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Query No. 25
Subject:
Accounting
for borrowing costs.1
A. Facts of the
Case
1. A public
limited company is engaged in the production of fertilisers for the last five
years. The company has recently set up a new plant at a different location for
the manufacture of Di Ammonia Phosphate (DAP),
a different fertiliser, with annual capacity of 19.2 lakh
tons equivalent to1.6 lakh tons per month. Cost of the project is around Rs.
2500 crore and has been financed through loans from various financial
institutions/banks to the tune of Rs.1600 crore and the balance amount has been
financed through internal accruals.
2. The
production process is carried on in three sub-plants. In the first two
sub-plants, raw materials are manufactured to be used ultimately in the manufacture
of final product in the third sub-plant. The raw materials manufactured in the
first two sub-plants can alternatively be purchased from other
sources and used
for manufacturing the
final product. The final
sub-plant has three
machines wherein the
final product can be
manufactured in any or all of the machines depending on the production plan.
The final sub-plant has been handed over to the company by the consultants in
September 2000. However, two intermediary plants are yet
to be handed over to the company by the plant consultants.
As per the agreement with the manufacturers, there is a requirement of
Guarantee Test (GT)/Performance Test (PT) of 72 hours before acceptance of the
plant, subject to satisfactory results. On sub-plant one, 72 hours GT/PT,
though started during March 2000, had not been completed on the date of sending
the query. On sub-plant two GT/PT was conducted on October
7-9, 2000 and after evaluation of test data, sub-plant two
was accepted on October 16, 2000. Out
of the three machines in
sub-plant three, on machine I,
GT/PT was conducted during October 7-9, 2000 and accepted on October 16, 2000 and on machine II, GT/PT was conducted during May 22-24, 2000, and
accepted on October 16, 2000. However, on machine III, GT/PT was waived off by
the company and accordingly, no GT/PT was carried out on machine III. In between,
the company had faced some technical problems with its intermediary plants
resulting into fluctuation
in the quantity of DAP produced on month to month basis. The
company
is undergoing trial production with effect from March 23,
2000 and DAP
produced by it is
well accepted in
the market. The
company produced
5.23 lakh tons of DAP and sold around 4.97 lakh tons at
normal selling price till November 2000 and there is no difficulty in selling
out DAP produced by its new plant. The month-wise break-up of quantity produced
and sold, for the year 2000, is given below:
Month Quantity of DAP Quantity of DAP
produced
(Tons) sold (Tons)
March 9,339 NIL
April 32,614 739
May 75,213
8,907
June 29,781 27,478
July 80,870 65,009
August 87,788
85,201
September 26,596 1,02,222
October 119,557 79,018
November 61,056 128,589
3. The
borrowing cost for financing the said project is around Rs. 400
crore. The company
had also taken
working capital loans
to fund the costs
of production during
the said trial
run. The cost
of the said borrowings is around Rs. 150 crore and
the value of the sale is around Rs. 500-600 crore.
4. According to
the querist, paragraph
11 of the
‘Guidance Note on
Treatment of Expenditure
During Construction Period’
(hereinafter referred to as the ‘Guidance Note’) states that as a
general rule it would be proper to capitalise all expenses incurred for
start-up and commissioning of the plant. The querist has referred to the last two
sentences of paragraph 12.2 of the Guidance Note which are reproduced below:
“Even during a period of test runs and experimentation, a
plant may be engaged in actual production, but until the test runs are
completed and the plant is properly adjusted on the basis thereof, it may not
be said to be ready for “commercial production”. The term “commercial
production” refers to production in commercially feasible quantities and in a
commercially practicable manner.”
5. The company
is expecting to streamline its production process and
to overcome all the technical problems within next two to
three months and it is expected that the plant will be able to achieve desired
level of production of DAP on
monthly basis. Accordingly,
all activities in the
nature of testing
and adjusting the
plant (with the
sub-plants) for commercial production
will be performed/completed. The
company contends that usually in the fertiliser industry, all plants run
at 100% or higher capacity utilisation
and in view
of the facts
mentioned above including significant
fluctuations in the
monthly production, the
plant cannot be said to have been put to its intended use. As per the
querist, in the view of
the company, the
plant can only
be said to
be put to its
intended use once it achieves a consistently high level of production (say 80% of installed capacity).
6. As per the
querist, the process of aligning capacities and production that is
in progress at
the trial run
stage, is not
routine administrative work.
Therefore, the plant cannot be described to be ready for its intended use (i.e.,
“production in commercially
feasible quantities and
in a commercially practicable
manner”) and interest cost may, therefore, be capitalised.
7. According to
the querist, as per paragraph
12.4 of the
Guidance Note, if a
plant is completed
and commissioned and
is ready for commercial production, but for some reason
does not start commercial production
immediately thereafter, the
expenditure incurred during
the intermediate period must
be treated as
revenue expenditure and
not capitalised, provided the
delays were not
inordinate and in such cases related interest costs may be amortised
over 3 to 5 years. In the view of the querist, as per paragraph 4.3 of the
Guidance Note, interest on working
capital
facilities incurred during
construction period is
to be carried forward in
the balance sheet
under the heading
“Miscellaneous Expenditure”
to be subsequently
written off to
profit and loss
account after the commencement
of commercial production
over a period
not exceeding 3 to 5 years. However, such expenditure is normally
charged to revenue.
8. According to
the querist, under the aforementioned circumstances, wherein the commercial
production is considerably delayed, in the light
of the recommendations set out in paragraph 13.4 of the
Guidance Note, such interest expenditure
may be treated
as part of
deferred revenue expenditure to
be amortised over a period not exceeding 3 to 5 years.
9. The querist
has referred to
paragraphs 6 and
14 of Accounting
Standard (AS) 16, ‘Borrowing Costs’, which are reproduced
below:
“6. Borrowing costs
that are directly attributable to the acquisition, construction or production
of a qualifying asset should be capitalised as
part of the
cost of that
asset. The amount
of borrowing costs eligible for capitalisation should be
determined in accordance with this
Statement. Other borrowing costs should be
recognised as an expense in the period in which they are
incurred.”
“14. The
capitalisation of borrowing costs as part of the cost of a qualifying asset
should commence when all the following conditions are satisfied:
(a) expenditure
for the acquisition, construction or production of a qualifying asset is being
incurred;
(b) borrowing
costs are being incurred; and
(c) activities that are necessary to prepare the asset for its
intended use or sale are in progress.”
10. The querist has
also referred to paragraph 19 of AS 16 which requires that “capitalisation of borrowing
costs should cease when substantially all the activities necessary to prepare
the qualifying asset for its intended use or sale are complete”. The Standard
also mentions that “an asset is normally ready for its intended use or sale
when its physical construction
or production is complete even though routine administrative
work might
still continue” (paragraph 20).
B. Queries
11. The querist has
sought the opinion of the Expert Advisory Committee on the following issues:
(a) Whether, in
view of the facts mentioned above, the aforesaid period (i.e., the period
starting from March 23, 2000 till date/ the
date of declaration
of commercial production)
can be considered as the period
of trial run and accordingly whether it can be considered that assets have not been put to their intended use.
(b) If the
answer to (a) above is in the affirmative, (i.e., the period starting from
March 23, 2000 till date/the date of declaration of commercial production is
considered as the period of trial run), whether, in view of paragraphs 14 and
19 of AS 16 and paragraphs 11, 12.4 and 13.4 of the Guidance Note, the borrowing costs incurred for the said period in respect of financing the DAP plant can be capitalised.
(c) If the answer to (a) above is in the negative, in view of paragraph 4.3 of the Guidance Note, whether the borrowing costs incurred during the said period in respect of financing the DAP plant can be treated as
deferred revenue expenditure to be amortised over 3-5 years.
(d) In view of
paragraph 4.3 of the Guidance Note, whether the interest paid on the funds
borrowed for working capital during the said period can be treated as deferred
revenue expenditure to be amortised over 3-5 years.
(e) If the
answer to (d) above is in the negative, whether the same can be recognised as
an expense in the said period in view of paragraph 6 of AS 16.
C. Points
considered by the Committee
12. The Committee
notes that according to the querist, trial production has started
with effect from
23rd March, 2000
and that till
the date of sending
the query the
trial production was
continuing. Accordingly, it
appears from the facts that according to the querist, the plant is not ready
to commence commercial production. Keeping in view the
issues raised by the querist, the Committee notes that the query relates to
treatment of borrowing costs incurred during the period after the start of the
trial runs.
13. The Committee
notes paragraphs 11.2, 11.4, 12.2, 12.4 and 13.4 of the Guidance
Note on Treatment
of Expenditure During
Construction Period, issued by
the Institute of Chartered Accountants
of India, reproduced below:
“11.2 As a
general rule, it
would be correct
to capitalise all expenses
incurred during this
period and in
connection with the process of start-up and commissioning of
the plant, for two reasons. In the first place, such expenses would be incurred
in order to bring the plant up
to the stage
at which it
can commence commercial production. In the second place,
this expenditure would normally be incurred before the plant is taken over. On
both these considerations,it would be fair and correct to capitalise the expenditure
incurred on start-up and commissioning the plant. The expenditure so incurred
may be capitalised in the same way
as other indirect construction
expenditure.”
“11.4 During the
period of test runs and experimental production it is quite possible that some income will be earned through
the sale of the merchandise
produced or manufactured
during this period. The sale revenue should be set off
against the indirect expenditure incurred during the period of test runs and
treated as suggested in para 15.2.”
“12.2 In several
cases, guidance may be available in selecting the official date of commencement
of production by reference to the date
of the inauguration
ceremony as well
as by reference
to the date which is publicly and
officially announced by the company as the
date on which
it has commenced
commercial production. It should
be borne in
mind, in this
connection, that “commercial production” is a term of somewhat
wider import than the mere term “production”. Even during a period of test runs and
experimentation,a plant may be engaged in actual production, but until the
test runs are completed and the plant is properly adjusted on the basis
thereof,it may not
be said to
be ready for
“commercial production”. The term “commercial production” refers to
production in commercially feasible quantities and in a commercially
practicable manner.”
“12.4 It is
important to note
in this connection
that what is significant for this purpose is the date
when the plant is ready for commercial
production and not
the date when
the plant actually commences commercial production.
Therefore, if a plant had been completed and commissioned and is ready for
commercial production, but the company for some reason or other, does not start
commercial production immediately thereafter, the expenditure incurred during
this intermediate period must be treated as revenue expenditure and cannot be
capitalised. This follows from an important rule, both in accounting principle
as well as in economic theory. The rule is that only those expenses should be
capitalised as part of the cost of an asset which relate to the acquisition or
construction of that asset or which
add anything to
the value or
utility of that
asset. When a plant
has once been
completed and is
ready for commercial production, the expenditure
incurred during the intervening period of delay in actually commencing
commercial production is neither related to the acquisition or construction of
the fixed assets nor does it add to
the value or
utility thereof –
consequently, it must
be written off as revenue expenditure and cannot be capitalised.”
“13.4 If commercial production is considerably delayed, the
problem which would arise
is that there
would be no
income during the period of such delay while, on the other
hand, the expenditure of a revenue nature incurred during this period would
have to be charged to the profit and loss account as mentioned above. If the
period of delay in commencing commercial production is extremely prolonged,
the only
possible concession which
may be made
is that the expenditure incurred during this
period can be treated as deferred
revenue expenditure, to be amortised over a period not exceeding 3to 5 years after the commencement of commercial production.
This procedure is not,
however, recommended as
a matter of
general policy or practice, but may be resorted to only in those
exceptional cases where fairly heavy revenue expenditure is incurred during a
prolonged period of delay in commencing commercial production. In any case, it
would be completely wrong to treat such expenditure as capital expenditure
since it does not add in any way to the value or cost
or utility of the plant
and other manufacturing
facilities which have already been constructed but which have remained
idle due to delay in commencing commercial production.”
14. The Committee
also notes paragraphs
9.4 and 9.5
of Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, issued by
the Institute of Chartered Accountants of India, which state as below:
“9.4 The expenditure
incurred on start-up and commissioning of the project, including
the expenditure incurred
on test runs
and experimental production, is usually capitalised as an indirect
element of the construction cost. However, the expenditure incurred
after the plant has begun
commercial production, i.e.,
production intended for sale or
captive consumption, is not capitalised and is treated as revenue expenditure
even though the contract may stipulate that the plant will
not be finally
taken over until
after the satisfactory completion of the guarantee
period.
9.5 If the interval
between the date a project is ready to commence commercial production and the
date at which commercial production actually begins is prolonged, all expenses
incurred during this period are charged to the profit and loss statement.
However, the expenditure incurred
during this period
is also sometimes
treated as deferred revenue expenditure to be amortised
over a period not exceeding 3 to 5 years after the commencement of commercial production.”
2
15. The Committee
notes that paragraphs 9.4 of AS 10 and 11.2 of the Guidance Note deal with
accounting for costs (including interest costs) incurred during
trial run prior
to the commencement
of commercial production.
Paragraph 12.2 of the Guidance Note describes when a plant can be
considered to have commenced “commercial
production”. Paragraph 9.5 of AS 10 and paragraphs 12.4 and 13.4 of the
Guidance Note are relevant
where the plant
is ready for commercial
production, i.e., the trial
run is over
but the commencement
of the commercial production has been delayed. The
Committee also notes that paragraph 12.4 of the Guidance Note does not recommend that costs
incurred should be deferred over a period of 3-5 years as stated by the querist
in paragraph 7 of the query.
16. The Committee
also notes that paragraph 4.3 of the Guidance Note recommends, inter alia, the
following treatment with regard to the interest on working capital incurred
during construction period :
“With regard to
interest charges and
commitment fees on
loans taken specially and exclusively for the purpose of providing
working capital,.…., it will be more appropriate to transfer the interest
charges and commitment fees during the period of construction to a separate
account which is
carried forward in
the balance sheet
under the group heading of
“Miscellaneous Expenditure” until it is subsequently written-off to
profit and loss
account after the
commencement of commercial
production, over a period not exceeding 3 to 5 years.”
17. The Committee
notes paragraphs 6,
14, 19 and
20 of Accounting Standard (AS) 16, ‘Borrowing
Costs’, issued by the Institute of Chartered Accountants of India, as stated in
paragraphs 9 and 10 above.
18. The Committee
is of the
view that duration
of a trial
run and experimental production
and when the
plant is ready
for commercial production is
based on factors
such as technological
evaluation of the readiness of the plant and machinery and
other facilities, the quality and the quantity of
the output produced,
etc. The Committee
notes that commercial production
means production in
commercially feasible quantities
and in a commercially practicable manner. The Committee is
of the view that in deciding the quantity of commercial
production, the basic consideration is
that the quantities
produced are adequate
to be sold in
the market. Achievement
of a particular
level of capacity
may not, therefore, be the deciding criterion since the quantity of the
production which can be commercially exploited in the market can be lower than
the optimum level of
capacity utilisation of
the plant. The
Committee is, therefore, of
the view that
when the plant
is ready for
commercial production, is a question of fact which should be determined
on the basis of the factors stated above. The Committee is further of the
view that in this regard, what
is relevant, is
the date when
the plant is
ready for commercial production
and not the
date when the
plant actually commences
commercial production. Normally the period of trial run is not very long. Where
the period of trial run gets prolonged due to abnormal reasons, abnormal period
should not be considered as a part of the trial run period for capitalisation
of expenditure.
19. The Committee
notes that a Clarification on Status of Accounting Standards and Guidance
Notes, published by the Institute of Chartered Accountants of India in April
2002 issue of the Journal ‘The Chartered Accountant’, states as below:
“In a situation
where certain matters
are covered both
by an Accounting Standard and a
Guidance Note, issued by the Institute of Chartered Accountants of India, the
Guidance Note or the relevant portion thereof
will be considered as superseded from the
date of the relevant Accounting Standard coming into effect, unless
otherwise specified in the Accounting Standard.Similarly, in a
situation where certain
matters are covered
by a recommendatory Accounting
Standard and subsequently,
an Accounting Standard is issued which also covers those matters, the
recommendatory Accounting Standard or the relevant portion thereof will be
considered as superseded from the date of the new Accounting Standard coming
into effect, unless otherwise specified in the new Accounting Standard.
In a situation
where certain matters
are covered by
a mandatory Accounting Standard
and subsequently, an Accounting Standard is issued which
also covers those
matters, the earlier
Accounting Standard or the
relevant portion thereof
will be considered
as superseded from the date of the new Accounting Standard becoming
mandatory, unless otherwise
specified in the
new Accounting Standard.”
20. The Committee
notes that AS 16 is mandatory in nature in respect
of accounting periods commencing on or after 1-4-2000. The
Committee also notes that
once an accounting
standard becomes mandatory,
any treatment in this
regard recommended in a guidance
note/statement automatically stands
withdrawn. The Committee is, accordingly, of the view that as per the requirements of AS
16, borrowing costs related to construction of an asset incurred upto the time
the asset is ready for its intended use, i.e., ready to commence commercial
production, should be capitalised,
and, thereafter, all
borrowing costs should
be charged to revenue; the Standard does not recognise
deferment of borrowing costs where
the actual commencement
of commercial production
is delayed. Thus, to that extent
AS 16 supersedes the Guidance Note. The Committee also notes that paragraph 9.5
of AS 10 is also superseded by AS 16 and accordingly, deferment of costs where
commercial production gets delayed is also not permissible.
21. The Committee
is of the
view that interest
on working capital
to fund the normal trial run also contributes to construction of plant
as trial run activity is regarded as an activity which is necessary to prepare
the asset for its
intended use. This
is because flaws
in the assets
noticed during trial run production are rectified to bring the plant to
its intended use. Thus, in
the view of
the Committee, interest
on working capital during trial run should also be
capitalised as per the requirements of AS
16, despite the recommendations to the contrary contained in
the Guidance Note on Expenditure During Construction Period, that such interest
can be deferred for
a period of
3 to 5
years after the
commencement of commercial
production.
D. Opinion
22. On the basis of
the above, the Committee is of the following opinion on the issues raised in
paragraph 11 :
(a) Whether the
plant can still be considered to be on trial run and the asset has been put to
its intended use is a question of fact to
be determined in
accordance with the
factors stated in paragraph 18 above.
(b) The
borrowing costs incurred during the normal period of trial run should be
capitalised.
(c) In view of
the requirements of AS 16, no borrowing costs can be treated as deferred
revenue expenditure.
(d) In view of
the requirements of AS 16, no interest cost can be treated as deferred revenue
expenditure to be amortised over 3 to 5 years. Paragraph 4.3 of the Guidance
Note, to the extent,
it allows deferment of interest costs stands withdrawn.
(e) The interest on working capital incurred during the normal period of trial run should be capitalised.
1 Opinion finalised by the Committee on 5.7.2001
2 The Institute of Chartered Accountants of India has issued
a clarification, published in
November 2001 issue of the Journal ‘The Chartered
Accountant’, which provides as below:
“It may be noted that paragraph 9.5 of AS 10…. relates to
“all expenses” incurred during the period. This expenditure would also include
borrowing costs incurred during the said period. Since AS 16 specifically deals
with the treatment of borrowing costs, the treatment provided by AS 16 would
prevail over the provisions in this respect contained in AS 10, as the provisions of AS 10 are general in nature
and apply to “all expenses”. |