1.30     Query

Capitalisation of financial charges related to pre-production period.

1.A company insured its new plant for manufacture of polyester staple fibre for Rs. 102 crores, besides its building for about Rs. 8 crores. The plant was under construction for the preceding two years and the commercial production has commenced in the preceding few months.

2.The company advised the insurance company that it proposed to insure the fixed assets of the plant at a cost, inclusive of, inter alia, pre-operative expenses, which was confirmed by the insurance company.

3. The company held further discussions with the representative of the insurance company to finalise the aggregate value of the fixed assets, inclusive of the pre-operative expenses. The said representative expressed certain reservations with regard to the financial charges proposed to be included in the value of the machinery- imported and indigenous. The querist has informed that these costs were incurred at the pre-operative stage, i.e., prior to commencement of commercial production. According to the querist, it was permissible to include them in the project cost if incurred by the company out of its capital and borrowings from the financial institutions who had advised that fire and allied insurance should be provided on the aggregate value of the fixed assets which is inclusive of the financial charges. The querist feels that since these costs have already been included in the fixed assets, it is in the interest of all concerned to take adequate fire insurance so that in the event of any exigency the company is indemnified for the full amount.

                                                                                    Opinion                                                  February 19, 1990

1.The Committee notes from the facts of the query that the querist’s question is on inclusion of financial charges related to the period prior to the commencement of commercial production in respect of its capital and borrowings. The Committee, therefore, restricts its reply to this question only. Also, the reply given hereinafter is from accounting point of view.

2.The Committee notes that the Research Committee of the Institute of Chartered Accountants of India has issued ‘Guidance Note on Treatment of Expenditure During Construction Period’, which, inter alia, provides guidance on treatment of financial charges incurred by a company during construction period. The Committee specifically notes the following recommendations made in this Guidance Note in this regard:

                        “Financial Expenses

4.1 These expenses would include interest charges and commitment fees on loans, as well as expenditure incurred for preparing and issuing loan agreements and other documents including debentures, trust deeds in favour of lenders, mortgage and hypothecation deeds, etc.

4.2 For the sake of a better understanding of the problem, it may be clarified that the expression “commitment fees” refers to the charges which are sometimes stipulated to be payable to the lenders between the date a loan agreement is finalised and the date the loan or any part thereof is actually taken by the company. The full interest charges begin to accrue in favour of the lender only from the date the loan is actually taken, but, in the meantime, the lender is committed to keeping in readiness the funds which he has agreed to lend. For this service, the lender sometimes charges a commitment fee, which is at a rate much lower than the full interest charges and which is, quite often, based on the difference between the full interest charges on the loan and the interest which the lender can earn during the period before the loan is availed of by a temporary or short-term investment of funds.

4.3 There is no doubt that interest charges and commitment fees incurred after the date of commencement of commercial production should be treated as revenue expenditure in the normal way. However, during the period of construction, both these charges would represent indirect construction expenditure and should be added to the total capital cost of the project. (This view has already been accepted by the Institute vide paragraph No. 3.25 of the Statement of Auditing Practices). These remarks would apply with particular force in the cases of loans which have been taken for the purchase of capital assets or for incurring capital expenditure. It is possible that the accounting treatment suggested in this paragraph may appear to be slightly controversial and unorthodox from a purely theoretical standpoint but, on practical considerations, the suggested treatment is probably fair and is also probably the most appropriate choice out of various alternatives, each of which is bound to be subject to some practical or theoretical objection. This view has now been accepted by the Supreme Court of India in the case of Challapalli Sugars Ltd., V. C.I.T. (1975) 98 ITR 167 (S.C). With regard to interest charges and commitment fees on loans taken specifically and exclusively for the purpose of providing working capital, the treatment suggested above may not be proper and, in this case, it will be more appropriate to transfer the interest charges and commitment fees during the period of construction to a separate account which is carried forward in the balance sheet under the group heading of “Miscellaneous Expenditure” until it is subsequently written-off to profit and loss account after the commencement of commercial production, over a period not exceeding 3 to 5 years.

4.4 It may be emphasized that the accounting treatment suggested in the foregoing paragraph would apply only to actual interest charges and commitment fees. It would not apply to any notional or imputed interest charges which are not actually incurred. For example, it would not be appropriate to compute the notional interest on the share capital during the period of construction and charge the same as an addition to the construction cost. The only exception to this would be in a case where interest is actually paid on share capital during the period of construction under Section 208 of the Companies Act, 1956, in which case, as mentioned in that Section, such interest charges can be capitalised as part of the construction cost or as part of the cost of the relevant plant and equipment.

4.5 Although it is stated in paragraph 4.3 that the interest charges on loans taken for the purpose of providing working capital cannot logically be treated as capital expenditure and added to the cost of fixed assets as an indirect charge relating thereto, these remarks would not apply to the case of a loan which is taken partly for the purpose of providing working capital and partly for the purpose of financing capital expenditure. In that case, the total amount of the loan should be reasonably apportioned between working capital and fixed capital expenditure; the interest during the construction period of the latter portion can be treated as indirect capital expenditure and added to the cost of the relevant fixed assets, in the same manner as is suggested in the early part of paragraph 4.3.

4.6 The cost and charges incurred for preparing and issuing loan agreements and other documents including debentures, trust deeds in favour of lenders, mortgage and hypothecation deeds, etc., are sometimes written off to profit and loss account, whereas in other cases, especially if the amount involved is heavy, the total amount is carried forward on the balance sheet as an item of “Miscellaneous Expenditure” and is written-off to revenue over a period of years. These alternative methods of accounting apply where such costs and charges are incurred after the commencement of commercial production. In the latter case, that is, where the total amount of such cost and charges are treated as deferred revenue expenditure, it is recommended that they should be written-off to revenue as soon as possible and, in any case, over a period not exceeding 3 to 5 years. Where however such charges are incurred during the period of construction, it is suggested that they should be capitalised in the same manner as interest charges.”

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