Query No. 1

Subject:

Treatment of engineering fee paid to a lumpsum turn

key contractor.¹

A. Facts of the Case

1. A public sector undertaking is engaged in refining and marketing of petroleum products. The company has entered into a lumpsum turn key (LSTK) agreement with a contractor for procurement, supply, commissioning, test run, etc., of a petrochemical plant at one of its refineries.

2. The querist has stated that the LSTK agreement with the contractor provides for residual process design, detailed engineering, procurement, supply, transportation, storage, fabrication, construction, installation, testing, pre-commissioning, commissioning and performance guarantee test run, and handing over of the plant to the company in lieu of one lumpsum amount agreed to by both the parties.

3. According to the querist, in order to facilitate payments, the LSTK agreement segregates the lumpsum price in the following categories:

       (a) Price for residual process design and detailed engineering,

       (b) Price for supply portion, and

       (c) Price for construction/installation portion.

4. The querist has stated that the contractor carries out all the jobs necessary to complete the project as per the agreement. As soon as all the works have been completed in all respects to the satisfaction of the engineer-in-charge of the company, final tests and commissioning of the complete system plant(s), equipment(s), vessels and machinery, and associated system, etc., as required in the specifications, are undertaken by the contractor at the risk and cost of the contractor under the overall supervision of the engineer-in-charge of the company. Upon satisfactory conclusion of the final tests and commissioning of the system, the engineer-in-charge issues a final tests and commissioning certificate, which certifies the date on which the final tests and commissioning of the system have been completed. As and from the date of the issue of final tests and commissioning certificate, the company is deemed to have taken over the work(s).

5. As per the querist, advance payments are being made to the contractor based on different stages of performance as agreed in the LSTK contract on account of all the three categories (residual process design and detailed engineering, supply, and construction/ installation). After completion of the contract, the contractor raises the final invoice and the company makes the final payment. Till the date of completion of the project, as mentioned in the above paragraph, all the advance payments made to the contractor are accounted for as capital advance and, accordingly, disclosed as capital work-in-progress in the financial statements. The querist has further clarified that the payment terms, as mentioned at paragraph 3 above are only in the nature of milestones for making payment under the LSTK contract and the ownership of the full project under such LSTK contract passes to the company only after satisfactory completion of the complete project.

6. On final completion of the project, capitalisation of assets under various heads, i.e., plant and machinery, equipments and appliances, buildings, furniture and fixtures, etc., is carried out in the books of the company based on the information provided by the contractor.

7. In this connection, the querist has mentioned that one of the elements of cost indicated in paragraph 3 above claimed by the contractor relates to detailed engineering and design of the plant. The examples of such process design and detailed engineering are designing layout of the equipments, ensuring that the length, size, thickness of equipments, pipes, etc., adheres to the safety norms, etc.

8. The querist has also drawn the attention of the Committee to paragraphs 9.1 and 10.1 of Accounting Standard (AS) 10,
‘Accounting for Fixed Assets’, issued by the Institute of Chartered Accountants of India, which state as under:

  “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; any trade discounts and rebates are deducted in arriving at the purchase price. Examples of directly attributable costs are:

                  (i) site preparation;

                  (ii) initial delivery and handling costs;

                  (iii) installation cost, such as special foundations for plant; and

                  (iv) professional fees, for example fees of architects and engineers.

The cost of a fixed asset may undergo changes subsequent to its acquisition or construction on account of exchange fluctuations, price adjustments, changes in duties or similar factors.” (Emphasis supplied by the querist.)

  “10.1 In arriving at the gross book value of self-constructed fixed assets, the same principles apply as those described in paragraphs 9.1 to 9.5. Included in the gross book value are costs of construction that relate directly to the specific asset and costs that are attributable to the construction activity in general and can be allocated to the specific asset. Any internal profits are eliminated in arriving at such costs.”

According to the querist, considering the above provisions of AS 10, the expenses incurred towards process design and engineering fees under the LSTK agreement are accounted for as a component of the cost of the fixed assets and, accordingly, apportioned among the various categories of the fixed assets.

B. Query

9. The querist has sought the opinion of the Expert Advisory Committee on the following issues in respect of accounting for expenses incurred towards engineering and design of the plant under the LSTK agreement:

          (a) Whether the accounting treatment of capitalising the expenditure incurred on process design and engineering cost as a                          component of the total asset is in order.

          (b) If the answer to (a) above is in the negative, whether the expenditure incurred on process design and engineering cost is to be                 separately accounted for as an intangible asset.

          (c) If the answer to (b) above is also in the negative, the suggested accounting treatment to be followed in this regard may be                 given.

C. Points Considered by the Committee

10. The Committee notes that the basic issue raised in the query relates to the treatment of expenditure incurred on process design and engineering cost in respect of various assets under the LSTK agreement. The Committee has, therefore, answered only this issue and has not touched upon any other issue arising from the Facts of the Case, such as, accounting treatment of payments made to contractor based on stages of completion.

11. As far as the expenditure relating to detailed engineering and design of the plant is concerned, the Committee notes paragraph 20 of AS 10 and paragraph 10 of AS 26, which state, respectively, as follows:

    AS 10

    “20. The 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.”

    AS 26

    “10. In some cases, an asset may incorporate both intangible and tangible elements that are, in practice, inseparable. In determining whether such an asset should be treated under AS 10, Accounting for Fixed Assets, or as an intangible asset under this Statement, judgement is required to assess as to which element is predominant. For example, computer software for a computer controlled machine tool that cannot operate without that specific software is an integral part of the related hardware and it is treated as a fixed asset. The same applies to the operating system of a computer. Where the software is not an integral part of the related hardware, computer software is treated as an intangible asset.”

12. From the above, the Committee is of the view that the expenditure on detailed engineering and process design consisting of layout of the equipments is an integral part of the related fixed asset and is also attributable to the cost of bringing the related asset to its working condition for its intended use. Hence, the expenditure on detailed engineering and process design should be allocated to various related fixed assets on the basis of benefit derived by these assets in this regard.

D. Opinion

13. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 9 above:

   (a) Yes, the accounting treatment of capitalising the expenditure incurred on process design and engineering cost as a          component of the total asset is correct.

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

   (c) The accounting treatment should be as stated at (a) above.

 

¹ Opinion finalised by the Committee on 27.3.2006