cash discount at the point of realisation of the sale proceeds as the obligation to pay commission/cash discount accrues only on realisation of the sale proceeds within a stipulated period and the quantum of which varies with the period. This practice has been followed by the company consistently since inception.

 

8 The statutory auditors of the company are, however, of the opinion that based on the ‘matching concept’, commission should be recognised as expenditure in the year of sale, even though the sale proceeds are not realised in that financial year. Although the statutory auditors have not taken exception to the method of accounting of cash discount, the company is of the opinion that the accounting issues involved are quite similar.

 

B . Query

 

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

(i) At what point of time does a ‘present obligation’ arise in respect of commission:

 

(a) Upon receipt of the order?

(b) On the company issuing an order confirmation?

(c) On delivery by the company against the order booked?

(d) On collection of the sale proceeds?

(e) On performing all the other obligations including collecting the sales tax declarations? 

(ii) At what point of time does a ‘present obligation’ arise in respect of cash discount:

 

(a) At the point of time of the sale?

(b) On realisation of the sale proceeds?

 

(iii) Accordingly, whether the practice presently followed by the company of recognising liability towards commission/cash discount only on realisation is correct.

 

(iv) If not, at what point of time should the company make a provision towards the commission payable/cash discount? Further, what should be the basis of provision which would be considered to be reliable in terms of paragraph 90 of the ‘Framework for the Preparation and Presentation of Financial Statements’, issued by the Institute of Chartered Accountants of India, as the percentage of commission payable/cash discount depends upon the number of days taken for realisation of sale proceeds and beyond certain stipulated period it is zero? Past history cannot be a guiding factor for estimation as the payment depends upon the present and future liquidity of the customer.

C. Points considered by the Committee

 

10. The Committee notes that the term ‘Accrual’ has been described in Accounting Standard (AS) 1, ‘Disclosure of Accounting Policies’, issued by the Institute of Chartered Accountants of India, as follows:

"Revenues and costs are accrued, that is, recognised as they are earned or incurred (and not as money is received or paid) and recorded in the financial statements of the periods to which they relate."

According to AS 1, ‘Accrual’ is a fundamental accounting assumption underlying the preparation and presentation of financial statements.

11. The Committee notes that the query basically relates to the issue about the point of time at which the commission to service agents and cash discount to other customers for prompt payment accrue for the purpose of recognition in the financial statements. According to the description of the term ‘accrual’ reproduced above, expenses should be recognised when they are incurred by the enterprise. Similarly, a liability or a provision therefor should be recognised when it accrues. As per the generally accepted accounting principles, a liability or a provision therefor accrues when an obligation arises. The Committee is of the view that in case of ‘service agent commission’, the obligation of the company arises only when a service agent collects the sale proceeds as per the prescribed time schedule and in the case of ‘cash discount’, the obligation of the company arises only when a customer makes the payment of the bill raised by the company within the prescribed time schedule.

 

12. The Committee is of the view that as far as ‘matching concept’ is concerned, which is an inherent aspect of accrual, the expenses of commission to service agents and cash discount allowed to the customers for prompt payment are matched with the saving of interest that is effected to the enterprise due to early receipt of sale proceeds/payments from customer. This is because the purpose of allowing commission and cash discount is to save interest on the proceeds realised from the service agents and customers before the end of the specified period.

 

D. Opinion

 

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

 

(i) The present obligation of the company in respect of commission to service agents arises only on collection of the sale proceeds.

 

(ii) Similarly, the present obligation in respect of cash discount arises on realisation of the sale proceeds from the customers.

 

(iii) Yes, the practice presently followed by the company of recognising liability towards commission/cash discount only on realisation is correct.

 

(iv) In view of (iii) above, there is no requirement of making a provision towards the commission payable/cash discount.

1Opinion finalised by the Committee on 25.3.2003.