In this article we will discuss about the Contingencies and Events Occurring after the Balance Sheet Date.
The term “contingencies” used in this Statement is restricted to conditions or situations at the balance sheet date, the financial effect of which is to be determined by future events which may or may not occur
Estimates are required for determining the amounts to be stated in the financial statements for many ongoing and recurring activities of an enterprise. One must, however, distinguish between an event which is certain and one which is uncertain.
The fact that an estimate is involved does not, of itself, create the type of uncertainty which characterizes a contingency. For example, the fact that estimates of useful life are used to determine depreciation, does not make depreciation a contingency; the eventual expiry of the useful life of the asset is not uncertain.
Also, amounts owed for services received are not contingencies even though the amounts may have been estimated, as there is nothing uncertain about the fact that these obligations have been incurred.
The uncertainty relating to future events can be expressed by a range of outcomes. This range may be presented as quantified probabilities, but in most circumstances, this suggests a level X)f precision that is not supported by the available information. The possible outcomes can, therefore, usually be generally described except where reasonable quantification is practicable.
The estimate of the outcome and of the financial effect of contingencies are determined by the judgement of the management of the enterprise.
This judgement is based on consideration of information available up to the date on which the financial statements are approved and will include a review of events occurring after the balance sheet date, supplemented by experience of similar transactions and, in some cases, reports from independent experts,
Accounting Treatment of Contingent Losses:
The accounting treatment of a contingent loss is determined by the expected outcome of the contingency. If it is likely that a contingency will result in a loss to the enterprise, then it is prudent to provide for that loss in the financial statements.
If there is conflicting or insufficient evidence for estimating the amount of a contingent loss then disclosure is made of the existence and nature of the contingency.
A potential loss to an enterprise may be reduced or avoided because a contingent liability is matched by a related counter-claim or claim against a third party. In such cases, the amount of the provision is determined after taking into account the probable recovery under the claim if no significant uncertainty as to its measurability or collectability exists.
Suitable disclosure regarding the nature and gross amount of the contingent liability is also made.
The existence and amount of guarantees, obligations arising from discounted bills of exchange and similar obligations undertaken by an enterprise are generally disclosed in financial statements by way of note, even though the possibility that a loss to the enterprise will occur, is remote.
Provisions for contingencies are not made in respect of general or unspecified business risks since they do not relate to conditions or situations existing at the balance sheet date.
Accounting Treatment of Contingent Gains:
Contingent gains are not recognised in financial statements since their recognition may result in the recognition of revenue which may never be realised. However, when the realisation of a gain is virtually certain, then such gain is not a contingency and accounting for the gain is appropriate.
Determination of the amounts at which Contingencies are included in Financial Statements:
The amount at which a contingency is stated in the financial statements is based on the information which is available at the date on which the financial statements are approved.
Events occurring after the balance sheet date that indicate that an asset may have been unpaired, or that a liability may have existed, at the balance sheet date are, therefore, taken into account in identifying contingencies and in determining the amounts at which such contingencies are included in financial statements.
In some cases, each contingency can be separately identified, and the special circumstances h situation considered in the determination of the amount of contingency. A substantial legal against the enterprise may represent such a contingency.
Among the factors taken into account by management in evaluating such a contingency are the progress of the claim at the date on which the financial statements are approved, the opinions, wherever necessary, of legal experts or other advisers, the experience of the enterprise in similar cases and the experience of other enterprises in similar situations.
If the uncertainties which created a contingency in respect of an individual transaction are common to a large number of similar transactions, then the amount of the contingency need not be individually determined, but may be based on the group of similar transactions.
An example of such contingencies may be the estimated uncollectable portion of accounts receivable. Another example of such contingencies may be the warranties for products sold.
These costs are usually incurred frequently and experience provides a means by which the amount of the liability or loss can be estimated with reasonable precision although the particular transactions that may result in a liability or a loss are not identified. Provision for these costs results in their recognition in the same accounting period in which the related transactions took place.
Events Occurring after the Balance Sheet Date:
Events which occur between the balance sheet date and the date on which the financial statements are approved, may indicate the need for adjustments to assets and liabilities as at the balance sheet date or may require disclosure.
Adjustments to assets and liabilities are required for events occurring after the balance sheet date that provide additional information materially affecting the determination of the amounts relating to conditions existing at the balance sheet date. For example, an adjustment may be made for a loss on a trade receivable account which is confirmed by the insolvency of a customer which occurs after the balance sheet date.
Adjustments to assets and liabilities are not appropriate for events occurring after the balance sheet date, if such events do not relate to conditions existing at the balance sheet date. An example is the decline in market value of investments between the balance sheet date and the date on which the financial statements are approved.
Ordinary fluctuations in market values do not normally relate to the condition of the investments at the balance sheet date, but reflect circumstances which have occurred in the following period.
Events occurring after the balance sheet date which do not affect the figures stated in the financial statements would not normally require disclosure in the financial statements although they may be of such significance that they may require a disclosure in the report of the approving authority to enable users of financial statements to make proper evaluations and decisions.
There are events which, although they take place after the balance sheet date, are sometimes reflected in the financial statements because of statutory requirements or because of their special nature. Such items include the amount of dividend proposed or declared by the enterprise after the balance sheet date in respect of the period convered by the financial statements.
Events occurring after the balance sheet date may indicate that the enterprise ceases to be a going concern.
A deterioration in operating results and financial position, or unusual changes affecting the existence or substratum of the enterprise after the balance sheet date (e.g., destruction of a major production plant by a fire after the balance sheet date) may indicate a need to consider whether it is proper to use the fundamental accounting assumption of going concern in the preparation of the financial statements.
The disclosure requirements herein referred to apply only in respect of those contingencies or events which affect the financial position to a material extent.
If a contingent loss is not provided for, its nature and an estimate of its financial effect are generally disclosed by way of note unless the possibility of a loss is remote. If a reliable estimate of the financial effect cannot be made, this fact is disclosed.
When the events occurring after the balance sheet date are disclosed in the report of the approving authority, the information given comprises the nature of the events and an estimate of their financial effects or a statement that such an estimate cannot be made.
The amount of a contingent loss should be provided for by a charge in the statement of profit and loss if:
(a) It is probable that future events will confirm that, after taking into account any related probable recovery, an asset has been impaired or a liability has been incurred as at the balance sheet date, and
(b) A reasonable estimate of the amount of the resulting loss can be made.
The existence of a contingent loss should be disclosed in the financial statements if either of the conditions in paragraph 10 is not met, unless the possibility of a loss is remote.
Contingent gains should not be recognised in the financial statements.
Events Occurring after the Balance Sheet Date:
Assets and liabilities should be adjusted for events occurring after the balance sheet date that provide additional evidence to assist the estimation of amounts relating to conditions existing at the balance sheet date or that indicate that the fundamental accounting assumption of going concern (i.e., the continuance of existence or substratum of the enterprise) is not appropriate.
Dividends stated to be in respect of the period covered by the financial statements, which are proposed or declared by the enterprise after the balance sheet date but before approval of the financial statements, should be adjusted.
Disclosure should be made in the report of the approving authority of those events occurring after the balance sheet date that represent material changes and commitments affecting the financial position of the enterprise.
The draft accounts of P Ltd. showed a profit for the year ended 31st March, 2012 of Rs 7,00,000 after tax but before taking into accounting the following items. It had retained earnings at the beginning of the year of Rs 5,00,000.
1. Cost of closing a plant during the year Rs 1,00,000. Another plant was dosed five years ago.
2. The sale for Rs 1,50,000 of an investment acquired 5 years ago at a cost of Rs 20,000.
3. The directors decided to write off goodwill appearing at Rs 2 lakh in the beginning of the year.
4. A debt of Rs 2,40,00 from a customer company (now in liquidation) has remained outstanding since 31st March. 2011, when no provision was made; the expected dividend is 10 p. in the rupee.
5. The taxation liability for prior year was agreed and showed that Rs 10,000 had been underprovided; the provision for tax for the year was Rs 6,50,000.
6. It was announced on 10th April, 2012 by a foreign government that one of the overseas plant would be nationalized, but compensation has been promised based on four times the expected annual profit This has averaged Rs 50,000 for the last five years. The net assets attributable to the plant and included in the balance sheet 31st March, 2012 are Rs 3,00,000.
7. A professional valuation of buildings owned by the company has shown a surplus over book values of Rs 4,00,000.
8. Research and development expenditure carried forward at the beginning to Rs 2,50,000. The previous policy has not changed and on the new basis only Rs 1,00,000 would have been carried forward.
You are required to state how these items will be dealt with in the final statements of account.
The following is the suggested treatment of each of the items along-with reasons (state briefly):—
(a) Interest on Debentures:
Interest for the full period for which the accounts are being prepared or for which the debentures have been outstanding during such a period should be provided.
Suppose, the following two items appear in a company’s trial balance at the end of a year:
Interest for the full year on Rs 4,00,000 @ is Rs 48,000. Because the amount paid is only Rs 12,000, another Rs 36,000 is still due. Since usually debenture interest is paid half yearly, it would appear that Rs 24,000 is already due for payment but that Rs 12,000 is not yet payable.
The term used for the former is “Accrued and Due” or “Outstanding”; the term for the latter is “Accrued” or “Accrued but not due”; Interest Outstanding will be shown in the Balance Sheet along with Debentures and Interest Accrued will be shown as a current liability. However, both items are short-term liabilities.
The Profit and Loss Account will be debited by Rs 48,000. But one should remember that interest paid on moneys borrowed for construction of an asset should be added to the cost of the asset concerned for the period of construction.
Once the asset comes into use, the interest paid will be a charge against revenue and debited to the Profit and Loss Account! This is according to legal decisions in income-tax cases and has the approval of the Institute of Chartered Accountants of India.
(b) Income Tax on Interest on Debentures:
Under the Income-tax Act, it is the duty of those who pay interest on securities to deduct tax from the interest payable at the prescribed rate and deposit it with the Government. (In case the securities are declared tax-free by the Government, the deduction will not be made.
Also no deduction will be made or deduction will be made at a lower rate if the income-tax officer gives a certificate to this effect to the person whom the interest is payable). The rate for deduction of income-tax at source is now-a-days 10%; rates change usually with every Finance Act which is passed every year by the Parliament.
The practical effect is that if a person holds, say, Rs 10,000 12% Debentures of a company, the interest payable to him by the company is Rs 1,200. But the company will have to deduct Rs 120 (10% of Rs 1,200) as tax, deposit it with the Government, and pay to the debenture-holder only Rs 1,080, the balance.
The entries for interest on debentures, as a whole, therefore, are as follows:—
Income-tax payable is a liability and will appear in the Balance Sheet until paid off.
(c) Discount or Cost of Issue of Debentures:
Discount or commission or cost of issue of debentures appears in the balance sheet but these should be written off as early as possible and in any case not later than the date of redemption of the debentures. Suppose, the following two entries appear in a company’s tri al balance on 31st March, 2012:
In this case, it would be advisable to write off one-fifth of Rs 15,000, viz., Rs 3,000 because the Debentures have to be redeemed in five years” time (counting from 1st April, 2011).
Ascertaining Profit for Managerial Remuneration:
Section 349 lays down how the net profits of the company will be ascertained for the purpose of the calculation of remuneration to directors manager or managing director. It corresponds more or less to the accepted ideas of calculating net profits of a concern. The following credits or incomes in addition to the gross profit should be taken into account:
Bounties and subsidies received from any Government, or any public authority constituted or authorised in this behalf, by any Government, unless and except in so far as the Central Government otherwise directs.
The following “incomes” or credits should not be taken into account:
(a) Premium on shares or debentures issued or sold by the company;
(b) Profits on sales by the company of forfeited shares;
(c) Profits of a capital nature including profits from the sale of the undertaking or any of the undertaking of the company, or any part thereof; and
(d) Profits from the sale of any immovable property or fixed assets of a capital nature comprised in the undertaking of the company, unless the business of the company consists, whether wholly or partly, of buying and selling such property or assets.
But where the amount for which any fixed asset is sold exceeds its written down value (calculated according to section 350), credit should be given for so much of the excess as is not higher than the difference between the original cost of that fixed asset and its written down value.
Suppose, a machine purchased for Rs 30,000, written down to Rs 18,000 by writing off depreciation, is sold for Rs 35,000. The managerial personnel are entitled to commission on Rs 12,000, i.e., excluding the profit over and above the original cost.
From the incomes of the company, the following have to be deducted:—
(a) all the usual working charges;
(b) directors’ remuneration;
(c) bonus or commission paid or payable, to any member of the company’s staff, or to any engineer, technician or person employed or engaged by the company, whether on a whole- time or on a part-time basis;
(d) any tax notified by the Central Government as being in the nature of a tax on excess or abnormal profits;
(e) any tax on business profits imposed for special reasons or in special circumstances and notified by the Central Government in this behalf;
(f) interest on debentures issued by the company;
(g) interest on mortgages executed by the company and on loans and advances secured by a charge on its fixed or floating assets;
(h) interest on unsecured loans and advances;
(i) expenses on repairs, whether to immovable property or to movable property, provided the repairs are not of a capital nature;
(j) contributions to charitable and other funds not directly relating to the business of the company not exceeding Rs 50,000 or 5 per cent of its average net profits during the three financial years immediately preceding, whichever is greater. These limits can be exceeded with the consent of the company in general meeting.
(k) depreciation calculated according to section 350. Under section 350 the depreciation (for the purpose of calculating commission to managerial personnel) is to be calculated according to the rates given in Schedule XIV of the Companies Act, 1956.
Depreciation includes only normal depreciation including extra and multiple shift allowances, excluding any special, initial or other depreciation or any development rebate. (Deduction on account of special, initial or other depreciation or any development rebate has since beta withdrawn under the Income-tax Act.)
If an asset is sold, discarded, demolished or destroyed before it is completely written off, the excess of the written down value over its sale proceeds (or its scrap value) has to be written off in the financial year in which the asset is sold, discarded, demolished or destroyed;
(I) the excess of expenditure over income which arises in computing the net profit in accordance with section 349 in any year (after the commencement of the Act) in so far as this excess has not been deducted in any subsequent year preceding the year in respect of which the net profits have to be ascertained;
(m) any compensation or damages to be paid in virtue of any legal liability including a liability arising from a breach of contract;
(n) any sum paid by way of insurance against the risk of meeting any liability such as is referred to in (m); and
(o) debts considered bad and written off or adjusted during the year of account.
Profits on which remuneration has to be allowed should be ascertained without deducting the following:—
(a) income tax and super tax payable by the company under the Income-tax Act or any other tax on the incomes of the company not covered by (d) and (e) above.
(b) any compensation, damages or payments made voluntarily, that is to say, otherwise than in virtue of a liability such as is referred to in (m) above; and
(c) loss of a capital nature including loss on sale of the undertaking or any of the undertakings of the company or of any part thereof not including any excess of written down value over its sales proceeds or scrap value of any asset sold, discarded, demolished or destroyed. (This excess has to be written off to the P. & L. A/c).
It should be noted that the Profit and Loss Account should have a statement attached showing how the profit has been ascertained for the purpose of commission due to directors, managing director or manager.
Remuneration to Directors:
Subject to section 198 which relates to the overall managerial remuneration (discussed later), the remuneration to directors is governed by section 309 of the Companies Act. It is to be determined either by the articles of the company or by a resolution or, if the articles so required, by a special resolution, passed by the company in general meeting subject to the following:—
(a) A whole-time director or a managing director may be paid remuneration either by way of a monthly payment or at a specified percentage of the net profits of the company or partly by one way and partly by the other.
But except with the approval of the Central Government:—
(i) if there is only one whole-time or managing director the percentage cannot exceed five; and
(ii) if there are more than one whole-time director, the percentage cannot exceed ten for all of them together.
(b) Part-time directors (i.e., those who are neither whole-time nor managing directors) may receive monthly, quarterly or annual payment with the approval of the Central Government or by way of commission if the company by special resolution authorizes such payment.
The total remuneration cannot exceed (1) one per cent of the net profits of the company if the company has a managing or whole-time director, or manager; or (2) three per cent of the net profits if the company has no manager, managing or whole-time director. The rates of one and three per cent respectively can be increased by the company in general meeting with the approval of the Central Government.
(c) A director who is in receipt of any commission from the company and who is either a whole- time or managing director cannot receive any commission or other remuneration from any subsidiary of such company.
It should be noted that remuneration to a director will include any remuneration paid to him for services rendered by him in any capacity except when (a) the services rendered are of a professional nature, and (b) in the opinion of the Central Government, the director possesses the requisite qualification for the practice of the profession.
In addition, a director may receive remuneration by way of a fee for each meeting of the Board, or a committee thereof attended by him according to the Companies Act, but the Government has decided that in case of whole-time or managing directors, no sitting fees will be payable.
Section 309 does not apply to a private company unless it is a subsidiary of a public company.
According to section 310, in the case of a public company, or a private company, which is a subsidiary of a public company, any increase in the remuneration payable to the directors requires the approval of the Central Government except in the following cases:—
(a) in cases where Schedule XIII is applicable (discussed later) and the increase is in accordance with the conditions specified in that Schedule; and
(b) where the increase is made in the fee payable for attending each meeting of the Board or a committee thereof and the increased rate does not exceed such sum as may be prescribed. (The prescribed sum is Rs 2,000 vide rule 10B of General Rules and Forms).
Similarly, according to section 311, for a public company, and a private company, which is a subsidiary of a public company, any increase in the remuneration of the managing or whole-time director on reappointment or appointment after the commencement of the Companies Act l956 requires approval of the Central Government except in cases where Schedule XIII is applicable and the increase is in accordance with the conditions specified in that Schedule.
Remuneration to the Manager:
Section 387 governs the remuneration to manager. A manager may receive remuneration by way of a monthly payment or by way of a specific percentage of the net profits of the company (calculated according to sections 349,350 and 351) or partly by way of a monthly payment and partly by way of percentage of profits.
The total remuneration cannot exceed five per cent of the net profits except with the approval of the Central Government.
Overall Managerial Remuneration:
Section 198 puts a maximum limit (exclusive of any fees payable to directors, for attending meetings of the Board or any committee of the Board) of eleven per cent of the net profits on total remuneration payable by the company to its directors, including managing directors and its manager (if any).
Managerial remuneration includes any expenditure incurred by the company.
(a) in providing any rent-free accommodation, or any other benefit or amenity in respect of accommodation free of charge; .
(b) in providing any other benefit or amenity free of charge or at a concessional rate,
(c) in respect of any obligation or service which, but for such expenditure by the company, would have been incurred by the person concerned; and ,
(d) to effect any insurance on the life of, or to provide any pension, annuity or gratuity for, the person concerned or his spouse or child. .
However if in any financial year a company has no profits or its profits are inadequate, the company may pay to Is managing or whole-time director or manager remuneration according to schedule XIII, part II, section II.
Prohibition of Tax-free Payments:
Section 200 prohibits the payment to any officer or employee remuneration free of tax or remuneration calculated by reference to or varying with the tax payable by him.