Query No. 13 Subject: (i) Recognition of disputed claims made to the defaulted buyers on account of loss on resale to third parties. A. Facts of the Case
1. A company (hereinafter referred to as ‘the company’) was set up in July, 1970 by the Government of India as a public sector undertaking registered under the Companies Act, 1956 in the field of marketing of cotton. The role assigned to the company under Textile Policy of June, 1985 was as under:
The above role of the company continued under the new Textiles Policy announced by the Government in November, 2000, except that the last stated function is no longer relevant as export of cotton is now under Open General License (OGL) from July, 2001.
2. Purchase Policy: The company is having a network of 14 purchase branches situated in 9 cotton growing States across India. Further, the company is having 3 sale branches. The Agriculture Produce Market Committee (APMC), constituted under the APMC Act of the respective State Governments regulates the sale of cotton by farmers in the regulated market yards. The raw cotton is sold by the farmers either in open auction or through tender system, as the case may be. Further, the raw cotton is sold by the farmers directly or through commission agents depending upon the bye-laws of APMC Act applicable in the respective States. The company procures cotton at around 250 market yards, called as purchase centres. The representatives of the company participate in such open auctions/tender and make purchase of the cotton. The cotton purchased from the farmers/through commission agents is sent to ginning and pressing factories hired by the company in the beginning of the season on job work basis for its processing and lint obtained is pressed into fully pressed bales, which are sold in the domestic as well as in the overseas markets.
3.Sale Policy : The company sells the cotton bales to the institutional buyer mills, National Textile Corporation’s unit mills (NTC), private mills and traders as per its sale terms and conditions. For sale of fully pressed bales, the company enters into sale contract with the buyers. As per clause No. 1 (a) of the sale contract, the buyers have to deposit minimum amount of Rs. ---- (Rs.1500/-) per bale within five working days from the date of contract. The company offers the bales to buyers for selection and accordingly, the buyers have to select the bales within the period mentioned in clause 2 of the sale contract. After selection/approval of bales, the buyer has to take delivery within free period by making the balance payment of contracted value. In case of failure on the part of the buyer to do so, the contract is liable to be cancelled at the option of the company (seller). In the event of such a cancellation, the company shall be entitled to resell the entire/balance quantity thereof, at any time and in any manner it deems fit and at the same time, reserving its right to recover any damage/loss sustained on such resale.
4. However, the company may carry or hold cotton on behalf of the buyer beyond free delivery period, subject to buyer complying with the conditions mentioned in clause 4 of the sale contract, i.e., providing lifting schedule to the company and payment of advance carrying charges for the period cotton is required to be carried over. In case payment is not made and delivery is not taken within such extended period also, the company may forfeit the advance payment inclusive of advance payment towards carrying charges and resell the cotton at any time and in any manner it deems fit and recover the losses/ damages from the buyer, if any, sustained in such a resale, inclusive of price difference, carrying charges and interest.
5. Due to steep fall in the cotton prices, in the second half of the cotton season 2010–11 (cotton season from October to September), many of the buyer mills have not made the balance payment for lifting of bales and therefore, defaulted in their contractual obligation. The company made all out efforts in pursuing these buyers for lifting of contracted bales. However, many of the buyers failed to execute the contracts. Therefore, the company had to take various steps against these defaulted mill buyers as per the contract terms, such as, resale of bales, issuance of notices for payment of losses so incurred by the company on such resale, issuance of legal notice to proceed under arbitration, appointment of arbitrator, etc. Further, after show cause notice, the company has banned future business dealings with these defaulted buyers and blacklisted them till the losses suffered by the company are made good by these defaulted buyers. Further, the company had taken up the matter with the Government of India, Ministry of Textiles, to stop the benefits under Technology Up-gradation Fund (TUF) to these defaulted mill buyers. Accordingly, the Office of the Textiles Commissioner, Ministry of Textiles, Government of India has passed Office Memorandum stating that the TUF subsidy will not be made available to textile industry/units which have been blacklisted for defaulting contracts with public sector undertakings.
6. As on 31.03.2011, a sum of Rs. 7.64 crore is lying to the credit of the defaulted buyers’ account in the books of account of the company towards advance deposits made as per the terms of the sale contract entered into between the company and the buyers, in respect of the default which took place in earlier years and for which the arbitration proceedings are in progress. As per the querist, in most of the cases, the arbitration awards are received in favour of the company.
7. The querist has stated that around sixty buyers have defaulted in lifting of around 2,72,645 bales in the second half of the cotton season 2010–11. After issuance of legal notices to these buyers, the company has resold all the bales at their risk and cost. The company has suffered a loss of around Rs. 215.00 crore on resale of these bales towards price difference, carrying charges, interest, etc. After adjustment of advance deposit and advance carrying charges, amounting to credit balances of around Rs. 45.00 crore, a net loss of Rs. 170.00 crore is recoverable from these defaulted buyers. As per the contract, the legal actions have been initiated against these defaulted buyers by the branches and after appointment of arbitrator, legal proceedings have commenced. The company has lodged the net claims of Rs. 170.00 crore in respect of defaulting mill buyers with various arbitrators after adjusting the credit balances of the defaulted buyers as per the sale contract.
8. The company, being a company registered under the Companies Act, 1956, has to comply with the provisions of various Accounting Standards issued by the Institute of Chartered Accountants of India (ICAI). In conformity with the provisions of Accounting Standard (AS) 9, ‘Revenue Recognition’, issued by the ICAI and on prudent consideration, the company defers revenue recognition, owing to significant uncertainty about ultimate collection in respect of claims for loss and interest thereon upto the date of claim lodged with the defaulting buyers for losses arising out of resale of quantities initially sold to them.
9 At present, any amount received as a deposit as provided in the sale contract and any advance against carrying charges is credited to the account of the purchaser (buyer). When the purchaser defaults in taking delivery of the cotton bales as per the sale contract, the company re-sells the cotton to a third party at the cost and risk of the defaulting buyers and lodges claim for the loss suffered by the company after adjusting the advance/deposit received from the defaulting purchaser. For recovering the net loss (after deducting the advance/deposit), the company sends legal notice to the purchaser and if the amount is not received, the company refers the matter to an arbitrator. No accounting entry is passed for the claim for net loss suffered by the company, but the same is shown as amount recoverable in a separate Memorandum Book. When the amount of net loss is recovered from the purchaser, the company credits the same to the profit and loss account as income. In sofaras the amount of advance/deposit received from the purchaser is concerned, the company keeps the same to the credit of the purchaser’s account and transfers the same to the credit of the profit and loss account in the year when the net loss is recovered from the purchaser.
10.Accounting Standard (AS) 9, ‘Revenue Recognition’, notified under the Companies (Accounting Standards) Rules, 2006 (hereinafter referred to as ‘the Rules’), states in paragraphs 9.1, 9.2, 9.5 and 10 as under:
11. Accordingly, as per the querist, revenue recognition is possible when it is reasonably certain that the ultimate collection will be made. Where there is no uncertainty of ultimate collection, revenue is recognised at the time of the transaction. Further, if at the time of raising of any claim, it is unreasonable to expect ultimate collection, revenue recognition should be postponed. Similarly, in the Guidance Note on Accrual Basis of Accounting, issued by the ICAI, it has been stated that recognition of revenue requires that revenue is measurable and it would not be unreasonable to expect ultimate collection. When recognition of revenue is postponed due to the effect of uncertainty, it is considered as revenue for the period in which the recovery of revenue becomes reasonably certain
12. The querist has further stated that the ICAI has issued Accounting Standard (AS) 29, ‘Provisions, Contingent Liabilities and Contingent Assets’ in 2003 and is effective from 1.4.2004. The company believes that the outstanding disputed claims which are not treated as revenue under AS 9 can be classified as a ‘contingent asset’. The term ‘contingent asset’ is defined in paragraph 10.5 of AS 29, notified under the Rules, as under:
Paragraphs 30 to 34 of AS 29 read as under:
Therefore, according to the company, the accounting policy of not treating the amount of claims lodged as revenue in the accounts is in accordance with AS 9 and AS 29, which are being followed consistently by the company for more than 18 years.
13. The querist has also stated that as regards the amount of advance/deposit received by the company from the defaulting purchasers as provided in the sale contract, at present, the company does not transfer the amount of such advance/deposit to the profit and loss account and keeps it to the credit of defaulting purchasers’ accounts as stated in paragraphs 6 and 7 above. This credit balance is treated as income only when the claim for net loss is settled and the amount is received from such purchaser. If a reference is made to clause 4 of the sale contract, it is evident that the company is entitled to forfeit the advance deposit as well as advance received towards carrying charges when the purchaser does not take delivery of the cotton contracted to be purchased and it is resold to a third party. Further, the company is making claim from the defaulting purchaser for the loss suffered on account of resale to a third party after deducting the advance received by the company. This shows that the advance amount is first adjusted against the total loss. In other words, the company is treating the advance amount as amount recovered from the defaulting purchaser against the total loss suffered by it. The defaulting purchasers have not raised any claim for refund of such advance/deposit and not objected to this adjustment against the total loss suffered by the company and there is no dispute about this amount. Considering these facts, the company is advised that such advances/deposits received from the defaulting purchasers can be recognised as income by crediting to the profit and loss account when the contracted cotton is sold to the third party and claim for net loss is made from such purchasers.
14.The company, therefore, desires to change its existing accounting policy and follow the following accounting method in the accounts for the year ending 31.3.2012:
15. The auditors of the company have desired to refer the matter to the Expert Advisory Committee (EAC) of the ICAI for opinion about change in the accounting policy for recognition of advance/deposit received from the defaulting purchasers as revenue which are deducted from gross loss on resale of cotton bales, before making claims for the net loss as stated in paragraphs 14 (i) and (ii) above. B. Query16.On the basis of the above, the querist has sought the opinion of the EAC on the following issues:
C. Points considered by the Committee17.The Committee, while expressing its opinion, has considered only the issues raised by the querist in paragraph 16 above and has not examined any other issue that may arise from the Facts of the Case, such as, recognition of forfeited advance received from the defaulted buyers as ‘revenue’ or ‘other income’, appropriateness of nomenclature used, accounting policy of the company for recognition of revenue in general, disclosure requirements in the financial statements, etc. Further, the Committee wishes to point out that its opinion is expressed purely from accounting point of view and not from any legal point of view. The Committee has presumed from the Facts of the Case (refer paragraph 13 above) that advances/deposits made by the defaulting buyers are not under dispute/arbitration. The Committee also notes that the existing accounting policy of revenue recognition, as stated in paragraph 14(iv) above, is silent on the timing of recognition of advances/deposits forfeited by the company, although in paragraph 9 above, it is mentioned that such forfeited advances/deposits are recognised as income when the net loss is recovered from the purchaser.
18. As regards the accounting for claims made to the defaulting buyers on account of the loss on resale, the Committee notes the definition of the term, ‘contingent asset’, as per AS 29, notified under the Rules, 2006, as reproduced by the querist in paragraph 12 above. The Committee is of the view that the disputed claims made to the defaulting buyers on account of loss on resale of cotton bales to third parties till their realisation is not virtually certain are contingent assets and accordingly, as per the requirements of AS 29, these should not be recognised in financial statements of the company till the realisation of income is virtually certain. However, these can be disclosed in the Directors’ report, where an inflow of economic benefits is probable. Therefore, the accounting policy adopted by the company of not recognising the disputed claims made to the defaulted buyers on account of loss on resale of cotton bales to third parties would be proper provided the realisation of revenue at the reporting date is not virtually certain.
19. As regards recognition of advance/deposit made by the defaulting buyers, which is forfeited by the company, the Committee notes the following definition of the term ‘income’ as per paragraph 69(a) and paragraphs 91 and 92 of the Framework for the Preparation and Presentation of Financial Statements, issued by the Institute of Chartered Accountants of India:
The Committee notes that in the extant case, the buyer makes advance payments to the seller which are subject to adjustment against sale consideration in proportion to the delivery taken by the customer. The seller has the right by contract to forfeit the said advances if the buyer fails to make the payments or take the delivery.
The Committee is of the view that in such case, since the buyer has defaulted the terms of the contract and is no longer entitled to adjust/refund of the advance consideration, the seller should recognise the advances as its income which result from the extinguishment of its liabilities to deliver the goods to the buyer. The Committee is further of the view that extinguishment of liabilities in the extant case occurs on cancellation of obligation under the contract. The point of cancellation should be determined keeping in view the facts and circumstances of the case.
20. Further, the Committee is of the view that since recognition of income of earlier years has not been made by the company as discussed in paragraph 19 above then it is an error of a prior period. Accordingly, the company should rectify its error and treat it as ‘prior period item’ in accordance with the requirements of Accounting Standard (AS) 5, ‘Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies’ in the reporting period in which such rectification is made.
D. Opinion
21. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 16 above
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