Query No. 27
Subject: Determination of ‘normal operating cycle period’ under revised Schedule VI to the Companies Act, 1956.[1] A. Facts of the Case 1. A company is a navratna defence public sector undertaking. It is a multi-unit (nine manufacturing units) and multi-product company (with over 350 products). The products are in the area of military communication, radars, naval systems, C4I systems, electronic warfare systems, etc. 2. The querist has stated that as per Note 1 to General Instructions for Preparation of Balance Sheet under Revised Schedule VI to the Companies Act, 1956, issued by the Ministry of Corporate Affairs (MCA), " An asset shall be classified as current when it satisfies any of the following criteria:
Similarly, "A liability shall be classified as current when it satisfies any of the following criteria:
Further, under Revised Schedule VI, an operating cycle has been defined as follows:
3. The querist has further stated that it has been clarified in the Guidance Note on the Revised Schedule VI to the Companies Act, 1956, issued by the Institute of Chartered Accountants of India (ICAI) that a company's normal operating cycle may be longer than twelve months e.g., companies manufacturing wines, etc. However, where the normal operating cycle cannot be identified, it is assumed to have duration of twelve months. Determination of operating cycle period in the company: 4. The products of the company are of different categories varying from small components to setting up of large communication systems each with different operating cycle varying from few months to more than a year. Also, there is no other comparable company, within India, with such a product mix. In view of the diversified product mix, it is not appropriate to determine a common operating cycle at company/unit level. 5. Also, determination of a common operating cycle at product level is not feasible since even in case of similar products, for example, radar, the operating cycle in respect of each contract (for supply of radar) can vary. This is due to the fact that each contract for radar may have its unique technical specification, complexity (leading to different production cycle time), installation and commissioning requirements (the time for installation and commissioning may vary depending on the terrain where a radar is required to be installed). 6. As the company is not in a position to determine operating cycle period at company/unit level/ product level, it has decided to determine operating cycle period at ‘individual contract level’. 7. According to the querist, normal operating cycle period can be determined mostly based on past data which is available either within the company or in the industry in which the company operates. As the company operates in the defence sector (almost 80% to 85% of its products are sold to Indian Defence Forces) and in most of the cases, the company is the sole supplier of its products, industry related comparative data is not available in respect of its products for determination of the normal operating cycle period. 8. Also, since in the company, majority of the contracts are unique (and do not generally have a precedent), it is not possible to determine its ‘normal operating cycle’ period as determination of the normal operating cycle period would presuppose that a similar production activity has been carried out earlier and hence a reference (i.e., normal) period is available. 9. The querist has also stated that taking twelve months as the normal operating cycle period citing non-determinability of normal operating cycle period would be misleading since this would amount to treating inventory/trade receivables relating to most of the high value contracts as non-current since the delivery period in respect of these contracts would be generally more than twelve months and going upto even 36 or 48 months. 10. Also, it is not uncommon for the contract execution period getting extended beyond its originally agreed date due to customer request (like change in specifications of the product, non-availability/readiness of installation site, etc.) or company's request (non-availability of material, technical issues, etc.). The company has also considered the extended period for execution of the contract, as mutually agreed between the parties (with or without levy of liquidated damages), as a part of the normal operating cycle period in the absence of a reference period (i.e., normal period) within which a contract is to be completed. 11. Considering all the above factors and after detailed discussions internally and with chartered accountancy firms, the company during the year 2011-12, has decided to determine operating cycle at individual contract level and has also treated the execution period in respect of each contract as its normal operating cycle period. 12. As per the querist, non-determination of the ‘normal operating cycle’ period at contract level raises an issue with respect to the current/non-current classification of assets and liabilities especially in relation to classification of inventory and trade receivables. Inventory 13. The querist has stated that as per revised Schedule VI norms, subject to other conditions, inventory purchased for execution of a contract would have to be classified as non-current if it is likely to be used beyond the normal operating cycle period of the contract. However, in the absence of determination of normal operating cycle period of a contract, the company has classified all inventories held against a contract as current till the contract is fully executed (however, inventory in respect of which provision – as non-moving/slow moving item – has been made is treated as non-current). According to the querist, while this appears apparently to be in contradiction to the classification criteria as defined in revised Schedule VI, it is in line with the ICAI clarification[2] that all inventory is current even in cases where provision for non-moving and slow moving items has been made (emphasis supplied by the querist). In view of the above, non-determination of normal operating cycle period at company/unit level does not seem to impact the company's current/non-current classification of inventory. Trade Receivables 14. The querist has further stated that as per revised Schedule VI norms, subject to other conditions, trade receivables realisable beyond the normal operating cycle would have to be classified as non-current. However, in the absence of determination of normal operating cycle period of a contract, the company has classified all trade receivables outstanding against a contract as current till their realisation. However, where contract execution period has been extended by the customer with a condition that liquidated damages will be levied for the delayed delivery, the amount equivalent to the liquidated damages leviable (normally limited, as per contract, to a maximum amount of 5%/10% of the value of delayed delivery) is treated as doubtful at the time of booking of the sale itself, and classified as non-current. In addition, trade receivables identified as doubtful as per the company's accounting policy are also classified as non-current. 15. The company is of the view that, on account of the above practice, non-determination of normal operating cycle period has no major impact on the company's classification of trade receivables due to the following reasons:
B. Query 16. On the basis of the above, the querist has sought the opinion of the Expert Advisory Committee on the following issues:
C. Points Considered by the Committee 17. The Committee notes that the primary question raised by the querist relates to the determination of normal operating cycle and classification of inventories and trade receivables as current or non-current assets in accordance with the revised Schedule VI to the Companies Act, 1956. The Committee has, therefore, considered only this issue and has not examined any other issue arising from the Facts of the Case, such as, classification of assets/liabilities other than inventories and receivables, accounting treatment of liquidated damages, revenue recognition and recognition of doubtful debts in relation to leviable liquidated damages, constituents of normal operating cycle period, classification of receivables that are on deferred credit terms, etc. 18. The Committee notes from the definition of ‘current asset’ as per Note 1 of ‘General Instructions for Preparation of Balance Sheet’ to the revised Schedule VI that for classification of an asset as current, it has to be determined whether that asset is expected to be realised or intended for sale or consumption within the company’s normal operating cycle period. Further, in case an asset is held primarily for trading, or is expected to be realised within 12 months after the reporting date or is a cash or cash equivalent, it may also be classified as a current asset. The normal operating cycle period has been defined as the time between the acquisition of assets and their realisation into cash or cash equivalents. Accordingly, for classification of inventories and debtors as current, it is to be seen as to whether at the reporting date, these are expected to be realised within the normal operating cycle of the company. They can also be classified as current if they meet any of the other relevant condition(s) as mentioned above. 19. As regards determination of normal operating cycle period, the Committee is of the view that normal operating cycle is the normal time taken from initial acquisition of assets for processing to their realisation into cash or cash equivalents. The Committee notes from the Facts of the Case that the company in the extant case is engaged in multiple businesses and product lines making it difficult to determine single normal operating cycle for the company. Further, the querist has also stated that in case of similar products also, the operating cycle varies due to unique technical specifications, etc. In this regard, the Committee notes the following paragraphs of the Guidance Note on the Revised Schedule VI to the Companies Act, 1956:
On the basis of the above, the Committee is of the view that in the extant case, normal operating cycle should be determined for different product lines and businesses considering their nature. The Committee is of the view that in common parlance, operating cycle refers to the time taken from the outflow of cash or cash equivalents for acquisition of assets for processing until the cash or cash equivalents realised therefrom. Thus, operating cycle in the extant case should be determined in respect of each of the product lines/businesses of the company on the basis of related cash outflows to cash realisation. The Committee is further of the view that in a single product line/business also, there could be different operating cycles depending on the milestones specified in the contract and complexity of the product, etc. The Committee is of the view that these milestones should also be considered while determining the normal operating cycle provided these result into realisation of cash. For example, where a contract has milestones according to which after a defined work has been performed, a payment becomes due within a specified period, these milestones should be considered for classification of assets and liabilities as current or non-current. Similarly, the Committee is of the view that the complexity of the product should also be considered while determining operating cycle for different product lines/businesses. The Committee is further of the view that if the company produces products of similar nature involving significantly different production time periods due to different levels of complexities involved, then such products should be considered to constitute different product lines. For instance, the company is producing radars – one type of radar may be constructed in say two months while the other type of radar may be constructed in say two years time because the latter type of radar is more advanced and involves more complex technology than the former. The Committee is of the view that in this case, the two radars should be considered to be constituting different product lines. Thus, the Committee is of the view that irrespective of the different types of contracts the company is engaged into, it should identify different nature of product lines and businesses in which it is engaged and then determine the normal operating cycle for each such product line and business. As regards the querist’s argument regarding absence of past experience or similar trend in the industry, the Committee is of the view that the operating cycle should be determined considering the normal estimated/expected time taken in performing each activity necessary for the products of similar nature. However, if it is not practicable for the company to determine operating cycle on the basis of above discussion, then operating cycle should be assumed to be 12 months. Therefore, the Committee is of the view that operating cycle cannot be determined on contract basis. 20. As regards classification of inventories as current assets, the Committee notes the following paragraphs of the Guidance Note on the Revised Schedule VI to the Companies Act, 1956:
As mentioned above, inventory is primarily intended for consumption or sale in the course of the normal operating cycle or for the purposes of being traded. Accordingly, it should be classified as a current asset. The Committee notes that in the extant case, the company purchases inventory for execution of a contract out of which certain items have been identified by it as non-moving/slow moving. Thus, in the extant case, inventories are held by the company for use in the manufacturing process and not for trading. The Committee has also considered the FAQs on the Revised Schedule VI, as referred by the query in paragraph 13 above. However, the Committee is of the view that if at any reporting date, a portion of inventory is identified as non-moving/slow inventory, it signifies that such inventories are not expected to be consumed within the normal operating cycle of the product or business to which it pertains. Hence, such inventories should be classified as ‘non-current’. 21. As regards classification of trade receivables, the Committee notes paragraph 8.8.3 of the Guidance Note on the Revised Schedule VI to the Companies Act, 1956 as given below:
From the above, the Committee is of the view that the classification of trade receivables should reflect the factual position in the context of realisablity within the normal operating cycle as discussed above. The Committee notes from the Facts of the Case that trade receivables equivalent to liquidated damages leviable for delayed delivery are considered as doubtful debts and hence are classified as non-current. The Committee does not agree with this classification of the company. The Committee is of the view that a trade receivable should be classified as current or non-current depending on its realisation within normal operating cycle as discussed above. The Committee further notes that the Revised Schedule VI requires disclosure of doubtful debts separately for current and non-current receivables. Thus, the Committee is of the view that the classification of doubtful debts should be based on the classification of trade receivables to which doubtful debts pertain. Accordingly, in the extant case, the entity’s classification of receivables that are not expected to be realised on account of levy of liquidated damages as non-current is incorrect. D. Opinion 22. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 16 above:
__________________________ [1]Opinion finalised by the Committee on 15.11.2013. [2] The Committee wishes to clarify that the stated clarification is only a part of the Frequently Asked Questions (FAQs) on the Revised Schedule VI, issued by the Corporate Laws and Corporate Governance Committee of the ICAI.
|