Query No. 14

Subject:

Booking of export sales/purchases of wheat and rice under subsidised quota of the

Government of India, purchased from another government undertaking. ¹

A. Facts of the Case

1. A company is a central public sector undertaking (hereinafter referred to as ‘the company’) under the administrative control of the Ministry of Commerce, Government of India, and is engaged in trading activities by way of export, import and domestic trade. It is purely a trading house. The company was a government canalised agency upto decanalisation era. Total turnover of the company during financial year 2003-04 was Rs. 8348.76 crore. The company, in addition to many other items, also exported wheat/ rice under the Government allocation from another government undertaking (hereinafter referred to as ‘the undertaking’) on subsidised rates during financial years 2003-04 and 2004-05. No private party was entitled to export these items directly from the undertaking.

2. The querist has summarised certain basic facts of the case, which are as below:

(i) Allocation of wheat and rice is done by the Ministry to the company from the undertaking at the specific rates.

(ii) Accordingly, the undertaking sells wheat and rice only to the company.

(iii) Purchase price is paid by the company to the undertaking through demand draft (DD).

(iv) Release order is given by the undertaking in the name of the company.

(v) RR/LR are in the name of the company.

(vi) Export order is in the name of the company though arranged by business associates.

(vii) The company issues sales tax declaration Form-H to the undertaking.

(viii) Letter of credit is opened by the importer in favour of the company.

(ix) Export documents are in the name of the company.

(x) Export packing credit (EPC) from the banker is availed by the company.

(xi) Bills are negotiated through the company’s banker and the proceeds are used to discharge the EPC availed.

(xii) Stock is hypothecated to the company’s banker and the bank has lien over the goods towards the EPC given to the company.

(xiii) The port trust holds the stock for the company.

(xiv) The company is the beneficiary of the insurance policy.

(xv) Risks and rewards of ownership of goods, as per the querist, are always with the company. In other words, at no point of time, risks and rewards of ownership of goods are transferred to business associates.

3. The querist has stated that to execute the export commitment and trading operations, the company is having an arrangement with its business associates to undertake the following activities:

       (i) Lifting the material from the godown of the government undertaking to port towns by road or rail.

       (ii) Receiving the material at the port town and moving them to the godown/transit port area.

       (iii) Segregation, if necessary, as per the requirement of the buyers.

       (iv) Arranging shipments as and when vessels take berth.

       (v) Fumigation of stock.

       (vi) Quality analysis.

       (vii) Arranging necessary documents for negotiations by the company.

4. The querist has stated that the company is primarily a trading entity and contracting party. It procures and sells goods as required by its associates on their behalf. It is one of the intermediaries in the process of trading. The procurement and supply is undertaken for and on behalf of business associates by the company. The company is having a fixed trade margin on export quantity, i.e., on Bill of Lading quantity. It takes 15% of the procurement price as a margin from the associates. Wherever the company is availing EPC/PCFC from its bank, interest cost is also being recovered from the associates. The agreement with the associates has clauses for indemnity to the company and recourse on the associate for any damages that may arise to the company under the contract. All the consideration for procurement and disposal flow through the company. The company remits the net cash flows less its fixed margin and the expenses incurred, to the associate.

5. According to the querist, the company records the purchases and sales against the above contracts based on the legal and contractual obligations assumed by the company and transfer of title to the goods passing through it under the contract. The Government Audit Party (GAP) is of the view that there is a violation of Accounting Standard (AS) 9, ‘Revenue Recognition’, issued by the Institute of Chartered Accountants of India, in recognising the purchase and sales since,

(a) the company is trading only with a fixed margin;

(b) all the activities from lifting of the material to the shipment are carried out by the associate; and

(c) the contract provides for indemnity to the company and allows the company to recover losses, if any, ultimately from the associate.

According to the GAP, “the risks and rewards are with the associate and there is an assignment of the contract to the associate”.

6. As per the querist, the company is of the view that AS 9 deals only with the timing of recognition of revenue and does not deal with the question of ownership which is more fundamental. Also, AS 9 does not deal with accounting for purchases. The ownership in the goods is passed on by the government undertaking to the company and the company has to book the purchases. According to the querist, the ownership rests throughout with the company until it is transferred by the company to the foreign buyer and it would be wrong if the company does not recognise the purchase and sale. Restricting its trade margin, is the company’s decision based on commercial considerations. The clauses for indemnity, etc., in the contract only provide for recourse to the company in case of loss but at first, the risk falls only on the company. AS 9 requires consideration of risks and rewards of ownership (emphasis supplied by the querist). Risks and rewards cannot be separated from ownership and AS 9 does not anywhere state that if there is anybody who has been made responsible for the risks, he will become the owner. The querist has argued that it should be appreciated that if such be the case, since all the risks are covered by insurance, the insurance companies would become the owner. According to the querist, all the documents and the events as per items (i) to (xv) of paragraph 2 above, confirm that the ownership of the goods rests with the company and, accordingly, purchases should be booked by the company.

7. The querist has also brought to the notice of the Expert Advisory Committee, two opinions issued by the Committee on booking of purchases and sales made through business associates vide Queries No. 1.17 and 1.18 of Compendium of Opinions, Volume XVI, wherein, as per the querist, the Committee has clearly opined that the fact to be seen is whether the ownership in the goods passes on to the company or not. Although, as per the querist, the present query is addressed by the above opinions, the Member, Audit Board (MAB) has desired that a fresh opinion may be sought.

B. Query

8. The opinion of the Expert Advisory Committee is sought on the following issues:

   (i) Whether booking of the purchases and sales by the company is in order.

   (ii) If not, what should be the correct accounting treatment?

   (iii) Whether the company is required to disclose such purchases and sales in the notes to accounts as a contravention of AS 9.

   (iv) Whether AS 9 is applicable for booking of such purchases.

   (v) Whether such purchases and sales are to be treated as assignment.

C. Points considered by the Committee

9. The Committee notes paragraph 17(b) of Accounting Standard (AS) 1, ‘Disclosure of Accounting Policies’, issued by the Institute of Chartered Accountants of India, which states as follows:

“17(b) Substance over Form

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.”

10. The Committee notes from the above that the transactions and events are accounted for and presented in accordance with their substance, i.e., the economic reality of events and transactions, and not merely in accordance with their legal form. In other words, it is the ‘economic reality’ that is important in accounting and not only the ‘legal reality’. In the context of revenue recognition, the principle of ‘substance over form’ is recognised by paragraph 6.1 of AS 9 as reproduced below:

“6.1 A key criterion for determining when to recognise revenue from a transaction involving the sale of goods is that the seller has transferred the property in the goods to the buyer for a consideration. The transfer of property in goods, in most cases, results in or coincides with the transfer of significant risks and rewards of ownership to the buyer. However, there may be situations where transfer of property in goods does not coincide with the transfer of significant risks and rewards of ownership. Revenue in such situations is recognised at the time of transfer of significant risks and rewards of ownership to the buyer. Such cases may arise where delivery has been delayed through the fault of either the buyer or the seller and the goods are at the risk of the party at fault as regards any loss which might not have occurred but for such fault. Further, sometimes the parties may agree that the risk will pass at a time different from the time when ownership passes.” (Emphasis supplied by the Committee.)

11. In the context of the query, the Committee notes that while the legal form is that the title to the goods passes on to the company, the substance of the transaction is that the company in question is only an agent of the business associates because of the following factors:

(a) The querist has specifically stated in paragraph 4 above that the company undertakes procurement and supply for and on behalf of business associates.

(b) The company is getting only a fixed percentage of trade margin as its service charges. It is specifically stated in paragraph 4 above that the company remits the net cash flows less its fixed margin and the expenses incurred, to the associate, which means that the risk of profit or loss arising out of the whole transaction is borne by the business associate and not by the company. The company is assured of its fixed margin and, therefore, it does not bear the risk of loss on this account.

(c) The agreement between the company and associates (a copy of which has been separately provided by the querist for the perusal of the Committee) clearly states that the business associate will indemnify the company against all claims/liabilities, if any, under the export contract.

(d) It is clear from the agreement with the business associate that most of the expenses such as letter of credit charges, amendment and negotiation fees, export duties/fares, survey/inspection charges, etc. are to be borne by the business associate. Also, the risk of inspection and quality is to be borne by the business associate.

(e) It is clearly mentioned in the above-said agreement that the business associate is fully responsible as to the correctness of the export price etc. and role of the company is limited to arranging EPC funds etc. and facilitating release of allocations for rice from the government undertaking.

12. With regard to the arguments advanced by the querist in paragraph 6 above, the Committee notes that the principle of substance over form does separate legal ownership from significant risks and rewards of ownership. In other words, while AS 9 does not state that if the buyer is made responsible for the risks he will become the owner, it does provide that in case significant risks and rewards in the goods are transferred to the buyer then only the sale should be booked by the seller. With regard to the argument advanced by the querist that if risks be the determining factor for becoming an owner, the insurance company will be the owner of all the goods, the Committee is of the view that this argument is fallacious since AS 9 nowhere states that the transfer of significant risks and rewards of ownership results into the transferee becoming the owner of the goods. Further, the insurance company may assume the risks yet it does not get the rewards from the goods and for recognition of revenue, it is the transfer of both significant risks and significant rewards that is of paramount importance. In other words, as per paragraph 6.1 of AS 9 (as reproduced in paragraph 10 above), in a situation where significant risks and rewards of ownership are transferred, it is not necessary that the property in the goods, i.e., the legal ownership is also transferred. On the transfer of significant risks and rewards of ownership, the buyer becomes the ‘economic owner’ of the goods even though he is not the legal owner of the goods. This principle has been recognised in many other accounting standards, for example, Accounting Standard (AS) 19, ‘Leases’, issued by the Institute of Chartered Accountants of India, recognises that in the situation of a finance lease, the lessee should show the assets acquired under such a lease in his balance sheet, even though he is not the legal owner of the assets.

13. The Committee agrees with the querist that AS 9 does not deal with recognition of purchases by a buyer. The Committee is, however, of the view that the principle of recognition of revenue stated in AS 9 can be extended to recognition of purchases by the buyer. The Committee is, therefore, of the view that just as the seller should recognise sale on the transfer of significant risks and rewards of ownership in the goods, the buyer should recognise the purchases when he assumes significant risks and rewards of ownership in the goods. Accordingly, in the view of the Committee, the buyer can recognise purchases, only when he has acquired significant risks and rewards of ownership in the goods.

14. The Committee also notes that the opinions of the Expert Advisory Committee on Queries No. 1.17 and 1.18 contained in Volume XVI of the Compendium of Opinions are based on the consideration of transfer of ‘significant risks and rewards of ownership’ and not on whether the ‘ownership’ in the goods is passed on as claimed by the querist in paragraph 7 above. On this consideration, the Committee had opined that since the significant risks and rewards in the goods do not pass on to the concerned trading company, it cannot book the purchases/sales made on behalf of the business associates as its own purchases and sales.

15. On the basis of the above, the Committee is of the view that although the ownership of goods vests with the company, the significant risks and rewards from the ownership of goods vest with the business associates. Hence, in the present case, the company is merely an agent of the business associate and therefore, it should not recognise sale and purchase of goods in its books of account, but should recognise only the service charges as its revenue.

D. Opinion

16. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 8 above:

(i) No, booking of the purchases and sales by the company is not in order.

(ii) The correct accounting treatment would be to recognise only service charges as its revenue.

(iii) Since the company should not recognise such purchases and sales in its books of account, the question to disclose the  same as purchases and sales in the notes to accounts does not arise. However, the company may, if it so desires, disclose the gross amounts of the transactions in the notes to accounts, but not as purchases and sales.

(iv) No, AS 9 is applicable in respect of revenue recognition only. However, its principles can be extended to recognition of purchases, as stated in paragraph 13 above.

(v) Since purchases and sales are made on behalf of the business associates, the company in question is acting, in substance, only as an agent.