1.18 Query

Treatment of loss arising from damage and obsolescence of equipment during

construction/development period of a project of an ongoing company.

1. A subsidiary of an existing public sector company has more than seventy collieries and five washeries spread all over Bihar. It is engaged in development and operation of coal mines, washeries, other units for production of coal, washed coal, coal products and marketing of the same. All the units/collieries/establishment are treated as profit centers.

2. The company has one coal washery project under construction, (Estimated capital cost Rs. 1,30.41 crs.). Plant and machinery items required for the project had arrived at the project site. Few equipments such as control panel, ash monitors and density controller, costing Rs.428.64 lakhs procured in 1983/1989, became obsolete and got damaged before installation, during the accounting year 1995-96.

3. As per the accounting policy of the company, all expenditures incurred during development period of the projects are capitalised and amortised over the life of the assets after project is commissioned and brought under revenue. According to the querist, this policy is in line with the internationally accepted accounting standards including the Guidance Note on the subject issued by the Institute of Chartered Accountants of India.

4.  As per the above accounting policy, the value of the obsolete control panel valuing Rs. 428.64 lakhs for the washery project was not charged to profit and loss account of the company in 1995-96. The value of the damaged and obsolete equipment will be reduced from the capital work-in-progress and transferred from the head ‘Plant and Machinery’ to development expenditure after the project is commissioned, as per the company’s accounting policy.

5. The Comptroller & Auditor General of India commented on the accounts of the company for the year 1995-96 as follows in the above matter:

“Equipments valuing Rs. 428.64 lakhs procured in 1983/1989 for a project turned out to be damaged/obsolete in 1995-96 due to prolonged and inefficient storage in open space. Since such abnormal losses are subject to amortisation at the earliest not later than over a period of 3-5 years, non-provision of at least 1/5th of the said abnormal loss has resulted in understatement of loss by Rs. 85.13 lakhs, understatement of Miscellaneous Expenditure (to the extent not written off or adjusted) (Schedule - N) by Rs. 342.91 lakhs and overstatement of Capital Work-in–progress by Rs. 428.64 lakhs.”

6.  The company’s contention is that the losses arising out of the damage/ obsolescence to the equipment will be amortised against revenue of the washery project over a period of 3-5 years when commercial production from this project commences. This is as per the guidelines given in the Guidance Note on Treatment of Expenditure During Construction Period, issued by the Institute of Chartered Accountants of India. The contention of the Audit (CAG) is that such postponement of amortisation is possible only in case of a new company floated for a project. The querist is unable to see any logic in the contention of the audit as also the views expressed in the Institute’s Guidance Note referred to above.

7.  The opinion of the Expert Advisory Committee has been sought whether the contention of the audit is correct.

                                                            Opinion                                                     May 19,1997

1. The Committee notes that as per Accounting Standard (AS) 1, on ‘Disclosure of Accounting Policies’, issued by the Institute of Chartered Accountants of India, ‘prudence’ is one of the major considerations governing the selection and application of accounting policies, which has been defined as below:

“In view of the uncertainty attached to future events, profits are not anticipated but recognised only when realised though not necessarily in cash. Provision is made for all known liabilities and losses even though the amount cannot be determined with certainty and represents only best estimate in the light of available information”.

2. The Committee further notes paras 24, 25 and 26 of Accounting Standard (AS) 10 on ‘Accounting for Fixed Assets,’ issued by the Institute of Chartered Accountants of India, as below:

“24.      Material items retired from active use and held for disposal should be stated at the lower of their net book value and net realisable value and shown separately in the financial statements.

25.       Fixed asset should be eliminated from the financial statements on disposal or when no further benefit is expected from its use and disposal.

26.       Losses arising from the retirement or gains or losses arising from disposal of fixed asset which is carried at cost should be recognised in the profit and loss statement.”

3. The Committee also notes that “Guidance Note on Audit of Miscellaneous Expenditure Shown in Balance Sheet’, issued by the Institute of Chartered Accountants of India, states inter alia, in para 3 that “unless some benefit from the expenditure can reasonably be expected to be received in future and unless the amount of such benefit is reasonably determinable, there is no justification for carrying forward the expenditure for being written-off in subsequent periods. Also, the amount of expenditure to be carried forward should not exceed the expected future revenue/other benefits related to the expenditure”.

4. From the above, a general principle of accounting emerges that when no benefit is expected from the use of an asset, it should be eliminated from the financial statements and any consequential loss should be immediately written off in the profit and loss account.

5. With regard to enterprises at the construction stage the Committee notes paragraph 9.8 of the Guidance Note on Treatment of Expenditure During Construction Period, issued by the Institute of Chartered Accountants of India, which recommends as under:

“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.”

6. The Committee notes from the above that the principle of accounting stated at para 4 above cannot be applied to an enterprise which is at the construction stage since, after the commencement of commercial production, normally, a project may take some time to reach substantial capacity utilisation stage. Accordingly, it is permitted to amortise such deferred revenue expenditure over a period of three to five years. In other words, the general principle of immediate write-off of the asset in respect of which no future benefit is expected is not applicable due to the special nature of the enterprise at the construction stage. However, in the view of the Committee, where the enterprise itself is not at construction stage, there is no reason to deviate from the said general principle.

7.  On the basis of the above, the Committee is of the opinion that it is prudent to write off the entire loss arising from damage and obsolescence to the equipment during construction/development period of the washeries project in the profit and loss account for period in which the loss is incurred.

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