Query No. 10

Subject:

Revenue recognition pending physical delivery.¹

A. Facts of the Case

1. A leading engineering product company caters to the vital sectors of the economy, such as, infrastructure, surface transportation, mining and defence. The company is a public sector enterprise under the administrative control of the Ministry of Defence. With a turnover of Rs. 2601.79 crore inclusive of excise duty and Rs. 2423.87 crore net of excise duty for the financial year 2006-07, as per the querist, the company is market leader in earthmoving and mining products. The company is consistently making profits right from inception. For the financial year 2006-07, the profit before tax was Rs. 316.04 crore registering a growth of 10.73% over previous year. The company is a fast growing engineering product company with export presence in as many as forty two countries spanning over Asia, Africa and South American countries. For the financial year 2006-07, the export turnover was Rs. 110.73 crore and, according to the querist, it is expected to increase manifold in the future.

2. The company has three manufacturing units located at Kolar Gold Fields (KGF), Bangalore and Mysore. It has marketing and service centres spread all over India. The KGF unit manufactures dozers, excavators, loaders, walking draglines, rope shovels and sophisticated aggregates catering to the needs of mining and defence sectors. The Bangalore unit manufactures rail coaches, EMUs, wagons, overhead inspection vehicles for Indian Railways and also logistics vehicles (tatra variants), mechanised pontoon bridges and ground support system for the Integrated Guided Missiles for use by the Defence. In addition, Bangalore unit is manufacturing for the first time in India, metro rail coaches under licence from a company of Korea. The Mysore unit manufactures highly sophisticated dumpers, graders, aircraft towing tractors, the weapon loading systems and high powered internal combustion engines. All these products are highly technology intensive and call for an array of manufacturing technologies.

3. The company’s significant accounting policy (copy of the Annual Report of the company for the year 2006-07 has been furnished by the querist for the perusal of the Committee) on revenue recognition is as under:

      “Policy No. 4(i):

Sales set up for products viz., equipments, aggregates, attachments and ancillary products, is made when these are unconditionally appropriated to the valid sales contract after pre-despatch inspection by the specified authority.”

According to the querist, the above policy is being followed consistently by the company. Further, the policy has been validated by both the statutory auditors and the Comptroller and Auditor General of India (C&AG) (Government audit). Further, as per the querist, the accounting policy as stated above provides for setting up sales when the goods are unconditionally appropriated to the sale contract irrespective of delivery, once the Goods Consignment Notes (hereinafter referred to as GC Notes) are issued in favour of consignee, i.e., customers. The company does not retain any further right of disposal over the equipment.

4. During the finalisation of accounts for the financial year 2006- 07, it was felt by the Government audit that there is a need to seek the opinion of the Expert Advisory Committee of the Institute of Chartered Accountants of India regarding the validity and acceptability of the aforesaid accounting policy.

5. As per the policy, the revenue from the sale of equipments, aggregates, components and attachment are recognised based on valid sales contract. This fact is also disclosed by way of notes to accounts. Further, revenue is recognised in respect of these products only on the basis of pre-despatch inspection.

6. During the year 2006-07, the sales set up of Rs. 184.87 crore was based on goods (covered by customer orders) handed over to the transporters and the said handing over was duly evidenced by the GC Notes issued by the said transporters. The Principal Director of Commercial Audit (the ‘PDCA’) felt that it was not possible to conclude that the company has forgone its right and title to the goods by merely handing over the same to the transporters, especially when such transporters were not specifically customer nominated transporters (emphasis supplied by the querist) and goods were in the custody of the company till the transporter was in a position to place a suitable vehicle to transport the equipment.

7. The transit insurance and transportation are arranged by the company wherever the terms of contract so provide. The amounts of insurance premium and freight charges are reimbursed by the customer in such cases. This is a trade practice normally followed in this nature of industry to enhance customer satisfaction and loyalty.

8. The company is of the view that in the case of ex-works sale contracts, once the goods are handed over to the transporters, the company does not retain any effective control/ownership on such goods. The risks and rewards of ownership automatically pass on to the customer. Further, according to the querist, there exists no uncertainty in expecting the ultimate collection of sale proceeds which can be verified by records of subsequent collections.

9. The querist has referred to the Appendix to Accounting Standard (AS) 9, ‘Revenue Recognition’, which, according to the querist, states that revenue should be recognised notwithstanding that physical delivery has not been completed so long as there is every expectation that delivery will be made. The said Appendix to AS 9 also stipulates that item (goods) must be on hand, identified and ready for delivery to the buyer at the time the sale is recognised rather than there being simply an intention to acquire or manufacture the goods in time for delivery. As per the querist, in the case of the company, the items (goods) in question were on hand, duly identified. Thus, according to the querist, the conditions for the recognition of revenue as laid down in paragraphs 10 and 11 of AS 9 have been duly fulfilled.

10. The querist has informed that all the equipments are heavy earth moving machinery which are transported in disassembled condition by either low bed or semi low bed trailers only. Normally, these vehicles (low bed/semi low bed trailers) are in short supply. Even most of the renowned transporters do not own such vehicles in adequate numbers. Hence, such vehicles are perennially in short supply. Also, these transporters do not have adequate storage space and lifting tackles for loading and un-loading in their premises. Hence, the equipments are often in the custody of the company even though the receipt thereof is acknowledged by way of GC Notes.

11. The querist has referred to section 30 of the Sale of Goods Act, 1930, which envisages a situation of a seller, having sold goods, continues or is in possession of the goods or of the documents of title to the goods. According to the querist, the said Act, as such, does not state that the sale can take place only after parting possession of the goods by the seller. The querist has stated that the said Act, in terms of section 39, prima facie recognises the delivery to a carrier for the purpose of transmission to the buyer as delivery to the buyer where, in pursuance of a contract of sale, the seller is authorised or required to send the goods to the buyer by a carrier, whether named by the buyer or not (emphasis supplied by the querist). According to the querist, in law, the goods or the documents of title representing the goods belong to or vest with the buyer though these are in the possession of the seller or the carrier and GC Notes or documents issued by the transporter duly signed acknowledging the receipt of goods, whether actual or constructive, is deemed to be a “Delivery”.

12. According to the querist, it is not uncommon that the vehicle as specified in the GC Note is placed by the transporter after the date mentioned in the GC Note. This situation arises due to nonavailability of vehicles as mentioned in paragraph 10 above. Hence, it cannot be construed that the delivery – actual or constructive, has not taken place.

13. Also, during the financial year 2006-07, the sales set up of Rs. 84.12 crore was based on goods covered by customer orders, but which were physically available in the premises of the company consequent upon a communication received from the customer/ customers that for the time being, the said customer/customers was/were not able to take delivery of the goods. This is a case of delivery delayed at buyer’s request. In this case also, the Government auditors felt that since the items/goods were lying in the premises of the company, the company had not forgone the control/ownership of such goods and consequently the risks/ rewards of such goods had not been passed on to the customer/ customers.

14. It was contended by the company that as per paragraph A1 of Appendix to AS 9 (mentioned in paragraph 9 above), revenue should be recognised notwithstanding that physical delivery has not been completed so long as there is every expectation that delivery will be made especially when the delivery is delayed at buyer’s request. However, items must be on hand, identified and ready for delivery. In the instant case, the items were physically available, duly identified and ready for delivery. It was, therefore, felt by the company that the sales set up in respect of such cases was in order.

15. The querist has suggested that cognizance may be taken of the earlier opinions issued by the Expert Advisory Committee contained in Compendium of Opinions-Volume VII (query 1.12) and Compendium of Opinions-Volume XI (query 1.39). As per the querist, in these cases, the opinion of the Expert Advisory Committee is to recognise the sales when goods are appropriated to the contract by delivering to the transporter for transmission to the buyer, that too, in respect of FOR destination contracts. The query being raised is in respect of contracts with delivery on exworks basis. In this background, it is reiterated by the querist that what is applicable to FOR destination cases is much more relevant to the cases where terms of delivery are on ex-works basis.

B. Query

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

        (i) Whether booking of sales where delivery is delayed at buyer’s request is in order; and

        (ii) Whether booking of sales on the basis of GC Notes from the transporter is in line with AS 9.

C. Points considered by the Committee

17. The Committee notes that the basic issue raised by the querist relates to revenue recognition in respect of the two issues mentioned in paragraph 16 of the query. Therefore, the Committee has examined only these issues and has not examined any other issue that may be contained in the Facts of the Case, such as, measurement of revenue when products are sent in disassembled condition, etc. Further, since the querist has raised the query in the context of AS 9, the Committee proceeds on the assumption that AS 9 is the applicable standard. Incidentally, the Committee notes that the amounts of sales booked merely on basis of GC Notes as well as sales booked for which delivery is delayed at buyer’s request as per Facts of the Case (mentioned in paragraphs 6 and 13 above) differ from the respective amounts disclosed in Notes to Accounts. However, since the query involves revenue recognition issue and not amounts, the said difference does not affect the opinion of the Committee.

18. The Committee notes the following paragraphs from AS 9:

       “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.”

       “10. Revenue from sales or service transactions should be recognised when the requirements as to performance set out in paragraphs 11 and 12 are satisfied, provided that at the time of performance it is not unreasonable to expect ultimate collection. If at the time of raising of any claim it is unreasonable to expect ultimate collection, revenue recognition should be postponed.”

       “11. In a transaction involving the sale of goods, performance should be regarded as being achieved when the following conditions have been fulfilled:

          (i) the seller of goods has transferred to the buyer the property in the goods for a price or all significant risks and rewards of ownership have been transferred to the buyer and the seller retains no effective control of the goods transferred to a degree usually associated with ownership; and

         (ii) no significant uncertainty exists regarding the amount of the consideration that will be derived from the sale of the goods.”

        [Emphasis in paragraph 6.1 of AS 9 supplied by the Committee.]

Paragraph 12 of AS 9 deals with performance for rendering of services, and hence, not reproduced above.

19. The Committee notes from the above that the time of transfer of all significant risks and rewards of ownership may be different from the time of transfer of legal ownership, and that for accounting purposes, revenue in such cases should be recognised at the time of transfer of significant risks and rewards of ownership to the buyer.

20. The Committee is of the view that the question when the transfer of significant risks and rewards of ownership takes place depends on particular facts and circumstances of the case, including the terms of the contract, express and/or implied, and the conduct of the parties. Various factors should be considered for ascertaining the timing of passing of significant risks and rewards of ownership. For example, factors like who bears the risk of damage when the goods are lying in the company’s premises after appropriation, who bears the risk of damage during transit, who is taking the insurance, whether the goods produced are substantially complete, whether the company can sell the goods to another party or pledge the same after appropriation to the contract, etc., will have to be taken into account in determining the timing of transfer of significant risks and rewards of ownership. In some situations, the company may be able to transfer risk of damage to insurance company but not to the customers. As such, mere receipt of GC note may not necessarily indicate that all significant risks and rewards of ownership have been transferred to the customers.

21. The illustration given in Appendix to AS 9 mentioned by the querist in paragraphs 9 and 14 above is reproduced below:             

      “Delivery is delayed at buyer’s request and buyer takes title and accepts billing.

Revenue should be recognised notwithstanding that physical delivery has not been completed so long as there is every expectation that delivery will be made. However, the item must be on hand, identified and ready for delivery to the buyer at the time the sale is recognised rather than there being simply an intention to acquire or manufacture the goods in time for delivery.”

22. The Committee notes that in the above illustration, it is specifically stated that it deals with a situation where delivery is delayed at buyer’s request and buyer takes title and accepts billing. All the three conditions are cumulative which must be met apart from identification of goods, readiness for delivery and expectation of delivery. It appears that the querist is under the impression that mere identification of goods, readiness for delivery and expectation of delivery are sufficient for revenue recognition. If so, the Committee does not agree with the querist’s view. Thus, for example, if the buyer simply requests for delayed delivery, but there is express or implied understanding that risk of damage before actual delivery to the carrier rests with the seller, then, revenue recognition before actual delivery to the carrier is not appropriate. Similarly, if the buyer does not accept title and/or billing, revenue recognition is not appropriate.

23. The Committee notes that the querist has not stated whether all the above conditions were met while recognising revenue in respect of goods lying in the premises of the company where delivery is delayed at buyer’s request. As stated above, only if all the above conditions are met, revenue recognition will be appropriate where delivery is delayed at buyer’s request. In such circumstances, there is no retention of control/ownership of the goods. Even here, an element of caution should be exercised. For example, the condition that there is every expectation that delivery will be made will be met if as soon as the customer asks for delivery and if it is the responsibility of the company to arrange for transport, then the company should be able to deliver the goods within the stipulated time or reasonable time. Otherwise, the risk of loss due to the fault of the company after the delivery request from the customer may be retained by the company.

24. The two earlier opinions of the Committee cited by the querist in paragraph 15 above dealt with the case of actual delivery of goods to the transport carrier and not mere receipt of GC Notes without delivery. Hence, these opinions are irrelevant for the given Facts of the Case. Further, in the cited two opinions, the Committee clearly expressed its view that booking of sales is permitted on delivery to the transporters, if in the facts of the case, significant risks and rewards of ownership in the goods do not remain with the company.

D. Opinion

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

(i) The booking of sales where delivery is delayed at buyer’s request is in order only if the buyer takes title and accepts the billing subject to the condition that the items are on hand, identified, ready for delivery, there are no further conditions with respect to acceptability by the buyer and there is every expectation that delivery will be made as discussed in paragraphs 22 to 24 above. Further, other factors, as discussed in paragraph 20 above should also be taken into consideration.

(ii) Booking of sales on the basis of GC Notes from the transporter (without actual delivery) is not in line with AS 9, unless risks and rewards of ownership are passed on to the buyer even before actual delivery to the transporter, having regard to the facts and circumstances of the case, including the terms of the contract, express and/or implied, and the conduct of the parties.

¹ Opinion finalised by the Committee on 30.4.2008