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Short Note on Application of Accounting Standard (AS) 15
The article is divided into
the following points:
1.
Introduction
2.
Scope
4.
Provisions of Payment of Gratuity Act, 1972
5.
Provisions of Income Tax Act, 1961
6.
Provision for leave encashment
8.
Relevant Provisions of Accounting Standards
9.
Some Cases
10.
Disclosure
11.
Disclaimer
Accounting
Standard (AS) 15, “Accounting for Retirement benefits in the financial
statements of Employers” requires provision for Gratuity on accrual basis. This
means that there has to be a provision for gratuity every year in the financial
statements of employers.
This short note illustrates the methods available, a brief recitation of relevant provisions of the Payment of Gratuity Act, 1972 and of the Income Tax Act, 1961. This note was basically designed from the point of view of the employers for ease in application of the standard. However, every attempt has been made to make the article comprehensive by discussing auditors’ duties in this regard. It also includes some cases explaining the overall provisions of the Accounting Standards.
AS-15 provides for two Accounting methods for provision for Gratuity as under:
1. Actuarial Valuation by an actuary who may be appointed for the purpose
What is Actuarial Valuation (in brief)? Actuarial
valuation is the process used by an actuary to estimate the present value of
benefits to be paid under a retirement benefit scheme and the present values of
the scheme assets and, sometimes, of future contributions.
2. As per prudent estimate assuming that all employees or a majority of employees would retire in the next year in case of small concerns.
The estimate may be arrived at as follows:
Salary last drawn * 15 * No. of completed years of service / 26
Example:
An employee’s salary for the month of March 20XX is as follows:
Basic Salary: Rs.1500 p.m.
D.A.: Rs.450 p.m.
Date of appointment as per appointment letter 01.06.1994 i.e. 7 years
Thus the total liability for Gratuity for the above employee as on 31.03.2001 would be: (1500 + 450) * 7 *15 / 26 = Rs.7875/-
The estimate of Rs.7875/- arrived at would be total liability. From the estimate, amounts already provided for Gratuity in previous years, if any, should be deducted and any excess should be provided for as provision for Gratuity by debiting Profit and Loss Account and crediting Gratuity Fund Account.
·
Provisions of Payment of Gratuity Act, 1972 in
brief
Who is covered under the Act? : All establishments employing 10 or more persons on any day during the preceding 12 months are covered under the Act.
Who is eligible for Gratuity? : As per Sec. 2(e) of the Act, any person who has rendered continuous service of 12 months is an employee eligible for Gratuity under the Act.
When does liability for payment arise? : By virtue of Sec. 4(1) of the Act, Gratuity shall be payable to an employee on the termination of his employment after he has rendered continuous service, for not less than 5 years –
1. On his superannuation
2. On his retirement or resignation
3. On his death or disablement
Whether an employee employed for less than 5 years is eligible? : A question may arise whether provision is necessary for an employee who is employed for less than 5 years as payment is to be made only if the employee has rendered a continuous service of 5 years.
Para 12 of AS-15 states the cost of retirement benefits to an employee results from receiving services from the employees who are entitled to receive such benefits. Consequently, the cost of retirement benefits is accounted for in the period during which these services are rendered. Accounting for retirement benefits only when employees retire or receive benefit payments does not achieve the objective of allocation of those costs to the periods in which the services are rendered.
Also as per Sec. 4(2) of the Act, the liability for Gratuity is to be calculated on the basis of total no. of completed years of service including first five years. Moreover, the condition of payment on completion of five years is not applicable when the employee discontinues service due to death or disablement.
Also, normally, no concern would like its newly recruited employees to leave within a short time. Hence, even if the employee has not rendered a continuous service of less than 5 years, Gratuity liability has to be provided for in case of such employee.
Where should the amount of Gratuity provided for be kept? : As per Sec. 4A of the Act, every employer liable to gratuity under the Act, is required to take an insurance cover with the LIC of India. If the establishment is exempted from maintaining such fund by any order or notification of the Central Government, the employer is required to create a Gratuity Trust Fund and assign the management of the fund with a Board of Trustees.
·
Provisions of Income Tax Act, 1961
Sec. 40A(7) read with Sec. 43B provides that provision for Gratuity made in the Account books shall be allowed as deduction in computing Income Tax Liability in that assessment year in which Gratuity is actually paid or is actually deposited in cash in an approved gratuity fund. Thus, if it is shown by way of appropriate evidence that the amount has been actually paid / deposited, it would be allowed as a deduction in computation of Tax.
·
Provision for Leave encashment :
There is a difference between Gratuity and Leave Salary. Provision for Gratuity arises by statute whereas Provision for Leave Salary arises by way of contract.
Normally contracts provides any or both the methods for leave salary:
1. Annual Payment of Leave Salary
2. Payment of Leave Salary whenever the employee retires or leaves service for any reason.
In both the above cases, it is necessary to provide for accruing liability. Where payment is to be made only when the employee leaves, it is recommended that provision be made on the basis of actuarial valuation.
Auditor’s duties in this regard are contained in the following Statements on Standard Auditing Practices (SAPs):
1. SAP-1 “Basic Principles Governing an Audit”
2. SAP-9 “Using the work of an expert”
3. SAP-18 “Audit of Accounting Estimates”
SAP-9 defines an expert as a person, firm or other association of persons possessing special skill, knowledge and experience in a particular field other than accounting and auditing. Thus, an actuary is an expert. Hence, any reference to an expert may also be construed as reference to an actuary.
SAP-1 states that when the auditor uses the work of an expert, he will continue to be responsible for forming and expressing his opinion on the financial information. However, he will be entitled to rely on work performed by others, provided he exercises adequate skill and care and is not aware of any reason to believe that he should not have so relied. The auditor should obtain reasonable assurance that work performed by other auditors or experts is adequate for his purpose.
SAP-9 enumerates in detail the auditor’s responsibilities in regard to verifying the work of an expert. The provisions as contained in the SAP as briefly stated below:
Para 5 under the head “Determining the Need to Use the work of an Expert” specifically states by way of example the use of an expert for the purpose of actuarial valuation. However, it further states that the auditor should consider the following factors while determining whether to use the work of an expert:
1. The materiality of the item being examined in relation to the financial information as a whole.
2. The nature and complexity of the item including the risk of error therein, and
3. The other audit evidence available with respect to the item
Para 7 under the head “Skills and Competence of the Expert” states that when the auditor plans to use the work of an expert as audit evidence, he should satisfy himself as to the expert’s skills and competence by considering the expert’s :
· Professional qualification, licence or membership in an appropriate professional body; and
· Experience and reputation in the field in which the evidence is sought
However, when the auditor uses the work of an expert employed by him, he will not need to inquire into his skills and competence.
Para 9 states that the auditor should take particular care when the expert is employed by the client or is in some way related to the client.
Para 9 – 15 discusses the procedures that may be undertaken by an auditor while evaluating the work of an expert. When the auditor intends to use the work of an expert, he should examine evidence to gain knowledge regarding the terms of the expert’s engagement. The auditor should also seek reasonable assurance that the expert’s work constitutes appropriate audit evidence in support of the financial information by considering the source data used, the assumptions and methods used and, if appropriate, their consistency with the prior period and the results of the expert’s work. The auditor should consider whether the expert has used source data which are appropriate to the circumstances by making inquiries of the expert to determine how he has satisfied himself that the source data are sufficient, relevant and reliable and conducting audit procedures on the data provided by the client to the expert to obtain reasonable assurance that the data are appropriate. It clarifies in clear words that the appropriateness and reasonableness of assumptions and methods used and their application is the responsibility of the expert. Thus, the auditor can rely on the actuary’s report. It is the actuary’s responsibility to ensure that the method adopted for actuarial valuation is correct. However, the auditor should obtain an understanding of those assumptions and methods so as to satisfy himself that prima facie they are reasonable based on the auditor’s knowledge of the business and on the results of his audit procedures. Where after performing the above procedures, the auditor is not satisfied with the result of the work of the expert; he should attempt to resolve the inconsistency by discussions with the client and the expert. In some cases, the auditor may engage another expert to resolve the inconsistency. If even after performing the additional procedures, the auditor is not satisfied, he should express a qualified opinion, disclaimer of opinion or an adverse opinion, as may be appropriate.
SAP-18 states that the auditor should obtain sufficient appropriate audit evidence regarding accounting estimates. It defines an accounting estimate as an approximation of the amount of an item in the absence of a precise means of measurement. The examples given therein includes Provision for retirement benefits in the financial statements of employers. Thus provision for Gratuity and Leave encashment is an accounting estimate as per the SAP and the auditor has to comply with it in this regard.
The auditor should obtain sufficient appropriate audit evidence as to whether an accounting estimate is reasonable in the circumstances and, when required, is appropriately disclosed in the financial statements. The disclosure norms are contained in Schedule-VI of the Companies Act, 1956 and AS-15.
The auditor should adopt one or a combination of the following approaches in the audit of an accounting estimate:
1. review and test the process used by management to develop the estimate;
2. use an independent estimate for comparison with that prepared by management ; or
3. review subsequent events which confirm the estimate made.
The steps ordinarily involved in reviewing and testing of the process used by management are:
1. evaluation of the data and consideration of assumptions on which the estimate is based;
2. testing of the calculations involved in the estimate;
3. comparison, when possible, of estimates made for prior periods with actual results of those periods; and
4. consideration of management’s approval procedures
· Relevant provisions of Accounting Standards
Para 29 of AS 15 states as follows:
“Any alterations in the retirement benefit costs arising from –
(a) Introduction of a retirement benefit scheme for existing employees or making of improvements to an existing scheme, or
(b) Changes in the actuarial method used or assumptions adopted,
should be charged or credited to the statement of profit and loss as they arise in accordance with AS 5, “Net profit or loss for the period, Prior period items and Changes in Accounting Policies”. Additionally, a change in an accounting policy is disclosed in accordance with Accounting Standard (AS) 5, “Net Profit or loss for the Period, Prior period items and Changes in Accounting Policies”.
Para 30 of AS 15 states as follows:
“When a retirement benefit scheme is amended with the result that additional benefits are provided to retired employees, the cost of the additional benefits should be accounted for in accordance with Para 29”.
Para 5 of AS 5 states as follows:
“All items of income and expense which are recognized in a period should be included in the determination of net profit or loss for the period unless an accounting standard requires or permits otherwise”
Para 12 is of utmost significance, which states as follows:
“When items of income and expense within profit or loss from ordinary activities are of such size, nature or incidence that their disclosure is relevant to explain the performance of the enterprise for the period, the nature and amount of such items should be disclosed separately.”
The definitions contained in AS 5 are very significant in understanding the provisions and hence are stated below:
Ordinary Activities: Ordinary Activities are any activities that are undertaken by an enterprise as part of its business and such related activities in which the enterprise engages in furtherance of, incidental to, or arising from, these activities.
Extraordinary items: Extraordinary items are incomes or expenses that arise from events or transactions that are clearly distinct from the ordinary activities of the enterprise and, therefore, are not expected to recur frequently or regularly.
Prior Period items: Prior period items are incomes or expenses, which arise, in the current period as a result of errors or omissions in the preparation of the financial statements of one or more prior periods.
Paras 23, 25, and 27 are also relevant which deal with changes in accounting estimates.
Para 23 states that the effect of a change in accounting estimate should be included in the determination of net profit or loss in the period of the change, if the change affects the period only or the period of the change and future periods if the change affects both.
Para 25 states that the effect of a change in an accounting estimate should be classified using the same classification in the statement of profit and loss as was used previously for the estimate.
Para 27 states that a change in estimate, which is expected to have a material effect, should be disclosed.
· Some Cases on Accounting Standards
If Provision for Gratuity and/or leave encashment is made for the first time: If the provision for gratuity is made for the first time then unless the enterprise is relatively new, a huge amount would have to be provided for. In this case, the provisions of Para 29 of AS 15 and Para 12 of AS 5 become relevant. Also, it is neither a prior period item nor is an extraordinary item as it does not arise from any omission or errors in preparation of previous financial statements and is an ordinary activity of the enterprise. However, as the amount is large enough to affect materially the financial statements, it should be disclosed separately on the face of the Profit and Loss for the period. Also, provision for the first time unless it is the first financial statement of the entity, would be a change in accounting policy and hence would be required to be disclosed and the effect of such a change would be required to be quantified.
If new scheme is introduced by which the liability increases: Here also, Para 29 of AS 15 and Para 12 of AS 5 comes into picture. Also, it is not a prior period item as the introduction of a new scheme is in the current year and therefore no error or omission results in the preparation of financial statement of prior periods. The change in the amount would be as a result of a change in accounting estimate and therefore the treatment of such change would be in accordance with Paras 23, 25 and 27 of AS 5. Such a change does not result in change in accounting policy. Also, as per Para 22 of AS 5, where it is difficult to distinguish between a change in an accounting policy and a change in an accounting estimate, the change is treated as a change in accounting estimate, with appropriate disclosure.
If the entity changes from estimate method to actuarial valuation or vice versa: Such a change would naturally be a change in accounting policy and would be required to be disclosed separately and the effect of such change would be required to be quantified.
If the actuary changes the methods and/or assumptions: AS 5 defines accounting policies as the specific accounting principles and the methods of applying those principles adopted by an enterprise in the preparation and presentation of financial statements. Thus, if the effect of such a change is material, it should be treated as a change in accounting policy and should be disclosed separately quantifying the effect of such a change.
·
Disclosure of change in Accounting Policy
Where the entity changes from cash basis to accrual method such change in accounting policy can be disclosed as under:
“In order to comply with AS 15, Accounting for Retirement Benefits in the Financial Statements of Employers, the company has changed its accounting policy of recognizing gratuity and other retirement benefits from cash to accrual basis. Had the company followed its previous policy then the profit for the period and reserves and surplus as shown in the balance sheet would have been more by Rs.XXXX and Current Liabilities and Provisions would have been less by the same amount.”
· Disclaimer :
Any opinions expressed other than where specific reference has been made in the above note, is a personal opinion of the author. There may be alternative treatments or methods.
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