Expert Advisory Committee
ICAI-Expert Advisory Committee
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Query No. 29

Subject: Accounting treatment of raw-materials sent to manufacturer by the company for getting finished product.[1]

A. Facts of the Case

1. A company (hereinafter referred to as ‘the company’), a Government of India enterprise incorporated under the Companies Act, 1956, is engaged in the business of transmission of power from the generating units to different State Electricity Boards (SEBs) through its transmission network. The company owns and operates more than 90 per cent of India’s inter-state power transmission system (ISTS). It operates a network of 96,229 circuit kilometers of interstate transmission lines, 158 EHV AC and HVDC substations. The company intends to continue rapidly increasing its capacity to maintain and grow its leadership position and adding more transmission lines and substations.

2. For construction of transmission lines, one of the major material is conductor. The company is not manufacturing the conductor. It is being purchased from various manufacturers in India. Aluminium is the main raw material to manufacture the conductor.

3. To explore the possibilities in reduction in the cost of conductor, the company is undertaking a pilot project of getting conductor manufactured wherein the aluminium will be procured by the company from aluminium manufacturer and supplied to the manufacturer of conductor for conversion into finished product, i.e., conductor.

4. The company is purchasing aluminium from aluminium manufacturer (hereinafter called ‘supplier’). The aluminium is being supplied directly to the manufacturer of conductor (hereinafter called ‘manufacturer’) on endorsement in favour of manufacturer by the company. The company also raises the invoice for sale to the manufacturer. The company does not collect any payment from the manufacturer of conductor at this stage against the aluminium supplied and shows it as trade receivable in the books. Copies of the contract agreement with the manufacturer and the invoice raised for supply of aluminium rods have been supplied by the querist for the perusal of the Committee.

5. The querist has stated that the manufacturer, after processing aluminium along with some other raw materials and consumables (purchased by manufacturer at its own cost) like steel, wire, grease etc., manufactures the conductor and supplies it to the company and raises the invoice with full value of conductor as per the contract entered with the company. The company pays the invoice amount after deducting the cost of aluminium already supplied to the manufacturer for the conductor. The contract agreement is also entered with the manufacturer with complete break-up of cost of conductor and adjustment of cost of aluminium. It may be mentioned that the objective of the company in making this arrangement is primarily to enable it to derive the benefit of cheaper input costs (since the company would get better priced sums due to bulk purchases) and possibly greater assurance of timely delivery since the company itself is a PSU. The fact that the manufacturer is not required to finance the cost of raw material inputs during the production cycle is merely incidental and not the object of the transaction. The value of the invoices raised for sale of aluminium to the manufacturer shall not be significant in comparison to the turnover of the company (less than 5%).

6. The salient features of agreements with the supplier and the manufacturer are given below:

(i) MOU with the Supplier:

(a) The company will be giving its annual requirement to the supplier for purchase of aluminium rod. The supplier will deliver the material as per the company’s requirements.

(b) The price of the aluminium rod varies from time to time.

(c) Under MOU, the company will be eligible to receive quantity discounts on fulfillment of conditions given in MOU and also PSU discount. Such discounts / rebates given by the supplier may not be passed on to the manufacturer.

(d) The company will make payment to the supplier for the quantity purchased.

(ii) Terms of Letter of Award (LOA) issued to the Manufacturer:

(a) Scope of Work: Design, manufacture including delivery of aluminium rod from the supplier’s work located at various places in India to be sold by the company to the manufacturers on ‘sale-in-transit’ basis on purchase of same from the supplier from time to time during contract execution for manufacturing of ASCR Zebra conductor, matching with agreed work schedule, loading, transportation & insurance, unloading, storage and handling of aluminium at works of manufacturer, arranging all other raw materials and consumables etc., on manufacturer costs, conversion of raw material into finished ASCR Zebra conductor, testing and supply on FOR destination site basis of the conductor(s) as detailed in bidding documents.

(b) Pricing: The total price of the manufacturer includes:

(i) Ex-price for ASCR Zebra conductor

(ii) Total charges for transportation and insurance of conductors from supplier works to destination

(iii) Testing charges

(c) Terms of Payment:

(i) Manufacturer will not make any payment for invoice raised by the company for aluminium rod.
(ii) The company will make payment for invoice amount raised by the manufacturer after deducting cost of aluminium rod supplied by it.

(iii) Terms of Supply Agreement with the Manufacturer:

Points relating to Accounting Treatment

(a) Design, manufacture including taking delivery of aluminium rod from the supplier’s work located at the manufacturer’s plant to be sold by the company on sale-in-transit basis.

(b) Loading, transportation & insurance, unloading, storage and handling etc.

(c) Conversion of aluminium rod into finished ASCR Zebra conductor and supply on FOR destination site of the company as per contract.

(d) Pricing

1. Ex-work cost of price for ASCR Zebra Conductor.

2. Add :

a. Transportation and insurance from supplier work to destination site
b. Type test charges for test to be conducted.

(e) The ex-work cost of price for ASCR Zebra Conductor shall be determined based on following:

(i) Cost of aluminium rod supplied by the company

(ii) Inward freight and insurances

(iii) Cost of steel wires, grease and other consumables

(iv) Conversion cost (after set-off of input tax paid/CENVAT credit availed on aluminium rod)

(iv) Terms of Post-Bid Discussion with the Manufacturer:

(i) The manufacturer further confirms that in no case he will use aluminium from any other source other than that of the company under this contract. It also confirmed that the aluminium rod sold to him by the company under this contract on ‘sale-in-transit’ basis shall be utilised by him for supplies to be made under this contract only.

(ii) As per the provision of bidding documents, a quantity of 1.1860 MT of aluminium rod per km of finished ASCR Zebra conductor, will be sold by the company to the manufacturer on sale-in-transit basis. However, in case of actual tonnage of aluminium rod in different lot(s) exceeds the tonnage requirement worked out as above for finished Zebra conductor manufactured from corresponding lots(s), such excess quantities shall be considered to be sold by the company to manufacturer at extra cost.

(iii) The manufacturer also confirms that in the event of award, it shall not enter into any hedging/forward contract for aluminium.

(iv) The manufacturer is responsible to take necessary insurance policies in its own name for the aluminium rod to be sold to the manufacturer by the company during contract execution from time to time. Such policies shall adequately cover the manufacturer’s risks during transit of material to its works, storage, processing etc. till ex-works despatch of the finished conductor from its works.

(v) The manufacturer confirmed that it shall raise his invoice for payment of different price component as per the provision of bidding documents. It further confirmed that for determining other cost components in ex-works price, it will mention the following distinctly and separately:

(a) Cost of aluminium rod (worked out at proportionate value while raising invoice for progressive payment and final payment i.e., 90% of the cost and 10% of the cost respectively) (sale price of aluminium rod) (inclusive of excise duty and CST paid, as applicable) sold from time to time to manufacturer by the company on sale-in-transit basis) for manufacturing of different lots of conductors; plus

(b) Inward freight

(c) Set-off of additional CENVAT credit

Based on the aforesaid, the company will recover the sale price of aluminium rod (inclusive of excise duty and CST paid) sold to the manufacturer on sale-in-transit basis from time to time during the contract execution from the manufacturer’s respective invoices raised for payment of ex-works price component at different stages on proportionate basis.

vi) Material (aluminium rod) traceability and accounting

“The material accounting involves (i) receipts of raw material at stores (ii) issuing for production/work in progress and (iii) despatches of finished product. Relevant records will be maintained for identification/ traceability of material received from the company at every stage and the procedure.”

As regards the insurance requirement in respect of raw material (viz., aluminium rods) and finished good (viz., conductor), the querist has seperatley informed that the bid documents basically cover selling of conductor by the manufacturer to the company, i.e., ex-works supply from the supplier to the site and relevant clause for insurance requirement is provided in clause 28 of the ‘General Conditions of Contract’ of the Contract Agreements with the Manufacturer, a copy of which has been supplied by the querist for the perusal of the Committee. As regards insurance requirements in respect of raw material, the querist has referred to Appendix -3 (Insurance Requirements) to the contract agreement which while providing insurance requirements in respect of finished goods provide as follows:


“In addition to aforesaid insurance, the supplier shall also be responsible to take necessary insurance policies in its own name for the Aluminium Rod to be sold to the Supplier by the Purchaser during contract execution from time to time. Such Policies shall adequately cover the Supplier’s risks during transit of material to its works, storage, processing etc, till ex-works despatch of the finished conductor from its works.”

In view of above, for raw material, the manufacturer has to take insurance to cover his risk in his own name from the time the materials sold and during manufacture and upto despatch.

7. The querist has also stated that considering the above facts, the transactions can be accounted
for by one of the following methods:

Alternative 1:- Procurement of aluminium from the supplier be accounted for as ‘purchase of goods’ and aluminium given to the manufacturer may be accounted for as ‘sale of goods’ in the statement of profit and loss. Purchase of conductors from the manufacturer may be accounted for as construction material in the balance sheet.
Alternative 2:- Procurement of aluminium may be accounted for as input raw material as ‘construction stores’ in the balance sheet. Additional cost charged by the manufacturer for conversion of aluminium into conductor may be included under ‘construction stores’ as and when charged or simply as contract costs as and when incurred.

8. Arguments in favour of Alternative 1:

a. The entire documentation right from inception of tender procedure as well as contract agreement and other supplementary documentation consistently refers to sale of the aluminium rods by the company to the manufacturer.
In accordance with the above arrangement, Form ‘C’ will be issued with concessional payment of sales tax. CENVAT credit will be taken by the manufacturer which reduces the cost of conductor. All this is on the presumption that the transaction will be depicted as purchase and sale. Returns of sales tax and excise will be filed considering transaction as purchase and sale. In case the transaction is not accounted as per Alternative 1, the company will have to pay higher taxes.
b. The requisite compliances under the indirect tax laws referred to in the said documentation also consistently treat the said transaction as a transaction of sale of aluminium rods. The company through the contract agreement, has in fact entered into a contract whereby the manufacturer has agreed to supply certain conductors to the company. The said contract agreement has certain in-built safeguards to ensure use of appropriate material.
c. It is noted that aluminium rods sold by the company as ‘sale-in-transit’ to the manufacturer falls under a different tariff chapter under excise regulations from the chapter dealing with conductors which are sold by the manufacturer to the company.
d. The manufacturer has to take insurance of aluminium rods in its name and not in the name of company. This would indicate that the risk has already passed on to the manufacturer.
e. Accounting Standard (AS) 9, ‘Revenue Recognition’, contains certain illustrations which do not form part of the Accounting Standard. One of the illustrations deals with the situation sale/repurchase agreements i.e., where seller concurrently agrees to repurchase the same goods at a later date. This illustration does not squarely apply to the facts of the case as the goods (namely the conductor) supplied by the manufacturer to the company are distinct from aluminium rods sold by the company to the manufacturer in terms of their physical forms as well as their characteristics (apart from different excise categorisation) and therefore, the analogy of sale and buyback of the same goods may not be directly applicable.
f. The querist has also mentioned that in case of Rashtriya Ispat Nigam Ltd. vs. State of A.P.(1998) 109 STC 425(SC); N.M. Goel & Co. vs. STO (1989) 72 STC 368(SC); CST vs. Mohammad Zahoor (1975) STC 414(SC); and Hindustan Steel Ltd. vs. State of Orissa(1970)26 STC 302(SC), it has been held that “Material supplied by the contractee: This has been a controversial question. In building contracts, materials such as bricks, coal and cement, when supplied to contractor and value of such supplies deducted from the contract value, was held to be a sale. By use or consumption of materials in the work of construction, there is passing of the property in the goods from the contractee to the contractor. By appropriation and by the agreement, there is a sale, which is liable to tax.” However, in case of Cooch Behar Contractors Asso. vs. State of West Bengal (1996) 103 STC 477 (SC), it has been further held that “there could be a works contract where the customer supplies material free of cost to the contractor, with the condition that such material is supplied to the contractor on bailment, where the ownership of the material always vests with the contractee. The cost is nowhere reflected in the contract and consequently, no deduction is made from the running bills of the contractor. In such a situation, as there is no transfer of property in goods passing from the contractee to the contractor, there shall not be a sale. On the other hand, if prices of such goods are deducted from or adjusted against the bills or dues of the contractor, it will be considered as sale and their value form part of the contractual transfer price, for the purpose of the tax.”

 

9. Arguments in favour of Alternative 2:

(i) On examination and analysis of above clauses of LOA, Post Bid documents and agreement between the manufacturer and the company, a view emerges that, by endorsing purchase of aluminium rod on the invoice documents of supplier in favour of the manufacturer, terming the same as ‘sale-in-transit’, do not constitute sale of aluminium rod by the company to manufacturer.

(ii) By endorsement of documents, rights in the goods do not pass to the manufacturer, right in goods is transferred when there is no encumbrance to the buyer. That is to say the buyer has all the rights to use the goods, in the manner it likes. It can use it for own consumption or re-sell the same to any person at the price, time and venue, as it likes.

(iii) Paragraph 5 to ‘A. Sale of Goods’ of Illustrations to AS 9 clearly, inter alia, states as given under:

“5. Sale/repurchase agreements i.e. where seller concurrently agrees to repurchase the same goods at a later date.”

To apply the above paragraph, it is not necessary that re-purchase material should be same material which has been sold earlier. Substance is more important than form as given in the Accounting Standard (AS) 1, ‘Disclosure of Accounting Policies’ of the Institute of Chartered Accountants of India.

(iv) The agreement/arrangement between the manufacturer and the company involves delivery of material to the manufacturer with restricted use and repurchase agreement for follow-on product.

Since there is no actual sale to and purchase from manufacturer, the company should not account in books as sales and purchase.

 

B. Query

10. On the basis of the above, opinion of the Expert Advisory Committee is sought by the querist on the correct accounting treatment between alternative 1 or 2 mentioned in paragraph 7 above or any other alternative.

C. Points considered by the Committee

11. The Committee notes that the basic issue raised by the querist is whether the supply of raw material (viz., aluminium rod) by the company to the manufacturer for manufacturing conductors to be supplied back to the company should be regarded as sale by the company. In other words, whether the supply of raw material to the manufacturer can be considered as an independent transaction from the transaction of purchase of the conductors from the manufacturer given the fact that such conductors would be manufactured only by using the raw material supplied by the company. The Committee has, therefore, considered only this issue and has not examined any other issue that may be contained in the Facts of the Case, such as, accounting treatment of other costs incurred to manufacture conductors, accounting treatment in the books of the manufacturer, etc. Further, the Committee wishes to point out that the opinion expressed hereinafter is purely from accounting point of view and not from the view point of interpretation of any legal enactment, such as, Sale of Goods Act, 1930 and enactments relating to Excise, CENVAT, VAT, etc., since in accordance with Rule 2 of its Advisory Service Rules, the Committee is prohibited from doing so.

12. The Committee notes that in the extant case, the aluminium rods are procured by the company and supplied to the manufacturer of conductor for conversion into finished product, i.e., conductor. As regards the issue whether the aluminium rods sent to the manufacturer can be treated as sales by the company to the manufacturer, the Committee notes paragraph 17(b) of Accounting Standard (AS) 1, ‘Disclosure of Accounting Policies’, which states as follows:

“b. Substance over Form

The accounting treatment and presentation in financial statements of transactions and events should be governed by their substance and not merely by the legal form.”


The Committee notes from the above that the transactions and events are accounted for and presented in accordance with their substance, i.e., the economic reality of events and transactions, and not merely in accordance with their legal from. In other words, it is the ‘economic reality’ that is important in accounting and not only the ‘legal reality’.

13. The Committee further notes that Accounting Standard (AS) 9, ‘Revenue Recognition’, notified under the Companies (Accounting Standards) Rules, 2006, provides as follows:

“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.”

The Committee notes that as per the principles enunciated above, revenue should be recognised when all significant risks and rewards of ownership are transferred to the buyer and the seller retains no effective control of the goods transferred to a degree usually associated with ownership. From the Facts of the Case, the Committee notes that although the legal form of the transaction is that the company is raising invoice on the manufacturer for the supply of raw material to it and the manufacturer has also taken an insurance policy in his name for the goods supplied to him, the substance of the transaction is that the company still retains effective control on the aluminium rods transferred to the manufacturer and the significant risks and rewards relating to ownership of raw material (aluminium) are not transferred to the manufacturer, as explained below:

 

(i) The ‘Terms of Post-Bid Discussion with the Manufacturer’ as given in paragraph 6 above provide that the aluminium rods transferred to the manufacturer can only be used for the manufacturing of conductor of the company and cannot be used for any other purposes. In other words, the manufacture will not use aluminum from any other source other than that supplied by the company. It clearly indicates that the manufacturer has no control on the aluminum rods to be used in the manufacture of conductor and the company controls the usage of aluminium rods.
(ii) As per the provision of bidding documents as given in paragraph 6(iv) above, “a quantity of 1.1860 MT of aluminium rod per km of finished ASCR Zebra conductor, will be sold by the company to the manufacturer on sale-in-transit basis. However, in case of actual tonnage of aluminium rod in different lot(s) exceeds the tonnage requirement worked out as above for finished Zebra conductor manufactured from corresponding lots(s), such excess quantities shall be considered to be sold by the company to manufacturer at extra cost”. From this provision, it is clear that an estimated quantity of aluminium rod is sent to the manufacturer for use in the manufacture of finished product and if there is excess consumption of material, then that excess quantity only is considered as sale to the manufacturer. In other words, the company does not sell aluminium rods to the manufacturer rather it issues raw materials on estimated basis in proportion to finished goods.
(iii) As per the ‘Terms of Post-Bid Discussion with the Manufacturer’ as given in paragraph 6(iv) above, the manufacturer will maintain relevant records for identification/ traceability of material received from the company at every stage and the procedure. Further, it is noted from the contract agreement between the company and the manufacturer that the company will also receive a declaration from the manufacturer regarding utilisation of aluminium rods supplied to it by the company. These facts further provide evidence that the company is controlling the material sent by it to the manufacturer.
(iv) While raising ex-works invoice, the manufacturer mentions different price components stating separately the price charged for aluminium rods, inward freight, insurance, cost of other consumables and conversion cost (after set off of the CENVAT credit on account of aluminium rods and scrap value of raw materials). Hence, the invoice raised basically segregates the various components being reimbursed by the company alongwith the conversion cost. Thus, the manufacturer is not charging for the end product but is primarily charging for the conversion cost and other cost being incurred by him for conversion of aluminium rods into conductor.
(v) It was further noted from the price break-up on invoice as per the contract agreement that the same price of aluminium rod is being charged by the manufacturer as is being incurred by the company in respect of the aluminium rods. Thus, the manufacturer does not possess any price risk or reward associated with the ownership of aluminium rods.
(vi) The manufacturer cannot enter into any hedging/forward contract for aluminium rods, which indicates that the manufacturer neither has any control on the aluminium rods nor it can hedge its risk, if any, arising in respect of raw material or obtain any benefit out of it.

 

14. From the above, the Committee is of the view that in the extant case, the manufacturer does not have control on the use of aluminium rods supplied to it by the company. The Committee is also of the view that even though invoices may be raised for raw materials transferred to the manufacturer, significant risks and rewards of ownership and effective control on the goods still vest with the company. Therefore, in the view of the Committee, there is no sale to the manufacturer. In fact, the company pays to the manufacturer only for conversion of aluminum rod into conductor. Accordingly, the Committee is of the view that no revenue from sales should be recognised on despatch of raw materials to the manufacturer rather, the company should treat them as its own inventory and should account for it accordingly. The company should also make adequate disclosures so as to clearly disclose that such inventory is lying in the premises of the manufacturer for finished product, viz., conductor.

15. The Committee also wishes to point out that the treatment of transactions under MoU arrangements as purchase and sales of the company for the purposes of taxation cannot be the criteria for determining the true nature of the transactions and their correct accounting treatment.

D. Opinion

16. On the basis of the above, the Committee is of opinion that that to account for the raw material supplied by the company to the manufacturer as its own inventory is the appropriate alternative. However, the company should also make adequate disclosures so as to clearly disclose that such inventory is lying in the premises of the manufacturer of the conducter, as stated in paragraph 14 above.

 

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[1]Opinion finalised by the Committee on 15.11.2013