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Accounting of foreign income on cash basis.

Written By Admin on Sunday, 25 May 2014 | Sunday, May 25, 2014


Expert Opinion finalised by the Committee on 17.3.2008


A. Facts of the Case

1. A Government of India enterprise under the Ministry of Steel, is executing engineering and consultancy jobs and preparing various reports like feasibility report, project report, etc., for clients in India and abroad. According to the querist, the company is following accrual basis of  accounting as  per  the  Companies  Act,  1956. Accordingly, revenue is recognised on accrual basis and as per the applicable accounting standards.

2. The querist has informed that long back, the company used to follow accrual basis of accounting in case of foreign consultancy jobs also, in line with domestic jobs. However, due to various reasons prevailing in the countries like Nigeria, Iran, Bangladesh, etc., where most of the clients were located, receipt of payment from the clients became uncertain. The querist has further informed that the company had to make provision for bad debts/write off the bad debts frequently as per the audit observations on the ground of uncertainty of realisation. However, constant follow up for realisation of the payment continued and in some cases, the company realised the payment after an abnormally long period. Recognition of income due to receipt of these payments used to create confusion as to whether these should be treated as current year’s income or prior period income. According to the querist, though the  amounts were insignificant but  occurrence  of  such events was not insignificant. However, to avoid frequent provisioning of bad debts/write off in a particular period due to uncertainty and subsequently recognising it as income in future, the company started following the practice of recognition of foreign income on receipt basis.

3. The querist has informed that the company has also disclosed the basis of accounting in case of foreign consultancy jobs in the notes to the accounts. The company is following the same practice consistently every year. However, this is not specifically mentioned in the accounting policy of the company for revenue recognition. The querist has mentioned that the company provides only consultancy services and is not involved in export of any plant or machinery whatsoever. Income from foreign services is also insignificant and low which is even less than 1% of the company’s total turnover.

4. The querist has further clarified that in respect of foreign consultancy jobs, the company gets orders from various overseas clients with specific fees, terms of payment, etc. The company raises invoices from time to time as per the orders. Therefore, no uncertainty either with respect to the measurement of the payment that is to be received from the client or in respect of the creditworthiness of the client is envisaged at the time of receipt of order. However, due to various reasons, uncertainty arises at a later date.

B. Query

5. The querist has sought the opinion of the Expert Advisory Committee on the following issues:

(a) Whether the company can continue the same practice, i.e., cash basis of accounting for foreign consultancy jobs or should it follow the accrual basis of accounting.

(b) Whether  there  is  any  deviation/violation  of  the Companies Act, 1956 or any Accounting Standard.

C. Points considered by the Committee

6. The Committee notes section 209(3) of the Companies Act, 1956, which states as follows:

“(3)  For  the  purposes  of  sub-sections  (1)  and  (2),  proper books of account shall not be deemed to be kept with respect to the matters specified therein,–

(a) if there are not kept such books as are necessary to give a true and fair view of the state of affairs of the company or branch office, as the case may be, and to explain its transactions; and


(b) if such books are not kept on accrual basis and according to the double entry system of accounting.”

7. The Committee also notes ‘accrual’ as one of the fundamental accounting assumptions for the preparation and presentation of financial  statements  as  given  in  Accounting  Standard  (AS)  1, ‘Disclosure of Accounting Policies’. It notes its definition as per paragraph 10 of AS 1 as follows:

“c. Accrual

Revenues and costs are accrued, that is, recognised as they are earned or incurred (and not as money is received or paid) and recorded in the financial statements of the periods to which they relate. ...”

The Committee notes that the Guidance Note on Accrual Basis of Accounting, issued by the Institute of Chartered Accountants of India (ICAI), recognises that the accounting treatment contained in the Guidance Notes, Accounting Standards, etc., issued by the ICAI are primarily based on accrual accounting. Thus, adoption of accounting treatment recommended in these documents  would ensure that an enterprise has followed accrual basis of accounting. Accordingly, the Committee is of the view that the company would be deemed to have followed accrual basis of accounting for revenue recognition if it follows the principles for recognition of revenue as laid down in Accounting Standard (AS) 9, ‘Revenue Recognition’.

8. The Committee notes that AS 9 lays down the following three conditions for recognition of revenue:

(a) Performance of the act giving rise to revenue. (b) Measurability of the revenue.
(c) Collectability of the revenue.

With respect to the effect of uncertainties on revenue recognition, the Committee notes paragraphs 9.1 to 9.3 of AS 9, which provide as follows:

“9.1  Recognition  of  revenue  requires  that  revenue  is measurable and that at the time of sale or the rendering of the service it would not be unreasonable to expect ultimate collection.

9.2 Where the ability to assess the ultimate collection with reasonable certainty is lacking at the time of raising any claim, e.g., for escalation of price, export incentives, interest etc., revenue recognition is postponed to the extent of uncertainty involved. In such cases, it may be appropriate to recognise revenue only when it is reasonably certain that the ultimate collection will be made. Where there is no uncertainty as to ultimate collection, revenue is recognised at the time of sale or rendering of service even though payments are made by instalments.

9.3 When  the  uncertainty  relating  to  collectability  arises subsequent to the time of sale or the rendering of the service, it is more appropriate to make a separate provision to reflect the uncertainty rather than to adjust the amount of revenue originally recorded.”

9. The Committee notes on the basis of the information provided by the querist in paragraph 4 of the Facts of the Case that the uncertainty with regard to collectability of foreign income arises subsequent to the receipt of the order. The Committee is of the view that when the three conditions for recognition of revenue read with paragraphs 9.1 to 9.3 of AS 9 reproduced above are met in respect of the foreign consultancy jobs, the company should recognise revenue in its books of account. If uncertainty as to its collection arises subsequent to recognition of revenue, it would be appropriate to create a provision for bad and doubtful debts. However, if the collectability of revenue is not reasonably certain at the time of raising claim therefor, recognition of revenue should be postponed. In such cases, revenue should be recognised when it becomes reasonably certain that ultimate collection will be made. The assessment with respect to collectability should be made separately for each transaction.

10.  The Committee notes that owing to reasons given by the querist in paragraph 2 above, i.e., frequent provisioning on account of frequent occurrences of uncertainty of collection and insignificance of the amounts involved, the company resorted to cash basis of accounting in respect of the foreign income, i.e., in effect it departed from the provisions of AS 9 in respect of foreign income. The Committee notes that mere difficulties arising on account of frequent provisioning of bad debts/write-offs of such debts  is not a sufficient reason to allow foreign income to  be accounted for on cash basis and is contrary to the requirements of AS 9, the fundamental accounting assumption of accrual and section 209(3)(b) of the Companies Act, 1956.

11.  In respect of the other reason of recognising foreign income on cash basis, viz., the insignificance of the amount of foreign income, the Committee notes from the Preface to the Statements of Accounting Standards, issued by the Institute of Chartered Accountants of India, which states, inter alia, that, “The Accounting Standards are intended to apply only to items which are material.” The same principle has also been specifically stated in paragraph 3 of the Annexure A ‘General Instructions’ to the Companies (Accounting Standards) Rules, 2006, notified by the Central Government. Further, the Committee notes ‘materiality’ as one of the consideration for selection and application of accounting policies as defined in AS 1 and certain excerpts from paragraphs 3 and 5 of Standard on Auditing (SA) 320 (AAS 13), ‘Audit Materiality’, issued by the Institute of Chartered Accountants of India which are reproduced below:

“Materiality

Financial statements should disclose all “material” items, i.e. items the knowledge of which might influence the decisions of the user of the financial statements.”

“3. Information is material if its misstatement (i.e., omission or erroneous statement) could influence the economic decisions of users taken on the basis of the financial information. Materiality depends on the size and nature of the item, judged in the particular circumstances of its misstatement.…”

“5. The concept of materiality recognises that some matters, either individually or in the aggregate, are relatively important for  true  and  fair  presentation  of  financial  information  in conformity with recognised accounting policies and practices. The auditor considers materiality at both the overall financial information level and in relation to individual account balances and classes of transactions…”

12.  From the above, the Committee is of the view that though ‘accrual’ is one of the fundamental accounting assumptions, the materiality threshold is applicable to this accounting assumption also.  If an information is not material, on the consideration  of materiality as mentioned in the above paragraph, its accounting would not have any effect on the decisions of the users of the financial statements. Accordingly, it needs to be determined under the specific facts and circumstances of the company concerned as to whether the revenue from foreign consultancy jobs, either individually or in aggregate, can influence the decisions of the users of the financial statements. For this purpose, apart from the volume of transactions and quantum of turnover, other  factors such as nature of the item, impact on profit/loss, etc., should also be considered. The assessment of what is material is a matter of professional judgement to be determined on each balance sheet date.

D. Opinion

13.  On the basis of the above, the Committee is of the following opinion in respect of the issues raised in paragraph 5 above:

(a) The company should follow accrual basis and not the cash basis of accounting to account for income from foreign consultancy jobs unless the said income is not considered material as discussed in paragraphs 11 and 12 above.

(b) Recognition of income from foreign consultancy jobs on cash basis, in the case under consideration, is contrary to the requirements of the Companies Act, 1956, AS 1 and AS 9, unless the said income is not considered material as discussed in paragraphs 11 and 12 above.


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