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A. Facts of the Case
1. A public sector company is engaged in refining and marketing of petroleum products. The company has entered into agreements with a foreign Licensor for the transfer of know-how for installation of Petrochemical Plant at one of its refineries. The query raised pertains to accounting for payments under the agreements as given below.
2. The Licensor has developed and/or acquired technical information, know-how and patent rights relating to a Process for the production of a specified product. The company has entered into two agreements with the foreign licensor namely, Licence Agreement and Engineering Agreement.
Licence Agreement – the Licensor has agreed to grant the Licensee (the ‘company’) a non-exclusive, perpetual, non-transferable licence under patent rights containing right:
(a) to use each of Processes in the corresponding Unit;
(b) to use in carrying out the Processes in the corresponding Unit for any apparatus, catalysts, solid sorbents or desorbents therefor; and
(c) to export, sell or use in any country, the products of each of the Processes produced in the corresponding Unit.
Payment terms of the licence fee are usually as follows:
(i) First instalment becomes due and payable on the signing of the agreement, i.e., before the implementation of the project.
(ii) Next instalments become due and payable during the course of implementation of the project on reaching certain milestones.
(iii) Last instalment becomes due and payable after the commencement of commercial production from the project and completion of other conditions, such as, performance guarantee test run, etc.
Engineering Agreement – The Licensor has to provide engineering and technical services in connection with the design of the plant.
3. The querist has explained the accounting treatment in respect of the expenditure incurred on technical know-how fees relating to manufacturing process (Licence Agreement) as below:
The erstwhile paragraph 16.5 of Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, which, in respect of the company, was withdrawn w.e.f. 1st April, 2003, is reproduced below:
“Know-how related to plans, designs and drawings of buildings or plant and machinery is capitalised under the relevant asset heads. In such cases depreciation is calculated on the total cost of those assets, including the cost of the know-how capitalised. Know-how related to manufacturing processes is usually expensed in the year in which it is incurred.”
The querist has drawn attention of the Expert Advisory Committee to its earlier opinion on ‘Treatment of know-how cost’ published as Query No. 1.34 in Compendium of Opinions-Vol. XVII. Paragraph 4 of the said opinion, inter alia, reads as below:
“Thus, the Committee is of the opinion that if the said costs pertain basically to manufacturing process know-how, to that extent these should not be capitalised.”
In line with the above, the expenditure incurred on technical know-how fees relating to manufacturing process, not being capital in nature, has been charged off by the company to profit and loss account consistently in the respective years of its incurrence. [Emphasis supplied by the querist.]
4. Further, the querist has drawn attention of the Expert Advisory Committee to paragraph 56 of Accounting Standard (AS) 26, ‘Intangible Assets’, which, inter alia, reads as below:
“56. In some cases, expenditure is incurred to provide future economic benefits to an enterprise, but no intangible asset or other asset is acquired or created that can be recognised. In these cases, the expenditure is recognised as an expense when it is incurred. …”
As per the querist, it can be inferred from the above paragraph read with the principle laid down in the erstwhile paragraph 16.5 of AS 10 (quoted above) that payments for technical know-how relating to manufacturing process is not capital in nature but it is only an expenditure on an intangible item, which is to be expensed in the year of incurrence. In view of the above, the company has consistently followed the said principle even after introduction of AS 26 w.e.f. 1st April, 2003, following the underlying principle that the basic nature of technical know-how fees relating to manufacturing process not being capital in nature is not altered even after the introduction of AS 26. Accordingly, the expenditure incurred towards technical know-how relating to production process has been charged to revenue.
5. However, as per the opinion of the statutory auditors of the company, after the introduction of AS 26, all the conditions for treating such expenses as ‘intangible assets’ are met. [Emphasis supplied by the querist.] Their opinion is that since such payments to consultants/suppliers of technical know-how/licence are upfront lumpsum payments made by the company before and/or during the course of the implementation of the project and prior to the commencement of the production, they are not linked to production quantities. Further, economic benefits start flowing from use of intellectual property in the production process in the form of revenue from sale of products after the project is implemented and commercial production is commenced. Therefore, as per their view, the technical process know-how fee, as discussed above, creates an ‘intangible asset’ and, accordingly, should be treated as an ‘intangible asset’ as prescribed in AS 26.
6. The statutory auditors have drawn attention to the opinion of the Expert Advisory Committee given, as per the querist, on an identical issue contained as Query No. 4 in the Compendium of Opinions – Vol. XXIII (Opinion finalised by the Committee on 25.03.2003). The querist has given the extracts from the said opinion as below:
“19. On the basis of the above, the Committee is of the opinion that the management of the company ‘X’ should ascertain the extent of the know-how fees payable in respect of plans, layout and designs of buildings and/or design of the plant and machinery which should be capitalised under the relevant heads. Know-how fees which are not so related and pertain to the period prior to commencement of commercial production should be treated as deferred revenue expenditure and expensed over a period of 3 to 5 years after commencement of commercial production.”
“18. The Committee incidentally notes that the Institute of Chartered Accountants of India has issued Accounting Standard (AS) 26 on ‘Intangible Assets’. From the date the Standard becomes mandatory (…) the paragraphs of AS 10, and paragraph 9.7(a) of the Guidance Note, reproduced in paragraphs 13 and 14 above, would stand withdrawn. Accordingly, the know-how costs incurred under the two agreements should be treated in accordance with AS 26. …”
7. The querist has explained the accounting treatment in respect of the expenditure incurred on technical know-how fees relating to process design/plants/facilities (Engineering Agreement) as below:
As far as expenditure incurred on technical know-how relating to process design/plants/facilities is concerned, the same is capitalised as ‘intangible asset’ and amortised on a straight line basis over a period of ten years or life of the said plant/facility, whichever is earlier. Before the introduction of AS 26, the expenditure incurred on technical know-how relating to process design/plants/facilities was being capitalised as a part of the corresponding fixed asset.
8. The querist has given the accounting policy of the company as below:
“Costs incurred on technical know-how/licence fee relating to production process are charged to revenue in the year of incurrence.”
“Costs incurred on technical know-how/licence fee relating to process design/plants/facilities are accounted as ‘Work-in Progress - Intangible Assets’ during the construction period of the said plant/facility. At the time of capitalisation of the said plant/facility, such costs are capitalised as intangible asset and amortised on a straight line basis over a period of ten years or life of the said plant/facility, whichever is earlier, beginning from the quarter in which the said plant/facility is capitalised.”
B. Query
9. The querist has sought the opinion of the Expert Advisory Committee on the following issues:
(a) Whether the accounting treatment of charging to revenue in the year of payment of licence fee paid to acquire technical know-how (by way of upfront lumpsum payments before/during the course of implementation of the project and prior to commencement of production) is in order even after introduction of AS 26.
(b) Whether the accounting treatment of capitalising technical know-how fees relating to process design/plants/facilities as intangible assets and amortising the same on a straight line basis over a period of ten years or life of the said plant/facility, whichever is earlier is in order instead of capitalising the same as a part of the corresponding fixed asset as was being done till the introduction of AS 26.
(c) In case the answer to either query (a) or (b) is in the negative,
(i) what is the suggested accounting treatment for technical know-how fees relating to production processes and technical know-how fees relating to process design/plants/facilities?
(ii) what is the suggested accounting treatment for the past cases where after the introduction of AS 26, technical know-how fees relating to production processes has been charged to revenue and technical know-how fees relating to process design/plants/facilities has been capitalised as intangible assets and is being amortised on a straight line basis over a period of ten years or life of the said plant/facility, whichever is earlier?
C. Points considered by the Committee
10. The Committee notes that the basic issue raised by the querist relates to treatment of technical know-how fee related to production processes and technical know-how fee related to process design/plants/facilities after the introduction of AS 26. Therefore, the Committee has examined only this issue and has not examined any other issue that may be contained in the Facts of the Case, such as, treatment of these items before AS 26 became mandatory. Further, AS 26 overrides the ‘Guidance Note on Treatment of Expenditure during Construction Period’ issued by the Institute of Chartered Accountants of India to the extent the provisions of the Guidance Note are inconsistent with AS 26. The said Guidance Note has been withdrawn by the Council of the Institute of Chartered Accountants of India2 .
11. The Committee notes that an item of expenditure, such as, technical know-how fee may be incurred for different purposes as in the present case. In such cases, depending on the nature and purpose for which it is incurred, the relevant Accounting Standard will apply. In particular, if the expenditure is incurred in connection with the creation/acquisition of a fixed asset, it will be accounted for in accordance with AS 10. If it is incurred in connection with the creation/acquisition of an intangible asset within the scope of AS 26 or another Accounting Standard, it will be accounted for in accordance with the relevant Accounting Standard. In some situations, the expenditure may have to be charged to revenue, if required by the relevant Accounting Standard. Thus, the Committee is of the view that accounting treatment of expenditure on know-how fee depends on the nature and purpose for which it is incurred.
12. The Committee notes that paragraph 56 of AS 26 quoted by the querist in paragraph 4 above applies only if an item of expenditure, though incurred to provide future economic benefits, does not result in acquisition or creation of a tangible or other asset that can be recognised. Thus, if either a tangible asset or an intangible asset that can be recognised is created or acquired, the expenditure cannot be recognised as an expense. Similarly, if no such asset is created but a different accounting treatment is prescribed for that expenditure in another Accounting Standard, the expenditure cannot be recognised as an expense.
13. From the Facts of the Case, the Committee notes that know-how fee is related to three purposes, viz., (i) rights under the Lincence Agreement (‘Right to use process’), (ii) know-how relating to process (‘process know-how’) and (iii) know-how related to plant and facilities (‘plant know-how’). It is presumed that item (b) of the Licence Agreement mentioned in paragraph 2 above refers to ‘right to use apparatus, catalysts, solid sorbents or desorbents’ and not the cost of the same.
14. As regards plant know-how, the Committee notes that it is related to plant/facilities. The Committee notes the following paragraphs from AS 10:
“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; …”
“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.
21. The cost of a self-constructed fixed asset should comprise those costs that relate directly to the specific asset and those that are attributable to the construction activity in general and can be allocated to the specific asset.”
15. From the above, the Committee is of the view that to the extent the know-how fee is related to plant know-how, it should be capitalised as part of cost of relevant fixed assets. Initially, it may be booked to capital work in progress and identified with the relevant asset under construction if the expenditure is directly related to, or benefits, a particular asset under construction. For this purpose, a nexus between the expenditure and the benefit/relationship with the asset can be established technologically. If the expenditure is related to, or benefits, more than one asset under construction, it should be booked to ‘Capital Work in Progress – Pending allocation’ and capitalised as part of cost of the relevant assets appropriately at the time of completing the exercise of capitalisation. Further, the Committee is of the view that the mere fact that paragraph 16.5 of AS 10 has been withdrawn on AS 26 becoming mandatory does not alter the position, if an expenditure is otherwise covered by the abovementioned paragraphs of AS 10. This is also supported by the reasons given in paragraphs 11 and 12 above. The Committee, therefore, does not agree with the changed accounting policy of the company of treating the expenditure on plant know-how as an intangible asset on AS 26 becoming mandatory.
16. As regards the right to use process and process know-how, they are intangible items. They can be recognised as intangible assets only if they satisfy the definition and recognition criteria prescribed in AS 26. In this connection, the Committee notes the following paragraphs from AS 26:
“6.1 An intangible asset is an identifiable non-monetary asset, without physical substance, held for use in the production or supply of goods or services, for rental to others, or for administrative purposes.
6.2 An asset is a resource:
(a) controlled by an enterprise as a result of past events; and
(b) from which future economic benefits are expected to flow to the enterprise.”
“11. The definition of an intangible asset requires that an intangible asset be identifiable. To be identifiable, it is necessary that the intangible asset is clearly distinguished from goodwill. …”
“13. Separability is not a necessary condition for identifiability since an enterprise may be able to identify an asset in some other way. For example, if an intangible asset is acquired with a group of assets, the transaction may involve the transfer of legal rights that enable an enterprise to identify the intangible asset… Also, even if an asset generates future economic benefits only in combination with other assets, the asset is identifiable if the enterprise can identify the future economic benefits that will flow from the asset.
14. An enterprise controls an asset if the enterprise has the power to obtain the future economic benefits flowing from the underlying resource and also can restrict the access of others to those benefits. The capacity of an enterprise to control the future economic benefits from an intangible asset would normally stem from legal rights that are enforceable in a court of law. In the absence of legal rights, it is more difficult to demonstrate control. However, legal enforceability of a right is not a necessary condition for control since an enterprise may be able to control the future economic benefits in some other way.
15. Market and technical knowledge may give rise to future economic benefits. An enterprise controls those benefits if, for example, the knowledge is protected by legal rights such as copyrights…”
“18. The future economic benefits flowing from an intangible asset may include revenue from the sale of products or services, cost savings, or other benefits resulting from the use of the asset by the enterprise. For example, the use of intellectual property in a production process may reduce future production costs rather than increase future revenues.”
17. From the above, Committee is of the view that right to use process and process know-how meet the definition criteria of an ‘intangible asset’. These items are non-monetary assets, without physical substance. The process know-how is used to produce the product and sell it, for which the right to use the process is a must. Thus, both the intangible items are essential for producing and selling the product which results in a future economic benefit, viz., revenue. Thus, flow of future economic benefits to the company can be expected. Though the right to process is non-exclusive and non-transferable, it is perpetual and it arises out of the contract which can be enforced legally. Hence, the identifiability and control criteria are also met.
18. As regards the recognition criteria, the Committee notes the following paragraphs from AS 26:
“20. An intangible asset should be recognised if, and only if:
(a) it is probable that the future economic benefits that are attributable to the asset will flow to the enterprise; and
(b) the cost of the asset can be measured reliably.
21. An enterprise should assess the probability of future economic benefits using reasonable and supportable assumptions that represent best estimate of the set of economic conditions that will exist over the useful life of the asset.
22. An enterprise uses judgement to assess the degree of certainty attached to the flow of future economic benefits that are attributable to the use of the asset on the basis of the evidence available at the time of initial recognition, giving greater weight to external evidence.”
“24. If an intangible asset is acquired separately, the cost of the intangible asset can usually be measured reliably. This is particularly so when the purchase consideration is in the form of cash or other monetary assets.”
19. From the Facts of the Case, the Committee notes that the know-how fee for right to use process and process know-how is paid in the form of cash and, hence, normally reliable measurement criterion will be met. However, as is discussed in paragraph 23 below, the know-how fee may require some apportionment, for example, between plant know-how and process know-how. In such cases, apportionment should be made on a reasonable basis. Further, as noted in paragraph 17 above, flow of future economic benefits can be expected from the two intangible assets. The probability of flow of future economic benefits should be assessed by the company as per paragraph 21 read with paragraph 22 of AS 26, quoted in paragraph 18 above. If that assessment supports the expectation of inflow of probable future economic benefits, the expenditure incurred for right to use process and process know-how should be recognised as intangible assets. As regards measurement on initial recognition, the Committee notes that paragraph 23 of AS 26 reads as below:
“23. An intangible asset should be measured initially at cost.”
Thus, to the extent recognition criteria are met, the abovementioned intangible assets should be measured initially at cost and amortised in accordance with AS 26.
20. The Committee notes that paragraph 64 of AS 26 lists various factors to be considered in determining the useful life of an intangible asset. Further, the Committee notes the following paragraphs from AS 26:
“63. The depreciable amount of an intangible asset should be allocated on a systematic basis over the best estimate of its useful life. There is a rebuttable presumption that the useful life of an intangible asset will not exceed ten years from the date when the asset is available for use. Amortisation should commence when the asset is available for use.”
“72. The amortisation method used should reflect the pattern in which the asset's economic benefits are consumed by the enterprise. If that pattern cannot be determined reliably, the straight-line method should be used. The amortisation charge for each period should be recognised as an expense unless another Accounting Standard permits or requires it to be included in the carrying amount of another asset.
73. A variety of amortisation methods can be used to allocate the depreciable amount of an asset on a systematic basis over its useful life. These methods include the straight-line method, the diminishing balance method and the unit of production method. The method used for an asset is selected based on the expected pattern of consumption of economic benefits and is consistently applied from period to period, unless there is a change in the expected pattern of consumption of economic benefits to be derived from that asset. There will rarely, if ever, be persuasive evidence to support an amortisation method for intangible assets that results in a lower amount of accumulated amortisation than under the straight-line method.”
21. Thus, the intangible assets representing the right to use process and process know-how should be amortised as stated above. The Committee is of the view that process know-how and right to use process have equal useful life. Presuming that their useful life is 10 years, it is appropriate to amortise them over a period of 10 years or the life of the plant/facilities in connection with which they are being used, whichever is earlier. Straight-line basis of amortisation may be followed, if that method is appropriate. However, as per paragraph 63 of AS 26 quoted in paragraph 20 above, amortisation should commence from the date when the intangible asset is available for use.
22. To the extent the expenditure for know-how fee is not eligible for recognition as part of cost of fixed assets as explained in paragraph 15 above or as an intangible asset as explained in paragraph 19 above, it should be recognised as an expense, unless any part of the consideration is related to other items, such as, cost of catalysts. The treatment for such items is not an issue raised by the querist and, hence, the Committee does not address that issue.
23. The Committee is of the view that the fee under the agreements should be carefully analysed to see whether there are any other items inbuilt in the said fee or whether fee payable under Licence Agreement is related to any service within the scope of the Engineering Agreement or vice versa, and, if so, the fee should be apportioned to various items on a reasonable basis. For example, Engineering Agreement may include supply of know-how relating to process as well as plant/facilities requiring the apportionment of the know-how fee between the two. Similarly, it may include cost of training not separately chargeable, cost of catalyst not separately chargeable, etc. The Committee notes that paragraph 56 of AS 26, inter alia, cites the example of expenditure on training activities as an item to be expensed.
24. The Committee, therefore, is of the view that on AS 26 becoming mandatory, the company’s accounting policy of charging to revenue, in the year of payment, of licence fee is not correct, if criteria for recognition as an intangible asset are met. Even if recognition criteria are not met, amount to be recognised as expense need not be equal to instalment amounts paid/payable, as per the payment schedule. Further, while the Committee agrees with the accounting policy of capitalising the process know-how (process design) as an intangible asset, it does not agree with the policy of capitalising the plant know-how as an intangible asset. While the Facts of the Case do not contain payment terms for Engineering Agreement, in case the payment is to be made in instalments, the amount to be capitalised need not necessarily be equal to instalment amounts paid/payable. Further, the Committee agrees with the accounting policy on amortisation of only process know-how (and not plant know-how), if it is in accordance with the principles stated in paragraph 21 above.
25. To the extent the accounting treatment is not in accordance with the above paragraphs, it would be treated as an error which should be rectified as prior period items in accordance with Accounting Standard (AS) 5, ‘Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies’.
D. Opinion
26. On the basis of the above, without going into the correctness of the accounting treatment prior to AS 26 coming into effect as stated in paragraph 10 above, the Committee is of the following opinion on the issues raised by the querist in paragraph 9 above:
(a) The correct accounting treatment of licence fee paid to acquire technical know how, i.e., technical know-how fees would depend on the nature and purpose for which it is acquired as discussed in various paragraphs above.
(b) The accounting treatment of capitalising technical know-how fees relating to process design as an intangible asset after AS 26 became mandatory is in order. The amortisation of the same on a straight line basis over a period of ten years (presuming its useful life is 10 years) or life of the related plant/facility, whichever is earlier, after AS 26 becoming mandatory, is in order, if it is in accordance with the principles stated in paragraph 21 above. The accounting treatment of know-how fee relating to plant/facilities is not in order. For appropriate accounting treatment, refer to paragraph 15 above.
(c) (i) The correct accounting treatment for technical know-how fees relating to production processes (i.e., right to use process) is to recognise the same as an intangible asset (as in the case of know-how relating to process design), if recognition criteria prescribed in AS 26 are met. The correct accounting treatment for technical know-how fees relating to plant/facilities is to capitalise the same as part of cost of the relevant fixed asset. To the extent the know-how fee is not eligible for recognition as an intangible asset or capitalisation as part of cost of a (tangible) fixed asset, it should be recognised as an expense, unless it is for items which cannot be immediately expensed, such as, catalysts. In any case, expenditure amount need not necessarily be equal to the instalment amounts paid/payable as per payment schedule. Further, the know-how fee under the relevant agreements should be analysed as suggested in paragraph 23 above. The amortisation of the intangible assets should be in accordance with the principles stated in paragraph 21 above.
(ii) The errors arising out of incorrect accounting treatment in the past years after AS 26 became mandatory should be rectified as prior period items in accordance with AS 5. The accounting policy should also be amended to reflect the correct accounting treatment.
1Opinion finalised by the Committee on 5.3.2009
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.
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