1.17 Query:

Accounting treatment where commencement of

commercial production delayed.

1. A licence agreement was entered into by a public sector company, ABC Ltd., under the Ministry of Industry and M/s XYZ, Denmark, for transfer of technology, know-how, know-why, documentation and provide technical assistance and training etc., to enable ABC Ltd., to manufacture 40,000 FKM Optic Fibre in cables conforming to the specifications as per the agreement. The agreement provided for R & D tie up, supply of proprietory plant and machinery, purchase of finished products, proprietory raw materials and also to advise in drawing up the specifications and procurement of non-proprietory/or auxiliary plant and machinery to set up the manufacturing facilities for optic fibre and optic fibre cable. The production capacities envisaged at different stages were as under:

The guaranteed capacity was based on 2250 hours per year on three shift operations and 80% plant utilisation.

2. For the performance test, the agreement provided that during the start of and until the commercial production starts (No.3.c.1) XYZ shall advise regarding any alteration, modification, addition or replacement of industrial equipment, operating technique and methods, if any, which may be necessary to place the plant in a state to conform with XYZ’s process and the know-how. Such alterations, modifications, additions, or replacement could also be made by ABC provided that the cost of such alterations, modifications, additions or replacement as are attributable to XYZ’s error or omission shall be to the account of XYZ.

3. The performance test was to be conducted for a continuous period of 20 working days. Any deficiencies noticed during the performance test were to be dealt with as per the agreement as under:

            (a)            Interruption for reasons not attributable to XYZ -

(i)        In view of performance test for 20 working days, continuous operations for any similar one block of continuous run of 10 working days minimum may be taken for calculating the guaranteed capacity.

(ii)        If a block of 10 minimum working days was not available, second and third attempt for performance test of 10 days were to be carried out.

(iii)          On the failure of third attempt both parties shall agree to establish new conditions for final performance test taking into account the actual situation and the reasons for non-performance.

(b)            Due to reasons attributable to XYZ

(i)         To repeat the performance test for maximum of two more times within a period of twelve months from the first attempt.

(ii)        If the plant capacity is between 90% and 100 % of the guaranteed capacity, XYZ shall pay 1 % of the know-how fee for each full percentage of shortfall of guaranteed capacity.

(iii)        If the capacity is less than 90 % XYZ shall make good the deficiency including free supply of necessary additional industrial equipment within a reasonable period of time mutually agreed upon so that the capacity reaches at least 90 % of the guaranteed capacity and the shortfall to be compensated as in (ii) above.

4.  Under the agreement, XYZ supplied the plant and machinery for manufacture of cable, drawing of fibre from Performs (Draw Tower) and manufacture of Performs (MCVD). The company has spent Rs. 33.81 Crores on the MCVD Plant under the following major heads:

Plant & Machinery                                           Rs. 27.81 Crores

Pre-operational Expenses                                 Rs.  6.00 Crores

5. As per the agreement with the collaborator, M/s XYZ was to carry out the performance test 1.c.1 in June ’94 to establish the production level of 24000 FKM per year. Thereafter, performance tests 2.c.1 and 3.c.1 were to be carried out in October ’94 to establish the full capacity of 40000 FKM per year. XYZ gave performance trial run under performance test 1.c.1 in June ’94 for 13 days. However, the plant did not show the required output on a consistent basis due to technical problems. Thereafter, XYZ did not carry out the subsequent performance test to establish the plant performance which was scheduled in October ’94. The matter was, therefore, taken up with the collaborator and subsequently, the matter was also reported to the administrative ministry.

6. In view of the above fact that the performance test did not show the required results, the plant could not be commissioned commercially. However, following quantities were produced since 1994-95 on trial run:

7. The perform produced by the plant was not of required quality for the purpose of generating fibre. As a result, there had been a breakage of fibre to the extent of 35% (Approx.) due to substandard quality of Perform produced by the plant. In view of the fact that performance test did not show the required result and the Performs produced during trial runs were not of requisite quality, the expenditure incurred against MCVD plant is being shown under Capital Work-in Progress. The accounts of the company for the year 1995-96 disclosed the facts by way of a note as under:

“In view of the fact that the performance test 1.c.1 carried out by XYZ the collaborator, at Naini did not show the guaranteed output of 24000 FKM on consistent basis due to technical problems, XYZ did not carry out the subsequent performance tests scheduled in October, 1994 to establish the plant performance at 40000 FKM. The expenditure amounting to Rs. 3381.37 lacs incurred against MCVD plant, therefore, continues to be shown under Capital Work-in-Progress. Necessary adjustment shall be made in accounts once the plant gives guaranteed output on a consistent basis after carrying out required performance tests. However, out of the materials used during the trial runs of Phase III, the Performs found suitable have been used for manufacture of fibres.”

8. The querist has further supplied the following clarifications:

(i)         The collaborator is willing to carry out the performance tests 2.c.1 and 3.c.1 after the remaining payments under the collaboration agreement are released to them. Some clarifications are also proposed to be incorporated for evaluating the performance tests result. In some of the cases, the company has difference of opinion in the stipulated conditions.

(ii)        The technology passed on by the collaborator is already obsolete. The company cannot invest any more for any new technology at this stage. Keeping in view the market scenario, the company has already started on different designs etc. The company has already lost huge production and also the market.

(iii)       The optical fibre is backward integration to the optical fibre cable production. Therefore, no separate revenue has been generated from the production obtained. The fibre has been used in cable production.

(iv)       The raw material consumed for manufacture of fibre has been taken as the cost of production of optical fibre during the trial runs. The raw material expenses have been charged to operating expenses.

(v)        A question arose that if the performance test was unsuccessful, why the company had decided to continue production of the sub-standard product at lower capacity? Further, why the production of sub-standard product was decided to be increased in 1995-96 as compared to 1994-95? In this regard the company felt that since it had already invested huge sums towards procurement of plant and machinery, there was no option but to carry out trials and obtain as much production as could be possible. Fibre produced from such performs can be used for optic fibre cable production. Due to fibre breakage it will generate short length cable. As per the DOTs specifications the cable should be of the length of 2000 Mtrs. + 10 %, i.e., length ranging between 1800 mtrs. and 2200 mtrs. Cable which is less than 1800 mtrs. is termed as a short-length cable. DOT does not recommend use of short-length cables except to meet the length variation in the last patch of the route. Further, the short lengths is paid at 10% less than the price for a standard length for the lengths between 1000 mtrs. to 1800 mtrs. and 15% less for 500 mtrs. to 1000 mtrs.

9. The company is continuing the process of trial run during the current financial year as well. The result, however, remains the same. Opinion of the Expert Advisory Committee has been solicited on the following:

(i)         Should the plant be capitalised in view of the circumstances indicated above?

(ii)        Should the plant be continued to be shown in capital work-in-progress till it is rectified?

(iii)       Any other alternative accounting treatment to deal with the situation.

                                                                 Opinion                                      September 23, 1997

1. The Committee is of the view that the purpose of trial production is to ascertain whether the plant and machinery and other relevant facilities, as installed, give the intended output in terms of quality and quantity. If, during the trial run, which is of small duration (in present case 13 days as per para 5 of the query), the production standards are not met, normally, the production is stopped and necessary alterations/modifications in the plant and machinery.  It may be necessary to carry out trial run(s) further until the output of desired quality and quantity is obtained. The Committee notes that in the present case, the company did not do so, but continued the sub-standard production, and, in fact, increased its production in view of the fact that it had invested huge sums in the project. In other words, the decision to continue sub-standard production was prompted by commercial reasons. The Committee is, accordingly, of the view that the plant in question cannot be considered to continue in trial production and, therefore, should have been capitalised.

2.  The management may, however, consider charging depreciation at rates higher than those prescribed in Schedule XIV to the Companies Act, 1956, on technical evaluation basis keeping in view the factors affecting useful life of plant and machinery, such as, obsolescence. In this regard, the Committee draws attention of the querist to the definition of the term ‘useful life’ as per para 3.3 of Accounting Standard (AS) 6 on ‘Depreciation Accounting’, issued by the Institute of Chartered Accountants of India, as follows:

“‘Useful life’ is either (i) the period over which a depreciable asset is expected to be used by the enterprise; or (ii) the number of production or similar units expected to be obtained from the use of the asset by the enterprise.”

3. On the basis of the above, the opinion of the Committee on the issues raised by the querist in para 9 of the query is as follows:

(i)          Yes.

(ii)            No.

(iii)       In the given facts and circumstances, answers at (i) and (ii) above are the only accounting treatment along with the consideration of depreciation as explained in para 2 above and there is no alternative accounting treatment.

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