1.34 Query: Treatment of know-how cost.
1. A public sector undertaking (registered under the Companies Act, 1956) is engaged in refining and marketing of petroleum products having its refineries at various locations. The company has entered into a collaboration agreement with a foreign licensor for the transfer of know-how for installation of a petrochemical plant at one of its refineries.
2. The Licensor has developed and/or acquired technical information, know-how and patient rights relating to a process for the production of ‘X’ product. The company has entered into two agreements, with the foreign licensor, a Licence Agreement and an Engineering Agreement.
3. Under the ‘Engineering Agreement’, the Licensor has to perform engineering and technical services in connection with the design of a plant utilising the treatment and recovery process steps developed by them. The Engineering Agreement requires that the Licensor shall deliver a basic engineering package in two parts, viz.,
(i) A basic engineering specification which includes plans, designs and drawings to enable effective completion of detailed engineering, procurement, construction and start-up of the plant and data, documents and drawings that define the process, process flow diagrams and basic design of the plant.
(ii) Supervisory Operating Manual, which shall include information to enable the Licensee to develop step-by-step operating instructions. Besides the above, the Licensor shall provide technical assistance, training, analytical support, start-up services and post start-up services.
(iii) Licensee shall provide all materials and equipments necessary in connection with the design, engineering, construction and operation of the plant other than the above services to be provided by the licensor.
4. Under the ‘License Agreement’, the Licensor has agreed to grant the Licensee a non-exclusive license to use technical information, for the practice of the process to produce Product ‘X’ in the licensed plant, and the license shall be non-transferable. “Technical Information” is defined under the License Agreement as “technical information, plant know-how and trade secrets whether or not patented, utilised in or relating to the process, including apparatus therefor, but not including methods for manufacturing Proprietary Catalyst, which are owned or controlled by a Party hereto to the extent that said Party has the right to grant rights thereunder.” Licensed plant shall mean a plant for the production of `X’ product to be constructed at the refinery having a licensed capacity of 15,60,000 barrels per year of the feed stock.
5. For services to be performed under the Engineering Agreement, the company has to pay a consolidated lumpsum of USD 3,50,000 to the Licensor and for other ancillary services USD 875 per man day of services. In consideration of rights and licenses granted under the License Agreement, the company has to pay:
(a) A license fees of USD 2,00,000 for the licensed capacity (1.56 million barrels per year) of the licensed plant.
(b) Additional fully paid royalty for each barrel in excess of 1.56 million barrels per year, if in any year the number of barrels of feed stock exceeds the licensed capacity by 15%.
The payment for license fees as referred in (a) above shall be payable in 4 equal installments as follows:
6. According to the querist, normally in case of import of technology, the payments to the Licensor are made for technical know-how and for the services rendered under various heads such as license fees, basic engineering and designing, assistance for material procurement and commissioning and training etc.
7. The querist has drawn the attention of the Committee to Accounting Standard (AS) 10 on ‘Accounting for Fixed Assets’, issued by the Institute of Chartered Accountants of India, paras 16.4 and 16.5 thereof lay down that:
“16.4 Know-how in general is recorded in the books only when some consideration in money or money’s worth has been paid for it. Know-how is generally of two types:
(i) relating to manufacturing processes; and
(ii) relating to plans, designs and drawings of buildings or plant and machinery.
16.5 Know–how related to plans, designs and drawings of buildings or plant and machinery is capitalised under the relevant asset heads. In such cases depreciation is calculated on the total cost of those assets, including the cost of the know-how capitalised. Know-how related to manufacturing processes is usually expensed in the year in which it is incurred.”
8. In the view of the querist, the reference to charging of know-how expenses relating to manufacturing process in the year in which it is incurred refers to and can only mean any expenditure incurred on this account after the commissioning of the original plant which relates to the normal operation of the plant that is to be charged to revenue of the year.
9. In the accounts, the company has capitalised the payment of USD 2,00,000 made to the Licensor for License fees and USD 3,50,000 being fees for engineering and technical services based on the following:
(a) Payment is being made in consideration of the rights and licenses granted by the licensor to the licensee. It may be noted that through Engineering Agreement, the licensor has supplied know-how whereas through License Agreement it has granted license to use such know-how. The company cannot enter into any Engineering Agreement without License agreement and similarly License Agreement without Engineering Agreement.
(b) The license is non-exclusive and non-transferable and the license is “to use licensor’s technical information during the term of the agreement, for the practice of the processes to produce the product in the licensed plant.”
(c) This license gives the right to use the technical information in the plant over a period of time, which gives a benefit of enduring nature.
The benefit of license fees is not restricted to periodicity of one year to qualify as a revenue expense.
10. The querist has sought the opinion of the Expert Advisory Committee as to whether the amount of USD 2,00,000 paid to licensor for the license fees under the License Agreement is chargeable to revenue in terms of Accounting Standard 10 as referred to above or, whether the amount has been rightly capitalised.
Opinion March 17, 1998
1. The Committee notes that the querist has sought opinion only with regard to the accounting treatment of USD 2,00,000 paid in respect of the license fees under the License Agreement. The Committee accordingly restricts its opinion to this issue only.
2. The Committee notes that the basic principle regarding which costs should comprise the total cost of an item of fixed asset has been stated in para 9.1 of Accounting Standard (AS) 10 on `Accounting for Fixed Assets’ as below:
“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…”
3. The Committee also notes para 38 of AS 10, apart from paras 16.4 and 16.5 thereof, quoted by the querist, regarding treatment of know-how costs as below:
“38. Amount paid for know-how for the plans, layout and designs of buildings and/or design of the machinery should be capitalised under the relevant asset heads, such as buildings, plants and machinery, etc. Depreciation should be calculated on the total cost of those assets, including the cost of the know-how capitalised. Where the amount paid for know-how is a composite sum in respect of both the manufacturing process as well as plans, drawings and designs for buildings, plant and machinery, etc., the management should apportion such consideration into two parts on a reasonable basis.”
4. On the basis of the above, the Committee notes that only those costs that are directly attributable to bringing the asset to its working condition for its intended use should be capitalised. The Committee is, therefore, of the view that the nature of license fees paid under the License Agreement should be considered in this context. Accordingly, the said costs, if they are not directly attributable to bringing the assets concerned to their working condition for their intended use, should not be capitaised as part of the cost of the said assets. Thus, the Committee is of the opinion that if the said costs pertain basically to manufacturing process know-how, to that extent these should not be capitalised. _________________________
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