Creation and utilization of a contingency reserve

Fact of the case

• A listed public sector company was engaged in refining crude oil for the production of various petroleum products.
• As per the company, contingent liabilities in respect of show-cause notices issued by various government authorities were disclosed only in respect of those demands against which the company appealed or decided to appeal. The aggregate of such contingent liabilities in the books as on 31st March 2004, was Rs. 1039 million.
• The company stated that Indian refineries were required to pay international prices for crude oil and were entitled to receive from oil marketing companies, international prices for its products. The refining margins, the world over, were ruling at fairly high levels in the past two years, resulting in more than normal profits for the company.
• As per the company, it would not be necessary to create a provision for contingent liabilities. However, in line with the requirements of Accounting Standard 29, Provisions, Contingent Liabilities, and Contingent Assets, the company reviewed the items of contingent liabilities with a view to ascertain whether a provision was required and where required, a suitable provision would be created.

According to the company:

• AS 29 requires the creation of provision, if and only if, the liability is probable and not otherwise and
• Accordingly, no provision, even if it is named as a contingency provision, can be made for the contingent liabilities which do not warrant any provision.
• In view of the fact that there were a number of disputes involving large sums of money required to be shown as contingent liabilities and a number of cases where show cause notices were issued/likely to be issued, as a measure of prudence, the company desired to create a contingency reserve, as an appropriation of profits, so as to meet any eventuality that might arise in future.

Query-

• Whether the creation of a contingency reserve was permissible, as an appropriation in the profit and loss account.
• Whether it was necessary to establish any linkage with any specific item of contingent liability for creation of such a reserve.• Whether it would be necessary to establish a pattern for creation of such reserve from year to year or whether this could be created as a one-time measure based on the management’s discretion.
• Whether it was permissible to utilise the reserve in the event of crystallisation of any contingency, without routing the same through the profit and loss account.

EAC Opinion-

• On the basis of the definitions of the terms ‘provision’, ‘liability’, ‘contingent liability’ and ‘present obligation’ and paragraphs 14 and 68 of AS 29, the EAC was of the view that in case the requirements of AS 29 with regard to recognition of a provision or disclosure of a contingent liability were not met, the same were not required to be recognized/disclosed.
• With regard to the creation of a contingency reserve to meet certain contingencies as an appropriation of profit, from the accounting standpoint, there was no bar on the management. Thus, the management of a company can transfer a part of the profits to a reserve at its discretion subject to the relevant statutory requirements such as the Transfer of Profits to Reserves Rules, 1975.
• However, in the view of requirements of AS 5, on the crystallization of liability on account of an expense, the amount in this regard cannot be adjusted directly against the reserve. It has to be first recognized in the profit and loss account as a charge for the determination of the profit of the relevant year. The management may transfer a corresponding amount from the contingency reserve to the general reserve.
• The EAC was of the view that in case an expense or a provision is permitted to be adjusted against reserve directly, the relevant expense or provision would never be recognized in the profit and loss account which is not as per the generally accepted accounting principles.

Conclusion –

• Contingency reserve can be created as an appropriation in the profit and loss account.
• It was not necessary to establish any linkage with any specific item of contingency for the creation of a contingency reserve.
• From the accounting standpoint, there was no necessity to establish any kind of pattern for the creation of such a reserve from year to year. The creation of a reserve was the discretion of management and, therefore, can be a one-time measure.
• In the event of crystallization of any liability on account of an expense, the same has to be routed through the profit and loss account by way of a charge thereto. Accordingly, it was not permissible to utilize the reserve directly.

Manav Rajgaria, Audit Associate, SW India