Query No. 17

Subject:

Treatment of fees paid for prepayment of loan. 1

A. Facts of the Case

1. A public sector company, under the Ministry of Petroleum and Natural Gas is engaged in the business of refining crude oil. During the year 2000, the company started the activities to expand its capacity by another 3 million in addition to its existing capacity and the same was financed by various loans from Oil Industry Development Board (OIDB) under the same ministry and from internal accruals.

2. During the course of the project, the interest regime witnessed sweeping changes and the interest rates started to fall. Hence, the company approached funding agency under the same ministry, OIDB, to lower the interest costs or otherwise allow it to liquidate the existing high cost debts thereby paving the way for soliciting low cost funds from other agencies for which OIDB agreed. However, OIDB stipulated that the company would be required to pay a fee of 2% on the loan outstanding as ‘prepayment fee’, if the loans were repaid before the due date or ‘reset fee’ if it chose to avail lower cost loans from it.

3. The company worked out the cost-benefit analysis and found that the cost of debt is much cheaper even if the high cost loans are repaid with the above 2% prepayment fee. In the process, the company had repaid Rs. 678.03 crore (Rs. 183.03 crore on 14.07.2003 and Rs. 495.00 crore on 29.01.04) to OIDB and incurred an expenditure of Rs. 13.48 crore as prepayment fee for repaying the debts before the payment period by availing low cost loans from other banks. Most of the activities of the project were completed during the year 2003-04 and assets were capitalised in March 2004. While capitalising the assets, Rs.13.48 crore paid as prepayment fee, was also capitalised as borrowing costs with other interest cost.

4. The government auditors, while auditing the accounts for the year ended 31.03.2004, have raised an objection stating that:

(i) The payment of prepayment fee was not in the nature of interest and the same was not incurred for the acquisition of asset;

 

(ii) The benefit of lower rates of interest would accrue to the company after the date of capitalisation and hence, would result in lower interest charges in the income statements in future and, therefore, it would be appropriate to charge the said sum to revenue.

 

5. The company, however, relied upon paragraph 4 of Accounting Standard (AS) 16, ‘Borrowing Costs’, issued by the Institute of Chartered Accountants of India, wherein it is stated as follows:

"Borrowing costs may include:

(a) interest and commitment charges on bank borrowings and other short-term and long-term borrowings;

(b) amortisation of discounts or premiums relating to borrowings;

(c) amortisation of ancillary costs incurred in connection with the arrangement of borrowings;

…"

The company contended that the above definition is inclusive in nature and, therefore, the term ‘borrowing cost’ may include items of similar nature as stated in the above definition.

6. The company also relied upon paragraphs 7 and 14 of AS 16 wherein it is stated that:

"7. Borrowing costs are capitalised as part of the cost of a qualifying asset when it is probable that they will result in future economic benefits to the enterprise and the costs can be measured reliably. …"

 

"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."

7. As per the querist, since the payment of prepayment fee satisfies the above conditions and the total financing cost capitalised, inclusive of prepayment fees, does not exceed the total interest paid, the company thought it fit that the prepayment fee can be capitalised.

B . Query

8. The querist has sought the opinion of the Expert Advisory Committee as to whether the company is right in capitalising the prepayment fee paid for liquidating high cost debt and availing low cost debt in substitution of the high cost debt.

C. Points considered by the Committee

9. The Committee notes that AS 16 defines the term ‘borrowing costs’ as follows:

"Borrowing costs are interest and other costs incurred by an enterprise in connection with the borrowing of funds."

10. The Committee also notes paragraph 4 of AS 16 as reproduced in paragraph 5 above. The Committee notes that borrowing costs include interest and other costs incurred only in connection with the borrowing of funds (emphasis supplied by the Committee). The Committee also notes that although the list given by paragraph 4 of AS 16 is inclusive, it may include only those items of expense that are similar to those stated in the said paragraph, i.e., those which are incurred in connection with the borrowing or arrangement of borrowing. The Committee notes that the prepayment fee is incurred by the company for exitinguishment or liquidation of borrowings rather than for arrangement of borrowings. Therefore, it can not be regarded as a borrowing cost.

11. The Committee also notes that there is no nexus between the borrowings from OIDB and borrowings from other agencies. Therefore, it can not also be said that these costs are incurred for the arrangement of borrowings from other agencies.

12. The Committee further notes paragraphs 7 and 14 of AS 16 as reproduced in paragraph 6 above. The Committee notes that these paragraphs will apply only when an item is recognised as borrowing cost. These paragraphs by themselves do not lay down the criteria for the determination of an expense as a borrowing cost. Since as stated above, the prepayment fees is not a borrowing cost, paragraphs 7 and 14 of AS16 will not apply in the present case.

D. Opinion

13. On the basis of the above, the Committee is of the opinion that the company is not right in capitalising the prepayment fee paid for liquidating high cost debt and availing low cost debt in substitution of the high cost debt.

1 Opinion finalised by the Committee on 6.10.2004