Expert Advisory Committee
ICAI-Expert Advisory Committee
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Query No. 4

Subject:

Accounting treatment of licence fee paid to practice

Isocracking Process in a Hydrocracker Unit.1

A. Facts of the Case

1. ‘X’, a government company, incorporated on 22nd April, 1993, is engaged in refining of indigenous crude oil adopting state of the art technologies. It has also a marketing terminal and the refinery products are now being regularly despatched from it since 3rd April, 2000. The company is in its third year of operation and has made profit in the last two financial years.

 

2. ‘X’ entered into an agreement with company ‘Y’, relating to Isocracking Process, for imparting of know-how to practice the process in the Hydrocracker Isocracking Unit. Company ‘Y’ is the owner of patent rights. Is ocracking Process meansa catalytic process for treating a hydrocarbonaceous feed under specified conditions in the presence of a catalyst. Under the agreement, the licensor grants to the licensee a non- exclusive, non-transferable licence under the licensor’s patent rights and catalyst patent rights to practice Isocracking Process in the licensed unit. ‘X’ has entered into another agreement with ‘Y’, relating to ‘Process Design and Services Isocracking Unit’.

 

3. ‘Isocracking’ is a proprietary name and trademark of the licensor, i.e.,‘Y’. The licence includes –

(a) Know-how relating to Isocracking Process;

(b) Process design and service; and

(c) Catalyst supply.

The scope of the agreements includes basic engineering design package, process design for construction and front-end mechanical design. This also includes process manual, analytical manual and detailed design follow-up as well as supply of catalyst and expert services for construction guidance during equipment fabrication stage.

 

4. Clause 4.1 of the agreement relating to Isocracking Process, referred to in paragraph 2 above, empowers the licensee to receive ‘Technical Information’ for use in the licensed unit. Clause 5 of Schedule ‘A’ to the agreement defines the term ‘Technical Information’, as follows:

" ‘Technical information’ shall mean improvements and developments relating to and operating techniques necessary for the operation of Isocracking Process, in a stage of development, suitable for commercial use, developed prior to five (5) years from the effective date of this agreement, to the extent that, and subject to the terms and conditions (including the obligation to account to and/or make payments to others) under which, the person, firm, or company in question has the right to disclose such information to others".

5. The querist has informed that the services of the licensor were utilised totally during the construction period and the process has come into existence for commercial use.

 

6. The payment terms in respect of the Isocracking Process agreement, require ‘X’ to pay for the licence as royalty in four equal instalments to acquire the licence to practice the process. The royalty rates have been defined in the agreement. The payment terms for the royalty are as follows:

 

(a) First instalment shall become due and payable within 30 days of the effective date of this agreement.

 

(b) Second instalment shall become due and payable within 30 days following the day on which basic engineering design package for licensed unit is issued pursuant to the ‘Agreement relating to Process Design and Services’ entered into between the licensee and the licensor on the same date as this agreement;

 

(c) Third instalment shall become due and payable within 30 days following the start up of the licensed unit ; and

 

(d) Fourth instalment shall become due and payable within 180 days of the third instalment above.

7. The above payments were made on different dates depending on the progress of the project. The amount paid as per the schedule mentioned above for acquiring the licence was capitalised along with the cost of the plant and machinery of the Hydrocracker Unit. As per the querist, the payments towards the transfer of this know-how, termed as licence in the agreement, are referred to as royalty in the agreement.

 

8. ‘X’ is a government company and so it is subject to audit by the Comptroller & Auditor General of India under section 619 of the Companies Act, 1956. During the audit for the financial year 2001-02, C&AG made the following audit observation:

"Fixed Assets – Plant & Machinery (Schedule-D) Rs. 2,120.36 crore .The above amount includes Rs. 20.04 crore being the amount of process know-how for Isocracking Process for Hydrocracker Unit capitalised during 1994-95 to 2001-02 instead of considering the same as Deferred Revenue Expenditure. This has resulted in overstatement of Fixed Assets – Gross Block (Rs. 20.04 crore), overstatement of cumulative depreciation (Rs. 1.59 crore), understatement of Miscellaneous Expenditure written off (Rs. 6.01 crore) with corresponding overstatement of profit for the year by Rs. 4.42 crore".

9. According to the government auditors, the amount of Rs. 20.04 crore was the payment against process know-how for Isocracking Process and the entire amount should have been treated as deferred revenue expenditure. The querist has stated that during discussions with the C&AG, reference was made by C&AG to paragraphs 16.4, 16.5 and 16.7 of Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, read with paragraph 9.7(a) of the Guidance Note on Treatment of Expenditure during Construction Period, issued by the Institute of Chartered Accountants of India.

 

10. According to the querist, the contention of the C&AG was not accepted by the management of the company on the following grounds:

 

(a) The payment of Rs. 20.04 crore is a payment for licence fee to acquire a licence to create Isocracking Process and operate the plant. The Isocracking Process plant has been constructed with the technical know-how supplied, catalyst supplied and using designs and drawings supplied by the licensor. The personnel deployed by the licensor were available at site all through the time from discussion stage to trial run completion.

 

(b) Upon payment of the amount, the company acquires the legal right to use the Isocracking Process technology after the same has come into existence. The payment has nothing to do with the process know-how in the manner stated by the C&AG. This know-how is for creation of a process, which results in enduring benefit to the company in its operations. Without payment of this amount, the company could not have commissioned the Hydrocracker Unit. Therefore, in the view of the company, this should be rightfully construed, as part of the capital expenditure required to be incurred to bring the asset to its usable condition. Since the payment is not connected to process know-how related to after erection but pre-commercial production, the treatment given in the books of account does not violate paragraphs 16.4 to 16.7 of AS 10.

(c) Paragraph 20 of AS 10 states that cost of a fixed asset should comprise its purchase price and any attributable cost of bringing the asset to its working condition for its intended use. Therefore, the entire amount paid for acquiring the licence has been correctly capitalised as part of the cost of the plant.

 

(d) In the agreement, the word ‘royalty’ has been used in a common business parlance and this does not signify any sharing of profit for any future activity. This royalty has no link to the production, but is directly attributable to bringing the refinery process into existence.

 

(e) In this case, the expenditure for acquiring the licence cannot be considered as an expenditure of revenue nature. As mentioned in paragraph 2 above, the company has acquired the legal right to use this process technology after creation of the same, by paying this amount and that cost will be depreciated over the effective life of the asset.

 

(f) This process know-how can not be equated to product know- how. The licence has enabled the company to acquire technology to put up the plant including its design and layout. In a turnkey project, if a team of outside consultants working on construction had provided the design, such expenditure during construction period including design, etc., would have ranked for capitalisation as a pre-operative expenditure during construction period. The same was provided through technical information which was used by the company for construction of plant. The payment terms cannot determine the treatment as capital or revenue but the substance of payment, which was for process know-how meant for construction of the plant and bringing the asset into existence.

 

B . Query

 

11. The querist has sought the opinion of the Expert Advisory Committee on the issue as to whether the accounting treatment given by company ‘X’ for capitalising the amount paid for licence fee is correct and is in line with AS 10.

 

C. Points considered by the Committee

12. The Committee notes that the basic principle regarding costs that should comprise the total cost of an item of fixed asset has been stated in paragraph9.1 of Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, as below:

 

"9.1 The cost of an item of fixed asset comprises its purchase price, including import duties and other non-refundable taxes or levies and any directly attributable cost of bringing the asset to its working condition for its intended use;…"

 

13. The Committee also notes paragraphs 38 and 16.4 to 16.7 of AS 10, which are reproduced below:

"38. Amount paid for know-how for the plans, layout and designs of buildings and/or design of the machinery should be capitalised under the relevant asset heads, such as buildings, plants and machinery, etc. Depreciation should be calculated on the total cost of those assets, including the cost of the know-how capitalised. Where the amount paid for know-how is a composite sum in respect of both the manufacturing process as well as plans, drawings and designs for buildings, plant and machinery, etc., the management should apportion such consideration into two parts on a reasonable basis."

 

"16.4 Know-how in general is recorded in the books only when some consideration in money or money’s worth has been paid for it. Know- how is generally of two types:

          (i) relating to manufacturing processes; and

(ii) relating to plans, designs and drawings of buildings or plant and machinery.

16.5 Know-how related to plans, designs and drawings of buildings or plant and machinery is capitalised under the relevant asset heads. In such cases depreciation is calculated on the total cost of those assets, including the cost of the know-how capitalised. Know-how related to manufacturing processes is usually expensed in the year in which it is incurred.

 

16.6 Where the amount paid for know-how is a composite sum in respect of both the types mentioned in paragraph 16.4, such consideration is apportioned amongst them on a reasonable basis.

 

16.7 Where the consideration for the supply of know-how is a series of recurring annual payments as royalties, technical assistance fees, contribution to research, etc., such payments are charged to the profit and loss statement each year."

14. The Committee also notes paragraph 9.7(a) of the Guidance Note on Treatment of Expenditure during Construction Period, issued by the Institute of Chartered Accountants of India, which is reproduced below:

"(a) It is possible that, in addition to constructing the plant or other structures, the contractors may also agree to render other services. For example, the contractors may agree to supply technical know-how, train the technicians of the purchasing company, and provide credit facilities to the purchasing company by way of deferred payment terms in connection with the purchase cost under the contract. In such cases, the value of the additional services rendered by the contractors should be separated from the cost of the construction and accounted for accordingly. This would present no problem if the contract itself stipulates a separate consideration for the construction as well as for each such specific service. However, if the contract consideration is not so specified, the lump sum consideration would then have to be apportioned between the construction cost and the value of each such specific service in some suitable manner which is appropriate in the circumstances of the case. The basis of such apportionment should preferably be indicated in a footnote to the financial statements. In the example given above, the consideration, if any, which is paid separately for the value of the technical know-how supplied by the contractors, would have to be accounted for, depending on the nature of the technical know-how which is supplied. If the technical know-how which is supplied by the contractors relates to the construction of the plant, it may be added to the value of the plant. The only question in that case would be the apportionment of the total consideration for such technical know-how among the different units of the plant which are constructed by utilising the know-how. Such apportionments can be made in any suitable manner. Wherever possible, in making the apportionment, regard should be had to any data which may be supplied by the contractors and which may indicate a suitable basis for apportionment. Failing any such data, the apportionment may be made on the basis of the value or cost of the different units which are constructed or on the basis of the approximate time spent by the contractors in designing the construction of each unit, or on any other suitable basis. Care should be taken, however, to ensure that no part of the value of the technical know-how relating to construction is apportioned to any unit of construction which has not involved the utilisation of such know-how. If, on the other hand, the technical know-how which is supplied relates to productive facilities and processes, the value would have to be treated initially as an item of deferred revenue expenditure to be amortised in suitable instalments after the commencement of production, preferably over a period not exceeding 3 to 5 years after the commencement of production. Any consideration paid separately to the contractors for training the technicians of the purchasing company would have to be treated also as deferred revenue expenditure in the manner suggested in paragraphs 6.2 and 6.3 of this Note. Any expenditure by way of interest charges on the credit facilities provided by the contractor would have to be treated in the manner suggested in paragraph 4 of this Note, which deals in some detail with the various items of financial expenses."

 

15. The Committee is of the view that keeping in view the general principle of capitalisation of costs on acquisition/construction of fixed assets as per paragraph 9.1 of AS 10 reproduced at paragraph 12 above, the requirements of paragraph 38 of AS 10 and the recommendations contained in paragraph

 

9.7(a) of the Guidance Note, it is apparent that only those know-how costs which relate to plans, designs, drawings of buildings or plant and machinery are considered as costs that are directly attributable to bringing the asset to its working condition for its intended use or cost of construction. Know-how costs other than those specified as aforesaid should be charged to the profit and loss account. However, in respect of a project under construction, the know-how costs that can not be capitalised as aforesaid should be treated as deferred revenue expenditure and charged to profit and loss account over a period of 3 to 5 years after commencement of commercial production.

 

16. The Committee notes that in the present case, the company has entered into two agreements, namely, one relating to ‘Isocracking Process’ and the other to ‘Process Design and Services Isocracking Process’. Paragraph 2.1 of the first agreement states that, "This licence includes the right under Licensor’s Patent Rights and Catalyst Patent Rights to make or have made, either by themselves or through any of their agents or nominees, any apparatus and/or Isocracking Process Catalysts for Licensee’s use in practising Isocracking Process in Licensed Unit….". The Committee also notes from the first agreement that clause 4.3 thereof provides that the licensor’s obligation does not include the obligation to furnish or make available to the licensee detailed information with respect to the specific design, construction and/or operation of any commercial Isocracking Process plants. The Committee further notes that the second agreement, inter alia, provides as follows:

 

"Licensor, upon request and upon reasonable notice from Licensee and unless otherwise agreed by Licensee, in the United States of America will:

(1) Prepare and furnish for Licensee’s use a Basic Engineering Design Package;

(2) Prepare and furnish for Licensee’s use a Process Manual and an Analytical Manual for the Licensed Unit;

(3) Provide Detailed Design Follow-up;

(4) Review the design of the vacuum distillation unit plant prepared by Licensee’s contractor; and

(5) Review the design of the coker fractionator unit plant prepared by Licensee’s contractor."

 

The Committee notes that there are separate payment terms under the second agreement.

 

17. The Committee, on perusing the facts of the case and the copies of the agreements supplied by the querist separately, notes that the extent of the amount payable towards know-how fees with regard to drawings, designs, plans of buildings and/or plant and machinery, is not clear. However, some indications exist that certain know-how costs could be for the aforesaid purposes. For example, it is possible that, under the first agreement, an apparatus and/or Isocracking Process catalysts have been supplied to the company which should be capitalised as a part of the plant being tangible assets. Similarly, the basic engineering design stipulated under the terms of the second agreement may relate to the construction of the plant and machinery of the unit. The Committee is of the view that where the know-how costs are so related as aforesaid, the same should be capitalised as part of the cost of the relevant asset. The Committee is, therefore, of the view that the company should ascertain the extent to which the know-how fees relate to plans, layout and designs of buildings and/or design of the plant and machinery so that to that extent the amount can be capitalised, and the remaining know- how fees should be treated as deferred revenue expenditure and charged to profit and loss account over a period of 3 to 5 years after commencement of commercial production. The company may have to apportion such fees into two parts as prescribed in paragraph 38 of AS 10.

 

18. The Committee incidentally notes that the Institute of Chartered Accountants of India has issued Accounting Standard (AS) 26 on ‘Intangible Assets’. From the date the Standard becomes mandatory (i.e., 1st April, 2003 in case of enterprises whose equity or debt securities are listed on a recognised stock exchange in India or 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 and all other commercial, industrial and business reporting enterprises whose turnover for the accounting period exceeds Rs. 50 crore; and 1.4.2004 in respect of other enterprises) the paragraphs of AS 10, and paragraph 9.7(a) of the Guidance Note, reproduced in paragraphs 13 and 14 above, would stand withdrawn. Accordingly, the know-how costs incurred under the two agreements should be treated in accordance with AS 26. In this context, the company should also note the transitional provisions prescribed in paragraph 99 of the Standard.

 

D. Opinion

 

19. On the basis of the above, the Committee is of the opinion that the management of the company ‘X’ should ascertain the extent of the know- how fees payable in respect of plans, layout and designs of buildings and/or design of the plant and machinery which should be capitalised under the relevant heads. Know-how fees which are not so related and pertain to the period prior to commencement of commercial production should be treated as deferred revenue expenditure and expensed over a period of 3 to 5 years after commencement of commercial production.

 

1 Opinion finalised by the Committee on 25.3.2003.