Whether creation of provision for contingencies not known at the balance sheet date is appropriate

Fact of the case-

• A company was incorporated under section 25 of the Companies Act, 1956 to promote India’s trade by organising trade fairs and exhibitions in various parts of the country.
• From the year 2000-01, company charged 5% contingency charges from the participants/outside agencies on the income received from them by the company, with a intention to meet any unforeseen liability which may arise in future on account of injury/loss of life of visitors/exhibitors etc., due to fire, natural calamities & third party liability, etc.
• The company mentioned that, as a prudent policy, a matching provision for the same was also being made in the accounts & a suitable disclosure to this effect was also made in the notes to accounts. The 5% contingency charges were based on an assessment only, as the actual liability on this account could not be estimated.
• During the audit, the statutory auditors were of the view that no liability could be provided in the books of account unless the quantum of the liability and the details of the payee were known.
• The company’s contention was that the matching provision was being made against the amounts being recovered to discharge any future liability, which may or may not occur.

EAC Opinion–

• In respect of accounting for ‘contingencies’, Accounting Standard 4, ‘Contingencies and Events Occurring After the Balance Sheet Date’, was mandatory in respect of accounting periods commencing before 1-4-2004 and Accounting Standard 29, ‘Provisions, Contingent Liabilities and Contingent Assets’ was mandatory in respect of accounting periods commencing on or after 1-4-2004. In the extant case, AS 4 was applicable to this company as query related to the accounting period commencing before 1-4-2004.
• Thus EAC was of the view that in respect of contingencies against which provision was being created by the company, no situation existed on the balance sheet date & thus no probable that future events would confirm that a liability was incurred as at the balance sheet date. In view of this, the EAC enunciated that the provision for contingencies could not be created irrespective of the fact that a charge in this regard was made from customers.
• Also as per Accounting Standard 29, ‘Provisions, Contingent Liabilities and Contingent Assets’, in respect of the contingencies considered by the company, neither a present obligation existed as a result of past event, nor a reliable estimate could be made of the amount of the obligation. Accordingly, a provision could not be recognised for contingencies under the circumstances stated by the company.
• The EAC referred to Clause 7 of Part III of Schedule VI to the Companies Act, 1956 – “since the contingencies stipulated by the company were not known at the balance sheet date, the provision in this regard could not be created. Accordingly, the provision for contingencies created by the company was of the nature of a reserve”.
• Based on the above, the EAC opined that under the facts and circumstances of the case, creation of the provision for contingencies was not in conformity with AS 4 and AS 29 issued by the ICAI and Schedule VI to the Companies Act, 1956.

Pulkit Singh, Audit Associate, SW India