Query No. 4

Subject:           Presentation of interest expenses on advance received from customer.[1]

A.        Facts of the Case  
                                                  
1.         The querist is a defence public sector undertaking (hereinafter referred to as ‘the company’) under the Ministry of Defence and is engaged mainly in the construction of warships and submarines for Indian Navy.  The company had entered into an agreement for design, construction and delivery of multi-purpose support vessels with an overseas customer.  The agreement provided for payment of 20% on signing of the contract and 80% on delivery of the ship. The agreement also provided for refund of advance along with interest in case of cancellation of contract.  The relevant clause reads as under:

“The Contract shall allow a grace period for delay in delivery of forty days from the date of scheduled/ extended delivery without any Liquidated Damages payable by the Builder.  For delivery after the grace period, Builder to pay Liquidated Damages @ US$ 18,000/- per day or prorate thereof, till the actual day of delivery.  Buyers to have the right to cancel contract in case delivery is delayed (due to reasons excluding Force Majeure circumstances and delays due to Buyers’ account) beyond four months from the delivery date. However, in case of delays due to Force Majeure circumstances within the Builder’s Yard or at its Sub-contractor’s yard, Buyers shall have right to cancel the contract for delay in delivery beyond six months from the Delivery Date.  It is clearly understood and agreed by both parties that Buyers have the right to cancel contract for delay in delivery beyond six months from the Delivery Date, due to any reasons whatsoever, other than those delays due to Buyers’ account.

Upon such cancellation by the Buyer and upon the Buyer’s Demand, the Builder shall within 10 (ten) days refund full amounts of total sums paid by the Buyer to the Builder in advance of delivery together with interest @ 7% p.a. from the day following the date of receipt by the Builder of the pre-delivery installment to the date of refund.

            It is clearly understood that in the event of any conflict between this Clause and any other Clause in the Contract, the terms in this Clause shall prevail.”

During the financial year 2011-12, the overseas customer served the notice for termination of the agreements. The company had refunded the initial advance along with interest. 

2.         The company has been showing interest expenses in the accounts separately and not under ‘Other Expenses’.  Interest cost was disclosed under ‘Finance Costs’ as ‘Interest Expenses – Project Related’ in Note No 2.26 of the  Notes to Accounts, as shown below:

                                                             F. Y. 2011-12                F. Y. 2010-11

2.26     FINANCE COST                                        

Interest Expenses – Project Related        xx                                   xx
Others                                                 xx                                   xx
                                                                   xx                                  xx

3.         In view of the wide fluctuations in the expenses under the above category from year to year based on the stage of execution of the project, the company has been showing the expenses under two heads, viz., ‘Other expenses – project related’ and ‘Other expenses’, only to differentiate from the other expenses directly attributable to the project(s) as shown below as per the extracts of statement of profit and loss given in Note Nos. 2.27 and 2.28 of the Notes to Accounts.

2.27 OTHER EXPENSES – PROJECT RELATED

2.28     OTHER EXPENSES

4.         As per the querist, the Revised Schedule VI to the Companies Act, 1956 per se does not indicate any particular line item under which interest paid or payable is to be presented except under the head ‘Finance Cost’.

5.         The Government auditors has referred to paragraph 9.5.5 of the ‘Guidance Note on the Revised Schedule VI to the Companies Act, 1956’, issued by the Institute of Chartered Accountants of India and stated that the interest expenses under ‘Finance Cost’ include interest paid on borrowings from banks and others, on debentures, bonds or similar instruments etc. The interest paid on trade advances received from customer should not have been classified under ‘Finance Cost’ and should have been taken under ‘Other Expenses’, i.e., under Note No. 2.27 instead of 2.26.

6.         The querist has drawn the attention of the Committee to Annexure C of the Guidance Note on the Revised Scheduled VI to the Companies Act, 1956 which gives a comparison of Old and Revised Schedule VI. Annexure C of the Guidance Note, inter alia, states that under Revised Schedule VI, finance cost is to be reported on ‘aggregate basis’.  Based on the statements in the Guidance Note, the company presented interest paid/payable to the overseas customer under ‘Finance Cost (Interest Expenses – Project Related)’.

B.  Query

7.         In view of the above, the querist has sought the opinion of the Expert Advisory Committee as to whether the presentation of interest paid/payable on advance received from the customer is appropriate.

C. Points considered by the Committee

8.         The Committee notes that the basic issue raised by the querist relates to presentation of interest expenses on advance received from the customer on cancellation of the contract. 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, detailed accounting aspects of effects of cancellation of the contract by the customer, classification and disclosure of other expenses related and not related to project, accounting for interest expenses for a period from cancellation of contract till its payment, etc.

9.         The Committee notes that in the extant case, the advance received from the customer is not an interest-bearing liability during the existence of the contract. However, interest is payable if the contract is cancelled by the customer due to reasons not attributable to the customer.  The Committee is of the view that such interest is compensation payable to the customer. Under the terms of the contract, while the customer is entitled to refund of advance, the company is not compensated for any work done. Thus, in substance, the interest expense is a penalty levied on the company for failure to fulfil its contractual obligations within the time permitted under the contract. Accordingly, it should not be recognised as ‘finance cost’ in the financial statements and therefore, the presentation of interest expenses on advance received from the customer as ‘finance cost’ is not appropriate. 

D.        Opinion

10.       On the basis of the above, the Committee is of the opinion on the issue raised by the querist in paragraph 7 above that the presentation of interest expenses on advance received from the customer as ‘finance cost’ is not appropriate as discussed in paragraph 9 above.

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