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Query No. 1
Subject:
Accounting of foreign income on cash basis.1
A. Facts of the Case
1. A Government of India enterprise under the Ministry of Steel,
is executing engineering and consultancy jobs and preparing various
reports like feasibility report, project report, etc., for clients in India
and abroad. According to the querist, the company is following
accrual basis of accounting as per the Companies Act, 1956.
Accordingly, revenue is recognised on accrual basis and as per
the applicable accounting standards.
2. The querist has informed that long back, the company used
to follow accrual basis of accounting in case of foreign consultancy
jobs also, in line with domestic jobs. However, due to various
reasons prevailing in the countries like Nigeria, Iran, Bangladesh,
etc., where most of the clients were located, receipt of payment
from the clients became uncertain. The querist has further informed
that the company had to make provision for bad debts/write off the
bad debts frequently as per the audit observations on the ground
of uncertainty of realisation. However, constant follow up for
realisation of the payment continued and in some cases, the
company realised the payment after an abnormally long period.
Recognition of income due to receipt of these payments used to
create confusion as to whether these should be treated as current
year’s income or prior period income. According to the querist,
though the amounts were insignificant but occurrence of such
events was not insignificant. However, to avoid frequent provisioning
of bad debts/write off in a particular period due to uncertainty and
subsequently recognising it as income in future, the company
started following the practice of recognition of foreign income on
receipt basis.
3. The querist has informed that the company has also disclosed
the basis of accounting in case of foreign consultancy jobs in the
notes to the accounts. The company is following the same practice
consistently every year. However, this is not specifically mentioned in the accounting policy of the company for revenue recognition.
The querist has mentioned that the company provides only
consultancy services and is not involved in export of any plant or
machinery whatsoever. Income from foreign services is also
insignificant and low which is even less than 1% of the company’s
total turnover.
4. The querist has further clarified that in respect of foreign
consultancy jobs, the company gets orders from various overseas
clients with specific fees, terms of payment, etc. The company
raises invoices from time to time as per the orders. Therefore, no
uncertainty either with respect to the measurement of the payment
that is to be received from the client or in respect of the
creditworthiness of the client is envisaged at the time of receipt of
order. However, due to various reasons, uncertainty arises at a
later date.
B. Query
5. The querist has sought the opinion of the Expert Advisory
Committee on the following issues:
(a) Whether the company can continue the same practice,
i.e., cash basis of accounting for foreign consultancy
jobs or should it follow the accrual basis of accounting.
(b) Whether there is any deviation/violation of the
Companies Act, 1956 or any Accounting Standard.
C. Points considered by the Committee
6. The Committee notes section 209(3) of the Companies Act,
1956, which states as follows:
“(3) For the purposes of sub-sections (1) and (2), proper
books of account shall not be deemed to be kept with respect
to the matters specified therein,–
(a) if there are not kept such books as are necessary
to give a true and fair view of the state of affairs of
the company or branch office, as the case may be,
and to explain its transactions; and
(b) if such books are not kept on accrual basis and
according to the double entry system of accounting.”
7. The Committee also notes ‘accrual’ as one of the fundamental
accounting assumptions for the preparation and presentation of
financial statements as given in Accounting Standard (AS) 1,
‘Disclosure of Accounting Policies’. It notes its definition as per
paragraph 10 of AS 1 as follows:
“c. Accrual
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. ...”
The Committee notes that the Guidance Note on Accrual Basis of
Accounting, issued by the Institute of Chartered Accountants of
India (ICAI), recognises that the accounting treatment contained in
the Guidance Notes, Accounting Standards, etc., issued by the
ICAI are primarily based on accrual accounting. Thus, adoption of
accounting treatment recommended in these documents would
ensure that an enterprise has followed accrual basis of accounting.
Accordingly, the Committee is of the view that the company would
be deemed to have followed accrual basis of accounting for revenue
recognition if it follows the principles for recognition of revenue as
laid down in Accounting Standard (AS) 9, ‘Revenue Recognition’.
8. The Committee notes that AS 9 lays down the following three
conditions for recognition of revenue:
(a) Performance of the act giving rise to revenue.
(b) Measurability of the revenue.
(c) Collectability of the revenue.
With respect to the effect of uncertainties on revenue recognition,
the Committee notes paragraphs 9.1 to 9.3 of AS 9, which provide
as follows:
“9.1 Recognition of revenue requires that revenue is
measurable and that at the time of sale or the rendering of the service it would not be unreasonable to expect ultimate
collection.
9.2 Where the ability to assess the ultimate collection with
reasonable certainty is lacking at the time of raising any claim,
e.g., for escalation of price, export incentives, interest etc.,
revenue recognition is postponed to the extent of uncertainty
involved. In such cases, it may be appropriate to recognise
revenue only when it is reasonably certain that the ultimate
collection will be made. Where there is no uncertainty as to
ultimate collection, revenue is recognised at the time of sale
or rendering of service even though payments are made by
instalments.
9.3 When the uncertainty relating to collectability arises
subsequent to the time of sale or the rendering of the service,
it is more appropriate to make a separate provision to reflect
the uncertainty rather than to adjust the amount of revenue
originally recorded.”
9. The Committee notes on the basis of the information provided
by the querist in paragraph 4 of the Facts of the Case that the
uncertainty with regard to collectability of foreign income arises
subsequent to the receipt of the order. The Committee is of the
view that when the three conditions for recognition of revenue
read with paragraphs 9.1 to 9.3 of AS 9 reproduced above are met
in respect of the foreign consultancy jobs, the company should
recognise revenue in its books of account. If uncertainty as to its
collection arises subsequent to recognition of revenue, it would be
appropriate to create a provision for bad and doubtful debts.
However, if the collectability of revenue is not reasonably certain
at the time of raising claim therefor, recognition of revenue should
be postponed. In such cases, revenue should be recognised when
it becomes reasonably certain that ultimate collection will be made.
The assessment with respect to collectability should be made
separately for each transaction.
10. The Committee notes that owing to reasons given by the
querist in paragraph 2 above, i.e., frequent provisioning on account
of frequent occurrences of uncertainty of collection and
insignificance of the amounts involved, the company resorted to cash basis of accounting in respect of the foreign income, i.e., in
effect it departed from the provisions of AS 9 in respect of foreign
income. The Committee notes that mere difficulties arising on
account of frequent provisioning of bad debts/write-offs of such
debts is not a sufficient reason to allow foreign income to be
accounted for on cash basis and is contrary to the requirements of
AS 9, the fundamental accounting assumption of accrual and
section 209(3)(b) of the Companies Act, 1956.
11. In respect of the other reason of recognising foreign income
on cash basis, viz., the insignificance of the amount of foreign
income, the Committee notes from the Preface to the Statements
of Accounting Standards, issued by the Institute of Chartered
Accountants of India, which states, inter alia, that, “The Accounting
Standards are intended to apply only to items which are material.”
The same principle has also been specifically stated in paragraph
3 of the Annexure A ‘General Instructions’ to the Companies
(Accounting Standards) Rules, 2006, notified by the Central
Government. Further, the Committee notes ‘materiality’ as one of
the consideration for selection and application of accounting policies
as defined in AS 1 and certain excerpts from paragraphs 3 and 5
of Standard on Auditing (SA) 320 (AAS 13), ‘Audit Materiality’,
issued by the Institute of Chartered Accountants of India which are
reproduced below:
“Materiality
Financial statements should disclose all “material” items, i.e.
items the knowledge of which might influence the decisions of
the user of the financial statements.”
“3. Information is material if its misstatement (i.e., omission
or erroneous statement) could influence the economic
decisions of users taken on the basis of the financial
information. Materiality depends on the size and nature of the
item, judged in the particular circumstances of its misstatement.
…”
“5. The concept of materiality recognises that some matters,
either individually or in the aggregate, are relatively important
for true and fair presentation of financial information in conformity with recognised accounting policies and practices.
The auditor considers materiality at both the overall financial
information level and in relation to individual account balances
and classes of transactions…”
12. From the above, the Committee is of the view that though
‘accrual’ is one of the fundamental accounting assumptions, the
materiality threshold is applicable to this accounting assumption
also. If an information is not material, on the consideration of
materiality as mentioned in the above paragraph, its accounting
would not have any effect on the decisions of the users of the
financial statements. Accordingly, it needs to be determined under
the specific facts and circumstances of the company concerned
as to whether the revenue from foreign consultancy jobs, either
individually or in aggregate, can influence the decisions of the
users of the financial statements. For this purpose, apart from the
volume of transactions and quantum of turnover, other factors
such as nature of the item, impact on profit/loss, etc., should also
be considered. The assessment of what is material is a matter of
professional judgement to be determined on each balance sheet
date.
D. Opinion
13. On the basis of the above, the Committee is of the following
opinion in respect of the issues raised in paragraph 5 above:
(a) The company should follow accrual basis and not the
cash basis of accounting to account for income from
foreign consultancy jobs unless the said income is not
considered material as discussed in paragraphs 11 and
12 above.
(b) Recognition of income from foreign consultancy jobs on
cash basis, in the case under consideration, is contrary
to the requirements of the Companies Act, 1956, AS 1
and AS 9, unless the said income is not considered
material as discussed in paragraphs 11 and 12 above.
1 Opinion finalised by the Committee on 17.3.2008
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