Query No. 35.

Subject:

Capitalisation of expenditures in respect of projects under construction.¹

A. Facts of the Case

1. A public sector company registered under the Companies Act, 1956, is engaged in construction and operation of hydro-electric power projects. The revenue of the company comes mainly from sale of electricity generated by power station. Apart from power stations, which generate electricity and thereby revenue, the company has a number of hydro projects under construction stage. The company has a head office and a number of regional offices for administration of these projects/power stations. According to the querist, all the power stations/projects under construction/regional offices are independent accounting units. Similarly, head office is also an independent accounting unit. As per the querist, the activities of head office/regional office may be segregated into specific and general. The querist has stated that ‘specific’ implies the activities carried out at the head office which exclusively/mainly pertain to construction projects or power stations. Such activities are carried out by dedicated divisions, while under the ‘general’ activities, the head office carries out various functions, such as, finance, human resource (HR) and company secretariat, etc., which can not be exclusively associated with any project.

2. The querist has stated that all expenditures incurred at power stations which are in the nature of operation and maintenance, employee cost and interest cost, etc., are charged to the profit and loss account. Upto the financial year 2007-08, in respect of projects under construction, incidental expenditure net of miscellaneous income used to be carried as ‘Incidental Expenditure during Construction’ and capitalised on commissioning of the project as per the following accounting policy:

       “Projects under commissioning and other capital work-in-progress are carried at cost. In respect of projects under construction, incidental and attributable expenses (net of incidental income) including interest and depreciation on fixed assets in use during construction are carried as part of Incidental Expenditure during Construction to be allocated on major immovable project assets other than land and infrastructural facilities, on commissioning of the project.”

3. The querist has further stated that till the financial year 2007-08, all the expenditure incurred at head office after netting off any miscellaneous income was used to be debited to power stations and projects under construction on a systematic basis as per the following accounting policy:

       “Corporate office expenses are allocated as under:
            (a) On power station @ 1% of sale of energy for the year excluding taxes and duties.

          (b) In case of construction contract works awarded to and executed by the corporation @ 5% of the project expenditure incurred during the year except in case of contracts of rural electrification & Pradhan Mantri Gram Sadak Yojna (PMGSY), where allocation of expenditure in respect of dedicated division is made on the basis of services rendered.

            (c) The balance expenditure is allocated to construction projects in the ratio of net capital expenditure incurred during the year.”

Similarly, a systematic allocation of regional office expenses among construction projects and power stations was being followed. As such, expenditure of regional office and head office allocable to power station was getting charged to the profit and loss account of the power station. Such expenditure allocated to projects under construction got capitalised as incidental expenditure during construction and became part of ‘Capital Work-in-Progress’ in construction phase and thereafter as ‘Fixed Asset’ of that project.

4. According to the querist, the accounting policies as given in paragraphs 2 and 3 above were in line with the Guidance Note on Treatment of Expenditure during Construction Period², issued by the Institute of Chartered Accountants of India, which was withdrawn in the financial year 2008-09. Subsequent to its withdrawal, a need was felt by the company to review the aforesaid accounting policies. The issue was discussed with the company’s statutory auditors and it was agreed that for capitalisation of expenditure incurred during construction (whether at project or at regional office or at head office), provisions of Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, shall be followed. The relevant provisions of AS 10, notified under the Companies (Accounting Standards) Rules, 2006 have been reproduced by the querist as below:

       “9.2 Administration and other general overhead expenses are usually excluded from the cost of fixed assets because they do not relate to a specific fixed asset. However, in some circumstances, such expenses as are specifically attributable to construction of a project or to the acquisition of a fixed asset or bringing it to its working condition, may be included as part of the cost of the construction project or as a part of the cost of the fixed asset.” (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 9.5³ . 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.” (Emphasis supplied by the querist.)

5. The querist has stated that keeping in view the above, the accounting policies referred to in paragraphs 2 and 3 above have been replaced with a new accounting policy which is reproduced as below:

       “Projects under commissioning and other capital work-in-progress are carried at cost. Administration and general overhead expenses attributable to construction of fixed assets are identified and allocated on systematic basis on major immovable assets other than land and infrastructural facilities.”

In line with the above accounting policy, the following accounting treatment was finalised:

       At Construction Projects

       (a) Direct administration and other general overhead in construction projects:

       To be carried as expenditure during construction and to be capitalised at the time of commissioning of the project.

       (b) Expenses not directly related to construction of projects like training and advertisement expenses:

       To be charged to the profit and loss account of the construction project and shown as loss, to be absorbed in the profit and loss account of the company as a whole.

       At Head Office/Regional Office

       For treatment of administration and other general overhead of head office and regional office and allocation thereof among projects:

       (1) Divisions/departments of head office were identified based on the functions.

       (2) Broadly, the divisions/departments have been divided into following categories:

              (a) Group of divisions/departments, whose services can be directly identified:
                     (i) Divisions/departments rendering services mainly to construction projects;
                     (ii) Divisions/departments rendering services mainly to power stations;
                     (iii) Divisions/departments rendering services mainly to project management/consultancy works.

              (b) Support divisions, like finance, human resource and information technology & communication, etc. which render services to all the divisions /projects/units but services cannot be identified directly with any division/project/unit.

              (c) Other divisions, like corporate communication, vigilance, company secretariat, training & human development and research & development, whose functions are more of image building of the company.

       (3) Expenses of divisions/departments falling under (2)(b) above are allocated to divisions under (2)(a) and (2)(c) above in the ratio of employee cost of each group of divisions to firm-up the expenditure of (2)(a) and (2)(c) above. Expenditure of category (2)(a)(i) is allocated to construction project to be carried as “Expenditure during Construction’ and to be capitalised at the time of commissioning of the project. All other expenditures, i.e., (2)(a)(ii), (2)(a)(iii) and (2)(c) are charged to the profit and loss account.

6. As per the querist, accounts for the year 2008-09 were finalised using the aforesaid accounting policy and there was absolutely no issue from the statutory auditor of the company. Government auditor however raised an observation on the accounting treatment given by company in respect of administration and general overheads during the audit of accounts for the year 2008-09. The contention of the auditor was that the capitalisation of administration and general overheads of head office is not in accordance with AS 10 since the expenditure does not relate to any specific fixed asset and is general in nature. According to the querist, the auditor had not given any further justification for his observation. The management informed the auditor that capitalisation of administration and other general overheads expenditure which are directly attributable to construction of a project is in accordance with the principles enunciated in AS 10 as reproduced in paragraph 4 above.

7. Finding no consensus, the observation was however dropped on the assurance of the management that the issue arising out of withdrawal of the Guidance Note on Treatment of Expenditure during Construction Period vis-a-vis paragraph 9.2 of AS 10 and the accounting policy of the company as referred to in paragraph 5 above shall be referred to the Expert Advisory Committee of the Institute of Chartered Accountants of India for its expert opinion.

8. The querist has mentioned that the company is still of the opinion that its accounting policy referred to in paragraph 5 above is based on the principles of AS 10.

B. Query

9. Keeping in view the above, the querist has sought the opinion of the Expert Advisory Committee on the following issues:

       (a) Whether the accounting policy referred to in paragraph 5 above and consequential accounting treatment given by the company is in line with the provisions of AS 10.

      (b) If not, what should be the accounting treatment for such administration and general overheads of head office/regional office which can be directly associated with the construction of a project based on the services rendered by head office/regional office?

C. Points considered by the Committee

10. The Committee notes that the basic issue raised in the query relates to the accounting treatment of expenditure (including administration and other general overhead expenditure) incurred at various departments/divisions of head office and regional offices performing centralised functions for the construction of power projects. The Committee has, therefore, considered only this issue and has not examined any other issue that may arise from the Facts of the Case, such as, specific basis of allocation of the common expenditures incurred at these departments over various projects/assets, propriety of accounting treatment followed by the company before financial year 2008-09, etc. Further, as the querist has referred to only AS 10 in the context of construction of power projects, the Committee presumes that the underlying assets in all cases are ‘fixed assets’ covered under the provisions of AS 10. As the exact nature of the activities being performed by various departments is not clear from the Facts of the Case, the Committee’s opinion contained hereinafter is based on the general principles to be followed while accounting for expenditure incurred at departments engaged in providing services to the construction of power projects. The exact expenditures that are to be capitalised will have to be determined on the basis of the said principles.

11. The Committee notes that the accounting principles for determination of the cost of a self-constructed fixed asset, have been laid down, inter alia, in paragraph 10.1 of AS 10 which provides as follows:

       “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.”

The Committee further notes paragraphs 9.1 and 9.2 of AS 10 reproduced below:

       “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.

       …”

       “9.2 Administration and other general overhead expenses are usually excluded from the cost of fixed assets because they do not relate to a specific fixed asset. However, in some circumstances, such expenses as are specifically attributable to construction of a project or to the acquisition of a fixed asset or bringing it to its working condition, may be included as part of the cost of the construction project or as a part of the cost of the fixed asset.”

From a wholesome reading of the above paragraphs of AS 10, the Committee is of the view that the basic principle to be applied while capitalising an item of cost (including administration and other general overhead expenditure) to a fixed asset/project under construction/expansion is that it should be directly attributable to the construction of the project/fixed asset for bringing it to its working condition for its intended use. The costs that are directly attributable to the construction/acquisition of a fixed asset/project for bringing it to its working condition are those costs that would have been avoided if the construction/acquisition had not been made. These are the expenditures without the incurrence of which, the construction of project/asset could not have taken place and the project/asset could not be brought to its working condition, such as, site preparation costs, installation costs, salaries of engineers engaged in construction activities, etc. The above-discussed principle of avoidance of costs as the basis of identifying directly attributable cost for the purpose of capitalisation is also supported by Accounting Standard (AS) 16, ‘Borrowing Costs’. In the extant case, the Committee is of the view that it should be seen that whether the expenses incurred on the activities of various departments/divisions (including administration and other general overhead expenditure) are directly attributable to the construction as discussed above. Accordingly, if the expenses incurred at the various departments/divisions (including administration and other general overhead expenditure) are directly attributable to construction, these can be capitalised with the cost of the concerned fixed asset(s)/ project(s). 12. As regards basis of allocation of the expenses of these departments that can be allocated and capitalised to various projects or assets under construction, the Committee is of the view that the same should be allocated selecting an appropriate basis that reflects the extent of usage of service rendered by the department to the construction of the project.

D. Opinion

13. On the basis of the above and subject to the considerations contained in paragraph 10 above, the Committee is of the following opinion on the issues raised in paragraph 9 above:

       (a) The accounting policy and consequential accounting treatment would be in line with the provisions of AS 10 provided the expenses incurred on the activities of various departments/divisions (including administration and other general overhead expenditure) can be considered to be directly attributable to the construction of project(s)/ fixed asset(s) for bringing it(them) to its(their) working condition as discussed in paragraph 11 above and the expenses that have been allocated and capitalised to various projects or assets under construction, have been allocated selecting an appropriate basis that reflects the extent of usage of service rendered by the department to the construction of the project. .

       (b) The accounting treatment for administration and general overhead expenditure incurred at head office and regional offices should also be determined on the basis of the principles explained in paragraph 11 above.

¹Opinion finalised by the Committee on 22.1.2010

²The Guidance Note on Treatment of Expenditure during Construction Period has been withdrawn by the Council of the Institute of Chartered Accountants of India vide its decision at its 280th meeting held on August 7-9, 2008.

³ To be read as 9.4.