Expert Advisory Committee
ICAI-Expert Advisory Committee
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1.54 Query:           

Treatment of liquidated damages in the valuation of fixed assets.

 

1. A public sector undertaking formed as a company and registered under the Companies Act, 1956, with effect from 19.3.1986, is involved in overseas communication service. The company is in a hi-tech electronics field. For the year 1990-91, it has posted a revenue of Rs.395.43 crores and expenditure of Rs. 243.14 crores. The Company Law Board has appointed joint auditors for the company and the company is also subject to government audit u/s 619(4).

 

2.   The company is purchasing capital equipments from indigenous and overseas sources. The problem is relating to indigenous source of supply. According to the querist, invariably, the company keeps a clause in its purchase order relating to liquidated damages. In some cases, wherever the company is satisfied with the explanation of supplier, it does not invoke the liquidated damages clause. In other cases, where the explanation given by the supplier for delayed supply is not convincing, the company invokes the liquidated damages clause and deducts the amount in conformity with the purchase order and makes the balance payment to the party.

 

3. As per the querist, till the year 1989-90, the company had been following the practice of deducting liquidated damages from the equipment cost and capitalising the net value. During the year 1990-91, at the instance of the statutory auditors, the company has capitalised the purchased equipment at full cost and disclosed the liquidated damages deducted, as other income, in its profit and loss account. In the view of the querist, the reason for changeover of the practice was that the asset must be capitalised at its full value (emphasis supplied by the querist) presuming that if the liquidated damages clause had not been invoked, the asset would have been capitalised at the purchase value. Further, the liquidated damages had been imposed on the supplier due to failure on the performance with regard to delivery schedule. Secondly, the querist states that support had also been taken from an earlier opinion given by the Expert Advisory Committee published in the Compendium of Opinions, Volume I, Page No. I.117, Query No. 1.63(d). As per the querist, the referred opinion had been sought as to whether the liquidated damages/ penalty payable under the sale contract was allowed to be deducted from the sale price and shown net in the profit and loss account. The Committee had offered the opinion that separate disclosure of liquidated damages/penalty payable under the sale contract for delayed delivery is necessary if the amount is material and it would not be proper to deduct the same from the sales (emphasis supplied by the querist) and show the net amount in the profit and loss account. Though the specific question and opinion given by the Expert Advisory Committee was from the seller’s point of view, yet the company tried to visualise from the buyer’s viewpoint and decided to capitalise the equipment cost at purchase order price without any deduction (emphasis supplied by the querist) and to show the liquidated damages as ‘Other Income’. Further, in the view of the querist, there may also be a possibility that liquidated damages are refunded even after the year or so of the purchase and, the seller by persistent efforts, gets the refund of liquidated damages. In view of all these possibilities, it was thought fit to show the asset at original value, which is supported by Expert Advisory Committee’s opinion, Accounting Standard (AS) 10 on ‘Accounting for Fixed Assets’ (Para 9.1) and definition of Cost of Purchase as defined in the Guidance Note on Terms Used in Financial Statements; accordingly liquidated damages were shown as ‘Other Income’ for the year. Morover, in case if such liquidated damages were refunded at a later date, the querist has a doubt whether such refunded amount may be added to the asset for the purpose of depreciation and whether this treatment would be allowed.

 4.According to the querist, while auditing u/s 619(4), the government auditors had taken a different stand and commented upon the treatment given by the company. However, the Director General, P&T Audit had referred the matter to CAG for their opinion and did not, in the meantime, insist to open the accounts and correct it.

 5. As the matter is not free from doubt, the querist has solicited the opinion of the Expert Advisory Committee as to whether the asset should be shown at a value net of liquidated damages received or whether the asset should be shown at its full value and liquidated damages shown as other income.

 

                                                                              Opinion                             February 7, 1992

 

1. The Committee notes para 9.1 of Accounting Standard (AS) 10 on Accounting for Fixed Assets, which provides as follows:

 

“9.1 The cost of an item of fixed asset comprises its purchase price, including import duties and other non-refundable taxes or levies and any directly attributable cost of bringing the asset to its working condition for its intended use; any trade discounts and rebates are deducted in arriving at the purchase price. Examples of directly attributable costs are:

 

(i) Site preparation;

 

(ii) Initial delivery and handling costs;

 

                                            (iii)                   Installation cost, such as special foundations for plant; and

 

                                             (iv)                     Professional fees, for example, fees of architects and engineers.

 

The cost of a fixed asset may undergo changes subsequent to its acquisition or construction on account of exchange fluctuations, price adjustments, changes in duties or similar factors.”

 

2. The Committee also notes the underlying principle of the cost to be capitalised as is evident from para 9.8 of the Guidance Note on Treatment of Expenditure During Construction Period, which provides as below:

 

“9.8 During the course of construction of a big project, some losses are bound to occur. To an extent the losses may be treated as normal and added to the cost of the project. For instance, a wall may have to be pulled down and rebuilt. The total cost then can be capitalised. However, to the extent the loss is avoidable and results from inefficiency, mischief or an accident it should not be treated as part of the cost of the project. The amount of such a loss should be segregated and written off when production commences, over a period of three to five years.”

 

3. The Committee is of the view that liquidated damages are not directly attributable to the acquisition of capital equipment like trade discounts and rebates. They are also not adjustments in the price of the equipment. The damages result from inefficiency on the part of the supplier, i.e., delay in the supply of the equipment. In view of this, the liquidated damages received from the supplier cannot be adjusted in the cost of purchase.

 

4. On the basis of the above, the Committee is of the opinion that liquidated damages should be shown as income separately, in the profit and loss account, and not adjusted against the cost of the relevant asset acquired.

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