Query No. 1

Subject:

Accounting treatment of advance paid for construction of water

reservoir to be owned by the State Government. ¹

A. Facts of the Case

1. A 50:50 joint venture company (the ‘company’) was set up to takeover and run the captive power plants of one of the venturers located at Durgapur, Rourkela and Bhilai. The entire electricity generated by these three plants is sold to and consumed by that venturer. The company is presently expanding the capacity in Bhilai by setting up a 2x250 MW capacity power plant to meet the increased captive requirement of the venturer and sell surplus power to other customers. As the surplus power generated is likely to be sold to other beneficiaries, the tariff for such sale will be determined by the Central Electricity Regulatory Commission (CERC). While fixing the tariff, CERC allows 14% return on equity and also allows the cost of borrowing in addition to other operating and maintenance charges on a normative basis.

2. The company requested the Water Resources Department (WRD) of the State Government for allocation of the industrial water to meet the needs of this project and an ‘in principle’ approval was received for the same in August 2003 for allocation of industrial water from an existing canal. Subsequently, in September 2005, the State Government indicated that due to paucity of water in the canal, it would not be possible to supply water from the existing sources but suggested an alternative for assured water supply for Bhilai Expansion Project. As per the initial suggestion, one new reservoir was required to be constructed at a cost of Rs.150 crore which was required to be borne by the company in lieu of which the authority would have charged the company 1/4th of the normal rates for the water supplies in future.

3. Subsequently, the estimated cost of the reservoir has gone up from Rs. 150 crore to Rs. 205 crore on account of escalation in rates, and the State Government also revoked the policy of supplying water at a concessional rate as stated in paragraph 2 above.

4. The total capacity of the new reservoir is estimated to be 1.53 TMC and considering the requirement of 0.82 TMC water from the reservoir for the project, the State Government asked the company to proportionately contribute Rs. 110 crore out of the estimated cost of Rs. 205 crore for the share of water. Further, it has been indicated that in case of any increase/decrease in the completed cost of new reservoir, the proportionate share of the company shall also correspondingly increase/decrease.

5. Further, as per the State Government’s present policy, the said sum of Rs. 110 crore contributed by the company shall not bear any interest and shall be fully adjustable against water charges payable on annual basis as per the applicable rates for water in future. It is expected that considering the prevailing rate for industrial water, Rs. 110 crore deposited by the company shall be adjusted fully against annual water charges in a 12-13 year period and thereafter, water charges shall be payable to the State Government as per the then applicable rates.

6. While the ownership of the reservoir would vest with the State Government, water has been committed to be made available to this project of the company for the next thirty years as per an agreement with the WRD of the State Government. Also, till the construction of reservoir, water would be made available to the company from alternative sources.

7. Considering all the circumstances and the fact that the project cannot function without industrial water and such water is to be made available only by the State Government, the company’s Board in a meeting held in November 2007 had agreed to pay the sum demanded by the WRD. Only after acceptance of the company’s letter for sharing of cost of construction of Mohad reservoir, State Water Utilisation Committee sanctioned allotment of water from proposed Mohad reservoir for Bhilai expansion project in December 2007 on the following relevant conditions:

• Payment of amount of Rs. 110 crore in one instalment on demand from WRD.
• Any increase/decrease in completed cost of construction of reservoir to be borne by the company.
• Adjustment of the payment made by company against the water charges payable by the company at the then applicable rate.
• Construction of the reservoir to be carried out by WRD and ownership will also vest with them.
• Till the construction of Mohad reservoir, alternative arrangement for supply of water from Mahanadi project to be made available to the company.

8. On receipt of demand letter for Rs. 110 crore towards shared cost of construction of Mohad reservoir from the State Government, the company made the required payment in full in February 2008. The payment has been made out of the funds raised from lenders/promoters for financing the expansion project. The salient points of the agreement are as follows:

• Sanction letter for water allotment to form part of this agreement.
• The company shall pay for the water charges as per the applicable rates.
• Permission to the company to draw the allotted water from the Government source for 30 years.
• Further deposit of Rs. 1.5291 crore as water charges amount for three months period.

(The querist has furnished copies of the sanction letter, demand letter and draft agreement for the perusal of the Committee.)

9. Considering the commercial interest of the company and present regulatory norms applicable to power generating companies, the company capitalised the advance of Rs. 110 crore as a part of the project cost and intends to amortise it over a fixed period. Further, till such time the water charges are adjusted against Rs. 110 crore, the benefit of non-payment of water charges would be passed on to the customers. In such a case, Rs. 110 crore being a part of the project cost stands funded from term loan and equity already tied up for the project.

10. An alternative view which has been expressed regarding the accounting treatment of the amount of Rs. 110 crore paid to the State Government for the construction of the reservoir is to show it as a non-interest bearing advance recoverable in cash or kind (i.e., ‘loans and advances’, as a part of working capital) and adjust the water charges payable every year out of the advance. However, in such a case, availability of funds towards working capital advance of Rs. 110 crore for such purpose without any asset security and repayable over 12-13 year period may not be possible.

B. Query

11. The querist has sought the opinion of the Expert Advisory Committee as to whether the accounting treatment for the payment made to the State Government for construction of reservoir as capital expenditure is in order or not.

C. Points considered by the Committee

12. The Committee notes that the basic issue raised by the querist relates to appropriateness of treatment, in the company’s financial statements, of the non-interest bearing advance made to the State Government for construction of reservoir. Accordingly, the Committee has not touched upon any other issue that may be contained in the Facts of the Case, such as, impact of accounting treatment on tariff-fixation, etc.

13. The Committee notes that paragraphs 49 and 88 of the ‘Framework for the Preparation and Presentation of Financial Statements’, issued by the Institute of Chartered Accountants of India, give respectively, the following definition of and recognition criteria for an asset:

    “An asset is a resource controlled by the enterprise as a result of past events from which future economic benefits are expected to flow to the enterprise.”

    “88. An asset is recognised in the balance sheet when it is probable that the future economic benefits associated with it will flow to the enterprise and the asset has a cost or value that can be measured reliably.”

From the above, the Committee notes that it is the ‘resource controlled by the enterprise’ which can be recognised as an asset in the balance sheet. Therefore, the issue raised by the querist requires examination from the point of view of the nature of the resource that the company controls as a result of payment of Rs. 110 crore. For this purpose, the Committee has examined whether the payment of Rs. 110 crore results into recognition of a tangible asset, an intangible asset, a lease, or an advance to be adjusted in future against supply of water.

14. The Committee is of the view that if payment of Rs. 110 crore can be considered to result into a tangible asset, i.e., reservoir, then, the company should be able to control the reservoir. The Committee is of the view that an entity that controls an asset can generally deal with that asset as it pleases. For example, the entity having control of an asset can exchange it for other assets, employ it to produce goods or services, charge a price for others to use it, use it to settle liabilities, hold it, or distribute it to owners. Further, the Committee is of the view that an indicator of control of an item of (tangible) fixed asset would be that the entity is ordinarily responsible for the repair, maintenance, upgrade and replacement of that item. In other words, the entity should have the ability to decide how the fixed asset is operated and maintained and when it is replaced.

15. The Committee notes from the Facts of Case that the reservoir is the property of the State Government/WRD. The company is entitled to its allotted quantum of water supply only at the normal rates prevailing from time to time. It has no say on the distribution of water supply to others. While the company’s entitlement to water supply is more than insignificant (0.82TMC out of 1.53TMC), other parties together also take more than insignificant quantity of water (0.71 TMC out of 1.53TMC). Further, there is no indication that the company is responsible for repairs, maintenance, upgrade and reconstruction of the reservoir. Thus, none of the factors mentioned in paragraph 14 above indicating control of the reservoir by the company is evident. In other words, it appears that the company does not have continuing managerial involvement for the reservoir so as to exploit the reservoir in any way it wants. Thus, reservoir is not the resource controlled by the company, and therefore, the amount of Rs. 110 crore cannot be capitalised as ‘reservoir’.

16. The Committee now examines whether the payment of Rs. 110 crore results into an intangible asset for the company. The Committee notes that by giving an interest-free advance of Rs. 110 crore, the company has obtained a right to receive water supply for 30 years at normal rates prevailing from time to time, the payment for which is to be made by way of adjustment against the said advance. The whole of the amount of Rs. 110 crore paid by the company to the State Government would be utilised/adjusted towards the charges payable for supply of water in future at normal rates applicable at that time. Thus, the payment made can not be attributed to obtaining the right to get supply of water for 30 years. Hence, the Committee is of the view that capitalisation of Rs. 110 crore as an intangible asset is not possible.

17. The Committee also notes that as per the draft agreement with the WRD, except in the event of water shortage, the company has to pay water charges for at least 90% of total quantum of water allowed to be drawn by it, even if actual quantity of water drawn is less than 90% of total quantum of water allowed to be drawn. This requires examination whether this arrangement contains a lease and if so whether it is a finance lease or operating lease. The Committee is of the view that meeting any of the following conditions indicates that the arrangement contains a lease:

    (a) The company has the ability or right to operate the reservoir or direct others, such as, WRD to operate the reservoir in a manner it determines while obtaining or controlling more than an insignificant amount of the output or other utility of the reservoir, i.e., water.

    (b) The company has the ability or right to control physical access to the reservoir while obtaining or controlling more than an insignificant amount of the output or other utility of the reservoir, i.e., water.

    (c) Facts and circumstances indicate that it is remote that one or more parties other than the company will take more than an insignificant amount of the output or other utility, i.e., water from the reservoir during the term of the arrangement, and the price that the company will pay for the output, i.e., water is neither contractually fixed per unit of output (i.e., water) nor equal to the current market price per unit of output (i.e., water) as at the time of delivery of the output (i.e., water).

The Committee is of the view that none of the above conditions is met in the case under consideration. Hence, the Committee is of the view that the said arrangement does not contain a lease and, consequently, the question of treatment of the reservoir as an asset held under a finance lease (or even as an operating lease) does not arise at all.

18. The Committee further notes that, in effect, the company has paid an advance of Rs. 110 crore for future purchase of water at the rates prevailing from time to time. It is irrelevant that the advance is used by the State Government for part-financing the construction of the reservoir. Charges for the supply of water at the normal and prevailing rates are adjusted against the advance. This, in substance, means that the State Government/WRD has borrowed interest-free advance for supply of water and that the advance is used for the construction of the reservoir. All these factors indicate that the amount paid by the company to the State Government towards construction of reservoir is nothing but advance. Further, the Committee notes that as per Schedule VI ² to the Companies Act, 1956, ‘Loans and Advances’ include ‘Advances recoverable in cash or kind or for value to be received’. Hence, the Committee is of the view that the aforesaid amount should be disclosed as an ‘advance’ for future purchase of water. Depending on the use, water purchased is put to, the cost thereof would be capitalised or expensed, i.e., if the water purchased is used for construction purposes, the cost thereof would be capitalised to that extent. However, the cost of water purchased after the construction of the project is over, would be expensed.

D. Opinion
19. On the basis of the above, the Committee is of the opinion that the accounting treatment for the payment (of Rs. 110 crore) made to the State Government for construction of reservoir as capital expenditure is not in order. Refer paragraph 18 above for appropriate accounting treatment.

¹Opinion finalised by the Committee on 5.3.2009