In this article we discuss the accounting of CSR expenditure, particularly focusing on the issue relating to constructive and legal obligation under Indian GAAP.
Provisions relating to Companies Act, 2013 on CSR
1. The Companies Act requires that every company with net worth of Rs. 500 crore or more, or turnover of Rs. 1,000 crore or more or a net profit of Rs. 5 crore or more during any financial year will constitute a CSR committee.
2. The CSR committee will consist of three or more directors, out of which at least one director will be an independent director.
3. The CSR committee will:
(a) Formulate and recommend to the board, a CSR policy, which will indicate the activities to be undertaken by the company.
(b) Recommend the amount of expenditure to be incurred on the activities referred to in the CSR policy.
(c) Monitor CSR policy from time to time.
4. The board will ensure that company spends, in every financial year, at least 2% of its average net profits made during the three immediately preceding financial years. For this purpose, the average net profit will be calculated in accordance with the clause 198.
5. The company will give preference to local areas around where it operates, for spending the amount earmarked for CSR activities.
6. The board will approve the CSR policy and disclose its contents in the board report and place it on the company’s website.
7. If a company fails to spend such amount, the board will, in its report specify the reasons for not spending the amount.
8. Schedule VII of the Act sets out the activities, which may be included by companies in their CSR policies. These activities relate to (a) eradicating extreme hunger and poverty (b) promotion of education (c) promoting gender equality and empowering women (d) reducing child mortality and improving maternal health (e) combating HIV, AIDs, malaria and other diseases (f) ensuring environmental sustainability (g) employment enhancing vocational skills (h) social business projects (i) contribution to certain funds and other matters.
Naming and Shaming
The Companies Act does not prescribe any penal provision if a company fails to spend the amount prescribed on CSR activities. The board will need to explain reasons for non-compliance in its report. Thus many believe that there is no legal obligation to incur CSR expenditure. Creating a legal obligation under the Companies Act to incur CSR expenditure, would have created constitutional hurdles for the regulator. Hence the Government has chosen a path of applying moral pressure, by requiring disclosure of CSR expenditure. As there is no legal obligation to incur CSR expenditure, there would be no legal obligation to make good short spends of previous years or prohibition on taking credit in future years for excess amount spent on CSR.
The draft rules clarify that CSR is not charity or mere donations. CSR is the process by which an organisation thinks about and evolves its relationships with stakeholders for the common good, and demonstrates its commitment in this regard by adoption of appropriate business processes and strategies. CSR is a way of conducting business, by which corporate entities contribute to the social good. Socially responsible companies do not limit themselves to using resources to engage in activities that increase only their profits. They use CSR to integrate economic, environmental and social objectives with the company’s operations and growth.
From the draft rules, it is clear that CSR is based on shared values and should be a part of a company’s business strategy. It should not be seen as a discretionary expenditure. Certainly reputed companies can ill afford not to have CSR as part of their business strategy and spend the legislated amount on CSR. Hence, these companies would have, if not a legal obligation, atleast a constructive obligation to incur the CSR expenditure. The same cannot be said of companies that do not care about CSR or have cash flow problems and hence would not pursue CSR.
In a nutshell, as a result of the Companies Act 2013, for companies that meet the threshold, there may or may not be a constructive obligation. It is a company specific analysis that will have to be made.
Accounting of CSR expenditure
Assume, Company A meets one of the thresholds, and hence CSR is applicable to it. There are three scenarios with respect to CSR expenditure.
1. Company A spends 2% (determined in accordance with the Act) each year.
2. Company A spends nothing or less than 2% each year.
3. Company A spends more than 2% in one year, and may or may not take credit for the excess spend in future years
Scenario 1 is fairly straight-forward. Scenario 3 is not dealt with in this article. This article focusses on Scenario 2. How does Company A account for CSR expenditure in Scenario 2?
Author’s Response
To answer this question, one will have to answer three questions. Is there a legal obligation to spend on CSR? If there is no legal obligation, has the company created a constructive obligation for itself? How are constructive obligations accounted for under AS 29 – Provisions, Contingent Liabilities and Contingent Assets?
Based on discussions above, the author believes that there is no legal obligation to incur CSR expenditure. However, companies are advised to seek legal clarity on this matter. The answer to the second question, whether or not there is a constructive obligation, would depend on facts and circumstances of each case.
Paragraph 11 of AS 29 provides some insight on constructive obligation. It states “An obligation is a duty or responsibility to act or perform in a certain way. Obligations may be legally enforceable as a consequence of a binding contract or statutory requirement. Obligations also arise from normal business practice, custom and a desire to maintain good business relations or act in an equitable manner.”
Whether or not there is a constructive obligation, will be clear from facts and circumstances of each case. Infact the requirement of Companies Act 2013, could throw some light on whether constructive obligation exists in a given fact pattern. As per the Act, the CSR committee will: (a) Formulate and recommend to the board, a CSR policy, which will indicate the activities to be undertaken by the company (b) Recommend the amount of expenditure to be incurred on the activities referred to in the CSR policy (c) Monitor CSR policy from time to time. Further, the board will approve the CSR policy and disclose its contents in the board report and place it on the company’s website. The above disclosures should throw adequate light on whether or not there is constructive obligation in a given fact pattern.
Now the million dollar question. Assuming there is constructive obligation in a given fact pattern, would a company require to make provision for the short or nil spends, on the basis that the short or nil spends will be made good in the future years. The response of the standard setters on this issue has been very confusing.
Constructive obligations should be provided
The requirements in Indian GAAP, suggesting constructive obligations should be provided for are:
(a) AS 29 defines ‘obligating event’ as an event that creates an obligation that results in an enterprise having no realistic alternative in settling that obligation. This definition is capable of being interpreted as requiring a provision based on constructive obligation criteria rather than merely on legal criteria.
(b) Paragraph 11 of AS 29 describes obligation at a constructive level rather than on a legal basis. Paragraph 11 describes obligation as follows: “An obligation is a duty or responsibility to act or perform in a certain way. Obligations may be legally enforceable as a consequence of a binding contract or statutory requirement. Obligations also arise from normal business practice, custom and a desire to maintain good business relations or act in an equitable manner”.
(c) In the case of refund by retail stores, AS 29 requires a provision based on constructive obligation criteria and not on the basis of a legal obligation. The example contained in AS 29 is reproduced below.
Illustration 4: Refunds Policy
A retail store has a policy of refunding purchases by dissatisfied customers, even though it is under no legal obligation to do so. Its policy of making refunds is generally known. Present obligation as a result of a past obligating event – The obligating event is the sale of the product, which gives rise to an obligation because obligations also arise from normal business practice, custom and a desire to maintain good business relations or act in an equitable manner. An outflow of resources embodying economic benefits in settlement – Probable, a proportion of goods are returned for refund (see paragraph 23).
Conclusion – A provision is recognised for the best estimate of the costs of refunds (see paragraphs 11, 14 and 23).
(d)Paragraph 3 of AS 15 Employee Benefits states that “The employee benefits to which this Standard applies include those provided:……(c) by those informal practices that give rise to an obligation. Informal practices give rise to an obligation where the enterprise has no realistic alternative but to pay employee benefits. An example of such an obligation is where a change in the enterprise’s informal practices would cause unacceptable damage to its relationship with employees.” In the Indian context, bonus, increments, etc. are provided for based on constructive obligation rather than on the basis of a legal obligation. This is in accordance with AS-15. Thus the concept of constructive obligation is not an alien concept and is recognized not only in AS-29, but also other Indian standards such as AS-15. (e) AS 25 – ‘Interim Financial Reporting’, requires the constructive obligation criteria to be applied in making provision for bonus in interim periods. As per AS 25, “a bonus is anticipated for interim reporting purposes, if, and only if, (a) the bonus is a legal obligation or an obligation arising from past practice for which the enterprise has no realistic alternative but to make the payments, and (b) a reliable estimate can be made.”
Only legal obligations are provided, constructive obligations are not provided The requirements in Indian GAAP, suggesting constructive obligations should not be provided for are:
1. The view that constructive obligation should not be provided for is clearly confirmed in two EAC opinions. In a recent opinion published in The Chartered Accountant of July 2013, the EAC opined “Since as per Department of Public Enterprises Guidelines, there is no such obligation on the enterprise, provision should not be recognised. Accordingly, the Committee is of the view that the requirement in the DPE Guidelines for creation of a CSR budget can be met through creation of a reserve as an appropriation of profits rather than creating a provision as per AS 29. On the basis of the above, the Committee is of the view that in the extant case, it is not appropriate to recognise a provision in respect of unspent expenditure on CSR activities. However, a CSR reserve may be created as an appropriation of profits.”
Another opinion is contained in Volume 28, Query no 26. In this query EAC opined “A published environmental policy of the company by itself does not create a legal or contractual obligation. From the Facts of the Case and copies of documents furnished by the querist, it is not clear as to whether there is any legal or contractual bligation for afforestation, compensatory afforestation, soil conservation and reforestation towards forest land. In case there is any legal or contractual obligation, compensatory afforestation, felling of existing trees or even acquisition of land could be the obligating event depending on the provisions of law or the terms of the contract.”
2. AS 29 has rejected the concept of constructive obligation in regard to provision for restructuring costs (e.g. voluntary retirement cost), which is required to be provided for based on a legal obligation rather than when there is an announcement of a formal and detail plan of restructuring.
3. The draft Ind-AS ED corresponding to IAS 37 Provisions, Contingent Liabilities, and Contingent Assets, identifies constructive obligation as a difference between Ind-AS and AS-29.
This is reproduced below.
Major Differences between the Draft of AS 29 (Revised 20xx), Provisions, Contingent Liabilities and Contingent Assets, and Existing AS 29 (issued 2003)
1. Unlike the existing AS 29, the Exposure Draft of AS 29(Revised 20XX) requires creation of provisions in respect of constructive obligations also. [However, the existing standard requires creation of provision arising out of normal business practices, custom and a desire to maintain good business relations or to act in an equitable manner]. This has resulted in some consequential changes also. For example, definition of provision and obligating event have been revised in the Exposure Draft of AS 29 (Revised 20XX), while the terms ‘legal obligation’ and ‘constructive obligation’ have been inserted and defined in the Exposure Draft of AS 29(Revised 20XX). Similarly, the portion of existing AS 29 pertaining to restructuring provisions has been revised in the Exposure Draft of AS 29 (Revised 20XX).
Conclusion
Apparently, there are internal inconsistencies in AS 29. While some requirements of AS 29 require creation of provision toward constructive obligation; other aspects may be read as if the same may not be required. Overall, it appears that the ICAI does not favour creation of a provision with respect to constructive obligation. This is particularly clear from the two EAC opinions. However, it is unclear, how the EAC opinions can override some of the requirement under AS-29 which require a provision to be created for constructive obligation. This creates a huge anomaly; one that can be resolved only by suitably amending AS-29 to bring it completely in line with the intentions of the standard setters. The author does concede that at this stage, it may not be advisable to amend Indian GAAP. Rather it would be advisable to take swift steps to adopt IFRS/Ind-AS, and leave the past behind.
