Expert Advisory Committee
ICAI-Expert Advisory Committee
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Query No. 4

Subject: Accounting treatment of technical know-how.[1]

A. Facts of the Case

 

1. An industrial engineering company is engaged in the manufacture of earthmoving equipment for supply to various core sectors of the economy.

 

2. According to the querist, right from its inception, the company has been having collaboration agreements with earthmoving equipment manufacturers in various countries. These collaboration agreements relate to know-how comprising drawings and designs and training of personnel for manufacture of various earthmoving equipments. The terms and conditions usually provide for a lumpsum amount payable in instalments, viz., first instalment at the time of receipt of designs and drawings and subsequent instalments after a certain period of time. The company at no point of time had any occasion to have a collaboration agreement relating to plant and machinery.

 

3. The company was incorporated in 1964 and commenced its commercial production from 1965. Upto the financial year 1975-76, the payment for technical know-how was exhibited under the head ‘Miscellaneous Expenditure’ in the balance sheet and amortised over a period of time. From 1976-77 to 1990-91, the entire expenditure towards technical know-how was charged off to profit and loss account. During the financial years 1991-92 and 1992-93, the expenditure incurred on technical know-how was capitalised as a tangible asset and exhibited under the schedule of ‘Fixed Assets’ and depreciation charged at 16.67%. The querist has stated that based on the observations of the government auditors, from the financial year 1993-94 onwards, the company switched back to carry forward of such expenditure under the head ‘Miscellaneous Expenditure’ and its amortisation at the rate of 16.67%. As per the querist, the company adopted this policy as it considered prudent to do so. As per the querist, the company follows a uniform policy of amortising expenditure incurred on technical know-how over a period of 6 years on technical assessment.

 

4. The querist has informed that during the course of audit of accounts for the year 1996-97, the statutory auditors were of the view that the accounting policy followed by the company (viz., “Expenditure incurred on purchase of technical know-how fee is amortised over a period of six years on technical assessment”) was not in consonance with paragraph 16.5 of Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, which states that know-how related to manufacturing processes is usually expensed in the year in which it is incurred.

 

5. According to the querist, the company’s contention is that there is enough flexibility in-built in accounting for technical know-how as could be noticed from published annual reports of leading industrial establishments read with the opinion of the Expert Advisory Committee contained in Volume VI (Query No. 1.26), paragraph 9.7(a) of the revised ‘Guidance Note on Treatment of Expenditure During Construction Period, (which was issued after AS 10 became mandatory) and Accounting Standard (AS) 6, ‘Depreciation Accounting’.

 

6. The relevant portion of paragraph 9.7(a) of the Guidance Note referred to above reads as under :

 

“9.7   (a)  ..... If, on the other hand, the technical know-how which is supplied relates to productive facilities and processes, the value would have to be treated initially as an item of deferred revenue expenditure to be amortised in suitable instalments after the commencement of production, preferably over a period not exceeding 3 to 5 years after the commencement of production......”

 

7. The querist has stated that in view of the above, the company is of the opinion that the cost incurred on know-how is required to be matched with the income arising out of sale of equipment produced using such know-how. This criterion does not support the view of charging off the cost in the year of incurrence and hence accounting it as deferred revenue expenditure and amortising it over a number of years is a sound accounting practice.

 

8. The querist has also drawn attention to the following definition of ‘depreciable assets’ contained in Accounting Standard (AS) 6:

 

“Depreciable assets are assets which

 

                (i)  are expected to be used during more than one accounting period; and

 

               (ii)  have a limited useful life; and

 

              (iii)  are held by an enterprise for use in the production or supply of goods and services, for rental to others, or for administrative purposes and not for the purpose of sale in the ordinary course of business.”

 

9. According to the querist, technical know-how being in the nature of a tangible asset fulfils all the three criteria and hence, can be construed as a depreciable asset. Accordingly, since its life exceeds a year, it may not be correct to expense the same in the year in which the cost is incurred as this would result in a mismatch between revenue and cost. The querist has stated that this practice is common with many companies, keeping in view the decision of Ahmedabad High Court in the case of Elecon Engineering Co. Ltd. [1974] [96 I.T.R. 673 (Guj.)] which was later confirmed by the Supreme Court. The querist has argued that the law applicable regarding accounting for fixed assets under the Income-tax Rules would apply mutatis mutandis under the Companies Act also. In addition, as per Accounting Standard (AS) 6, ‘Depreciation Accounting’, the definition of depreciation includes amortisation of assets whose useful life is predetermined. Hence, amortisation of cost of technical know-how as a depreciable asset is permissible which would also enable the same to be included as an item of fixed assets under Schedule VI to the Companies Act, 1956.

 

B.  Query

 

10. The querist has sought the opinion of the Expert Advisory Committee as to whether the accounting practice followed by the company, i.e., amortising the cost of technical know-how procured for manufacturing processes, preferably over a period of 3-6 years, meets the requirements of company law/accounting practice.

 

C.  Points Considered by the Committee

 

11. The Committee is of the view that the manner of treatment of an item of expenditure in the books of account of an entity should be decided on the basis of the relevant accounting principles and practices rather than on the basis of the relevant tax provisions which might have been enacted to fulfil different objectives.

 

12. The Committee notes from the facts of the query that the technical know-how comprising drawings and designs and training of technical personnel, referred to in paragraph 2 of the query, relates prima facie to the process of manufacture of various earthmoving equipments and does not relate to plans or designs for plant and machinery.

 

13. The Committee further notes that paragraph 16.7 of Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, states as under:

 

“16.7  Where the consideration for the supply of know-how is a series of recurring annual payments as royalties, technical assistance fees, contribution to research, etc. such payments are charged to the profit and loss statement each year.”

 

The Committee observes that the payment for the technical know-how is a lumpsum amount, though payable in instalments over a period of years and is not in the nature of recurring payments as envisaged in paragraph 16.7 of AS 10. Therefore, paragraph 16.7 of AS 10 is not applicable in the present case.

 

14. The Committee further notes that paragraph 16.5 of the aforesaid Accounting Standard states as under:

 

“.... Know-how related to manufacturing processes is usually expensed in the year in which it is incurred.”

 

In the opinion of the Committee, the wording of the above paragraph is such that it merely describes a prevalent accounting practice rather than laying down a specific accounting treatment for the item in question. Also, the use of the word ‘usually’ in the above-mentioned paragraph indicates that AS 10 recognises that there are situations where expensing of such costs is not considered appropriate.

15. The Committee also notes opinion 1.26 contained in the Compendium of Opinions, Volume VI, issued by the Committee, referred to in paragraph 5 of the query.

 

16. The Committee further notes that the accounting treatment of expenditure incurred on know-how related to productive facilities and processes has been discussed in the ‘Guidance Note on Treatment of Expenditure During Construction Period’ issued by the Institute of Chartered Accountants of India. Paragraph 9.7(a) of this Guidance Note states as follows:

 

“.... the consideration, if any, which is paid separately for the value of the technical know-how supplied by the contractors, would have to be accounted for, depending on the nature of the technical know-how which is supplied. If the technical know-how which is supplied by the contractors relates to the construction of the plant, it may be added to the value of the plant. .... If, on the other hand, the technical know-how which is supplied relates to productive facilities and processes, the value would have to be treated initially as an item of deferred revenue expenditure to be amortised in suitable instalments after the commencement of production, preferably over a period not exceeding 3 to 5 years after the commencement of production. Any consideration paid separately to the contractors for training the technicians of the purchasing company would have to be treated also as deferred revenue expenditure....”

 

17. The Committee is of the view that though the Guidance Note lays down the accounting principles described in paragraph 9.7(a) in the context of projects under construction, these principles would also apply to enterprises which are already engaged in commercial activities.

 

D.  Opinion

 

18. On the basis of the above, the Committee is of the opinion that the payment for technical know-how comprising of drawings and designs and training of personnel of the nature specified in the query should be treated as deferred revenue expenditure to be separately disclosed in the balance sheet under the head ‘Miscellaneous Expenditure’ and should be written off preferably over a period of 3 to 5 years as may be decided by the company after taking into consideration the facts and circumstances of the case. The above treatment does not, in the opinion of the Committee, violate the provisions of the Companies Act, 1956 relating to annual accounts.

 

[1] Opinion finalised by the Committee on 13.8.1998.