Expert Advisory Committee

Query No. 30

Subject: 

Adjustment of losses on sale of fixed assets, writing-off inventory and doubtful receivables against capital reserves arising out of acquisition of business, capital redemption reserves and revaluation reserves.1

A. Facts of the Case

1. A company (hereinafter referred to as ‘the company’) is a 50:50 joint venture between two companies. The company is in the business of manufacture and sale of power/telecom cable joining kits, transformers, gas meters, energy meters & corrosion protection products and providing services. During the financial year 2010-11 (i.e., w. e. f. September 24, 2010), the company acquired the energy business, consisting of manufacture and sale of connectors, fittings and insulation products from another company, ‘A’ Pvt. Ltd, Bangalore, on going concern basis under slump sale agreement. Based on valuation report from an independent valuer, the company has recognised fixed assets, inventories and liabilities at fair value and a capital reserve of Rs. 1476.72 lakh being excess of assets acquired over purchase consideration paid. A detailed working of the same has been supplied by the querist for the perusal of the Committee. Apart from the above-mentioned capital reserve, the company also has capital redemption reserve and revaluation reserve in its books as on 31.03.2011. The break-up is as follows:

Rs. in lakh

Capital reserve created as above                  1476.72

Revaluation reserve                                     82.17

Capital redemption reserve                           250.00

1808.89

2. During the financial year 2012-13, the company has passed the following two entries by debiting the above capital reserve:

(i). Non-moving inventory acquired out of the above acquisition amounting to Rs. 1,06,813.10 written off by debiting the above capital reserve.

 

(ii). Fixed assets acquired out of the above acquisition have been scrapped and loss amounting to Rs. 1,04,117.81 has been debited to the above capital reserve.

From the above, it can be summarised that the company has adjusted the following losses against the above reserves:

(i)  Any loss/likely loss on sale/disposal of some of the fixed assets acquired from ‘A’ Pvt. Ltd.

 

(ii) Any shortages/write-off in inventory taken over from ‘A’ Pvt. Ltd. and transferred to Baroda (new manufacturing facility) from Bangalore on acquisition of business.

 

(iii) Old and doubtful receivables pertaining to any of the business of the company.

B. Query

3. In this context, the querist has sought the opinion of the Expert Advisory Committee   as to whether the correct accounting treatment has been applied by the company by debiting the above-mentioned reserves as per the provisions of the Accounting Standards and the Companies Act or any other law.

C. Points considered by the Committee

4. The Committee notes that the basic issue raised by the querist relates to adjustment of  losses on sale/disposal of fixed assets, writing-off inventories and old and doubtful receivables against capital reserves created from business acquisition, and capital redemption reserves and revaluation reserves already standing in the books of the company. The Committee has, therefore, considered only this issue and has not examined any other issue that may arise from the Facts of the Case, such as, valuation of assets and liabilities acquired by the company, detailed aspects of accounting for acquisition of energy business by the company, recognition of capital reserves, recognition of impairment loss on assets as per AS 28, etc. The Committee wishes to point out that as per Rule 2 of the Advisory Service Rules, the Committee has answered the issue only from accounting point of view and not from the angle of interpretation of any legal enactments, etc. The Committee notes that the Companies Act, 1956 does not specifically contain any provision for utilisation of capital reserve and revaluation reserve. Further, Companies Act, 1956 does not envisage utilisation of capital redemption reserve for writing off losses on sale of fixed assets as well as for writing-off inventory and doubtful receivables.  Accordingly, the relevant accounting standards as applicable to the circumstances mentioned above have been considered for expressing the opinion given hereinafter. 

5. As regards accounting for loss/likely loss on sale of fixed assets, the Committee notes paragraphs 24 to 26 and paragraph 32 of Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, notified under the Companies (Accounting Standards) Rules, 2006 (hereinafter referred to as ‘the Rules’) which are reproduced below:

“24. Material items retired from active use and held for disposal should  be stated at the lower of their net book value and net realisable value and shown separately in the financial statements.

 

25. Fixed asset should be eliminated from the financial statements on disposal or when no further benefit is expected from its use and disposal.

 

26. Losses arising from the retirement or gains or losses arising from disposal of fixed asset which is carried at cost should be recognised in the profit and loss statement.”

 

“32. On disposal of a previously revalued item of fixed asset, the difference between net disposal proceeds and the net book value should be charged or credited to the profit and loss statement except that to the extent that such a loss is related to an increase which was previously recorded as a credit to revaluation reserve and which has not been subsequently reversed or utilised, it may be charged directly to that account.”

From the above, the Committee notes that losses arising on sale or disposal of fixed assets should be recognised in the statement of profit and loss. However, in case of a previously revalued item, the loss to the extent it is related to an increase which was previously recorded as a credit to revaluation reserve and which has not been subsequently reversed or utilised, is charged directly to that account (revaluation reserve). From the Facts of the Case, the Committee presumes that revaluation reserve which stands in the books of the company does not pertain to the transferor company. In other words, revaluation reserve does not pertain to the assets acquired by the company in business acquisition. Thus, the losses arising on sale or disposal of fixed assets cannot be adjusted against revaluation reserve of the company. Accordingly, the losses arising on sale of fixed assets acquired by the company in business acquisition should be recognised in the statement of profit and loss. Further, as regards likely/expected loss on sale of fixed assets, the Committee is of the view that as per the existing accounting framework, only 'incurred' losses are recognised. However, in the context of assets retired from active use and held for disposal, there is possibility that the company may expect loss on their disposal due to difference between their net realisable value and net book value, which again as per AS 10 should be recognised in the statement of profit and loss. On the basis of the above, since the losses on sale or retirement of fixed assets are to be recognised in the statement of profit and loss, the question of their adjustment  against capital reserves and capital redemption reserves  does not arise.

6. As regards accounting for non-moving inventories, the Committee is of the view that these represent obsolescence of inventories which would be reflected in the determination of net realisable value of the inventories.  In the context of writing down the inventories to their net realisable value, the Committee notes the following paragraphs of Accounting Standard (AS) 5, ‘Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies’, notified under the 'Rules':

“5. All items of income and expense which are recognised in a period should be included in the determination of net profit or loss for the period unless an Accounting Standard requires or permits otherwise.”

“12. When items of income and expense within profit or loss from ordinary activities are of such size, nature or incidence that their disclosure is relevant to explain the performance of the enterprise for the period, the nature and amount of such items should be disclosed separately.”

“14. Circumstances which may give rise to the separate disclosure of items of income and expense in accordance with paragraph 12 include:

(a) the write-down of inventories to net realisable value as well as the reversal of such write-downs;

…” (emphasis supplied by the Committee)

From the above, the Committee is of the view that write-off of non-moving inventory should be included in the statement of profit and loss.

7. Further, as regards write-off of inventories due to shortages observed in the acquisition of business and writing off of old and doubtful receivables, the Committee is of the view that these represent losses. In this regard, the Committee notes the following paragraphs of the Framework for the Preparation and Presentation of Financial Statements, issued by the Institute of Chartered Accountants of India:

“77. The definition of expenses encompasses those expenses that arise in the course of the ordinary activities of the enterprise, as well as losses. Expenses that arise in the course of the ordinary activities of the enterprise include, for example, cost of goods sold, wages, and depreciation. They take the form of an outflow or depletion of assets or enhancement of liabilities.

 

78. Losses represent other items that meet the definition of expenses and may, or may not, arise in the course of the ordinary activities of the enterprise. Losses represent decreases in economic benefits and as such they are no different in nature from other expenses. Hence, they are not regarded as a separate element in this Framework.

79. Losses include, for example, those resulting from disasters such as fire and flood, as well as those arising on the disposal of fixed assets. The definition of expenses also includes unrealised losses. When losses are recognised in the statement of profit and loss, they are usually displayed separately because knowledge of them is useful for the purpose of making economic decisions.”

From the above, the Committee is of the view that losses also represent expenses and accordingly, these should be charged to the statement of profit and loss as per the requirements of paragraph 5 of AS 5. Accordingly, the Committee is of the view that any write-off of inventories and receivables cannot be adjusted against capital reserves, capital redemption reserves and revaluation reserves.

D. Opinion

8. On the basis of the above, the Committee is of the opinion that accounting treatment followed by the company of debiting capital reserves, capital redemption reserves and revaluation reserves in respect of losses arising on (i) retirement or sale or disposal of fixed assets, (ii) writing-off of inventory, and (iii) writing-off of doubtful receivables is not correct as per the provisions of the Accounting Standards as discussed in paragraphs 5, 6 and 7 above. 

_____________________________

¹Opinion finalised by the Committee on 7.2.2013.