A. Facts of the Case
1. Company B is engaged in the business of providing
infrastructure and marketing services for the telecommunication
industry. Company B is a 100% subsidiary of Company A, which is
a listed public company engaged in the business of providing
telecommunication services in India under a telecom license.
2. The ‘wireless’ business segment contributes about 75%
towards the total revenue of Company A on a consolidated basis.
Company A provides wireless telephony services by using Code
Division Multiple Access (CDMA) technology. The services are
provided through wireless telephone handsets, which are dedicated
to the network of the telecom service provider (as against Global
System for Mobile Communications (GSM) handsets which can be
used on any GSM network by changing the Subscriber Identity
Module (SIM) Card provided by the telecom operator). As per the
marketing arrangements between Company A and Company B, all
telephone subscribers are provided with the mobile connectivity
through Company A’s network (pursuant to holding a telecom
license) and the wireless handsets are provided by Company B.
3. Company B procures handsets from third party vendors and
sells them to third party distributors/dealers and retailers. All these
transactions are on a principal to principal basis. Company B sells
these handsets to the distributors/dealers and retailers at a
significant discount on the Maximum Retail Price (MRP). The
Company gets a Value Added Tax (VAT) credit on purchase and
pays VAT on sale of the handsets. The prices are reviewed on a
monthly basis. The historical data shows that these prices have
always been significantly lower than the cost at which Company B
acquired handsets from third party vendors.
4. The querist has informed that in the stand-alone financial
statements of Company B, the sale of handsets is netted off against
the purchase cost and the excess of purchase cost over sale
proceeds is included in the ‘Sales and Distribution Expenses’,
which are disclosed on a net basis in the profit and loss account.
In the consolidated financial statements of Company A, from the
Group’s point of view, the following note appears in the notes to
the consolidated financial statements:
“One of the main businesses of the Group is operating Mobile
Telecom Network. The Group is not engaged in the business
of trading in handsets required for accessing the Mobile
Telecom Network and consequently, purchases and sales of
handsets are not reflected as a trading activity. However, the
Group is required to provide such handsets to its customers
as a part of the marketing activity related to the Mobile Telecom
Network. The Group, therefore, provides such handsets after
purchasing them, the provision normally, being at a discount
to the acquisition price. The net loss on the provision of
handsets, including subsidies/commission given to distributors
and dealers, amounting to Rs. XXX is included as a part of
Selling Expenses”.
Further, the querist has mentioned that this view is based on the
argument that from the Group’s point of view, the purchase and
sale of handsets (at a conscious loss) is purely from the point of
view of acquiring a customer on the network. Hence, the excess
of purchase cost of handsets over the amount recovered from the
subscriber should be disclosed as selling and marketing cost in
the stand-alone profit and loss account of Company B and in the
consolidated profit and loss account. This view is based on the
substance of the transaction.
5. The querist has mentioned that there is a contrary view
according to which the sale and purchase of handsets should be
disclosed on a gross basis in the stand-alone profit and loss account
of Company B and consequently, in the consolidated profit and
loss account of the Group. This view is based on the following:
(i) Accounting Standard (AS) 9, ‘Revenue Recognition’,
clearly states that revenue is the gross inflow of cash,
receivables or other consideration arising in the course
of the ordinary activities of an enterprise from the sale of
goods, from the rendering of services, and from the use
by others of enterprise resources yielding interest,
royalties and dividends. Revenue is measured by the
charges made to customers or clients for goods supplied
and services rendered to them and by the charges and
rewards arising from the use of resources by them. Sale
of handsets clearly falls within this definition.
(ii) Not showing purchases and sale of handsets separately
would also not be in consonance with the requirements
of Part II of Schedule VI to the Companies Act, 1956.
The sale of handsets is a sale as per law. This sale is a
part of the operating activities of the Group without which
the telephony service cannot be provided.
(iii) Sale of handset at a loss to customers is a part of a
bundled contract, where such a sale is made at a loss in
anticipation of the profit that the company will earn based
on future usage by the customer.
(iv) A specific value/benefit is delivered to the company’s
customer and is not a general expense incurred towards
promotion of the company’s products.
(v) These are considered as sale and purchase from the
perspective of sales tax/VAT laws. The company should
not take a different view in determining the nature of the
transaction for accounting in its books.
(vi) The handset is an essential element in provision of
telecom services by the Group and it would therefore not
be appropriate to view the provision of the same to the
customers as just a marketing activity. Further, it can
also be argued that the handsets sold by the Group are
unique to its network and in substance the Group looks
at the total recoveries from a customer and not at the
break-up of these recoveries between those for handsets
and those for services. Purchase and sale of handsets is
thus an essential part of the operating activities of the
Group.
(vii) Net reporting of revenue is an exception rather than a
rule and therefore, may not be resorted to unless there
is a clear support for the same. Such support does not
seem to be available for offsetting sales to customers
against purchases from suppliers of handsets.
6. The querist has provided the following views that support the
disclosure of handset expenses as a marketing expense:
(i) AS 9 and Schedule VI require disclosure of gross
revenue. They do not require disclosure of partial
recoupment of “cost” as revenue. In substance, the
company is required to provide at its cost, handsets to
its customers as there is no independent market where
customers can acquire handsets. Therefore, it would be
necessary to provide the handsets to customers before
the company can sell airtime. The company would have
to incur the capital “cost” of handset, permit use and
recover the handset from the customer getting out of the
network. In fact, the company follows this route on sale
of fixed line telecom services. But given the volume of
mobile customers, it is practically impossible to keep
track of handsets. The company therefore gives away
the handset, safe in the knowledge that the customer
cannot do anything else with the handset as it can only
be used on the company’s network. The company is
able to recoup a part of the cost of the handset from the
customers. It is clearly not a “sale” price. It is impossible
to conceive that as a consistent long term policy a
business is carried on, on the basis that the “sale price”
is lower than “cost”. The recovery from the customer is
not “sale price”, it is recoupment of cost. The unrecouped
cost is correctly written off as a marketing expense.
(ii) Disclosure of sale price as part of trading business will
result in incorrect information to the reader of the financial
statements. It will imply that the company is in the
business of “trading” in handsets whereas the company
is not engaged in such a business unlike manufacturers
and dealers of handsets (mostly GSM handsets of general
use). Schedule VI refers to the turnover of goods “dealt
in” by the company. Handsets are not such goods.
(iii) The bundled service concept does not apply in case of
the company as it does not insist that the customer who
buys the handsets (and therefore is the recipient of a
subsidy) should have a long term contract with the
company. The customer is free to stop paying for the
network services at any time. The company may not
recover the balance of the marketing loss. The company
thus gives an upfront subsidy to attract a customer. The
company is able to reduce the upfront subsidy from an
amount equal to the entire cost of the handset (it would
have to give the handset free if it wants to sell airtime) to
a lesser amount as customers are willing to reimburse
(pay for) a part of the cost incurred by the company. The
customers have no interest in buying handsets as they
(the handsets) have no other use except on the
company’s network. What the customer pays is not really
the price of the handset. It is a product which has no
other use to him.
(iv) Handsets are capital equipment. A part of the capital
cost is recovered from the customer. The balance of the
cost is written off as a marketing expense as the company
has given up the ownership of the asset. This is the
essence of the accounting treatment adopted by the
company. To reflect this as a trading activity would be
contrary to the truth.
(v) The law relating to VAT is based on different concepts
and cannot be used to determine accounting principles.
(vi) It is true that net reporting of revenue is an exception.
But an item which is not revenue cannot be reported as
revenue. Gross reporting of recoupment of capital cost
as revenue would be incorrect accounting. The company’s
method of accounting does not report net revenue. It
reports “expense” or “loss” and correctly reports the net
expense or loss suffered by the company. The error is in
approaching an expense item as a revenue item. As an
expense item, it is correct and normal to report net
expense, net of recoveries. That is the method followed.
It is not an exception. It is normal accounting.
B. Query
7. The querist has sought the opinion of the Expert Advisory
Committee on the issue as to whether the current accounting
policy for disclosure of net loss on the supply of handsets to
airtime customers as marketing expenses in the profit and loss
account is appropriate or should purchase and sale of handsets
be disclosed separately as constituting trading turnover of products
dealt in by Company B.
C. Points considered by the Committee
8. At the outset, the Committee wishes to clarify that the opinion
sought by the querist relates to the accounting policy for the
disclosure of mobile handset expenses to be adopted in the
preparation and presentation of the stand-alone financial statements
of Company B and the consolidated financial statements of the
Group. The Committee also wishes to state that the opinion given
hereinafter is based on the extant generally accepted accounting
principles in India.
Stand-alone Financial Statements of Company B
9. The Committee notes the definition of the term ‘revenue’ as
per Accounting Standard (AS) 9, ‘Revenue Recognition’, which is
reproduced below:
“4.1 Revenue is the gross inflow of cash, receivables or other
consideration arising in the course of the ordinary activities of
an enterprise from the sale of goods, from the rendering of
services, and from the use by others of enterprise resources
yielding interest, royalties and dividends. Revenue is measured
by the charges made to customers or clients for goods supplied
and services rendered to them and by the charges and rewards
arising from the use of resources by them. In an agency
relationship, the revenue is the amount of commission and
not the gross inflow of cash, receivables or other consideration.”
10. The Committee notes that insofar as Company B is concerned,
under its arrangements with the company A, it is engaged in the
business of purchase and sale of mobile handsets, even though at
a loss. For Company B, it is an ordinary activity. Hence, gross
inflows from the sale proceeds of Company B is ‘revenue arising
in the course of ordinary activities’ as per the definition of ‘revenue’
in AS 9 which is reproduced above.
11. The Committee notes that selling and distribution expenses
are costs incurred to sell (e.g. advertising) and distribute (e.g.,
freight-out) goods. Excess of purchase price over sale proceeds
of handsets is not in the nature of selling and distribution expenses
for Company B; instead, sale of handsets represents revenue to
Company B as per AS 9.
12. The Committee notes the argument given in paragraph 6(i)
for disclosing excess of purchase price of handsets over the sale
proceeds as selling and distribution expenses. As per the argument,
it is contended that the sale price of the handset, which is at
discount, amounts to partial recoupment (recovery) of cost and not
revenue. The Committee is of the view that sale of handsets even
though it is at a discount represents revenue as the same
represents ‘charges made to customers for goods supplied’.
Therefore, any amount recovered from the customers for sale of
goods even at a lower amount is revenue. Further, it can be
argued that revenue in all cases is recoupment of costs, with or
without a return.
13. The Committee also notes the requirements of Part II of
Schedule VI to the Companies Act, 1956, with regard to disclosure
of revenue (turnover) as follows:
“3. The profit and loss account shall set out the various
items relating to the income and expenditure of the company
arranged under the most convenient heads; and in particular,
shall disclose the following information in respect of the period
covered by the account:
(i)(a) The turnover, that is, the aggregate amount for which
sales are effected by the company, giving the
amount of sales in respect of each class of goods
dealt with by the company, and indicating the
quantities of such sales for each class separately…”
14. The Committee notes that the querist has contended that one
reason for the current accounting policy being pursued is that the
handsets do not represent the ‘goods dealt with by the company’
as contemplated in the above requirements of Schedule VI. The
Committee disagrees with this reasoning given by the querist and
is of the view that as far as Company B is concerned, it purchases
and sells handsets, which amounts to handsets being the goods
dealt with by the company.
Consolidated Financial Statements
15. The Committee notes that Accounting Standard (AS) 21,
‘Consolidated Financial Statements’, requires in paragraph 13, inter
alia, as follows:
“13. In preparing consolidated financial statements, the
financial statements of the parent and its subsidiaries
should be combined on a line by line basis by adding
together like items of assets, liabilities, income and
expenses”.
Thus, once the separate financial statements of Company B
recognise the purchase and sale of mobile handsets on a gross
basis as discussed in the above paragraphs, the consolidated
financial statements would be prepared merely by adding the
purchases of Company B with the purchases of Company A and
the sales of Company B with the sales of Company A, resulting in
recognition of purchase and sale of handsets in the consolidated
financial statements.
D. Opinion
16. On the basis of the above, in respect of the issue raised in
paragraph 7, the Committee is of the opinion that the accounting
policy of netting off the proceeds from the sale of handsets against
their purchase price and disclosing the excess of the purchase
price over the sale proceeds as selling and distribution expenses
is incorrect. The correct accounting policy is to disclose purchase
and sale of handsets separately in the stand-alone profit and loss
account of Company B and in the consolidated profit and loss
account.
1Opinion finalised by the Committee on 30.1.2008. |