1.23    Query:

Treatment of liquidated damages received.

1. A company is a Government of India Undertaking, registered under the Companies Act, 1956. It is engaged in refining and marketing of petroleum products, having its refineries in Bombay and Visakhapatnam. The company’s Bombay Refinery has a Captive Power Plant with Gas Turbine Generating (GTG) sets alongwith corresponding Heat Recovery Steam Generators (HRSG). For the purpose of transportation and erection of GTG/HRSG, purchase orders were placed on a contractor with a Liquidated Damages Clause. In line with such clause, liquidated damages were payable by the contractor in cases of delay, the maximum amount of such damages being 5% of the contract value. It was also mentioned in the purchase order that “such amounts shall be deducted from the contract price”, which, in other words, amounts to price reduction.

2. The liquidated damages amounting to Rs.1.33 crores were credited to the capital work-in-progress and the net amount of Rs.26.59 crores was capitalised. Consequent to the above delay by the contractor, the company incurred additional pre-production interest amounting to Rs.1.36 crores (Rs.5.44 crores annually). If the vendor had not delayed the job, the company would not have incurred additional pre-production interest (PPI) of Rs.1.36 crores and also not recovered liquidated damages of Rs. 1.33 crores.

 3. In this context, the querist has given below relevant extracts from Para 15 of the Guidance Note on Treatment of Expenditure during Construction Period, issued by the Institute of Chartered Accountants of India:

“15.1…… attention is drawn to the undernoted paragraphs which deal with different items of indirect expenditure which may be capitalised as part of the cost of construction.

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Paragraph 4 – relating to interest charges and other financial expenses.

 

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15.2 From the total of the aforesaid items of indirect expenditure would be deducted the income, if any, earned during the period of construction, provided it can be identified with the project.”

4.   In line with the above, income earned during the period of construction, if identified with a project, should be deducted from the indirect expenditure such as interest charges, etc., that are capitalised as part of the cost of construction of the project. The amount of liquidated damages, which has been recovered as a reduction in the contract price, is clearly identified with the project in question and the same is directly attributable to the delay in execution of the project.

5.  On account of the delay, the additional amount of pre-production interest has been charged to the project which would not have been debited if the delay had not taken place. As such, the liquidated damages of Rs.1.33 crores and the pre-production interest of Rs. 1.36 crores are directly related to each other. Further, since the said liquidated damages were in the nature of reduction in contract price in terms of the purchase order quoted above, deduction of liquidated damages from the capital cost of equipments for the purpose of capitalisation is fully justified.

6. The querist has noted the opinion of the Expert Advisory Committee of the Institute of Chartered Accountants of India published against Query No.1.54 of Volume XI and Query No. 1.15 of Volume XIII of the Compendium of Opinions. It has been mentioned in both the opinions that liquidated damages should be shown as income on the ground that the same cannot be regarded as adjustments in the price of the equipments.

7. The querist is of the view that the instant case referred herein is distinct from the cases earlier referred to the Institute for which opinions as referred above have been given. The differences are detailed below:

i) Relevant purchase order in the instant case has a specific stipulation that the liquidated damages should be deducted from the contract price, which, in other words, amounts to price reduction. 

 

ii)  Liquidated damages levied on the contractor can be directly related to the pre-production interest charged to the project. As such, the amount of the liquidated damages, even if treated as income, should be rightly deducted from indirect expenditure (PPI) capitalised, in line with Para 15.2 of the Guidance Note referred above.

8.  Opinion of the Expert Advisory Committee of the Institute of Chartered Accountants of India is hereby sought as to whether crediting of liquidated damages to the capital work-in-progress and capitalisation of costs net of liquidated damages is in order in the light of the special provision in the purchase order for treating liquidated damages as price reduction and the provision of adjusting related income against indirect expenditure, i.e., preproduction interest as envisaged in the Guidance Note on Treatment of Expenditure during Construction Period quoted above.

 The Committee is of the view that whether or not the liquidated damages should be adjusted against the project cost would depend upon whether the liquidated damages are directly identifiable with the project and whether, in fact, they are received in mitigation of the extra project costs incurred and capitalised by the enterprise on account of the same specific events which gave rise to liquidated damages. Where and to the extent the liquidated damages meet the aforesaid stipulations in affirmative, the same should be adjusted in the cost of the project.

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