MISCELLANEOUS TECHNICA L S TATEMENTS ACCOUNTING FOR GOODS SOLD SUBJECT TO RESERVATION OF TITLE

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1 MISCELLANEOUS TECHNICA L S TATEMENTS Contents Introduction Accounting treatment Disclosure in accounts Quantification Relevance of the going concern concept Appendix Taxation Inland revenue Revenue Commissioners (Republic of I reland) - 12 November

2 Introduction 1 The Romalpa case (Aluminium Industries Vaassen B.V. v Romalpa Aluminium Limited), decided in the Court of Appeal on 16 January 1976, and reported in (1976) 1 W.L.R. 676, focused attention on certain terms of sale whereby the seller retains title to the goods sold and, in some cases, the right to other goods produced from them and the ultimate sale proceeds. The Interview case* (In re Interview Limited and the Companies Act 1963), decided in the High Court, Dublin on 7 March 1975, was also concerned with goods which had been supplied on the basis that they would remain the supplier's property until payment had been made. Such terms of sale, which have in the past been more common in some Continental countries, are now being introduced by an increasing number of companies in the United Kingdom and Ireland. 2 It should be noted that both the Romalpa case and the Interview case are concerned with the construction of particular contractual relationships which in themselves are not of general relevance. 3 Whether an effective reservation of title exists will depend on the construction of the particular contract in each case and this construction may vary, to some extent, according to the law of the country in which the goods are situated. The main effect of trading with reservation of title is that the position of the unpaid seller may be improved if the purchaser becomes insolvent. This is because goods sold by the seller which are still in the purchaser's possession remain the seller's property and the proceeds of on-sales by the purchaser may be regarded in law as being held in trust for the seller. It follows that the position of other creditors, either with the security of a floating charge or no security, may be adversely affected. AccountingTreatment 4 In drawing up the accounts of undertakings trading on terms whereby goods are supplied subject to a reservation of title, it is necessary to decide at what stage they should be treated as sold by the supplier and purchased by the party to whom they are supplied ('the customer'). In reaching his decision, it is considered that the commercial substance of the transaction should take precedence over its legal form where they conflict. The substance of transactions of this nature has to be decided from consideration of all the surrounding circumstances. 1

3 5 The circumstances surrounding the transaction may indicate that the reservation of title is regarded by the parties as having no practical relevance except in the event of the insolvency of the customer. The goods concerned may be supplied and payment for them may be due in a manner identical with other goods which are not subject to a reservation of title. In such circumstances, where the customer is a going concern, it is considered that the omission of the stock (or, if resold, the debtors) and of the corresponding liabilities from the balance sheet of the customer would prevent it from showing a true and fair view of the state of affairs. Similarly, the accounts of the supplier would also be distorted by the omission of such goods from sales and debtors. Accordingly it is recommended that in such circumstances the goods should be treated as purchases in the accounts of the customer and as sales in the accounts of the supplier. 6 In some instances goods may be supplied on terms such that the intention of the parties is that they are consignment stocks. It will then be appropriate to treat them as continuing to belong to the supplier until some event inconsistent with the supplier's ownership occurs. Indications that stocks should be regarded as consignment stocks might include: (a) (b) (c) the right of the customer to return them to the supplier; deferment of the obligation to pay for the goods until they have been sold by the customer; acceptance by the Customs and Excise Revenue Commissioners that Value Added Tax is not payable by reference to the time of delivery of the goods but to some later event, e.g., the appropriation of the goods by the customer. 7 Precedents for the accounting treatment of goods supplied as sales by reference to the substance rather than to the strict legal form of the transaction already exist in, for example, hire purchase sales and in certain export sales, which are often included in sales on despatch from the supplier's factory even though legal title may not have passed. Disclosure i n Accounts 8 Where the accounts are materially affected by the accounting treatment adopted in relation to sales or purchases subject to reservation of title, the treatment should be disclosed. 2

4 9 Where such transactions are accounted for by the purchaser on the basis recommended in paragraph 5 it will also be necessary to disclose the fact that the liability to suppliers may, in effect, be secured. It is not entirely clear whether such a liability is secured 'otherwise than by operation of law' so that its disclosure would be necessary to comply with paragraph 9 of the Second Schedule to the Companies Act 1967, of the Sixth Schedule to the Companies Act (Northern Ireland) 1960 and of the Sixth Schedule to the Companies Act 1963 (Republic of Ireland). Nevertheless, the fact that certain trade creditors might, in an insolvency, be in a position to obtain payment of the amounts due to them ahead of the holder of a floating charge and of the unsecured creditors, would normally need to be disclosed if such amounts were material. Quantification 10 The extent to which the liability to creditors may be secured should whenever possible be disclosed in the relevant note and the amount due to creditors protected by reservation of title should therefore be shown. There should be little difficulty in doing this if, for example, the reservation of title applies only to the purchase of a particular fixed asset or to goods from a single supplier. 11 It is recognised that in many businesses there would be major practical difficulties in quantifying the amounts protected by reservation of title. There are considerable variations in the form in which suppliers may seek to reserve title and doubt as to the legal effectiveness of some of them may exist. It would, therefore, be necessary to form a view on the legal construction of each such contract before the amount of the liabilities to be treated as secured could be assessed. Afurther difficulty would arise in the need to establish accounting procedures which not only enabled suppliers' ledger balances to be split according to the terms of sale, but also identified the amounts due to the secured suppliers in respect of unprocessed goods received notes. 12 If the amount of the liability to suppliers who have reserved title to the goods supplied cannot reasonably be quantified, it is recommended that the situation should be explained in the relevant note in terms that provide as good an indication as possible of the extent to which the creditors are protected in this way. 3

5 Relevence of the going concern concept 13 The accounting treatment of goods supplied subject to reservation of title recommended in paragraph 5 would only be appropriate in the context of a going concern. If the financial position of the company or other considerations throw doubt on the going concern concept, the accounting treatment of goods supplied on such term will need particular consideration. In the rare circumstances in which accounts are drawn up on some basis other than the going concern basis, it would be necessary to have regard to the strict legal position in relation to the liabilities, stock, debtors and cash. 14 The purchase of goods subject to reservation of title by the supplier may affect the position of the customer in relation to security given to other creditors. Such purchases might, for example, lead to a failure to maintain a required level of asset cover or the borrowing limits being exceeded. The implications on other securities can only be assessed by considering the terms of the relevant trust deeds or other instruments constituting the security. 4

6 Appendix Taxation The accountancy bodies have received the following replies to their request for clarification of taxation practice regarding Statement - Accounting for Goods Sold Subject to Reservation of Title: (a) Inland Revenue (U.K.) - 25 June 1976 "You sent me on 7 June your proposed statement on this subject. We regard your approach as entirely reasonable and do not want to make difficulties. At the same time we obviously see a risk that the "sensible" basis may be used by one party and the strict legal basis by another so that relief would be claimed by both. I must make it clear therefore that while we would accept accounts made for tax purposes by all the parties to the transaction, we must reserve the right to insist on the legal basis for all those concerned if one party claims it. We see no other taxation implications which would be unacceptable to us." (b) Revenue Commissioners (Republic of Ireland) - 12 November 1976 "We are prepared to accept for tax purposes accounts drawn up on the lines recommended, subject of course, to the same reservation as that made by the Board of Inland Revenue in the matter." It follows from the above replies that where both parties to the transaction follow the recommendations set out in this Statement no taxation difficulties will normally arise. 5