Expert Advisory Committee

Query No. 7

Subject:

Gross block of fixed assets used for construction activities during construction

period – Disclosure on commencement of commercial production.1

A. Facts of the Case

1. A public sector company, registered under the Companies Act, 1956, is engaged in construction and operation of hydroelectric power projects. For the purpose of construction of a project, the company constructs buildings(residential and non-residential), roads and bridges and also acquires leasehold land, furniture and fixtures, etc., in addition to construction of plant and machinery and temporary structures. All such assets are constructed/acquired much before the completion of the project. The company is depreciating all such assets during construction period and is capitalising the depreciation alongwith other items of ‘Incidental Expenditure during Construction Period’ in main components of the projects, i.e., dam, power house, tunnels and generating plant and machinery. The accounting policy of the company, which is being followed consistently, is as under:

"Projects under commissioning and other capital work-in-progress are carried at cost. In respect of projects under construction, incidental and attributable expenses including interest and depreciation on fixed assets in use during construction are carried as part of ‘Incidental Expenditure during Construction’ to be allocated on major immovable project assets other than land and infrastructural facilities, on commissioning of the Project."

2. The Comptroller and Auditor General of India (C&AG), based on the audit for the year 1994-95, issued the following comment:

"T he depreciation on original assets/equipments used during construction period has not been reduced from the gross value of these original assets/equipments at the time of capitalisation on commencement of the commercial operation of the respective projects. This has resultedin overstatement of Gross Block ……."

3. The querist has stated that the company, after due deliberations and recognising the principles laid down in paragraphs 9.4 and 14.3 of the Guidance Note on Treatment of Expenditure during Construction Period, issued by the Institute of Chartered Accountants of India (ICAI) and also Opinion No.1.31 of Volume XI, given by the Expert Advisory Committee of the ICAI, agreed with the view of the C&AG of India. Henceforth, it started reducing depreciation charged on fixed assets used during construction period from the gross value of the original assets/equipments at the time of capitalisation on commencement of the commercial operations in respect of all the projects commissioned during the year 1994-95 and afterwards. The company is following this policy consistently since then.

4. During the course of audit for the financial year 2001-02, the statutory auditors of the company, however, did not agree with the above treatment. The views of the statutory auditors were that paragraphs 9.4 and 14.3 of the Guidance Note and Opinion No. 1.31 of Volume XI are not applicable in respect of regular fixed assets which were acquired/constructed during construction period.

5. The company informed the statutory auditors that such assets, i.e., leasehold land, buildings, roads and bridges, furniture and fixtures, etc., are being used during construction period also for the purpose of construction of the project such as plant and machinery and temporary structures and a different treatment cannot be given to depreciation charged during construction on such assets. The statutory auditors, however, did not find the explanations of the company convincing and included the following qualification in their report:

"The Balance Sheet does not reflect the ‘original cost’ and accumulated depreciation of Fixed Assets in case of four Projects viz., …………. as required by Schedule VI to the Companies Act, 1956. All items of fixed assets which were acquired during the construction period have been stated at ‘written down value’ as at the end of the construction period, instead of the original cost. The recommendations of the Institute of Chartered Accountants of India vide Guidance Note on Treatment of Expenditure during Construction Period have been misconstrued and the original cost of even items like land, buildings, roads, etc., which were purchased or constructed during construction period, though not for construction activities, have been reduced as above. Only in case of special construction equipments and temporary assets created specially to facilitate construction of the Fixed Assets, which are not fixed assets in themselves, the above Guidance Note recommends the carry over of the same at an estimated cost, if the same is of use after construction period. This does not apply to independent items of Fixed Assets which are acquired for business purposes just because they are procured during construction period. Fixed Asset is defined in the Guidance Note on Terms Used in Financial Statements, issued by the ICAI, as ‘Asset held for the purpose of providing or producing goods or services and that is not held for resale in the normal course of business’. As per the requirement of Schedule VI to the Companies Act, 1956, and Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, fixed assets have to be stated at cost. As per fundamental principles of accounting, adjustment of provision for depreciation against the original cost of fixed asset is made only when either the item is scrapped, discarded or sold. None of the above situations have arisen to require the adjustment of the provision for depreciation against the original cost and hence, the entries passed in the books of account are also fundamentally wrong. The amounts appearing under ‘original cost’ and ‘accumulated depreciation’ are, therefore, understated against various heads of Fixed Assets as under:

Amount (Millions)

Leasehold Land	xxx
Buildings	xxx
Roads and Bridges	xxx
Sub-Station Equipments	xxx
Furniture, Fixture and Equipments	xxx
Transmission Lines	xxx
Miscellaneous Assets/Equipments	xxx	"

6 The C&AG of India, during audit u/s 619(4) of the Companies Act, 1956, for the year 2001-02, did not find merit in the qualification given by the statutory auditors and issued the following half margin:

"…… the auditors have reported that the exhibition of fixed assets acquired during the construction period in respect of four projects viz.……………… at their written down value as at the end of their construction period instead of original cost thereof is not in order and is in violation of AS 10 and Schedule VI to the Companies Act, 1956. As per paragraphs 9.4 and 14.3 of Guidance Note on Treatment of Expenditure during Construction Period, issued by the Research Committee of The Institute of Chartered Accountants of India, the cost of equipments acquired during the construction period of the project are utilised for the purposes of construction only. The cost of such assets as reduced by the amount of depreciation charged during the period of construction should be carried forward to the production period so that the accounts of the production period would begin with the depreciated value of such equipments, which would then be depreciated in normal way. Since the depreciation charged on such assets during the construction period of the project is allocated through IEDC to the constructed assets at the end of the construction period the consequent result is just shifting of the depreciation (of such assets) charged during construction period to the constructed assets at the time of capitalisation thereof. As such, exhibition of such assets at their written down value at the end of construction period of the project cannot be treated as violation of AS 10 and/or Schedule VI to the Companies Act, 1956. In view of the above, this qualification is not in order and may, therefore, be treated as set aside."

7. The statutory auditors, however, maintained their stand and replied as follows to the above noted half margin:

"………our qualification does not refer to the treatment of equipments acquired during construction period. It refers to regular fixed assets, which were acquired or constructed during construction period, like leasehold land, buildings, roads, etc. Construction equipments are not fixed assets in themselves but are assets procured to be used for constructing the fixed asset, viz., the Power House, Roads, Dams, etc. Our qualification, therefore, does not relate to the same. It relates to such of the fixed assets, whch had no connection witht he construction activity, but were independent fixed assets, but since these happened to be put to use during construction period or having become ready for use, depreciation/amortisation had been provided during construction period and such depreciation/ amortisation amount have been reduced from the original cost of the fixed assets.

Paragraphs 9.4 and 14.3 of the Guidance Note on Treatment of Expenditure during Construction Period, issued by the Research Committee, nowhere specify that the original cost of all the fixed assets procured during the construction period should be reduced by the amount of depreciation provided during construction period. Audit has rightly pointed out that the said paragraphs of the Guidance Note speak of construction equipments acquired during the construction period of the Project and are utilised for the purposes of the construction only. The Guidance Note prescribes two methods of dealing with such assets acquired for construction purposes: (a) The asset is capitalised and depreciated by estimating the appropriate useful life, or (b) the whole of the cost of the equipment is capitalised and no depreciation is provided and at the end of the construction period, the realisable value of the equipment is credited. In both the methods, what is ensured is that the cost of the construction equipment which is procured specially for the construction of the Project Asset less its realisable value is appropriately loaded to the cost of the self-constructed asset. And, if the construction equipment is found to be useful in the production period, the same is carried at its estimated value. This Guidance Note nowhere stipulates that regular assets, like leasehold land, office building, residential building, factory building, store, roads and bridges, electrical installations, computers, furniture and fittings, vehicles, etc. have to be rendered the same treatment.

With due respect, we beg to state that we are unable to understand as to what is intended to be conveyed by saying that "Since the depreciation charged on such assets during the construction period of the project is allocated through IEDC to the constructed assets at the end of the construction period the consequent result is just shifting of the depreciation of such assets charged during construction period to the constructed assets at the time of capitalisation thereof". There is no shifting of any item. Depreciation represents a charge for the use of a fixed asset and such depreciation is included in determining the cost of a self-constructed asset because the non-inclusion of the same would lead to under-costing. There is no shifting of the original cost of one fixed asset to another. The cost of every fixed asset remains unchanged except in prescribed situations like exchange rate variation, court award, etc. We may submit that the above Guidance Note deals with the particular subject of treatment of expenditure incurred during construction. It does not deal with the accounting and presentation of fixed assets, provisions relating to which are contained in Schedule VI to the Companies Act, 1956, and the Accounting Standard 10. …….

Under the circumstances, Audit may, therefore, be pleased to drop the draft comments."

8. The C&AG of India while finalising comments on the accounts for the financial year 2001-02 asked the company to inter-alia publish the following comment in its annual report:

" ………… The Company has followed the practice based on an opinion of the Expert Advisory Committee of the ICAI on the subject matter in respect of which the Statutory Auditor has a different view."

9. As per the querist, the C&AG of India has now further directed the company to seek clarification from ICAI whether the statutory auditors’ view that reduction of gross block of the assets used for construction of assets at the stage of completion of such assets as given in Opinion No. 1.31

of Volume XI of the Expert Advisory Committee of ICAI is contravening the provisions of the Companies Act, Accounting Standards and Guidance Note on Treatment of Expenditure during Construction Period.

10. The querist has drawn the attention of the Committee to the following portions of paragraphs 9.3 and 9.4 of the Guidance Note on Treatment of Expenditure during Construction Period:

"...... However, in addition to the construction of the chemical plant which needs specialised know-how, the project would also require the construction of employee housing, railway sidings, roads in the factory area, various utility and service facilities, etc., which the company may either construct on its own or whose construction may be entrusted by the company to various local contractors acting under the supervision of the company’s own engineers ......." (Extract from paragraph 9.3)

"In addition to any local construction work of the nature mentioned in the preceding paragraph, it is almost inevitable that the company will purchase various items of fixed assets during its construction or pre- production period. The commonest example of such a purchase would be the purchase of automobiles, transport equipment, furniture and fixtures, and office equipment, etc. Such assets would be required from the very inception of the company even before the company enters its productive stage. It is extremely likely that all or some of the fixed assets purchased during the construction period may be actually or indirectly utilised in the work of construction, in which case the appropriate depreciation charges during the period in which they are utilised in the work of construction should be treated as part of the indirect construction expenditure …" (Extract from paragraph 9.4) (Emphasis supplied by the querist)

11. The querist has stated that the hydroelectric power projects are constructed in remote areas and have long gestation periods varying from 6 to 8 years and even more in some cases. Further, construction of no project in hydroelectric sector can be visualised without the use of buildings, roads and bridges, leasehold land and furniture and fixtures, etc. As a matter of fact such infrastructure assets are pre-requisite for construction of a project.

12. The querist has referred to paragraph 2 of Opinion No. 1.31 of the Expert Advisory Committee (Volume XI). The Committee has opined that in the schedule of fixed assets for the period in which production begins, the figure of gross block of the fixed assets, which are used in the construction period and on which depreciation has been charged during the construction period and added to capitalised cost of fixed assets, should be reduced by such depreciation charged during construction period. Similarly, in paragraph 3 of the said opinion, the Committee has opined that the value of gross block shown in the balance sheet cannot exceed the actual cost incurred on such assets except in case of their revaluation.

13. The company is, therefore, of the view that if it were to reduce depreciation charged during construction period in respect of construction plant and machinery and temporary assets only, treatment may not be in accordance with the Guidance Note and the opinion referred to above.

B . Query

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

(a) Whether the reduction of gross block of the fixed assets, which are used in the construction period and on which depreciation has been charged during the construction period and added to capitalised cost of fixed assets as per Opinion No. 1.31 of Volume XI of the Expert Advisory Committee of ICAI, is contravening the provisions of the Companies Act, Accounting Standards and Guidance Note on Treatment of Expenditure during Construction Period;

(b) If not, whether the treatment being given by the company is correct.

C. Points considered by the Committee

15. The Committee notes from the facts of the case that the statutory auditors have stated that their qualification relates to those fixed assets that have no connection with the construction activity and were independent fixed assets and that the said assets had been purchased and put to use during the construction period, though not for construction activities. The auditors’ contention appears to be that the assets which are used for construction activities can not be considered as ‘fixed assets’ within the meaning of Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’. Thus, in their view, such assets which are of the nature of fixed assets, such as office buildings, cannot be considered as assets purchased exclusively for construction activity and, therefore, the accounting treatment recommended in paragraph 9.4 of the Guidance Note on Treatment of Expenditure during Construction Period and Opinion No. 1.31 of Volume X (not Volume XI as mentioned by the querist) of the Compendium of Opinions is not applicable, even though such assets are used for the construction activity. On the other hand, the contention of the company is that the assets, e.g., buildings, roads and bridges, furniture and fixtures were being used during construction period for the purpose of construction activity such as construction of plant and machinery and temporary structures and, accordingly, the treatment suggested in the aforesaid pronouncements are applicable to such assets.

16. The Committee is of the view that if an asset of the nature of a fixed asset within the meaning of AS 10, such as an office building, is used directly or indirectly for the purpose of construction, for example, it accommodates purchase department which, during construction period, performs the functions of purchasing various materials and supplies for the construction activity, depreciation on such a building would get charged to the other assets under construction, for example, the construction of the building, which would accommodate the plant and machinery. In such a situation, the office building, if fully used, directly or indirectly, for the purpose of carrying on various construction activities should be depreciated and the gross block of the building would be the depreciated amount on the commencement of commercial production as per the recommendations contained in paragraph 9.4 of the Guidance Note on Treatment of Expenditure during Construction Period and Opinion No. 1.31 of Volume X of Compendium of Opinions. Where such a building is partly used, only the relevant part of the depreciation would be charged to the construction cost of the other fixed assets. In such a case, the gross value of the building on the commencement of commercial production would be the depreciated amount, to the extent of the depreciation charged to the other assets. Where such a building is not at all used for construction activity, for example, it is rented out to a third party pending the commencement of commercial production, such a building cannot be considered to be used for construction activity and in such a case although the building would be depreciated during the construction period, yet its gross block would be the original cost at which the building was acquired or constructed. Thus, the determining factor is whether or not and the extent to which the buildings or other fixed assets are actually used for construction activity even though such fixed assets might have been purchased for regular use even after commencement of commercial production. In other words, it is not necessary that such assets are specially purchased only for the construction activity.

D. Opinion

17. On the basis of the above, the opinion of the Expert Advisory Committee on the issues raised in paragraph 14 above is as below:

(a) On commencement of commercial production, the gross block of the assets acquired/constructed during the construction period, even though they are of the nature of fixed assets within the meaning of AS 10, would be their depreciated cost, i.e., original cost less the accumulated depreciation during the construction period, provided the assets were fully/partly used during the construction period for the purpose of carrying on the construction activity which is a question of fact to be determined on the basis of the relevant information. This treatment is in accordance with Opinion No. 1.31 of Volume X of the Compendium of Opinions of the Expert Advisory Committee, the provisions of the Companies Act, 1956, Accounting Standard 10 and the Guidance Note on Treatment of Expenditure during Construction Period.

(b) Please see (a) above.

1 Opinion finalised by the Committee on 25.3.2003.