Query No. 27
Subject: Interest on funds borrowed generally and used for construction of properties meant for sale - whether to be capitalised.[1] A. Facts of the Case
1. A public sector company, recognised as a public financial institution under section 4A of the Companies Act, 1956, also undertakes construction of properties and thereafter sells the same. The company recognises profit in respect of such properties on the basis of the percentage of completion method. This, according to the querist, is as per Accounting Standard (AS) 7, ‘Accounting for Construction Contracts’.
2. The company borrows funds from time to time and utilises the same for lending activity (which is its main activity) and for other activities including construction of properties.
3. The querist has stated that as per paragraph 4 of ‘Guidance Note on Treatment of Expenditure during Construction Period’, issued by the Institute of Chartered Accountants of India, the financial costs (viz., interest charges) incurred during the period of construction should be added to the total capital cost of a project, if the funds have been borrowed specifically for the project. As this condition is not met, no interest has been charged to the project for construction of properties, although, according to the querist, the company has been incurring expenditure on the construction project out of borrowed funds for the past several years. This, according to the querist, has led to understatement of the work-in-progress.
4. The querist has contended that as the funds utilised in the construction activities are borrowed funds, the interest on funds utilised for construction at the average rate of interest on borrowed funds in respective years may be charged to the project with a corresponding credit to interest income account, thereby reducing the interest expenditure. This, according to the querist, will result in a true and fair comparison of interest paid on borrowed funds with interest income thereon.
5. The querist has made a reference to the Exposure Draft of a proposed Accounting Standard on ‘Borrowing Costs’, issued by the Accounting Standards Board of the Institute of Chartered Accountants of India, which proposes that interest on funds borrowed generally and used for the purpose of obtaining a fixed asset should be capitalised. According to the querist, on the same lines, such interest incurred by an enterprise for commercial/real estate development should be included in the work-in-progress.
B. Query
6. The opinion of the Expert Advisory Committee has been sought on the issue whether interest on funds utilised by the company for construction of properties to be sold later, which are not borrowed specifically but are used out of the overall borrowed funds available with the company, can be charged to the construction project.
C. Points Considered by the Committee
7. The Committee notes that the querist has sought the opinion of the Committee only with regard to accounting treatment of interest on funds utilised for construction of properties, which are not borrowed specifically for the purpose. The Committee, accordingly, restricts its opinion to this issue only. The Committee’s views are based on the existing authoritative accounting literature on the subject and do not take cognisance of the proposals contained in the Exposure Draft.
8. The Committee notes paragraph 3 of Accounting Standard (AS) 2, ‘Valuation of Inventories’ (revised 1999), which defines ‘inventories’ as below:
“Inventories are assets:
9. The Committee notes that the company is engaged, inter alia, in the business of construction of properties and selling the same. Therefore, the construction work-in-progress and the built-up properties held by the company for sale are in the nature of its inventories and not in the nature of fixed assets.
10. The Committee notes paragraph 12 of AS 2 (revised) which states as below:
“12. Interest and other borrowing costs are usually considered as not relating to bringing the inventories to their present location and condition and are, therefore, usually not included in the cost of inventories.” The Committee notes that use of the word ‘usually’ in the above paragraph indicates that the Standard recognises that under certain circumstances, interest and other borrowing costs are included in the cost of inventories. The Standard, however, does not specify the circumstances in which inclusion of interest and other borrowing costs in the cost of inventories is appropriate.
11.The Committee notes that the query relates to treatment of interest incurred for construction of properties which take a long period of time to be completed. The Committee notes that Accounting Standard (AS) 7, ‘Accounting for Construction Contracts’, deals, inter alia, with determination of cost of assets constructed under a contract that take a long period of time to be completed. The Committee is of the view that irrespective of whether an asset is constructed by an enterprise under a contract or on its own, the principles of measurement of cost remain the same though the basis of year-end valuation may differ. Accordingly, the Committee is of the view that the principles of determination of contract costs enunciated in AS 7 would be applicable to properties constructed by the company on its own for sale.
12. The Committee notes paragraphs 8.7 and 8.8 of AS 7 which state as below:
“8.7 Examples of costs that relate to the activities of the contractor generally, or that relate to contract activity but cannot be related to specific contracts, include:
“8.8 Costs referred to in paragraph 8.7 are usually excluded from the accumulated contract costs because they do not relate to reaching the present stage of completion of a specific contract. However, in some circumstances, general administrative expenses, development costs and finance costs are specifically attributable to a particular contract and are sometimes included as part of accumulated contract costs.”
13. The Committee notes from the facts of the query as stated in paragraph 2 above that the borrowings of the company are of a general nature and do not relate to any specific activity. The utilisation of the funds borrowed is at the discretion of the company. Under these circumstances, the interest on funds borrowed cannot be considered to be specifically attributable to a particular construction project undertaken by the company. As such, inclusion of interest on borrowed funds utilised for construction of properties is not appropriate in terms of the requirements of paragraph 8.8 of AS 7 reproduced above.
D. Opinion
14. On the basis of the above, the Committee is of the opinion that interest on funds utilised by the company for construction of properties to be sold later, which are not borrowed specifically but are used out of the overall borrowed funds available with the company, should not be included in the cost of construction of the properties.
The readers are advised to refer to Accounting Standard (AS) 16, ‘Borrowing Costs’, which has been issued subsequent to the finalisation of this opinion.
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[1] Opinion finalised by the Committee on 23.7.1999.
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