Expert Advisory Committee
ICAI-Expert Advisory Committee
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Query No. 27

Subject:

Books of account of franchise business and accounting implications thereof. 1

 

A. Facts of the Case

1. A public limited company is engaged in the business of manufacturing and marketing of country liquor, spirit and IMFL (Indian Made Foreign Liquor). It is engaged in the business of manufacturing of IMFL products of certain brand owners under an arrangement with them.

2. The querist has stated that the liquor is subject to state excise. It involves import duty on purchase of goods from another state and export duty implication on the sale of goods to the buyers located in another state (within India). Such duties on purchases and sales are called as import duty and export duty, respectively. Hence, the brand owners are getting their products manufactured and sold through manufacturing entities located in respective states. Further, being non-excise licensees for the concerned states, the brand owners are not allowed to do business in their name.

3. The products are being manufactured and sold in the name of the company. Being the permit based business, excise licences are also in the name of the company. Import permits for the purchase of finished goods by out of the state buyers are being obtained in favour of the company from the concerned state excise department and the export permit in respect of the same are being released in the name of the company by Madhya Pradesh Excise Department (for each consignment). The purchase invoices in respect of raw material, packing material and consumables are being issued in the name of the company (inspite of the fact that the purchases of the same are in absolute control of the brand owners). The sales invoices for the finished goods are also being issued in the name of the company (strictly in accordance with the specifications and instructions of the brand owners). The special bank account for the operation of the said business is also operated in the name of the company.

4. The necessary compliances under sales tax (filing of returns, necessary declarations/‘C’ Forms, assessments etc.), income tax (TDS, TCS under section 206C, etc.) and service tax on Goods Transport Agency (GTA) (registration, return, payment etc.) are also being done in the name of the company.

5. According to the querist, the business is under the control of the brand owners; they decide purchases (price, parties, quality and other terms/conditions) and sales (price, parties and other terms/conditions). The company is acting under the instructions/ specifications of the brand owners in accordance with the agreement executed between the parties.

6. The business is funded by the brand owners. The assets of the business (consisting of inventory, debtors/other current assets) and liabilities (creditors for supply of raw material, packing materials and consumables) are appearing in the name of the company but the company is under the obligation to deal with the assets in accordance with the instructions of the brand owners and is having right to recover/indemnify itself against the liabilities/losses arising, if any, in the said business.

7. The company is working for a fixed charge/ margin per case by using its factory/other infrastructure (irrespective of profits and losses of the business). The separate set of books of account, including inventory records are maintained by the company in respect of the arrangement with each concerned brand owner for the said business. The surplus in the business is being withdrawn by the brand owners as “brand owners entitlement” and in case of deficit (losses), the same will be funded/borne by the brand owners.

8. The querist has also referred the following issues for the consideration of the Expert Advisory Committee in the given situations:

(i) When the books of the business are considered to be forming part of the books of account of the company


(a) The documents of the transactions of the business (purchase/sales invoices, licence, permits related TCS certificates under section 206C, TDS certificates in respect of the payments/expenses) are in the name of the company. On the basis of supportings vis-a-vis the provisions of section 209(1) of the Companies Act, 1956, if the books of account of the business are treated to be forming part of the business of the company, the issue of implication of TDS on the brand owners entitlement vis-à -vis accounting implication on presentation of the same in the profit and loss account needs to be analysed.


(b) According to the brand owners, since they are responsible for the profit/ loss of the business, including the liabilities of the business, if any, (in spite of holding the same in the name of the company in view of technical requirements of excise laws) the said withdrawal is basically the surplus from the business. Hence, no implication of TDS would arise under any of the provisions of part B of Chapter XVII of the Income-tax Act, 1961. The querist has requested the Committee to consider the situation of treating books of account of the said business as forming part of books of account of the querist company in view of the provisions of section 209 (1) of the Companies Act, 1956 alongwith the relevant documents and at the same time, non-implication of TDS on the debit to the profit and loss account as the brand owners entitlement.


(ii) When books of the business are not considered to be forming part of the books of account of the company


Alternatively, if the company decides about non-inclusion of the said business in the financial statements of the company (in spite of sales/purchases etc., lying in the name of the company), the querist has referred the following issues:


(a) Differences in the details of TDS/TCS certificates issued vis-a-vis income-tax return filed and the books of account considered for the purpose of financial statements (as TDS/TCS pertaining to the division will not be included in the financial statements of the company). What would be the implication of delay/default in respect of the same vis-à -vis provisions of section 40 (a) and (ia) of the Income- tax Act, 1961 in the assessment of the company?


(b) Further, since the supporting documents are not in the name of the brand owners (inspite of the control, risks/rewards of the business), they are not in a position to consider the said transactions in their financial statements. In case of non-inclusion of the same in the financial statements of the company, what would be the implication?


(c) Further, in case of non-inclusion of the said business, in the financial statements, how the company is going to justify itself for issuance of TDS/TCS certificates and payments of service tax in respect of the said business?


(iii) Accounting treatment alongwith implication of the TDS on the brand owners entitlement.


B. Query

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

(i) What is the correct accounting treatment of the said transactions?


(ii) Whether the books of account of the business shall be forming part of books of account of the company or of the brand owner.

C. Points considered by the Committee

10. The Committee notes from the Facts of the Case that basically there are three issues raised by the querist, viz., (i) accounting treatment of the transactions carried on by the company in respect of the business of IMFL products on behalf of the brand owners, (ii) whether books of account of the said business shall form part of the books of account of the company or of the brand owners and (iii) Income-tax, TDS/TCS and other legal implications of the said transactions. Regarding the third issue, the Committee has not expressed any opinion since as per Rule 2 of the Advisory Service Rules of the Expert Advisory Committee, the Committee does not answer queries involving legal interpretation of various enactments. The opinion of the Committee, expressed hereinafter, is therefore, only from the accounting point of view.

11. The Committee notes paragraph 17(b) of Accounting Standard (AS) 1, ‘Disclosure of Accounting Policies’, which states as follows:

           “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.”

12. 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 from. In other words, it is the ‘economic reality’ that is important in accounting and not only the ‘legal reality’. From the Facts of the Case, the Committee notes that while the legal form is that all the documents such as excise licenses, import permits, purchase invoices in respect of raw material and packing material, sales invoices in respect of finished goods, special bank account for the operation of the said business, etc., are in the name of the company, the substance of the transaction is that the company is acting only as an agent of the brand owners as the significant risks and rewards of the business vest with the brand owners which is clear from the following facts:

(a) The querist has specifically stated in paragraph 5 above that the business is under the control of brand owners and the company is just acting under the instructions/ specifications of the brand owners.


(b) The company is getting only a fixed charge/margin per case irrespective of the profits or losses of the said business. The surplus of the business is being withdrawn by the brand owners and in case of deficit (losses), the same will be funded/borne by the brand owners.


(c) The company has the right to recover/indemnify itself against the liabilities/losses, if any, arising during the course of business. Thus, all significant risks related to the business are assumed by the brand owners.


(d) The control over the assets vest with the brand owners as the company is under obligation to deal with the assets in accordance with the instructions of the brand owners.


The liabilities of the business are also assumed by the brand owners.


(e) The terms and conditions related to purchases and sales such as price, parties, quality, etc. are decided by the brand owners.

13. On the basis of the above, the Committee is of the view that since the significant risks and rewards related to the ownership of IMFL products do not vest with the company, the sales and purchases of the said products should not be recognised in the books of account of the company; instead these should be recognised in the books of account of the brand owners. Similarly, the assets and liabilities of the said business should also not be recorded in the books of account of the company as these are being controlled by the brand owners, even though the supporting documents in respect of the same are being maintained by the company. The company should recognise its fixed charge/margin as its income in its financial statements. Regarding the accounting treatment of the brand owners’ entitlement, the Committee is of the view that surplus from the business which is the brand owners’ entitlement and withdrawn by the brand owners, is merely a cash outflow for the company and should, therefore be recorded as such in the books of the company. Hence, any such entitlement due to the brand owners should be credited to their respective accounts in the books of the company.

14. As far as the books of account to be kept by the company is concerned, the Committee notes that section 209(1) of the Companies Act, 1956, provides as follows:

             “209.(1) Every company shall keep at its registered office proper books of account with respect to –

(a) all sums of money received and expended by the company and the matters in respect of which the receipt and expenditure take place;


(b) all sales and purchases of goods by the company;


(c) the assets and liabilities of the company; and


(d) in the case of a company pertaining to any class of companies engaged in production, processing, manufacturing or mining activities, such particulars relating to utilisation of material or labour or to other items of cost as may be prescribed, if such class of companies is required by the Central Government to include such particulars in the books of account ...”

On the basis of the above and considering the fact that sales, purchases, assets and liabilities in respect of the business of IMFL products should not be recognised in the financial statements of the company, the Committee is of the view that for the purposes of Companies Act, 1956, the books of account maintained that enable the company to reflect various items of income (e.g. fixed charge per case) and expense in the financial statements of the company should be deemed to be the books of account of the company. In this regard, the Committee also wishes to again point out that the opinion expressed by the Committee is purely from the accounting point of view without consideration of any implications thereof, from the point of view of the provisions of TDS/TCS, Income-tax Act, 1961, or any other legal/statutory requirement.

D. Opinion

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


(i) The correct accounting treatment of the said transactions in the books of account of the company would be to recognise only the fixed margin/charge received by it rather than to recognise sales and purchases of the business of IMFL products as discussed in paragraphs 12 and 13 above. The company should also not recognise any asset or liability of the said business in this regard in its books of account. The brand owners entitlement paid by the company should be booked as a mere cash outflow. On the other hand, the brand owners should recognise the sales, purchases, assets and liabilities of the said business as their own, in their books of account.


(ii) Books of account of the company for the purposes of the Companies Act, 1956, should be the books of account maintained that enable the company to reflect various items of its income (e.g., fixed charge per case) and expense in the financial statements of the company. Sales, purchases, assets and liabilities relating to the business controlled by the brand owners should not be recorded in the books of account of the company even though supporting vouchers are in the name of company and are maintained by it.

1Opinion finalised by the Committee on 17.1.2007