Query No. 9

Subject:

Revenue recognition in respect of advance against depreciation

received by a power generating company.¹

A. Facts of the Case

1. A power generating company, within the meaning of section 2(4A) of the Electricity (Supply) Act, 1948, incorporated under the Companies Act, 1956, has developed 300 MW Baspa II Hydro Electric Project on Build, Own, Operate and Transfer basis under an implementation agreement with the Government of Himachal Pradesh (GOHP). The said project has been commissioned in June 2003 and is supplying the entire power being generated from the project to the Himachal Pradesh State Electricity Board under and in accordance with a power purchase agreement (PPA) executed between the company and the Board on 4th June, 1997, read with a supplementary agreement to the said PPA dated 28th February 2003.

2. According to the querist, under the terms of the said PPA, the company has to supply 12% of the power generated, free of cost to the Board and the balance 88% at tariff computed on the basis specified in the PPA. A copy of the relevant provisions of the PPA relating to the tariff has been separately provided by the querist.

3. The querist has stated that the tariff, inter alia, includes depreciation/ advance against depreciation for the tariff year to cover the amount of principal debt required to be paid in the relevant tariff year with 4.3% of the capital cost being treated as depreciation and balance amount being treated as advance against depreciation. Such advance against depreciation shall be adjusted against depreciation payable by the Board after the expiry of debt redemption period. The net effect of this provision is that depreciation/advance against depreciation is higher during the initial period to meet the loan repayment schedule and lower in later period. The written down value method of depreciation allowed under the Companies Act, 1956 and the Income-tax Act, 1961 also gives higher depreciation in initial years and lower depreciation in later years.

4. As per the querist, the tariff, in Rs. per unit, computed on the basis of the provisions in the PPA, payable by the Board to the company shall be approximately as under:
 

The company is raising the invoices for the power to the Board based on the tariff as determined under the provisions of the PPA.

5. Further, according to the querist, the depreciation for the purpose of the profit and loss account is to be considered as per the provisions of the Companies Act, 1956, which provide that the amount of depreciation to be charged in the books shall be at the rates specified in Schedule XIV to the Companies Act, 1956 and is apparently not related to the depreciation/ advance against depreciation considered for the purposes of computation of tariff under the terms of the PPA.

6. As per the querist, there are two views expressed in the matter. One view is that the advance against depreciation should be excluded from the revenue and transferred to ‘Income received in advance account’ in the balance sheet. The querist has stated that the Expert Advisory Committee of the Institute of Chartered Accountants of India, in its opinion given to another company (contained in Compendium of Opinions Volume XVII, No. 1.31) has opined that it is in order to exclude the revenue related to advance against depreciation from the revenue and to transfer it to ‘Income received in advance account’. The other view is that the consideration of advance against depreciation is only a part of the mechanism/principle to determine the tariff for various years and the entire income based on the tariff so determined could be considered as revenue. According to the querist, this view is apparently further supported by the following:

(a) PPA does not provide that any part of the tariff is payable as advance to be adjusted in future.

(b) PPA does not provide for any recovery from the company on account of inclusion of any advance against depreciation in the tariff, in case the PPA is prematurely terminated at any stage.

(c) The company has an unconditional right to receive the full amount based on the tariff computed on the principles given in PPA from year to year.

(d) The company is free to utilise the revenue so received for any purpose and there is no restriction like building any reserve to meet future liability.

(e) There is no concept of fixed or levelised tariff either during PPA period or thereafter. In fact, the rates necessarily remain variable throughout the PPA period from year to year as shown in the table above.

The querist has stated that the company has also been advised that since the Board has agreed to certain principles to compute the tariff for various years, the tariff so computed will determine the revenue and taking any part of such income to the ‘Income received in advance account’ will neither be in accordance with the provisions of the PPA nor will reflect the true and fair picture of the income.

B. Query

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

(a) Whether the depreciation/advance against depreciation considered in the computation of tariff and not the depreciation as per the provisions of the Companies Act, 1956 should be charged against the revenue for the purposes of determining profitability of the company.

(b) Whether it would be appropriate to consider the entire accrued income based on the tariff determined under the terms of the PPA (such tariff being inclusive of advance against depreciation during initial years) as revenue in the profit and loss account.

C. Points considered by the Committee

8. The Committee notes that paragraph 8.6.5.1 of the Power Purchase Agreement (PPA), separately provided by the querist with his query, requires as follows:

“During the period when the debt is outstanding as per the approved financial package, the payment on this account will be equal to the amount of principal required to be paid in the relevant tariff period/ tariff year subject to the condition that the amount payable for a full tariff year shall not be more than an amount equal to 1/12th (one twelfth) of the loan component of the capital cost as per the approved financial package. Out of the amount as paid on account of depreciation/advance against depreciation for debt redemption period, an amount worked out @ 4.3% of the capital cost for each such full period of 12 months, shall be treated as the payment made on account of depreciation and the balance amount shall be treated as advance against depreciation. After the expiry of the debt redemption period, the total amount already paid/payable by the Board to the company on account of advance against depreciation shall be adjusted against the depreciation payable by the Board for the future period at a per annum rate of 4.3% of the capital cost. No further payments on account of depreciation shall be made by the Board to the company after the debt redemption period until the entire amount of advance against depreciation is fully adjusted against the amount that would have otherwise been payable by the Board on this account, i.e., at a per annum rate of 4.3% of the capital cost. After the full adjustment of the advance against depreciation, further payments on account of depreciation shall be made at an annual rate of 4.3% of capital cost as per the approved financial package, subject to the condition that the total payment on account of depreciation shall not exceed 90% of the capital cost as per the approved financial package. For the purpose of computing the capital cost, the capital cost will be reduced by the value of leased assets as on the scheduled date for commercial operation of the unit(s)/project as per the approved financial package. The amount of depreciation/advance against depreciation, for a part of the year shall be worked out, if necessary, on pro-rata basis.”

9. The Committee is of the view that the advance against depreciation is allowed with the objective of enabling the electricity company to recover depreciation higher than that as would be allowed as per the rates of depreciation notified by the Central Government from time to time for the purpose of fixation of electricity tariff so that the company may be able to generate internal resources for the payment of loans. The Committee further notes from the facts of the query that this advance against depreciation will be adjusted in later years.

10. The Committee notes that as per the accrual basis of accounting “revenue is recognised as it is earned” (paragraph 2.5(i) of the Guidance Note on Accrual Basis of Accounting, issued by the Institute of Chartered Accountants of India). The Committee further notes that where revenue, or part thereof, received/receivable, during a particular period, is to be adjusted in future, to that extent the revenue received/receivable is not considered as earned, but is treated as revenue received in advance. The Committee is, accordingly, of the view that in the present case, that part of the tariff, which arises because of inclusion of advance against depreciation, should be treated as revenue received in advance since the said advance will be adjusted in later years against the depreciation.

11. With regard to the arguments given in favour of the view that the revenue to the extent of advance against depreciation should not be treated as income received in advance but should be recognised in the year in which the same is received/receivable, the views of the Committee are as below:

(a) PPA provides that the advance against depreciation is to be adjusted against depreciation in future. Since the tariff is based on depreciation, it amounts to excess tariff being received in the initial years which gets adjusted in the later years through the depreciation route.

(b) Even though the PPA does not directly provide for any recovery from the company on account of inclusion of any advance against depreciation in the tariff in case the PPA is prematurely terminated at any stage, paragraph 5 of Schedule II to the PPA provides for the recovery of the advance against depreciation indirectly. The Committee is of the view that the issue should be examined on going concern basis.

(c) The arguments that the company has unconditional right to receive the full amount based on the tariff and the fact that the company is free to utilise the revenue for any purpose are not relevant in deciding when the revenue should be recognised. In many other cases also, advances received are utilised by the recipients on receipt, but that in itself does not mean that the revenue has also been earned and, therefore, should be recognised. For example, an advance may have been received for sale of goods in future. This advance may be utilised by the enterprise. This does not mean that revenue on sale of goods should also be recognised at the stage when advance is utilised even though the sale is not complete.

(d) The recognition of revenue is determined on the basis of the generally accepted accounting principles whether or not there is any concept of fixed or levelised tariff. Accordingly, the view of the Committee contained in paragraph 10 above is in accordance with the generally accepted concept of matching since the revenue is appropriately matched with the cost, (i.e., the depreciation).

12. The Committee is of the view that since the company has been incorporated under the Companies Act, 1956, the company should charge depreciation as per the provisions of the Act.

D. Opinion

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

(a) The depreciation as per the provisions of the Companies Act, 1956, should be charged against the revenue for the purposes of determining profits/losses of the company.

(b) The advance against depreciation included in tariff should be treated as income received in advance keeping in view the generally accepted accounting principles so that the profit and loss account and the balance sheet of the company reflect a true and fair view of the profit earned and the state of affairs, respectively.

¹ Opinion finalised by the Committee on 28.4.2005