Expert Advisory Committee

1.39 Query

Treatment of disputed performance guarantees.

1. M/s. XYZ Limited, a public sector undertaking, manufacturing cement, under its expansion plan, engaged M/s. WN Limited for fabrication and supply of main machinery and equipments of its clinkerisation plant and cement grinding plant.

2. The letter of intent placed on M/s WN Ltd. in 1974-75, provided for a performance guarantee of the various sections of plant; figures of per hour output, power consumption etc. were specified. It was stipulated that after the erection and trial run, performance tests of the various sections of plant would be undertaken. Standards of liquidated damages towards performance failure were specified. As per the performance guarantee clause, M/s WN Ltd. gave bank guarantees totaling Rs. 64 lakhs. The maximum amount of liquidated damages as per bank guarantees was limited to the amount specified therein and it was stipulated that M/s XYZ Ltd. will be the sole judge as to whether performance failure had taken place and the banks will remit the amount to M/s XYZ Ltd. on invocation of the bank guarantee. The letter of intent also provided for reference of dispute to arbitrators, one to be appointed by each party.

3. The bank guarantees were extended from time to time as the performance tests could not be completed or given as agreed by M/s WN Ltd. The first phase of the plant was under trial run up to March 1982 and the second phase up to March 1984. Finally, M/s. XYZ Ltd. were of the opinion that the equipments supplied by M/s WN Ltd. did not meet the standards of performance as provided in the letter of intent. Hence, the company invoked the bank guarantees of Rs. 64 lakhs in 1986-87. The matter was disputed by M/s WN Ltd. and a suit was filed by them in the court for a reference of dispute to arbitration in terms of the arbitration clause.

4. While finalizing the accounts for the year 1986-87, the amount of Rs.64 lakhs realized by invoking the performance guarantee was kept by M/s XYZ Ltd. under the head “Current Liabilities” as “Performance Guarantee Suspense Account”, the matter being under dispute. The Board of Directors, while adopting the accounts of the company, were of the view that it was incorrect to show the amount under current liabilities and advised to transfer the same to Capital Reserve. The matter was discussed with the statutory auditors, who did not agree with the views of the Board. The amount was also not credited to plant and machinery account as it was felt that it was not practical to ascertain which part of the plant was to be adjusted. Moreover, it was felt that this would also involve recalculation of depreciation charged to profit and loss account in past years. Finally, after approval of the statutory auditors, the sum of Rs.64 lakhs received by invoking the bank guarantees was credited to ‘Other Income A/c’ by the company and simultaneously a provision was made as “Provision for replacement of plant & machinery”. The sum of Rs. 64 lakhs was also shown as contingent liability of the company, in the notes forming part of the accounts.

5. The querist wishes to have the opinion of the Committee on the following issues:

(a) Whether the company was right in initially showing the amount of Rs. 64 lakhs received on invoking the bank guarantees as “Performance Guarantee Suspense A/c” under the head ‘Current Liabilities’ as the matter was disputed by M/s W.N. Ltd. before High Court.

(b) Whether the amount could be transferred to Capital Reserve as advised by the Board, keeping in view the fact that the company had accumulated losses for Rs. 656.81 crores and that as per Part III of Schedule VI to the Companies Act, 1956, the term ‘Reserve’ shall not include any amount retained by way of providing for any known liability. (According to the querist, the expression ‘liability’ shall include all liabilities in respect of expenditure contracted for and all disputed or contingent liabilities).

(c) Whether the company was right in treating Rs. 64 lakhs received by invoking performance guarantee as its income for the year, when the matter was under dispute before the court.

(d) What would be the most appropriate accounting treatment in the above matter?

Opinion December 21, 1988

1. The Committee notes that according to Accounting Standard (AS) 10, Accounting for Fixed Assets”, issued by the Institute of Chartered Accountants of India, “the cost of a fixed asset may undergo changes subsequent to its acquisition or construction on account of exchange fluctuations, price adjustment, changes in duties or similar factors”. Thus, AS 10 recognises that price adjustments subsequent to the acquisition of an item of fixed asset may necessitate a revision of its historical cost.

2. The Committee further notes that Accounting Standard (AS) 6, “Depreciation Accounting” recommends that “where the historical cost of a depreciable asset has undergone a change due to increase or decrease in long term liability on account of exchange fluctuations, price adjustments, changes in duties or similar factors, the deprecation on the revised unamortised depreciable amount should be provided prospectively over the residual useful life of the asset.”

3. It is recognised that an asset is actually a bundle of services to be received by the enterprise in future from its use. The price to be paid for acquiring the asset is determined by an enterprise considering the services that it expects to receive from the asset. In general, the price of an asset with a lower standard of performance (in terms of output per unit of time, consumption of inputs, etc.) would also be lower compared to another asset with a higher standard of performance. It can be argued on this basis that, in case an asset fails to meet the performance standards stipulated in the contract and the supplier pays damages for the same, it would be appropriate that the damages so received by the enterprise should go towards reducing the price paid for the asset to the extent the amount of damages is representative of reduction in the standard of performance. That portion of damages which is in the nature of penalty should be treated as ‘other income’ and disclosed as suggested in para 4 below.

4. On the basis of the above, the Committee is of the view that, in the circumstances cited by the querist, the most appropriate course of action would be to keep the amount of guarantees invoked (i.e., Rs.64 lakhs) in a suspense account till such time that the dispute is settled. In case the dispute is settled in favour of company, it would be appropriate to effect change in the historical cost of the fixed asset(s) concerned, to the extent the liquidated damages represents reduction in the standard of performance. The total guarantee amount received can be apportioned amongst the various items of plant and machinery concerned on a reasonable basis, e.g., in proportion of gross value of various items of plant and machinery concerned. As recommended by AS 6, the change in the historical cost in the above circumstances would not require recomputation of depreciation for the past years. However, the depreciation charge for future years would require to be suitably adjusted to take account of the change in the historical cost of fixed assets. That part of the liquidated damages which does not represent reduction in the standard of performance, should be treated as other income and should be disclosed as an ‘Extraordinary Item’ as recommended in Accounting Standard (AS) 5 on ‘Prior Period and Extraordinary Items and Changes in Accounting Policies’, issued by the Institute of Chartered Accountants of India. However, if it is not possible to ascertain the extent of the amount penalty, the entire amount should be deducted from the cost of the assets concerned.

5. The opinion of the Committee on the issues raised by the querist in para 5 of the query, is as below:

(a) The company was right in showing the amount of Rs. 64 lakhs received on invoking the bank guarantees as “Performance Guarantee Suspense A/c”, under the head ‘Current Liabilities’, until the settlement of the dispute. The Committee is further of the opinion that in case the dispute is settled in favour of the company, the amount should be adjusted as recommended in para 4 above.

(b) No.

(d) The appropriate method has been stated in (a) above.

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