1. A company is engaged in the business of manufacture and sale of soft ferrite components. The company commenced installation of its production facilities in 1990. Out of the total project cost of Rs. 2,674 lakh, Rs. 1,836 lakh was financed through borrowings from financial institutions. The project was ready for commercial production on 1st April, 1993. It actually commenced commercial production on that date. Interest on the aforesaid borrowings till that date aggregating to Rs. 314 lakh was capitalised and included in the carrying cost of related fixed assets. However, interest on the aforesaid borrowings could not be paid to the lenders due to the financial difficulties faced by the company.

2. During the year ended 31st March, 1995, the company repaid the aforesaid principal amount of borrowings aggregating Rs. 1,836 lakh in one instalment under the terms of a financial arrangement agreed with the lending financial institutions. In accordance with the arrangement, the lender waived the payment of interest on such borrowings till the date of repayment of the principal amount. Interest so waived included Rs. 314 lakh being interest till the project was ready for commencement of commercial production. There is no stipulation, regarding compliance with any future obligation, attached to such waiver.

3. In the financial statements for the year ended 31st March, 1995, the waiver of interest capitalised in prior years, as mentioned in paragraph 1 above, was considered as a capital profit. According to the querist, in the absence of any specific pronouncement/opinion till then, the aforesaid accounting treatment was considered prudent. Accordingly, Rs. 314 lakh was credited to capital reserve in that year. Also, the company adopted the accounting policy of writing back such capital reserve against annual depreciation charge pertaining to such interest capitalised over the life of the fixed assets capitalised on commencement of commercial production. The company has consistently followed the aforesaid accounting policy till the last audited financial statements for the year ended 30th September, 2002.

5. The statutory auditors hold the view that the balance (net) of capital reserve as at 30th September, 2002, should be considered as income and credited to the profit and loss account for the year ended 31st March, 2003, to be drawn up for income-tax purposes.

6. The management of the company believes that the accounting policy set out in paragraph 3 above is prudent and appropriate in view of the following:

(i) Interest having already been capitalised to the cost of the fixed assets, the reversal due to waiver of interest should also go through the same process.

(ii) Since the profit and loss account was not debited by interest earlier, credit to the profit and loss account for waiver of interest would overstate income for the year in which such adjustment is effected.

(iii) Adequate disclosure of the treatment made by the company by way of explanatory note has been made in the financial statements.

B . Query

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

(a) Whether the accounting treatment followed by the company by crediting the interest waived to capital reserve and consistently writing back such capital reserve against annual depreciation charge over the life of the related fixed assets contravenes generally accepted accounting principles (GAAP) in India or it does not appropriately reflect the financial position of the company as at the date of the balance sheet.

 

(b) Whether the contention of the statutory auditors that the balance (net) in capital reserve (arising from waiver of interest) should be credited to the profit and loss account in the current year, is in compliance with GAAP.

 

(c) In case the contention of the statutory auditors is considered appropriate, whether the resulting credit to the profit and loss account for the current year should be considered as a prior period income. What will be the most appropriate accounting treatment of such credit?

C. Points considered by the Committee

8. The Committee wishes to point out that its opinion given hereafter is for the accounting purposes, with a view to reflect a true and fair view of the state of affairs and the operating results. Accordingly, the opinion may not necessarily be relevant for income-tax purposes. The Committee presumes that interest related to the period prior to commencement of commercial production was properly capitalised in accordance with the generally accepted accounting principles as prevailing at that time in India.

9. The Committee notes that historical cost of a fixed asset comprises expenditure incurred in connection with its acquisition/construction as well as for additions to or improvements thereof. If, subsequently, it is determined that an expenditure attributable to the acquisition/construction of an asset is not incurred, e.g., due to retrospective change in duties, the historical cost of the asset, as recognised earlier, undergoes a change in this regard as per the generally accepted accounting principles. Thus, where interest was capitalised as a part of historical cost of an asset, which is subsequently waived, the historical cost of the asset should be reduced to that extent. The Committee is, accordingly, of the view that the amount of interest waived, which was included in the cost of fixed assets, should have been adjusted in the cost of the said assets instead of transferring the amount to capital reserve and the adjustment thereof in the amount of depreciation, as is being done by the company, though the impact on the profit and loss account would not have been different. Since this was not done, the company should adjust in the current year the cost of the fixed assets and the accumulated depreciation with effect from the date of the waiver.

10. While arriving at the opinion, the Committee also considered its earlier opinion on a similar issue which is published in Volume XVIII of the Compendium of Opinions, whereby it was opined that interest related to pre- commencement of commercial production period which was capitalised as a part of cost of fixed assets concerned, should be recognised as income in the profit and loss account for the period in which the interest is waived. The Committee notes that the reason given for the aforesaid opinion is that since interest is waived in view of financial difficulties of the company in question, it is not attributable to the acquisition/construction of assets. Therefore, it cannot be adjusted against historical cost of the assets and should be recognised as income for the year. The Committee does not agree with the aforesaid opinion, since it is of the view that cost of an asset should represent the expenditure which is actually incurred and if it is determined that an item of cost which was capitalised correctly, but subsequently, is not to be actually paid, should be reduced from the cost of the asset.

D. Opinion

11. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 7 above:

(a) The accounting treatment followed by the company is not correct as per the GAAP. The correct accounting treatment should have been as stated in paragraph 9 above.

(b) The auditor seems to have relied on the opinion issued by the Committee earlier (referred to in paragraph 10 above). However, the Committee, as mentioned above, is of a different opinion.

(c) Since the answer to (b) above is not in the affirmative, this question does not arise.

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1 Opinion finalised by the Committee on 28.10.2003.