1.76     Query

Incidental Expenditure during Construction Period

 The problem relates to a Fertilizer Project costing about Rs. 200 crores. It is expected that it may take 5 to 7 years to complete the project.

 During the construction period, it is natural that certain fixed assets like Vehicles, Furniture and Fixtures, Earthmoving/Levelling equipment, Office equipment etc. are acquired. Besides because of long gestation period of the project civil works relating to Township Buildings, railway Siding and some Factory Buildings (Stores Rooms, Administration Block, Control Room etc) are constructed and are also put to use during the construction period.  Expenditure on Township Buildings and Railway Siding is substantial and these may be put to use 2/3 years before the commencement of commercial production. Once these assets are put to use, these have to be depreciated.

 During the construction period the project has necessarily to incur various expenses which prima facie are of a revenue nature usually known as ‘indirect expenditure during construction’ (IEDC). In a fertilizer project, these expenses may be 25% to 30% of the direct capital expenditure and in monetary terms about Rs. 40 to Rs. 50 crores. Normally, these expenses are accumulated year after year under ‘Expenditure during Construction pending allocation’ and allocated to plant and Machinery and Buildings when the project goes into commercial production.

 So far as Plant and Machinery are concerned, the allocation poses no problem as all the expenditure incurred on these is shown as ‘Capital Work in Progress’ and the capitalisation (transfer to fixed block) is done at one stage only when the commercial production commences. The difficultly arises in the case of civil works and railway siding which have been already completed and are being used for construction purposes and on which depreciation is also provided.

 It cannot be denied that a part of the IEDC relates to these items also, specially, interest, salaries of engineers, technicians, workers and other overheads and it is but logical that a part of IEDC is loaded to these assets also. But in practice this results in certain difficulties. In this connection attention is invited to para 15.3 of Institute’s ‘Study on Expenditure during Construction’ which is reproduced below:

 “While the construction work is in progress the various items of indirect capital expenditure may be carried forward to be ultimately included as part of the indirect cost of construction. It is not necessary to make any attempt to apportion the various items of indirect capital expenditure to any specific asset or assets while construction work is still in progress. However, after the construction work is completed, it will be necessary to tackle the problem of the specific allocation of the total indirect capital expenditure to the various individual asset or assets”.

 In view of the above facts opinion is sought on the following matters:

 (a)        Whether expenditure on civil works and railway siding should be capitalised as soon as these are completed and put to use or the expenditure could be allowed to remain under “Capital Work in Progress” and capitalisation done only when the commercial production starts. If the second alternative is recommended, whether adjustment for depreciation on higher cost of these assets resulting from loading of IEDC needs to be done from the date the asset was capitalised and put to use. It may be mentioned that in case arrears of depreciation are required to be adjusted it will set in a chain reaction as depreciation will affect IEDC which in turn will affect the cost of assets and consequently their depreciation and so on.

 (b)        In case the opinion is that the expenditure on civil works and railway siding should be capitalised when completed and put to use, whether a portion of IEDC should be allocated to these at the time of capitalisation. If so, what should be the basis of allocation?  It may be noted that these assets may be completed and put to use on different dates in a year.

 (c)        Any other solution to the problem within the framework of generally accepted accounting practice.

                                                                                  Opinion                                                 October 12, 1981

 In the opinion of the Committee, the under-noted paragraphs of the Institute’s above mentioned publication are more directly of relevance to the enquiries by the querist:

In particular, the following extracts from the Institute’s  above-mentioned  publication are reproduce below as they directly relate to the facts of the querist’s case:

 (a)        From Paragraph 9.4: (i)  “ It is extremely likely that all or some of the fixed assets  purchased during the construction period may be actually or indirectly utilised   in the work of construction, in which case the appropriate depreciation charges during the period in which they are utilised in the work of construction should be treated as part of the indirect construction  expenditure and dealt with in the manner suggested in paragraph 5 of this Note which deals with the treatment of indirect expenditure during construction”.

“If some equipment purchased during the period of construction has been utilised only partly for purposes of construction, a part of the depreciation thereon, on the basis of a suitable proportion, should be capitalised as an indirect expenditure incurred during the construction period.  Thereafter, the total cost of the equipment purchased during the construction period less the depreciation charged during that period should be carried forward to the production period so that the accounts of the production period would begin with the depreciated value of equipment, which would then be further depreciated in the normal way”.

(b)From Paragraph 9.5:  (i)  “Where the work of construction is likely to be prolonged, it is inevitable that certain facilities would have to be acquired or constructed especially for the purpose of the construction. In some cases these facilities can be used with suitable adjustments after the commencement of production, whereas in other cases, they would have to be scrapped or dismantled after completion of construction”.

“It is submitted that is such cases, the proper procedure would be initially to capitalise the cost of all such temporary facilities and equipment. Logically, depreciation should be charged on such facilities and equipment during the period of construction, but in actual practice this may not always be possible because of the difficulty involved in ascertaining the fair amount of such depreciation. Therefore, a more convenient method in practice would be initially to capitalise the full cost of such temporary facilities, services and equipment, and thereafter to credit against this cost the residual or scrap value thereof at the end of the construction period. In those cases where the temporary facilities and equipment are sold or scrapped or are intended to be sold or scrapped at the end of the construction period, the value to be credited would be the actual or estimated sale value or scrap value. Where, however, the assets are intended to be taken over by the company for use in production at the end of the construction period, the value to be credited would have to be estimated on some reasonable basis. Therefore, the initial cost of the temporary facilities and equipment less the value credited at the end of the construction period, should be treated as an element of the indirect cost of construction and dealt with accordingly in the manner suggested in paragraph 5 of this Note, dealing with the subject of indirect expenditure during construction. In effect, what this means is that the depreciation in the value of the temporary facilities and equipment used during the construction period would be charged to the cost of construction”.

(c)        From paragraph 17.16: “Any complete units of fixed assets purchased or acquired during the construction period should be shown in the accounts as “fixed assets” or “capital expenditure”, for example, transport equipment, furniture and fixtures, and office equipment”.

 

(d)       From paragraph 17.17:  “Similarly, it would be appropriate to capitalise the value of any facilities or equipment which have been acquired or built specially for the purpose of construction, for example, temporary housing for construction labour, temporary warehouses for construction stores, temporary water and power construction, and purchase of construction equipment such as cranes, earth moving equipment, etc.”

(e)       From paragraph 17.18 : “It is recommended that depreciation should be charged during the construction period on any items of fixed assets or temporary construction facilities used during the period of construction. Such depreciation may be charged either by applying the normal depreciation rates to the original cost of such assets or, in the alternative, the depreciation may be charged indirectly by capitalising the difference between the original cost of the equipment of facilities and the sale or scrap value thereof at the end of the construction. The latter method is particularly appropriate in the case of special construction equipment and temporary construction facilities. In either case, the depreciation provided during the construction period should ordinarily be treated as part of the indirect construction cost and capitalised accordingly. If any item of fixed assets used during the construction period is retained by the project for use after production, the residual book value of such assets should be depreciated in the normal way after commencement of production”.

The Committee thus expresses its opinion in reply to the querist’s enquires as under:

(a)        The expenditure on the said assets (including and appropriate loading for indirect expenditure incidental or related to the construction of the said assets and incurred up to the date of their construction) should be capitalised on their construction being completed.

(b)        The basis of allocation of such related indirect expenses to the said assets would depend on the facts and circumstances of each case. For this purpose, guidance may be availed of from the observation in paragraph 15 of the institute’s abovementioned publication.

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