Expert Advisory Committee
ICAI-Expert Advisory Committee
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Query No. 7

 

Subject:     

Accounting treatment of cost of construction

borne by lessee in lieu of lease premium.[1]

A. Facts of the Case

1. A public sector company (hereinafter referred to as ‘the company’) undertakes projects in various fields of telecommunication.  It has entered into an agreement with another public sector undertaking (hereinafter referred to as the ‘PSU’).  Under the agreement, the PSU has provided a piece of land to the company for construction of two office blocks - one for the use of the PSU and the other to be given by the PSU to the company on lease for 99 years.  The company shall be paying the agreed lease rental every year.  According to the querist, the cost of construction of the two blocks has been depicted by the company in its books of account as lease premium and the same is being written off proportionately during the lease period of 99 years.

 

2. Relevant extracts from the ‘Construction and Maintenance Agreement’ entered into between the company and the PSU are reproduced below:

 

“The total cost of building as a whole comprising ‘the company’ block, the ‘PSU’ block and common area is estimated not to exceed Rs. 600 lakhs without air-conditioning and captive power.  The said cost of Rs. 600 lakhs shall be borne by ‘the company’ out of its own funds.  The cost of air-conditioning and captive power for the ‘PSU’ block shall be borne by ‘the PSU’ directly.  The capitalised cost of the building not exceeding Rs. 600/- lakhs will not be actually paid by ‘the PSU’, but the same shall be treated as lease premium for the portion of the space in the building to be leased to ‘the company’ under separate agreement.  When such agreement will be signed, it shall be treated for all purposes that ‘the PSU’ has paid off the construction cost and no dues of whatsoever nature shall be payable by ‘the PSU’ to ‘the company’ towards construction cost of the building. The building for all purposes shall be owned by ‘the PSU’. Once the lease deed is signed between the parties it shall be treated for all purposes that consideration for ‘the company’ constructing the building for ‘the PSU’ has flown from ‘the PSU’ to ‘the company’ fully.”

 

3. In the balance sheet of the company, in the Fixed Assets Schedule, the agreed cost of construction of the two blocks (i.e. Rs. 600 lakhs) has been shown as ‘Building - Office (leasehold)’. The following note has also been given in the said Schedule :

 

“Building - Office (leasehold) represents premium on acquisition of perpetual rights which is initially for 99 years lease.”

 

4. The company has also given the following note on the accounts:

 

“Company has constructed office building on the land owned by the PSU.  As per Construction and Maintenance Agreement with the PSU, the company has constructed two office blocks - one for the company itself and the other for the PSU, at a total cost of Rs. 611.04 lakhs.  In accordance with the Agreement, Rs. 600 lakhs are to be treated as lease premium by the company.  Accordingly, Rs. 600 lakhs have been amortised in the accounts proportionately for a period of 99 years w.e.f. 04.03.1998, i.e., the date of commencement of the lease period.  Rs. 11.04 lakhs which were incurred additional have been charged to the Profit and Loss Account in the year 1997-98.”  (The names of the company and the PSU have been omitted.)

 

5. According to the querist, while the statutory auditors agreed with the above treatment, the government auditors were of the view that the proportionate construction cost of the office block being used by the company should be capitalised and depreciation provided thereon at the rates given in Schedule XIV to the Companies Act, 1956.  Thus, in the government auditors’ view, the proportionate construction cost of only the block constructed for the PSU should be treated as lease premium.

 

B.  Queries

6. The querist has sought the opinion of the Expert Advisory Committee on the following issues:

 

 

(a) Whether the disclosures made by the company and treatment of the full amount of construction cost agreed with the PSU as lease premium is in order; or

 

(b)  whether the proportionate cost of construction of the block constructed for the PSU should be shown as land (leasehold) and amortised over 99 years whereas the cost of the company’s block should be depreciated in accordance with the straight line depreciation rates given in Schedule XIV to the Companies Act;

 

(c) whether there is any alternative to (a) and (b) above.

C. Points Considered by the Committee

7. The Committee observes the following from the facts of the query:

 

(i)  While the accounting policy disclosed by the company states that the lease is a perpetual one, the other statements made in the query seem to suggest that the lease is for a period of 99 years and not a perpetual one.  The Committee’s opinion is based on the presumption that the latter is correct.

 

(ii)  It appears that the actual cost of construction of the composite building over and above the agreed cost of Rs. 600 lakhs would also not be borne by the PSU.

 

(iii) The agreed cost of the construction of the building (Rs. 600 lakhs) is non-refundable even on the expiry of the lease period.

8. From the facts of the query, the Committee notes that the cost of construction of the composite building represents an expenditure whose benefits will flow to the company over the lease term.  The Committee further notes that the ‘Guidance Note on Accounting for Leases’ issued by the Institute of Chartered Accountants of India does not specifically deal with the treatment of such expenditure.

 

9. The Committee is of the view that it is the total cost of construction of the two office blocks (and not the agreed cost of construction of the two blocks or the cost of construction of only the office block being used by the company) that represents the consideration paid by the company for acquiring leasehold rights in respect of the office block for its use.

 

10. The Committee notes the following definitions of the terms ‘Depreciation’ and ‘Depreciable Asset’ as given in Accounting Standard (AS) 6, ‘Depreciation Accounting’:

 

“3.1  Depreciation is a measure of the wearing out, consumption or other loss of value of a depreciable asset arising from use, effluxion of time or obsolescence through technology and market changes.  Depreciation is allocated so as to charge a fair proportion of the depreciable amount in each accounting period during the expected useful life of the asset.  Depreciation includes amortisation of assets whose useful life is predetermined.”

 

“3.2  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.”

11. The Committee observes that the expenditure on construction of the composite building qualifies all the conditions of a depreciable asset.  Accordingly, such expenditure needs to be amortised over its useful life, i.e., the lease term of 99 years.

 

12. As regards the manner of amortisation, the Committee notes that paragraph 20 of AS 6 provides as follows:

 

“20. The depreciable amount of a depreciable asset should be allocated on a systematic basis to each accounting period during the useful life of the asset.

 

In the absence of any other systematic basis representing the time pattern of consumption of benefits of the expenditure, the Committee believes that the amortisation of the expenditure over the lease term should be done on straight line basis.

 

13. The Committee also notes the following requirements of Schedule VI to the Companies Act, 1956, in respect of disclosure of fixed assets:

 

“*Fixed Assets:

 

Distinguishing as far as possible between expenditure upon (a) goodwill, (b) land, (c) buildings, (d) leaseholds, (e) railway sidings, (f) plant and machinery, (g) furniture and fittings, (h) development of property, (i) patents, trade marks and designs, (j) livestock and (k) vehicles, etc.

 

*Under each head the original cost, and the additions thereto and deductions therefrom during the year, and the total depreciation written off or provided up to the end of the year to be stated.”

 

14. The Committee is of the view that the disclosures made by the company (as set out in paragraphs 3 and 4 above) clearly bring out the nature of the asset (i.e. building) as well as the fact of its having been acquired on leasehold basis and meet the disclosure requirements of Schedule VI reproduced above.

 

D. Opinion

15. Based on the above, the Committee is of the following opinion on the issues raised in paragraph 6 above:

 

(a) In view of the fact that the entire cost of construction of the two office blocks is to be borne by the company and that no amount is to be refunded to the company by the PSU on the expiry of the lease period, the amount to be capitalised is the entire cost of construction of the two office blocks, i.e.,


Rs. 611.04 lakh. The capitalisation of this amount under the head “Buildings (leasehold)” is appropriate. Such capitalised cost should be amortised over the lease term of 99 years on straight line basis.  Subject to the above, the manner of disclosure followed by the company is appropriate.

 

(b) See (a) above.

(c) See (a) above.

___________

 

[1] Opinion finalised by the Committee on 4.3.1999.