Expert Advisory Committee

Query No. 10

Subject:

Accounting for incidental expenditure on

transmission lines ready for use but not in operation.1

A. Facts of the Case

1. A Government of India enterprise is engaged in the business of transmission of power from the generating units to different State Electricity Boards. With the growing investment in power sector, it also undertakes construction of following projects:

(i) New transmission systems linked with the generating units. A transmission system consists of transmission lines, substations for transmitting the power, and switchyards at generating units.

(ii) Transmission systems for strengthening of existing power network.

(iii) High Voltage Direct Current (HVDC) substations to transfer bulk power from one region to another.

(iv) State of art unified load despatch and communication centres for effective and efficient management of grids on real time basis.

2. The querist has stated that the tariff for the transfer of power is regulated by Central Electricity Regulatory Commission (CERC). As per the querist, the tariff is fixed mainly on the basis of capital cost of the project and operational expenditure, viz., return on equity, depreciation, interest on loan and working capital, O&M expenditure, foreign exchange rate variation(FERV) and income-tax. The tariff is allowed from the date of commercial operation.

3. According to the querist, all the assets of the company are capitalised when they are ‘ready for intended use’ in accordance with the provisions of various Accounting Standards. The problem arises in the case of new transmission systems linked with the generating units. Generating units and transmission systems involve long gestation periods. The environmental and natural calamities add to the uncertainties in the completion of the projects in time. Further, because of comparative higher cost involved in setting up a generating unit it is imperative that transmission system has to be ready well before generating unit starts operation. Sometimes, it happens that a transmission line is ready but substations are not ready or switchyard at generating units is not ready. Power can flow only when all the systems are ready. Even though efforts are made at various levels for synchronizing the construction of these systems, there are some cases where the transmission system is ready but can not be used due to the reason that generating unit is not ready.

4. The querist has stated that since the tariff is based on capital cost, the Project Investment Board of the Government of India, in some cases, allows capitalisation of the expenditure during the intervening period when transmission system is ready but generating unit is not ready. CERC has also directed the company to explore the possibility of capitalising such expenditure during the intervening period.

5. According to the querist, in view of various provisions of the Accounting Standards, the company is not capitalising the expenditure of the intervening period stated above but is treating the same as Deferred Revenue Expenditure. The accounting policy of the company in this regard is given below:

"The transmission system is capitalised when it is ready for intended use. However, in case of delay in commercial operation/earning revenue, the revenue expenditure (excluding interest charges) incurred during the intervening period is treated as Deferred Revenue Expenditure(DRE) and amortised over a period of five years from the year of commercial operation/earning of revenue. The depreciation charge is postponed till the year of commercial operation."

6. The above accounting policy is followed only in cases of prolonged delay. In cases of short delay within a financial year, the expenditure is charged to revenue. The querist has stated that the policy is based on paragraph 9.5 of Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, as well as paragraphs 13.4 and 13.5 of the Guidance Note on Treatment of Expenditure during Construction Period, issued by the Institute of Chartered Accountants of India. The querist has reproduced the relevant paragraphs as below:.

AS 10

"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."

Guidance Note on Treatment of Expenditure during Construction Period.

"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 3 to 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." (Emphasis supplied by the querist.)

"13.5 After commercial production has been commenced, it is customary to provide depreciation on fixed assets for the full annual period disregarding any short periods during the year when particular assets have remained idle due to various reasons. This is only a rule of practical convenience but the application of the rule also takes into consideration the fact that an asset does depreciate to some extent even during idle periods and also, when fixing the depreciation rate, some regard is usually given to the fact that there will inevitably be a few idle periods when the particular plant or machinery will not remain in use. However, if there is delay in commencing commercial production, it is suggested that it would not be necessary to provide depreciation on fixed assets during this period. In other words, it would be necessary to provide depreciation on fixed assets only as from the date when commercial production is actually commenced." (Emphasis supplied by the querist.)

7. The company has, upto financial year 2000-2001, treated the interest on borrowings for the intervening period as deferred revenue expenditure.In the Journal, ‘The Chartered Accountant’ of November 2001, the Institute of Chartered Accountants of India has clarified that provisions of paragraph 9.5 of AS 10 will not be applicable in respect of borrowing costs. From the financial year 2001-02, borrowing costs for the intervening period have been charged to revenue with retrospective effect by the company.

8. The querist has stated that during the discussions with the government auditors, the following views emerged:

Auditors’ views

Management’s views

(1 ) The word ‘ some times ’ in Accounting Standard 10 is used with reference to the following exceptional cases:

(i) The enterprise must be a new one (refer paragraphs 12, 13 and 16 of Guidance Note on Treatment of Expenditure during Construction Period);

(ii) There should be no income derived during the period of profit an dloss ac count (refer paragraph 13.4);

(iii)Where fairly heavy revenue ex pe nd it ure is incurred during a prolonged period of delay incommencing commercial production;and

(iv) Further, it is amply clarified that treating the revenue expenditure incurred during the intervening period is not, however, recommended as a matter of general policy (refer paragraph

13.4 of Guidance Note on Treatment of Expenditure during Construction Period).

It would, thus, be clear that a company cannot always treat the expenditurein curred during the intermediate period (i.e., the date when the plant is ready for commercial production and the date at which commercial production a ctually be gins) as deferre dreve nueexp enditure As per paragr aph 12.3 of the Guidance Note on Treatment of Expenditure during Construction Period, issued by Institute o f Chartered Accountants of India, all expenditure of revenue nature must be charged to the profit and loss account from the moment the plant is completedand commissioned and isready for comme rcial production.

Since the said conditions referred to in the Guidance Note have not been fulfilled by the company, the Accounting Policy disclosed by the company is contrary to the letter and spirit of Accounting Standard 10.

(2) Reference is invited to paragraph 9.5 of Accounting Standard 10 (Accounting for Fixed Assets) which inter alia states that 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. Further, Accounting Standard 6 , ‘Depreciation Accounting’, provides that depreciation is a measure of effluxion of time / and accordingly the depreciati on should be provided and charged to profit and loss account from the date the asset is capitalised and is ready for use (also refer Compendium of Opinions – Volume XI, Query No 1.19).

(i) The auditors’ contention that word ‘sometimes’ in AS 10 is used with reference to specific four cases is not specifically given in the Guidance Note but interpreted by the auditors. For example, case

(ii) pointed out by the auditors reading as

"There should be no income derived during the period of profit and loss account " (paragraph 13.4) has been derived from paragraph 13.4 which reads as under :

"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.

"Interpreting the above guidance that there should be no income during the period is not correct.

(ii) Similarly, new business as well as new project shave been interchangeably used in paragraphs 12, 13 & 16 of the Guidance Note . (Emphasis supplied by the querist.)

(iii) Each transmissi online is considered as a separate project which is evident from the following:

(a) GOI approval is obtained for each Transmission System.(b) Tariff is notified separately for each line.

(d) Under Income -tax Act deduction under section 80

IA is available for new lines commissioned after 1.4.99.

(iv) In both the cases where expenditure has been treated as

DRE, there is prolonged delay of approximately more than 2 years.

Accounting Policy of not charging the depreciation in case of delay in commercial operation is based on paragraph 13.5 of Guidance Note on Treatment of Expenditure during Construction Period, issued by ICAI, which reads as under:

" However, if the reisdelay i n commencing commercial production, it is suggested that it would not be necessary to provide depreciation on fixed assets during this period. In other words, it would be necessary to provide depreciation on fixed assets only as from the date when commercial production is actually commenced." (Emphasis supplied by the querist.)

Useful life of the assets is specified in the Electricity Supply Act. The company defers the depreciation during the intervening period and depreciates the entire cost during the usefull if especified u nder the Electricity Supply Act as reduced by the period in which depreciation is deferred.

9. The querist has stated that the present case should be considered as an exceptional case that transmission system has to be ready before the generating unit starts operation and transmission system can be used only after completion of generating unit.

B . Query

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

(a) whether the company can consider the above assets mentioned at paragraph 1 above as ready for intended use on completion of the system, i.e., transmission line, substations and switchyard at generating units and the generating units.

(b) If the answer to (a) above is in the negative,

(i) Whether the treatment of expenditure as DRE and deferment of depreciation in accordance with paragraph 9.5 of AS 10 and paragraphs 13.4 and 13.5 of the Guidance Note on Treatment of Expenditure during Construction Period, is correct.

(ii) Whether there can be any exception to the clarification issued by the Institute in November 2001 regarding non- applicability of provisions of paragraph 9.5 of AS 10 in respect of ‘borrowing costs’. At present, there appears to be a contradiction that expenditure can be treated as DRE as per AS 10, whereas interest on borrowings cannot be treated as DRE.

C. Points considered by the Committee

11. The Committee has not addressed the accounting treatment followed by the company in respect of borrowing costs, viz., charging the borrowing costs to revenue with retrospective effect as stated in paragraph 7 above, since the issue has not been raised by the querist.

12. The Committee notes paragraph 16.1 of the Guidance Note on Treatment of Expenditure during Construction Period, issued by the Institute of Chartered Accountants of India, as reproduced below:

"16.1 The major part of this Note is devoted to a consideration of the accounting problems relating to new capital projects while they are in the stage of construction. Somewhat similar accounting problems are also encountered by an existing enterprise when it embarks on a programme of capital expansion concurrently with current production."

The Committee is, therefore, of the view that although the major part of the Guidance Note deals with accounting problems faced by a new enterprise, it also addresses similar problems faced by the enterprises embarking on new projects.

13. The Committee notes from the facts of the case that the company in question is engaged in the business of transmission of power from the generating units to different State Electricity Boards. The Committee is of the view that once the new transmission system is ready to commence commercial production, it should capitalise the project without waiting for the completion of the sub-station and switchyards at the generating units and the generating units itself. In other words, capitalisation of the transmission line project cannot be kept pending until the sub-station and switchyards at the generating units and the generating units are complete.

14. The Committee notes that paragraph 13.4 of the Guidance Note, as reproduced in paragraph 6 above, requires that the expenditure incurred during the period of delay in commercial production should be treated as deferred revenue expenditure only in those exceptional cases where fairly heavy revenue expenditure is incurred during a prolonged period of delay in commencing commercial production. Paragraph 9.5 of AS 10 (reproduced in paragraph 6 above) provides that sometimes if the interval between the date a project is ready to commence commercial production and the date at which commercial production begins is prolonged, the expenditure incurred during this period can be treated as deferred revenue expenditure to be amortised over a period not exceeding 3 to 5 years after the commencement of commercial production. On the basis of the above, the Committee is of the view that the expenditure incurred during delay in actually commencing commercial production should be treated as deferred revenue expenditure only if the two conditions are fulfilled, i.e., the period of delay is prolonged and fairly heavy revenue expenditure has been incurred. The querist has stated in paragraph 6 above that as per the accounting policy of the company, the expenditure incurred during delay in commencing commercial production is treated as deferred revenue expenditure only in the cases of prolonged delay. The Committee is of the view that the criterion of expenditure incurred to be heavy in amount should also be met.

15. The Committee notes that the Institute of Chartered Accountants of India has clarified 2the status of Accounting Standards and Guidance Notes 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."

16. On the basis of the above, the Committee is of the view that paragraph

13.5 of the Guidance Note, reproduced in paragraph 6 above, which permits not to charge depreciation on fixed assets between the date the project is ready to commence commercial production and the date on which project actually commences commercial production, stands superseded by Accounting Standard (AS) 6, ‘Depreciation Accounting’, which recognises in the definition of the term ‘depreciation’ that depreciation is a measure of, inter alia, effluxion of time. The said definition is reproduced below:

"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."

17. On the basis of the above, the Committee is of the view that depreciation should be charged for the period between the date when the project is ready to commence commercial production and the date on which it actually starts commercial production and accordingly, should be considered as a part of the deferred revenue expenditure.

18. The Committee also notes the announcement 3 issued by the Institute of Chartered Accountants of India with regard to the status of certain provisions of AS 10 pursuant to the issuance of Accounting Standard (AS) 16, ‘Borrowing Costs’, in respect of the treatment of borrowing costs incurred between the date the project is ready to commence commercial production and the date it actually commences commercial production. The relevant portion of the announcement is reproduced below:

"It may be noted that paragraph 9.5 of AS 10 as reproduced above 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"."

19. On the basis of the above, the Committee is of the view that the borrowing costs incurred between the date the project is ready to commence commercial production and the date on which it actually commences commercial production should be charged to the profit and loss account and cannot either be treated as deferred revenue expenditure or capitalised.

20. The Committee incidentally also notes that the Institute of Chartered Accountants of India has issued Accounting Standard (AS) 26, ‘Intangible Assets’, which comes into effect in respect of accounting periods commencing on or after 1st April, 2003, and is mandatory in nature from that date for the following:

(i) Enterprises whose equity or debt securities are listed on a recognised stock exchange in India, and enterprises that are in the process of issuing equity or debt securities that will be listed on a recognised stock exchange in India as evidenced by the board of directors’ resolution in this regard.

(ii) All other commercial, industrial and business reporting enterprises, whose turnover for the accounting period exceeds Rs. 50 crores.

21. The Committee notes paragraphs 55(a) and 56 of AS 26 which are reproduced below:

"55. Expenditure on an intangible item should be recognised as an expense when it is incurred unless:

(a) it forms part of the cost of an intangible asset that meets the recognition criteria (see paragraphs 19-54)".

"56. In some cases, expenditure is incurred to provide future economic benefits to an enterprise, but no intangible asset or other asset is acquired or created that can be recognised. In these cases, the expenditure is recognised as an expense when it is incurred. For example, expenditure on research is always recognised as an expense when it is incurred (see paragraph 41). Examples of other expenditure that is recognised as an expense when it is incurred include:

(a) expenditure on start-up activities (start-up costs), unless this expenditure is included in the cost of an item of fixed asset under AS 10. Start-up costs may consist of preliminary expenses incurred in establishing a legal entity such as legal and secretarial costs, expenditure to open a new facility or business (pre-opening costs) or expenditures for commencing new operations or launching new products or processes (pre-operating costs);

(b) expenditure on training activities;

(d) expenditure on relocating or re-organising part or all of an enterprise."

22. The Committee is of the view that on AS 26 becoming mandatory, the expenditure incurred between the date the project is ready to commence commercial production and the date at which the commercial production actually begins cannot be treated as deferred revenue expenditure pursuant to the requirements of paragraphs 55 and 56, since such an expenditure does not create an intangible asset, and, therefore, will have to be expensed.

D. Opinion

23. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 10 above:

(a) The company should consider the assets mentioned at paragraph 1 above as ready for intended use on completion of the transmission system. In other words, it is not necessary that the transmission system, sub-stations and switchyard at generating units and the generating units should be complete to consider that the transmission line is ready to commence commercial production.

(b)(i) The treatment of expenditure as deferred revenue expenditure in accordance with paragraph 9.5 of AS 10 and paragraph 13.4 of the Guidance Note on Treatment of Expenditure during Construction Period is correct. Not charging depreciation during the period of prolonged delay after the transmission system is ready for commencement of commercial production is not correct. In other words, depreciation should also be considered a part of the deferred revenue expenditure. This treatment would, however, change after AS 26, ‘Intangible Assets’, comes into effect.

(b)(ii) There can be no exception to the clarification issued by the Institute in November 2001 regarding non-applicability of the provisions of paragraph 9.5 of AS 10 in respect of borrowing costs. There is no contradiction in view of the said clarification.

1Opinion finalised by the Committee on 25.3.2003.

2 Published in ‘The Chartered Accountant’, April 2002, page 1242.

3 Published in ‘The Chartered Accountant’, November 2001, page 699.

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