Provision for gratuity not shown in balance-sheet and extent of company’s liability on account of gratuity also not disclosed - Companies Law - Circular : No. 13/77

Circular : No. 13/77 [8/31/211/77-CL-V], dated 21-11-1977. Subject:- Provision for gratuity not shown in balance-sheet and extent of company s liability on account of gratuity also not disclosed Whether amounts to not disclosing a true and fair view of the state of affairs It has been observed that some companies which do not make any provision for gratuity liability in their accounts, do not even add suitable note to the balance-sheet disclosing the extent of the company s liability on this count. Some companies make a bald statement by way of a note to accounts, saying that the gratuity liability has not been ascertained or the gratuity liability is being accounted for on cash basis . The plea of the companies that gratuity liability has not been ascertained nor could be ascertained does not meet with the requirements in this regard of Schedule VI to the Act. It is essential that the gratuity liability is ascertained in accordance with the normally accepted methods, as recommended by the Institute of Chartered Accountants of India in paras 4.1 to 4.1-3 (para 2.2 of the Revised Statement) of Statement on Treatment of Retirement Gratuity in Accounts (Annex 1) issued by it, and if a suitable provision is not made in the accounts, or there is an under provision, the amount of gratuity liability so estimated or left unprovided, as the case may be, should be indicated by way of a note to the accounts. In case the company does not provide for the gratuity liability or does not state the quantum of gratuity liability by way of a note, the balance-sheet and profit and loss account cannot be regarded as disclosing a true and fair view of the state of affairs. It is hence the duty of the auditors to qualify their reports to this effect and specifically state that the requirements of Schedule VI have not been complied with properly. This has also been made clear in paras 8.7 and 8.8 (paras 9.12 and 9.13 of the new edition) of the Statement on Auditing Practices issued by the Institute of Chartered Accountants of India. ANNEX 1 STATEMENT ON THE TREATMENT OF RETIREMENT GRATUITY IN ACCOUNTS 1. Introduction 1.1 The Council of the Institute of Chartered Accountants of India issues the following note for the guidance of its members on the accounting and other problems arising from payments of retirement gratuity to employees. It is hoped that this note will be useful to members both in industry and in practice in determining the best practice to be followed in regard to the accounting treatment of retirement gratuity. 1.2 The expression retirement gratuity refers to amounts payable to the employees of a business enterprise on their voluntarily or in other circumstances terminating their service with the employer, in accordance with the provisions of the applicable law, a legally enforceable arrangement or by virtue of a course of conduct. The word gratuity meaning a payment made voluntarily is somewhat inappropriate for inclusion in the expression retirement gratuity . Historically, however, gratuity on retirement was, in fact, paid voluntarily, but over a period of time, while the term has remained unchanged it has acquired a contractual or obligatory character. Indeed the Payment of Gratuity Act, 1972 uses the term gratuity while imposing a statutory obligation to pay it. 1.3 Since this note is concerned with the treatment of retirement gratuity in accounts, no attempt has been made to discuss the detailed legal provisions of the Payment of Gratuity Act, 1972. Nevertheless in Appendix A will be found an abstract of the relevant provisions of the said Act, with reference to important matters like eligibility rates, disqualification and the basis of computation. 2. Financial arrangements to meet gratuity liability 2.1 Three different approaches appear to have been adopted in India to meet the financial obligations for payment of retirement gratuity. These are : (1) Cash basis - Payments actually made on account of gratuity are debited to the revenue account in the year in which the gratuity becomes due and payable and no provision is made in respect of accruing liability for retirement gratuity during the service life of an employee. (2) Accrual basis - Provision is made in the books of the enterprise for the accruing liability for gratuity by debit to the revenue account in each year, the aggregate provisions made being reflected in the balance-sheet. (3) Gratuity fund - A separate gratuity fund administered by trustees is constituted by a trust deed, and contributions are handed over each year to the trustees and charged to the revenue account. The rules relating to the recognition of a gratuity fund for income-tax purposes are given in Part C of the Fourth Schedule to the Income-tax Act, 1961. Often the trustees do not administer the fund themselves but arrive at an arrangement with the Life Insurance Corporation of India through a Group Gratuity Insurance Policy to administer the fund. 2.2 The need to provide for accruing gratuity liability is based on sound accounting considerations and exists regardless of whether in the computation of taxable profit, it is or is not allowed as a deduction. At the same time it is appreciated that when deciding whether or not to make provision for accruing gratuity liability, management may find that special circumstances exist which provide a valid justification for not making a provision. The Council is of the opinion that in all such cases, when provision for accruing gratuity is not made, or if made is inadequate, the matter should be referred to by way of a note in the accounts indicating the total accrued liability, appropriately calculated or the shortfall in the provision, as the case may be. 2.3 When an enterprise decides for the first time to make provision for gratuity in its accounts or to set up a gratuity fund, it is faced with the problem of making provision for and/or providing funds to cover the accrued gratuity liability in respect of the entire past service put in by the employees. Appropriate arrangements can, however, be devised to spread the provision of funding in respect of a part or the whole of such initial liability over a period of years. 2.4 Whether or not a separate gratuity fund should be created by an enterprise is entirely within the discretion of the management. The principal consideration in arriving at the decision on the subject is one of finance. Where funds which are required to be set aside for the gratuity liability are employed in the business and not separately invested, they may earn an income higher than the yield which would be realised when the funds are invested in approved securities as required for a separate gratuity fund. On the other hand, income from the investments of the funds is not subject to taxation, whereas income earned by investment of fund in own business is subject to taxation. A valid comparison must, therefore, be between the gross rate of interest that a gratuity fund can earn and the net rate of return that investment in own business can give. It is possible that on such a comparison, it may be found that the finance needed to provide for gratuity through the creation of a separate gratuity fund may, in certain circumstances, be lower than the finance needed when the funds are employed in the business. 3. Need for use of actuarial techniques 3.1 When it is desired to evolve a financial arrangement to cover accruing gratuity liability through the second or the third method referred under para 2.1 above, the first step must clearly be to obtain an estimate of the liability accruing from year to year. As on a particular date, neither the amount of accrued gratuity in respect of past service, nor the date of its payment are known with certainty. Since gratuity is payable at exit from service, the date of payment would depend on the cause of exit, that is, on whether the employee continues in service till normal retirement or dies or withdraws from service earlier. The amount of accrued gratuity depends on the salary at exit from service and, at times, also on the cause of exit. For computing financial provisions, it also becomes necessary to make assumptions regarding investment returns likely to be earned in future. Accordingly, determination of the cost of accruing gratuity benefits can, only be made on the basis of assumptions regarding the future course of a variety of events. As a consequence, it is not possible to ascertain with certainty, either the present value of accruing gratuity liability or the financial provisions required to meet such liability as it emerges. Techniques of making estimates of this nature are developed in actuarial science and the problems of estimating the liability in respect of accruing gratuity benefits and devising appropriate financial arrangements to meet such liability fall within the province of the actuary. As the actuarial estimates are based on forecasts regarding future course of events, it becomes necessary for the actuary to keep the changing experience in respect of such events under constant review and to re-examine the working of financial arrangements in the light of such review. Thus arises the need for periodical actuarial valuations. 3.2 Provisions for gratuity liability are sometimes based on estimates of gratuity liability made on the assumption that each employee would withdraw from service on the estimation date and gratuity based on his past service and current salary would be immediately payable to every eligible employee. Of course, this assumption is far removed from reality, since all employees are unlikely to withdraw immediately. This could happen only where the employer discontinues his business, whereas normally all accounts are prepared on the assumption of continuity of business. Provisions made on the basis of such estimates cannot be considered as determined on a scientific basis and they are likely to distort appreciably the picture presented by the accounts. Since over provision is as undesirable as under-provision, it is recommended that the provision for gratuity as well as the note relating to under-provision, over-provision or non-provision, as the case may be, should be based, as far as possible, on a computation determined by the use of actuarial principles. Where for any reason, an actuarial computation has not been obtained, and the provision is made or the disclosure of under-provision, over-provision or non-provision is based on any other method of computation, the accounts should clearly disclose this fact and should indicate broadly the basis of calculation. 3.3 It is, however, recognised that there may be circumstances under which an actuarial valuation is not called for. For example, in the case of a small company or where the number of employees is negligible, the cost and trouble involved in obtaining an actuarial valuation may not be justified. Consequently, an enterprise with very few employees may calculate the provision for gratuity or the amount to be disclosed as not provided, over-provided or under-provided, by reference to an ad hoc calculation based on the assumption that all employees are entitled to gratuity at the end of the accounting year, rather than by way of an actuarial computation. Nevertheless, in such a case, the accounts should disclose that the provision or the disclosure is based on a method of calculation other than an actuarial computation. 3.4 Whether an actuarial investigation and valuation of liabilities should be carried out each year or whether it would be adequate to carry out such investigations and valuation of liabilities at less frequent intervals say once in three years, is a matter which could best be left to be decided in consultation with the actuary. Some of the factors which will determine the interval between the two actuarial investigations are: (a) the purpose of the investigation, i.e., whether to determine the rate of contributions to the Gratuity Fund, and to determine periodically the adequacy of the fund, or to make provisions in the annual accounts for accruing gratuity liability or to state in note to the balance-sheet the amount of total accrued gratuity liability not provided for in the accounts; (b) the method of costing valuation to be adopted by the actuary; (c) the employee strength, its age/service profile, rate of employee turnover and frequency of changes in dearness allowance amounts. (if the accruing liability from year to year is unlikely to fluctuate widely, it may be possible to carry out the actuarial investigations at less frequent intervals); (d) changes in gratuity benefit rules; (e) provisions in the gratuity trust fund rules regarding frequency of actuarial valuation. In the opinion of the Council, an actuarial valuation should be carried out at least once every three years except in situations where the consulting actuary advises valuations at more frequent intervals or advises a special investigation during a normal three-year inter-valuation period. 3.5 Where an actuarial valuation is made every year, the accruing liability (to be provided in the accounts or to be referred to in the balance-sheet) for the year will be directly determined. Where, however, an actuarial investigation and valuation of liabilities is carried out at less frequent intervals, say once in every three years, the actuary will provide the estimates of accruing liability for the following two years, at the time of each triennial valuation. It should be clearly understood that after the immediately following triennial valuation the accruing gratuity liability determined for the third year will necessarily contain an adjustment for the over/under-provisions made in the preceding two years. 3.6 The accounts of each respective year should clearly disclose whether the gratuity provision reflected in the accounts is based on an actuarial valuation made at the end of the accounting year or an actuarial valuation made at an earlier date. In the latter case, the method by which the annual accrual has been determined should also be briefly described. 3.7 The observations in the foregoing paragraphs relating to a provision for gratuity in the accounts also apply in a case where no provision or inadequate provision is made but the estimated amount of the gratuity liability is disclosed. In other words, the method to be adopted for determining either the amount of the disclosure or the amount of the provision is roughly identical. 3.8 Where an enterprise has established a gratuity fund, similar observations would also apply in determining the annual contributions to the fund subject, however, to the overriding requirement that such contributions must be in accordance with the rules of the fund, the provisions of the trust deed, and the requirements of the Income-tax Rules relating to approved gratuity funds. 4. Gratuity liability uncovered by provisions 4.1 As indicated in para 2.3 above, on the first occasion when provision for gratuity liability is made, it may be decided that the provisions to cover a part or the whole of the initial liability in respect of past service should be spread over a number of years. During such period the total accumulated provision would not suffice to cover the entire accrued liability in respect of past service. Even after provisions are started, owing to special circumstances, it may be found that increase in the liability during a particular year is too large to be observed by the provisions normally expected in respect of that year. Such sudden large increases in liability may arise as a result of improvements of benefits under a gratuity scheme, sizeable increases in the level of salaries as a result of revision of scales of basic salary or dearness allowance as well as from the need for a change in actuarial assumptions. When such an event occurs, it may be permissible to spread the provisions to cover a part of such increase over a period of years provided that the amount charged in the profit and loss account of the year is not less than the amount properly chargeable to that year and the amount for which the provision is deferred does not exceed the increase in the liability pertaining to the past services of the employees. The tax implications of such a procedure, both regarding the allowance in the year in which the provision is deferred and in subsequent years will have to be carefully considered. During the period over which the total provisions are spread, the accumulated provision may fall short of the total accrued gratuity liability up to that date. Hence, whenever and for whatever reason the provisions made fall short of the accrued gratuity liability for past service, the quantum of such under-provision should be disclosed in a note to the balance-sheet. 4.2 Where a gratuity fund is constituted and the fund is not sufficient to cover the full accrued liability, the difference between the accrued liability, in respect of past service and the accumulated fund should be either provided for in the accounts of the enterprise or should be suitably disclosed by way of a note to the balance-sheet. Even where the trustees of the gratuity fund have made arrangements with the Life Insurance Corporation of India through a group gratuity policy, it would be necessary to examine whether any of the past service accrued liabilities have remained uncovered and if so provide for or to refer to the same in a note to the balance-sheet. 5. Provisions and tax implications 5.1 The amount of total accrued past service liability or of accruing liability for the year or the rate of contribution to the Gratuity Trust Fund will be determined by the actuary on a gross basis, i.e., without taking into account whether such provisions/contributions will be allowed as deductible items under the Income-tax Act. However, where the amount provided for gratuity in the balance-sheet is held to be not allowable as a deduction in computing the employer s taxable income, the allowance under the Income-tax Act would be made when the liability finally emerges, that is, when under the terms governing the payment of gratuity, it actually becomes due to the employee. The net cash cost of gratuity payment to the enterprise is not, therefore, the gross amount of the gratuity but the amount of the gratuity less the benefit derived from its deductibility for the tax purposes. In calculating the accruing liability for gratuity, credit may therefore be taken for the ultimate expected saving in tax. Thus if the rate of tax applicable to the employer is 60 per cent, provision may be made at the rate of 40 per cent of such part of the gross liability appropriately calculated. If the gratuity is provided for or disclosed on a net-of-tax basis, disclosure should be made both of the gross amount of gratuity liability and the net amount thereof after tax. 5.2 In making the above calculations, a question arises as to whether the liability under the Companies (Profits) Surtax Act, 1964, should also be taken into account in determining the likely reduction in the amount of tax to be deducted from the gross amount of gratuity. Two approaches are possible. On the one hand, as surtax now forms a more or less permanent feature of the tax assessment in the country, it may appear reasonable to take surtax into account in calculating the net-of-tax liability. On the other hand, as the calculation of surtax depends on a number of factors and there can be no easy way of ascertaining whether there would be a liability for surtax in the future year in which gratuity is paid, or the precise magnitude of the profits chargeable to surtax (the incidence and rate of surtax depending on the amount of the capital base), it can be argued that surtax should not be taken into account when calculating the net-of-tax rate. In the event of an enterprise adopting the first approach, namely, taking into account surtax, it is suggested that some estimate may be made of the likely surtax liability based on the average ratio which surtax bears to the total profit of the company over the past few years, for example, if it is found that surtax liability during the three immediately preceding years was equal to 9 per cent, 10 per cent and 11 per cent of the profits of the company, the average of 10 per cent may be adopted as a reasonable basis for calculating the surtax liability. While both the views are possible, on balance, it would appear more desirable to calculate accruing liability for gratuity on a net-of-tax basis without taking into consideration the surtax liability. 5.3 The net-of-tax method of calculating accruing liability of gratuity is, however, not appropriate unless there is a reasonable assurance that the enterprise will earn taxable profits in future to enable it to claim a deduction from such taxable profits when the liability for gratuity is discharged. This assurance would not normally be available where an enterprise has a large carry-forward of unabsorbed depreciation, development rebate, investment allowance or tax losses and/or has been incurring losses and there does not appear to be a reasonable possibility of its earning sufficient profits in the immediate future to wipe off such carried forward deductions. 5.4 Where the net-of-tax method is adopted, a problem is created by changes in the rates of taxation applicable to the employer. Several possible methods could be used such as, a standard rate of tax which is not varied from year to year, or a recomputation of total liability net-of-tax each year and providing for the difference between the amount calculated as at the beginning and at the end of the accounting period respectively. It is recommended that since the gross liability for gratuity is recalculated at the end of each year in the light of the facts as known at that time, it would be logical that the net-of-tax amount should also be recalculated on the basis of tax rates in force as at the date on which the recalculation is made. 5.5 Where adequate provision for gratuity is made gross, that is, without considering the tax benefit the actual payment is debited to the provision for gratuity. Where, however, a provision is made net-of-tax, certain accounting problems may arise. The most satisfactory method would be to debit the gross amount of the gratuity to the provision account. At the same time, the provision for tax for the accounting year in which the payment is made should be made without taking into amount the relief in respect of the gratuity payment. The additional liability so provided for should then be transferred from the provision for taxation account to the provision for gratuity account. in the Council s opinion, if adjustments are made in accordance with the above method, there is no necessity for showing the movements in the provision accounts.