Query No. 1

Subject:

Treatment of capital expenditure on assets not owned by the company. ¹

A. Facts of the Case

1. The querist is a Government of India company engaged in the construction and operation of thermal power plants in the country. The company has also diversified into hydro power generation, coal mining and oil & gas exploration, etc. The company is registered under the Companies Act, 1956 and being an electricity generating company, is governed by the provisions of the Electricity Act, 2003. The company prepares its annual financial statements as per the provisions of the Companies Act, 1956. The company is also listed with the Bombay Stock Exchange and the National Stock Exchange.

2. The company is functioning in the regulated environment. The querist has stated that the tariff for sale of energy from its stations is determined by the Central Electricity Regulatory Commission (CERC), following the cost-plus basis. Tariff for sale of energy in case of a thermal power generating station comprises two components, namely, annual capacity (fixed) charges and variable charges. The capacity charges mainly consist of interest on loan capital, depreciation, return on equity, normative operation and maintenance expenses, interest on working capital, etc. and to a large extent depend on the admissible capital cost of a generating station. The variable charges consist of primary fuel cost on normative basis.

3. The company is establishing a hydro power project (4 X 200MW). The project site is situated in a remote area which does not have basic infrastructure and communication facilities for setting up of a power plant at the time of taking up of the project. Before taking up the construction activity of the power project, the company has to construct or widen the existing approach roads to the project site, lay pipelines for water, arrange for power construction, etc. For executing the above-mentioned project, higher rated power was required which did not exist at the time of taking up of the project. The company requested the concerned State Electricity Board (SEB) that the nearby sub-stations of the SEB may be augmented by providing additional MVA transformers and constructing two additional 33 KV lines from sub-station to the project site for drawl of the construction power. The SEB agreed to carry out the modification work at a cost of Rs. 5.03 crore on deposit works basis. The querist has explained that ‘deposit works basis’ is the execution of capital works, for example, construction of roads, canals, construction-power lines, laying of railway tracks, etc. by the government departments (contractors), viz., Public Works Department, State Electricity Boards, Water Resource Department, government companies, etc., on behalf of PSUs/other companies on the basis of actual cost of works plus an agreed percentage of profit over the actual cost. The querist has informed that under ‘deposit works basis’, on receipt of request from the company, the contractor prepares an estimate of the work required to be executed and forwards it to the company for taking internal approvals. Based on the agreed estimates of the work, advances are paid to the contractor for execution of the work. Normally, separate account for each work is maintained by the contractor and the amount received from the company is accounted for as receipts in that account and the corresponding expenditure incurred are also accounted in the same deposit account as expenditure. Based on the statement of account received from the contractor, advances are adjusted and accounted for as capital work-in-progress. On completion of work, fund utilisation certificate is provided by the contractor along with the agreed percentage of profit and the final payment is settled. Based on the above principles of ‘deposit works’, advances have been released to the SEB periodically in the present case. On these lines, payments/deposits have been made in instalments and adjusted on completion of work progressively. As per the querist, the SEB has informed that the ownership of the sub-station after the proposed modifications and the 33 KV lines shall remain with them. Copy of the Memorandurn of Understanding (MOU) signed by the company with the SEB has been supplied by the querist for the perusal of the Committee.

4. The querist has stated that the expenditure on such capital works, which is required for carrying out construction of the project and the ownership of which does not vest with the company, is being accounted for as ‘capital expenditure on assets not owned by the company’ and disclosed in the Schedule of ‘Capital Work-in-Progress’ distinctly during construction period and thereafter disclosed in the Schedule of ‘Fixed Assets’ on completion. Further, such capital expenditure is being amortised over a period of four years from the year in which the first unit of the project concerned came into commercial operation. The related accounting policies followed by the company in this regard are reproduced below:

    “Capital expenditure on assets not owned by the company is reflected as a distinct item in capital work-in-progress till the period of completion and thereafter in the fixed assets”.

    “Capital expenditure on assets not owned by the company is amortised over a period of 4 years from the year in which the first unit of project concerned comes into commercial operation and thereafter from the year in which the relevant asset becomes available for use. However, such expenditure for community development in case of stations under operation is charged off to revenue”.

The querist has stated that the above treatment is being followed keeping in view the requirements of the Guidance Note on Treatment of Expenditure during Construction Period ² , issued by the Institute of Chartered Accountants of India.

5. The querist has further stated that consequent to the withdrawal of the above-mentioned Guidance Note, accounting for such expenditure is to be done in line with the provisions of paragraphs 9.1 and 10.1 of Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, which are 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. …” (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 9.5. 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.”

According to the querist, in line with the above-mentioned provisions of AS 10, the expenditure on augmentation of the sub-station and laying of additional 33 KV lines, incurred by the company is directly related to the construction of the power project. The company is of the view that the said expenditure may continue to be accounted for as ‘capital expenditure on assets not owned by the company’ and amortised over a period, i.e., four years from the date when the first unit of the project comes into commercial operation since this expenditure is of capital nature and the benefit will accrue to the company for more than one year. Further, as per the querist, the above expenditure has been incurred for bringing the project for its intended use and the ownership of this capital asset does not vest with the company.

6. The querist has further stated that in case the above expenditure is charged off to revenue consequent to the withdrawal of the Guidance Note on Treatment of Expenditure during Construction Period, this expenditure will neither be serviced as a part of fixed charges nor it will be allowed as a part of operation and maintenance (O&M) charges as provided by the CERC in the tariff regulations. Accordingly, charging of the expenditure on augmentation of sub-station to the profit and loss account will not be in line with the true spirit of the tariff regulations notified by the CERC, which is based on cost-plus-return basis. Further, as per the querist, charging of such expenditure to the profit and loss account shall also not be in accordance with the provisions of AS 10.

B. Query

7. Keeping in view the withdrawal of the Guidance Note on Treatment of Expenditure during Construction Period and the nature of the industry, where the tariff is decided on cost-plus-return basis, the querist has sought the opinion of the Expert Advisory Committee on the following issues:

C. Points considered by the Committee

8. The Committee notes that the basic issue raised by the querist relates to the accounting treatment of the expenditure incurred by the company on augmenting of sub-stations and construction of transmission lines (hereinafter referred to as ‘strengthening of power transmission system’), for construction of power projects during the construction period. Therefore, the Committee has examined only this issue and has not touched upon any other issue that may arise from the Facts of the Case, such as, expenditure incurred on community development, etc. Further, in the absence of any information to the contrary, the Committee presumes that the expenditure incurred by the company on strengthening of the power transmission system is not adjustable against any payment to be made by the company towards future use of the transmission system.

9. 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 an expenditure incurred by an enterprise can be recognised as an asset only if it is a ‘resource controlled by the enterprise’. Therefore, the issue raised by the querist requires examination from the point of view of the type of the resource that the company controls, if any, as a result of expenditure on strengthening of transmission system. For this purpose, the Committee has examined whether the expenditure results into recognition of a tangible asset or an intangible asset.

10. The Committee is of the view that the above-mentioned expenditure can be considered to result into a tangible asset, i.e., sub-station or transmission line, only when, the company is able to control such asset(s). 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 fixed asset would be that the entity can restrict the access of others to the benefits derived from that asset. This view is also supported by the principles enunciated in paragraph 14 of Accounting Standard (AS) 26, ‘Intangible Assets’, as reproduced in paragraph 12 below.

11. The Committee notes from the Facts of the Case that the ownership of sub-station after the modifications and the augmented transmission lines shall remain with the SEB. The company is entitled to its allotted quantum of power supply. It has no say on the distribution of power supply to others. Thus, none of the factors mentioned in paragraph 10 above indicating control of the company is evident. Thus, sub-station or transmission line is not the resource controlled by the company and therefore, the expenditure incurred by the company on strengthening of transmission system cannot be capitalised as a separate tangible asset.

12. The Committee now examines whether the above-said expenditure results into an intangible asset for the company. In this context, the Committee notes the following paragraphs from AS 26:

    “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.

    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.”

    “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. …”

From the above, the Committee is of the view that the expenditure incurred by the company on strengthening of transmission system not owned by the company does not meet the definitions of the terms ‘asset’ and ‘intangible asset’ as, even though the economic benefits are expected to flow to the enterprise from such facilities, the company does not have control over such facilities. Accordingly, such expenditure cannot also be capitalised as a separate intangible asset.

13. Now, the question arises as to whether the expenditure incurred on sub-stations and transmission lines that are not owned by the company, could be considered as a component of the cost of a fixed asset/project. In this context, the Committee further notes paragraphs 9.1 and 10.1 of AS 10, which are reproduced in paragraph 5 above. The Committee is of the view that the basic principle to be applied while capitalising an item of cost to the cost of 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 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’. From the above, the Committee is of the view that expenditure incurred on strengthening of power transmission system, cannot be considered as directly attributable cost and accordingly, the same cannot also be capitalised as a component of fixed asset.

14. The Committee further notes that paragraph 56 of AS 26 provides 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. …”

From the above, the Committee is of the view that the expenditure incurred on strengthening of power transmission system should be expensed and charged to the profit and loss account of the period in which these are incurred.

15. As far as accounting treatment given by the company in respect of ‘capital expenditure on assets not owned by the company’ constituting the expenditure on strengthening of power transmission system is concerned, 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 these are not contrary to an Accounting Standard. Hence, the recommendations of the ‘Guidance Note on Treatment of Expenditure during Construction Period’, after AS 26 becoming applicable to the company (even before the withdrawal of the said Guidance Note) were applicable only to the extent these were not contrary to the provisions of AS 26. Therefore, since, after AS 26 became applicable to the company, the expenditure incurred on strengthening of transmission lines was not expensed by the company as per the requirements of AS 26, as discussed above, the same is an error committed in the prior years which should be rectified in the financial statements and disclosed as a ‘prior period item’ of the period in which such rectification is carried out in accordance with the requirements of Accounting Standard (AS) 5, ‘Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies’.

16. As far as the impact of accounting treatment of the expenditure on strengthening of power transmission system on tariff as per the tariff regulations is concerned, the Committee is of the view that the accounting treatment of an expenditure is to be determined on the basis of the nature of the expenditure as per the generally accepted accounting principles. It is on this basis that the treatment to be accorded by the company in the present case to the expenditure on strengthening of the power transmission system has been arrived at in the above paragraphs. Whether or not this expenditure should be made a part of fixed charges or O&M charges for tariff fixation as per the tariff regulations is a matter to be considered by the relevant authority/company.

D. Opinion

17. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 7 above:

    (i) No, the existing accounting treatment followed by the company of capitalising the expenditure which, as per the querist, is essentially required for construction of power plants or making it available for its intended use, as ‘capital expenditure on assets not owned by the company’ and amortising the same over a period of four years, is not in order.

    (ii) (a) The capital expenditure on strengthening of power transmission system not owned by the company should be expensed by way of charge to the profit and loss account of the period in which these are incurred.

       (b) ‘Capital expenditure on assets not owned by the company’ appearing in the schedule of fixed assets at its written down value, being an error should be rectified and disclosed as a ‘prior period item’ as per the requirements of AS 5 in the financial statements of the period in which such rectification is carried out as discussed in paragraph 15 above.

The 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.

¹ Opinion finalised by the Committee on 18.3.2010

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.