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A. Facts of the Case
1. A limited company having its registered office in India is a group member of a transnational player in the global gases and engineering industry. The company’s gases division is engaged in the manufacture and sale of industrial, medical and special gases to customers across industries. The company also has a Project Engineering Division which executes turnkey projects for both in-house and third parties.
2. The querist has stated that the company has an established customer base in steel industry as oxygen is required in large quantities for steel making. Based on Long Term Agreements (LTAs), typically of 15 to 20 years’ duration, entered into with such steel companies, plants owned by the company, are built within the customer’s premises for ‘across the fence’ supplies of gases to them as well as to other customers in the merchant market in the region. Such Build-Own-Operate (BOO) schemes for gas supplies to major customers, particularly in the steel industry, is an established business model for the company. Time being the essence of such schemes where any delay by the company in building and commissioning of its plants to commence supplies of gases to its customers on dates as mentioned in the LTAs could cause substantial financial losses to them and vice-versa, stringent liquidated damage clauses for delays by either party feature prominently in LTAs.
3. The company has entered into one such LTA dated 31st May, 2006 for supply of industrial gases to a customer by installing an air separation plant (the plant) at the customer’s steel works premises on Build–Own-Operate (BOO) basis. As per one of the clauses of the ‘general conditions’ of the agreement, the company is liable to pay ‘late start liquidated damages’ to the customer if there is a delay in the commencement of gas supply from the plant after the target commencement date due to the company’s fault and the customer is ready to consume gas at its expanded steel making facility.
4. As per the agreement, the target commencement date was 31st March, 2008, being the date on which the company estimated that it would be able to start fulfilling its obligation to supply gas from the plant. However, as per the querist, due to delay by the main equipment supplier of the plant and other related problems at site, the company was not ready to commission the plant and commence supplies on the target commencement date and instead, was ready for supply of gases only in November 2008. At this stage, due to the economic downturn, the customer requested to further delay the start-up of the plant which was finally commissioned in February 2009.
5. The company capitalised the total cost of the project in its books of account in March 2009 after trial runs of the plant were successful. The company follows the calendar year as its financial year. The querist has stated that the company is now in the process of negotiating a settlement with the customer for the delays in plant commissioning on both its own as well as on the customer’s part. As a result of such negotiation, the company will have to pay late start liquidated damages to the customer for the delayed commissioning of the plant due to its inability to have the plant ready for supply of gases on the appointed target commencement date of 31st March, 2008.
6. The querist has drawn the attention of the Committee to paragraph 20 of Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, which states as under:
“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.”
As per the querist, the plant was brought to its working condition for its intended use, i.e., for supply of gas to the customer in November 2008. The point for consideration is whether liquidated damages payable for delay in commissioning the plant should be treated as cost attributable for bringing the plant to its working condition for its intended use (supply of gas to the customer) within the ambit of paragraph 20 of AS 10.
B. Query
7. Based on the facts stated above, the querist has sought the opinion of the Expert Advisory Committee on the following issues:
(a) Whether the amount to be paid by the company on account of liquidated damages due to delay in commencement of supply of gases to the customer consequent upon delay in bringing the plant to its working condition on the appointed target commencement date can be capitalised in its books of account as additional cost attributable to the project (capitalised in March 2009) in accordance with the provisions of AS 10 and any other related Accounting Standard or statute.
(b) If the answer to (a) above is in the negative, whether the liquidated damages payable can be treated as deferred revenue expenditure to be amortised over a period of 3 to 5 years after the commencement of commercial production.
(c) If the answer to (b) above is also in the negative, whether the only option available to the company will then be to charge off the amount of liquidated damages as an expense in the profit and loss account .
(d) Generally, on any other issue related to the subject.
C. Points considered by the Committee
8. The Committee notes that the basic issue raised in the query relates to the treatment of liquidated damages payable by the company for delay in commissioning of the plant. The Committee has, therefore, considered only this issue and has not touched upon any other issue that may arise from the Facts of the Case, such as, appropriateness of capitalisation of the plant by the company in March 2009, compensation receivable by the company, if any, on account of request by the customer to delay the start-up of the plant, compensation receivable by the company, if any, for the delay by the main equipment supplier of the plant, expenses incurred during the period the plant is ready to commence production and the actual date of commencement of production, etc.
9. The Committee notes from the Facts of the Case that the plant has been constructed by the company under BOO scheme. Therefore, in the view of the Committee, the provisions related to self-constructed assets would apply in the present case. In this context, the Committee notes paragraph 20 of AS 10 as reproduced by the querist in paragraph 6 above, and paragraph 21 of AS 10 which is reproduced below:
“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.”
The Committee further notes that paragraph 10.1 of AS 10 provides that 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. The Committee notes that paragraph 9.1 is relevant to the case under consideration which states as 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.
The cost of a fixed asset may undergo changes subsequent to its acquisition or construction on account of exchange fluctuations, price adjustments, changes in duties or similar factors.”
10. The Committee notes from the Facts of the Case that the ‘late start liquidated damages’ are payable by the company on account of delay in the commencement of gas supply from the plant on the target commencement date. The Committee is of the view that such expenditure cannot be said to be attributable to bringing the plant to its working condition for its intended use. Such expenditure is not attributable to the construction activity. It is also not in the nature of price adjustment on account of which cost of a fixed asset may undergo a change subsequent to its construction. The Committee is of the view that the liquidated damages are of the nature of a penalty resulting from non-fulfillment of the terms of the agreement, in this case, the target date of commencement of gas supply. The amount of liquidated damages is a compensation to the customer for loss of revenue on account of non-supply of gas by the company. Accordingly, the Committee is of the view that such expenditure cannot be capitalised and should be expensed by way of charge to the profit and loss account as no future benefit is expected from the same.
D. Opinion
11. On the basis of above, the Committee is of the following opinion on the issues raised in paragraph 7 above:
(a) The amount to be paid by the company on account of liquidated damages due to delay in commencement of supply of gases to the customer consequent upon delay in bringing the plant to its working condition on the appointed target commencement date cannot be capitalised in its books of account as additional cost attributable to the project (capitalised in March 2009) in accordance with the provisions of AS 10 or any other Accounting Standard or statute.
(b) The liquidated damages payable cannot be treated as deferred revenue expenditure to be amortised over a period of 3 to 5 years after commencement of commercial production as explained in paragraph 10 above.
(c) The company should charge off the amount of liquidated damages as an expense in the profit and loss account.
(d) The Committee, as per its Advisory Service Rules, answers only specific queries raised by the querist on accounting and/or auditing principles and allied matters and as a general rule, the Committee does not answer open-ended general queries. See paragraph 8 above.
1Opinion finalised by the Committee on 18.3.2010 |