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Query No. 11
Subject:
Accounting for expenditure in proportion to sales
by a hydroelectric power generating enterprise
for
the purpose of interim financial statements –
whether appropriate.1
A. Facts of the Case
1. A public sector enterprise registered under the Companies
Act, 1956, is engaged in construction and operation of hydroelectric
power projects.
2. The querist has stated that generation of electricity in hydro
projects mainly depends on availability of machine and water.
Machine is always available throughout the year except for planned
outage and in rare circumstances, break down of machine.
Availability of water is seasonal because in summers and monsoon
season, availability of water is more due to melting of snow and
increase in flow of water due to rains as compared to other seasons.
As such, in the first two quarters of the financial year (April to
September), being the summer and rainy seasons, generation of
electricity is more as compared to the last two quarters of the
financial year (October to March).
3. The company is under the regulatory regime, and tariff (sale
price) for electricity is fixed by Central Electricity Regulatory
Commission (CERC). The regulator fixes tariff in the form of
annual fixed charges (AFC). AFC is normally fixed by CERC for a
period of 5 years and it is determined keeping in view the
capital cost of power station, loan repayment schedule, capital
structure, etc. The constituents of AFC are six components as
detailed below:
A. Interest on loans
Interest on outstanding loans towards capital cost duly taking
into account the schedule of repayments, as approved by the
authority, is allowed in AFC.
B. Depreciation
Depreciation is calculated for each year as per straight line
method at the rate of depreciation as prescribed by the CERC.
Value base for the purpose of depreciation shall be historical
cost of assets. Depreciation during the life of the project is
limited to 90% of the approved capital cost.
C. Advance against depreciation (AAD)
To meet out cash flow for repayment of loans, this additional
amount is provided limited to 1/10th of loan. AAD in a year
shall be restricted to the extent of difference between
cumulative repayment and cumulative depreciation up to that
year. In other words, to facilitate repayment of loan towards
capital cost, short fall of depreciation to the extent of 1/10th of
the loan amount or actual repayment whichever is lower, is
allowed by CERC in the form of AAD.
D. Return on equity
Return on equity is allowed @ 14% p.a. on admitted amount
of equity.
E. Operation and maintenance (O&M) expenses
1.5% of approved capital cost further escalated at 4% p.a. for
the subsequent years is allowed as O&M expenses.
F. Interest on working capital
Interest on working capital is allowed on the sum of the
following amounts:
- O&M expenses for 1 month.
- Maintenance spares @ 1% of the historical cost
escalated @ 6% per annum from the date of commercial
operation.
- Receivables equivalent to two months of fixed charges
for sale of electricity. Interest rate for above purpose is
to be taken equivalent to short-term prime lending rate
of SBI.
Tariff for a year is fixed in such a way that 90% of the capital cost
of the project is recovered through depreciation and AAD over the
project life which is around 35 years in addition to other components
as explained above.
4. The querist has further stated that the quantum of AFC as
fixed above is linked with design energy. The design energy means
the quantum of energy which would be generated in a year by a
particular power station. Design energy is fixed considering
availability of water in each calendar month of the year and installed
capacity of the power station and the same remains unaltered
throughout the life of the power station. As such, in 1st half of the
financial year, being the rainy and snow melting period, design
energy has been fixed more as compared to later half of the
financial year. Further, design energy is identified for each calendar
month of the year. In other words, design energy is a sort of
theoretical quantity in terms of million units which is fixed considering
all related parameters at the time when a project is sanctioned for
construction. Actual generation may be either higher or lower of
the design energy. In case actual generation exceeds design
energy, extra generation is compensated over and above AFC.
Like wise, if the generation is less than a certain percentage of
design energy due to reasons within the control of generating
company, recovery of AFC is reduced.
5. The AFC is recovered in two parts from the buyers:
(1) Energy charges
(2) Capacity charges
The energy charges are the product of actual generation limited to
design energy and “Energy Rate per KWH”. The Energy rate per
KWH is the lowest variable rate per KWH applicable in case of
thermal power station operating in the region. The difference of
AFC and annual energy charge is known as capacity charge which
is recovered monthly prorata in the ratio of units sold.
6. As per CERC rules, monthly billing is done on the basis of
generation data (known as ‘Regional Energy Account’) received
from Regional Power Committee. Keeping in view the principle explained in paragraph 4 above, in the first half of the year, more
recovery of AFC is made as compared to the second half of the
year. This implies that in the first half of the year, recovery towards
interest on loan, interest on working capital, depreciation, AAD
and O&M expenses is more compared to the recovery in the
second half of the year, whereas all cost components are recorded
in the accounts on actual basis following accrual system. Moreover,
in the second half of the year, recovery towards cost (built in AFC)
is less and cost actually incurred will be more. Therefore, results
of the first half would be showing major portion of annual profit
whereas the second half would be showing either low profit or may
result even in loss. As such, according to the querist, results of the
two halves of the same year would not be comparable and the
matching concept of revenue and expenditure would also not be
met. Similarly, the quarterly results of all the quarters are not
comparable.
7. The querist has informed that to address the problem of
comparability and to comply with the matching principle of
accounting, for the purpose of interim financial statements, the
company has been following the principle of recognising
depreciation, AAD, interest on loan and some components of O&M
expenses (self insurance contingency and cost of employee benefits
based on actuarial valuation) in proportion to actual sales for the
period to projected sales for the year (emphasis supplied by the querist). This treatment which is being followed consistently and is
supplemented by a suitable disclosure through notes to accounts
is as under:
“April to September is the peak period of generation because
of availability of water. Accordingly, depreciation, AAD, interest
on loan, self insurance and provision for long term employee
benefits and post employment benefits in terms of Accounting
Standard (AS) 15 (revised 2005), ‘ Employee Benefits’, which
form part of O&M expenses have been recognised in the
interim financial statements in proportion to actual sales for
the period to projected sales for the year.”
8. According to the querist, the above treatment is followed to
match the revenue of interim period with the cost for that period in order to present the true and fair view. In the half year accounts
for the period ended 30.09.2007, the following disclosure was
made through notes to accounts:
“Tariff is fixed by CERC in terms of prescribed norms, which
is known as annual fixed charges (AFC). AFC consists of
interest on loan, depreciation including advance against
depreciation (AAD), operation & maintenance (O&M) expenses,
interest on working capital and return on equity. April to
September is the peak period of generation because of
availability of water. Accordingly, depreciation, AAD, interest
on loan, self insurance and provision for long term employee
benefits and post employment benefits in terms of Accounting
Standard 15 (revised 2005), which form part of O&M expenses
have been recognised in interim financial statements in
proportion to actual sales for the period to projected sales for
the year resulting into lower profit after tax for the half year
ended 30.09.2007 by Rs.259.20 crore.”
9. In nutshell, as per the querist, the above treatment is being
followed owing to following:
(i) Being under regulatory regime, cost plus assured return
in terms of return on equity (ROE) is recovered through
tariff.
(ii) Profit should be more or less equal to assured return
less short recovery of any expenses. This fact would
not be reflected from the financial statements, if all costs
are booked as period costs and are not matched with
revenue.
10. However, the disclosure as mentioned in paragraph 8 above
was referred to by the statutory auditors in their report as below:
“Refer Para 14 of notes to accounts regarding certain expenses
including depreciation, AAD, interest on loan, self insurance
and long term employees benefit and post employment benefits
having been recognised in the financial statements for the
half period ended 30th September, 2007, in proportion to actual
sale for the half year to projected sale for the full year.
Consequently, profit for the half year is lower by Rs.259.20
crore.”
11. The contention of the auditors is that such costs are period
costs and should not be recognised in proportion of actual sales to
budgeted sales.
B. Query
12. The querist has sought the opinion of the Expert Advisory
Committee as to whether the accounting treatment followed by the
company is correct.
C. Points considered by the Committee
13. The Committee notes from the Facts of the Case that at one
place (paragraph 6), it is mentioned that all cost components are
recorded in the accounts on actual basis following accrual system,
whereas at another place (paragraph 7), it is mentioned that the
company has been following the principle of recognising
depreciation and other cost components in proportion to actual
sales for the period to projected sales for the year. Thus, there
seems to be a contradiction in the Facts of the Case. The
Committee’s opinion is based on the presumption that the company
in question is charging the annual fixed charges (AFC) fixed by
the CERC as expenses in the financial statements, which is in
proportion to actual sales for the period to projected sales for the
year. The Committee has not examined whether the amounts
recognised in respect of the AFC in the financial statements are
as per the Generally Accepted Accounting Principles, particularly
those prescribed in the Accounting Standards, as that issue has
not been raised. The Committee has, thus, examined only the
question raised, viz., spreading the AFC over the interim financial
statements due to seasonality of operations.
14. The Committee further notes from the Facts of the Case that
AFC is fixed by CERC for a period of 5 years. Thus, the Committee
presumes that rate of recovery of AFC as a part of tariff does not
change over a period of 5 years. The Committee also notes that
apart from annual fixed charges which are considered by CERC in
the fixation of tariff charges, certain variable charges are also factored in the tariff fixation which have not been stated by the
querist in the Facts of the Case. However, this fact does not affect
the opinion on the issue raised.
15. The Committee notes from the Facts of the Case that the
revenues generated by the company are seasonal due to more
availability of water in the first two quarters of the year. In this
context, the Committee notes paragraphs 16, 18, 19, 27, 36 and
37 of Accounting Standard (AS) 25, ‘Interim Financial Reporting’,
which provide as follows:
“16. An enterprise should include the following
information, as a minimum, in the notes to its interim
financial statements, if material and if not disclosed
elsewhere in the interim financial report:
(a) …
(b) explanatory comments about the seasonality of
interim operations;
…
The above information should normally be reported on a
financial year-to-date basis. However, the enterprise
should also disclose any events or transactions that are
material to an understanding of the current interim period.”
“18. Interim reports should include interim financial
statements (condensed or complete) for periods as
follows:
(a) balance sheet as of the end of the current interim
period and a comparative balance sheet as of the
end of the immediately preceding financial year;
(b) statements of profit and loss for the current interim
period and cumulatively for the current financial year
to date, with comparative statements of profit and
loss for the comparable interim periods (current and
year-to-date) of the immediately preceding financial
year;
(c) cash flow statement cumulatively for the current
financial year to date, with a comparative statement
for the comparable year-to-date period of the
immediately preceding financial year.
19. For an enterprise whose business is highly seasonal, financial
information for the twelve months ending on the interim reporting
date and comparative information for the prior twelve-month period
may be useful. Accordingly, enterprises whose business is highly
seasonal are encouraged to consider reporting such information in
addition to the information called for in the preceding paragraph.”
“27. An enterprise should apply the same accounting
policies in its interim financial statements as are applied
in its annual financial statements, except for accounting
policy changes made after the date of the most recent
annual financial statements that are to be reflected in the
next annual financial statements. However, the frequency
of an enterprise’s reporting (annual, half-yearly, or
quarterly) should not affect the measurement of its annual
results. To achieve that objective, measurements for
interim reporting purposes should be made on a year-todate
basis.”
“36. Revenues that are received seasonally or
occasionally within a financial year should not be
anticipated or deferred as of an interim date if anticipation
or deferral would not be appropriate at the end of the
enterprise’s financial year.
37. Examples include dividend revenue, royalties, and
government grants. Additionally, some enterprises consistently
earn more revenues in certain interim periods of a financial
year than in other interim periods, for example, seasonal
revenues of retailers. Such revenues are recognised when
they occur.”
16. On the basis of paragraphs 36 and 37 of AS 25 reproduced
above, the Committee is of the view that the company cannot
defer recognition of revenue in the interim financial statements if
these are seasonal in nature; these have to be recognised as these occur during the interim periods. Similarly, keeping in view
the requirements of paragraph 27 of AS 25, the company has to
follow the same accounting policies in its interim financial statements
as are applied in its annual financial statements in respect of
expenses also. Recognising the seasonal nature of various
industries, AS 25 suggests certain disclosures to be made, e.g.,
under paragraph 16(b) and paragraph 19 of AS 25 (see also
Appendix 2 of AS 25). Thus, AS 25 does not allow different basis
of recognition and measurement of revenues and expenses for
seasonal industries; only additional disclosures are required or
permitted.
D. Opinion
17. On the basis of the above, the Committee is of the opinion
that the accounting treatment followed by the company is not
correct.
1 Opinion finalised by the Committee on 30.4.2008
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