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Query No. 36.
Subject:
Capitalisation of expenditures in respect of projects under construction. 1
A. Facts of the Case
1. A Government of India enterprise incorporated under the Companies Act, 1956, is engaged in the business of transmission of power from the generating units to different State Electricity Boards (SEBs) through its transmission network. With the growing investment in power sector, it also undertakes construction of new transmission systems linked with the generating units as well as systems strengthening schemes of the existing networks.
2. The querist has stated that keeping in view the large incremental capacity addition requirements of the current five year plan and to fulfill the macro objective of power sector, i.e., power to all by 2012, the company is oriented towards implementation of generation evacuation schemes, strengthening of regional grids, development of an integrated national grid with flexibility for power transfer from one region to another and to have in place the requisite load despatch facilities for ‘real time grid operation’. Thus, the major stress of the company is on construction activities.
3. The querist has further stated that the business model of the company is different from other organisations. In other organisations, construction activities are carried out in concentrated manner at one particular place and accordingly, all the ancillary activities, such as, engineering and contract related activities can also be carried out at that particular place. In the case of the company, the transmission lines and related subs-stations are to be constructed all over the country. The construction activities are scattered over a vast area. As such, it is not possible that ancillary activities, such as, engineering, pre and post award contractual activities, fund raising and payment to contractors are also decentralised along with the construction activities. Support for these activities is given by corporate office as well as respective Regional Headquarters (RHQs). Further, as per the querist, in case of other organisations, the number of construction projects being carried out are limited, say, maximum 5 to 10, whereas, in the case of the company, the number of ongoing construction projects in a year are 50 to 60. Therefore, to achieve the economies of scale, the common activities of the construction projects are carried out in a centralised manner at Corporate Centre (CC) and RHQs.
4. According to the querist, since CC and RHQs are contributing substantially to construction activities, the expenditure of CC and RHQs is to be allocated to construction activities on some rational basis. For allocating the CC and RHQ expenditure, following methodology is being followed:
The entire expenditure of CC and RHQs is classified into different departments. After the classification, expenditure is further classified into departments exclusively looking after construction, operational activities and common activities. Expenditure relating to departments carrying out construction activities is taken as Incidental Expenditure During Construction (IEDC) whereas expenditure relating to departments carrying out O&M activities is charged to the profit and loss account directly. Expenditure relating to common departments is allocated to IEDC and profit and loss account in the ratio of capital outlay and transmission charges.
5. As per the querist, the rationale behind the allocation of common expenditure based on capital outlay and transmission charges is that the capital outlay represents the financial implication of construction activities carried out during the year and transmission charges represent the operational activities carried out during the year. If in any year, capital outlay is more, meaning thereby, more construction activities, higher amount shall be transferred to IEDC. If the construction activities are reduced, the capital outlay and consequently, amount to be transferred to IEDC will also get reduced.
6. The accounting policy representing the above methodology is disclosed in the schedule of accounting policies and is reproduced below:
(a) The common expenses (net) of corporate office and regional offices are allocated to various diversified activities of the company, viz., transmission, telecom, consultancy and accelerated power development and reform program (APDRP) in the ratio of the respective income/reimbursement of each activity.
(b) The common expenses thus allocated are further allocated to incidental expenditure during construction (IEDC) and revenue in transmission and telecom activities in the ratio of capital outlay thereof and revenue, i.e., transmission charges (excluding income tax recovery) and telecom income.
7. The querist has stated that the above-mentioned methodology and accounting policy are based on paragraphs 9.2 and 10.1 of Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, notified under the Companies (Accounting Standards) Rules, 2006, in respect of self-constructed fixed assets (which are applicable to the business activity being undertaken by the company), as reproduced 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.”
“10.1 … 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. …”
According to the querist, as the company is engaged in self-construction of transmission lines and substations, the expenditure of corporate centre and RHQs is being allocated to specific assets constructed during the year.
8. During the course of supplementary audit of accounts, the government auditor raised a half-margin in respect of the above accounting policy, which is reproduced below:
“As per paragraph 9.32 of the Accounting Standard (AS) 10, issued by the Institute of Chartered Accountants of India (ICAI), administration and other general overhead expenses which do not relate to a specific fixed asset should be excluded from the cost of fixed assets. However, as per accounting policy No.7 of the company, the common expenses (net) of corporate office and regional offices are allocated to various diversified activities of the company viz. transmission, telecom, consultancy & accelerated power development and reform program (APDRP) in the ratio of the respective income/reimbursement of each activity. The common expenses are further allocated to Incidental Expenditure during Construction (IEDC) and revenue in transmission and telecom activities in the ratio of capital outlay thereof to transmission charges (excluding income tax recovery) and telecom income.
Accordingly, the company has allocated an amount of Rs. 384.02 crore being expenditure related to corporate office (206.33 crore) and regional offices (Rs. 177.69 crore). Out of total expenditure of Rs. 384.02 crore, an amount of Rs. 214 crore has been treated as IEDC and balance Rs. 170.02 crore has been charged to revenue. Thus, accounting policy of the company is not in accordance with AS 10 issued by ICAI as these expenditures of corporate office and regional offices do not relate to any specific fixed asset and are general in nature. As such, entire amount of Rs. 384.02 crore including Rs. 214 crore should also have been charged to revenue instead of booking under the head IEDC.
This has resulted in understatement of expenses, overstatement of ‘Capital Work in Progress-IEDC’ and profit for the year by Rs. 214 crore.”
The querist has also reproduced below the sub-directions issued by the government auditor to the statutory auditor of the company:
“After withdrawal of the Guidance Note on Treatment of Expenditure during Construction Period3 , whether allocation of administrative and general overhead expenses pertaining to some divisions, such as, Contract Services, Monitoring, Engineering, etc., to project under construction is in line with the provisions of Accounting Standard 1 (it appears that the reference is to AS 10), since these expenses do not relate to a specific project.”
9. As per the querist, the company defended the accounting policy based on the following:
(a) Auditor was requested to refer 2nd part of paragraph 9.2 of the notified AS 10, which reads as follows:
“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.”
According to the querist, this clearly implies that administration and other general overhead expenses can be included in the capital cost under certain circumstances.
(b) The accounting policy is based on paragraph 10.1 of AS 10 as explained in paragraph 7 above.
(c) That out of total incidental expenditure during construction (IEDC) of Rs. 214 crore of CC and RHQs, Rs. 96 crore pertains to departments which are exclusively looking after construction activities. Balance Rs. 118 crore has been allocated out of expenditure of common departments, such as, HR, finance, vigilance, law, etc.
(d) Construction activities are predominant in the working of Corporate Centre and RHQs. This is reflected by the following :
The total number of employees engaged in CC in O&M Departments of various segments, i.e., Director (Operations) office, operation services, system operation, private investment, DMS, telecom, etc., is 176 out of total manpower of 943 employees. To support the above O&M staff of 176, manpower of common departments, such as, finance, HR, IT, materials, company secretary, vigilance, etc. shall not be more than 90, i.e., 50% of 176. Thus, if construction activities are taken out of CC working, manpower will get reduced to maximum 264 which is 28% of total manpower of CC. Thus, 72% expenditure of CC can be considered as specifically attributable to construction activities. Similarly, as per the querist, 63% expenditure of RHQs can be considered as specifically attributable to construction activities. The above, according to the querist, clearly establishes that CC and RHQs are substantially contributing to construction activities.
(e) There is no change in AS 10 which requires any change in the accounting policy of the company. If AS 10 is to be followed in the manner proposed by the auditor, i.e., ‘general administration and overhead expenditure which relate to specific asset only should be included in the cost of fixed assets’, then, for each project, additional manpower will have to be deployed which will carry out the support services being offered by CC and RHQs. This will increase the manpower and overhead cost and thereby increase the capital cost of the projects.
(f) A committee of senior executives of the company representing different departments was constituted to review the present accounting policy of allocation of CC and RHQ expenditure. The committee has analysed the working of different departments in detail. It has given the conclusion that:
(i) Common departments of corporate centre and RHQs are contributing to construction activities to the extent of 60 to 70%.
(ii) It will be more rational if O&M budget/expenditure and construction budget/expenditure are considered for the purpose of allocation of such expenditure (of common departments) between revenue and capital.
(g) The querist has stated that some other companies in the power sector have followed the same methodology from the current financial year which is being followed consistently by the company since the last 4-5 years. The only difference is in respect of allocation of expenditure of common departments.
(h) According to the querist, if expenditure of common departments is allocated based on the recommendation of the committee as mentioned at (f) above or based on the methodology being followed by some of the PSUs, more amount will be transferred to IEDC resulting in increase in profit. However, to maintain consistency and conservatism, it is considered prudent to follow present accounting policy in practice.
10. The querist has stated that during the discussion with the government auditor, it was agreed to refer the matter to the Expert Advisory Committee (EAC) of the Institute of Chartered Accountants of India (ICAI) and accordingly, the half-margin was dropped.
B. Query
11 (i) The querist has stated that in the Announcement regarding Withdrawal of Guidance Note on Treatment of Expenditure during Construction Period, issued by the Institute, it was stated that the Guidance Note is not relevant in the present day context. It was not explained how the Guidance Note is not relevant in the present day context. If it has been considered that the Guidance Note is not relevant considering the provisions of AS 10 or Accounting Standard (AS) 26, ‘Intangible Assets’, the querist has stated that these standards were applicable long before and not issued in the year of withdrawal of the Guidance Note. Considering the construction activities being carried out by the companies, such as, the company in the present case, some dispensation is to be considered by the ICAI before the withdrawal of the Guidance Note. The Committee has been requested to give its view as to whether withdrawal of the above Guidance Note requires the companies to review its accounting policies regarding allocation of common expenditure.
(ii) Considering the nature of business of the company of substantially carrying out the construction activities, CC and RHQs contributing to construction activities to the extent of 60-70% and considering the increase in project cost in case common activities being carried out by CC & RHQ are carried by separate staff for each specific project, the querist has requested the Committee to review the above accounting policy based on the facts and circumstances of the company and give its considered opinion on the following issues:
(a) Whether no amount of expenditure incurred on common departments be allocated to project cost irrespective of the fact that these departments are substantially contributing to construction activities.
(b) Whether the accounting policy and methodology being followed for allocation of expenditure of corporate centre and regional head quarters of the company is in accordance with the generally accepted accounting principles and AS 10.
(c) If not, the methodology to be followed for allocating expenditure of CC and RHQ to IEDC, since some expenditure of CC and RHQ is essentially to be allocated to IEDC considering the construction activities being carried out.
C. Points considered by the Committee
12. The Committee notes that the basic issue raised in the query relates to the accounting treatment of expenditure incurred at various departments of corporate centre and regional head quarters performing centralised functions for the construction of power transmission lines and related sub-stations (hereinafter referred to as 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, accounting policy of the company in respect of activities other than construction of power projects, specific basis of allocation of the common expenditures incurred at various departments of corporate centre and regional head quarters, 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. The Committee has not examined the appropriateness of classification of various departments as relating to construction activity/O&M activities/common services. 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.
13. 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 to a fixed asset/project under construction 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 are directly attributable to the construction as discussed above. Accordingly, if the expenses incurred at various departments are directly attributable to construction, these can be capitalised with the cost of the concerned fixed asset(s)/ project(s).
14. 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.
15. With respect to the review of accounting policies by the company pursuant to withdrawal of the Guidance Note on Treatment of Expenditure during Construction Period, the Committee notes that as per the Announcement on Clarification on Status of Accounting Standards and Guidance Notes, issued by the Institute of Chartered Accountants of India, “In a situation where certain matters are covered both by an Accounting Standard and a Guidance Note, issued by the Institute of Chartered Accountants of India, the Guidance Note or the relevant portion thereof will be considered as superseded from the date of the relevant Accounting Standard coming into effect, unless otherwise specified in the Accounting Standard. …” Accordingly, the Committee is of the view that the recommendations of a Guidance Note would be applicable only to the extent that these are not contrary to an Accounting Standard. Hence, the recommendations of the ‘Guidance Note on Treatment of Expenditure during Construction Period’ even before its withdrawal were applicable only to the extent these were not contrary to the provisions of an Accounting Standard and therefore, the question of revision of accounting policies merely on account of withdrawal of the Guidance Note, in the instant case, does not arise.
D. Opinion
16. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 11 above:
(i) The recommendations of the ‘Guidance Note on Treatment of Expenditure during Construction Period’ even before its withdrawal were applicable only to the extent these were not contrary to the provisions of an Accounting Standard and therefore, the question of revision of accounting policies merely on account of withdrawal of the Guidance Note, in the instant case, does not arise. See paragraph 15 above.
(ii)(a) Allocation and capitalisation of expenses related to various departments of corporate office and the regional headquarters to the projects/assets under construction should be done provided the expenses incurred on the activities of these departments 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 13 above.
(b)&(c) Subject to paragraph 12 above, the Committee is of the opinion that while allocating and capitalising the expenditure related to various departments of corporate office and the regional headquarters to the projects/assets under construction, it should be seen that whether the expenses incurred on the various activities of various departments at corporate centre and regional headquarters 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 13 above and that the basis of allocation is selected on an appropriate basis that reflects the extent of usage of services rendered by the department to the construction of the project. If the above-said requirements are complied with, the Committee is of the opinion that the accounting policy and methodology of the company for allocation of expenditure would be in accordance with AS 10 and other generally accepted accounting principles.
1Opinion finalised by the Committee on 22.1.2010
2Paragraph 9.3 of AS 10, issued by the ICAI has been renumbered as paragraph 9.2 in AS 10, notified under the Companies (Accounting Standards) Rules, 2006.
3The 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.
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