Query No. 1

Subject:  Treatment of reversal of writing off of development expenses recognised under capital work in progress.[1]

A.        Facts of the Case  

1.         A company (hereinafter referred to as the ‘company’) was in the process of developing Gas Insulated Switchgear (GIS) technology due to huge market demand. GIS technology helps in stable power supplies. The said technology was developed in one of the subsidiaries of the company located at Hungary. Expenses incurred during research phase were expensed out. The development had started from the year 2002 onwards and all the eligible expenses, which comprised material costs, salary costs of employees directly engaged in development of GIS technology and other expenses such as, testing fees, professional fees, etc. had been capitalised and kept under capital work-in-progress (CWIP). The purpose of expenses was solely to develop GIS technology. The eligible expenses incurred during development phase were capitalised under CWIP as per the Hungarian Accounting Law (sections 24 and 25) (a copy of the Hungarian Accounting Law has been supplied by the querist for the perusal of the Committee). The same was also considered as CWIP while preparing and presenting consolidated financial statements of the company as per Indian Generally Accepted Accounting Principles (GAAPs). However, due to failure in some of the significant tests where result was not as per set internal standards and not meeting the criteria of cost-benefit for incremental cost due to poor market conditions, the company did not utilise its resources further. Accordingly, the company could not launch the product and had written off CWIP as an extra-ordinary depreciation at local level as per the Hungarian Accounting Law. The querist has separately informed that conditions as mentioned in paragraph 44 of Accounting Standard (AS) 26, ‘Intangible Assets’ were satisfied at the time of initial recognition and were continuously satisfied till the write-off of capital work-in-progress as extra-ordinary depreciation except conditions as mentioned in sub-paragraph (d) and to some extent sub-paragraph (e).

Extra-ordinary depreciation, in the books of the company's subsidiary was provided in compliance with the Hungarian Accounting Law (sections 53(1)(b) and 53(2)). As mentioned in section 53(2) of the Hungarian Accounting Law, the CWIP was not derecognised and removed from the asset register and books of account. Instead, it was retained at gross value along with the same amount of accumulated depreciation as the company had not terminated the development activities and also the result of development was not sold or scrapped. Thus, asset was very much in existence but with zero value.

2.         The querist has stated that vide section 53(3) of the Hungarian Accounting Law, such extra-ordinary depreciation can be reversed when the reasons for which the depreciation was provided, no longer exist. The company is now re-exploring the opportunity of developing the GIS technology once again as there is breakthrough in design configuration of existing technology which will help the company to generate business and positive cash flow. The said technology will remain in market for next 10 years. Further, as the market has improved significantly for Gas Insulated Switchgear and significant orders are also received from customers, conditions as mentioned in sub-paragraph (d) are now satisfied. Thus, on the basis of positive commercial prospects, the company now intends to reverse the extra-ordinary depreciation and bring back the CWIP to the extent of lower of market value or value in use which had been written off in the earlier year (section 57 of the Hungarian Accounting Law). The querist has also separately informed that fine-tuning of product configuration subsequent to improvement in market conditions has led to successful development of know-how of GIS technology.

3.         The querist has also stated that as the subsidiary company is effecting the reversal of extra-ordinary depreciation in compliance with the Hungarian Accounting Law, the same should be consistent with the Indian GAAPs also as the financial statements of subsidiary will be consolidated as per Accounting Standard (AS) 21, ‘Consolidated Financial Statements’ and paragraph 20 of AS 21 stipulates about uniform accounting policies.

B. Query

4.         The querist has sought the opinion of the Expert Advisory Committee on the following issues:

C. Points considered by the Committee

5.         The Committee, while answering the query, has considered only the issues raised in paragraph 4 above and has not examined any other issue that may arise from the Facts of the Case, such as, recognition of expenses incurred in research phase, accounting treatment in the standalone financial statements of subsidiary company as per the Hungarian Accounting Law, capitalisation of various expenses as development expenses, etc. The Committee also presumes from the Facts of the Case of the query that the issues have been raised in the context of consolidated financial statements of the company as per the Indian GAAPs. Therefore, the Committee has opined on the issues raised in paragraph 4 above only from the angle of consolidated financial statements of the company. Further, from a combined reading of the relevant facts of the query, the Committee has presumed that the conditions of paragraph 44 of Accounting Standard (AS) 26, ‘Intangible Assets’, notified under the Companies (Accounting Standards) Rules, 2006 (hereinafter referred to as the ‘Rules’) were satisfied initially at the time of capitalisation of development expenses and continuously till charging off of extra-ordinary depreciation under sections 53(1)(b) and 53(2) of the Hungarian Accounting Law and that at the time of charging off of the extra-ordinary depreciation, the conditions of paragraphs 44 (d) and (e) of AS 26 were not being satisfied in the context of Indian Accounting Standards. Also, at the time of reversal of extra-ordinary depreciation, condition mentioned at paragraph 44 (d) is presumed to be satisfied and since the querist has informed that the GIS technology has been developed, it is presumed that the condition at paragraph 44 (e) was also satisfied at that time.

6.         As far as consolidated financial statements are concerned, the Committee notes that the company should follow uniform accounting policies for like transactions and other events in similar circumstances as per paragraphs 20 and 21 of Accounting Standard (AS) 21, ‘Consolidated Financial Statements’, notified under the ‘Rules’, which are reproduced as follows:

“20. Consolidated financial statements should be prepared using uniform accounting policies for like transactions and other events in similar circumstances. If it is not practicable to use uniform accounting policies in preparing the consolidated financial statements, that fact should be disclosed together with the proportions of the items in the consolidated financial statements to which the different accounting policies have been applied.

21.    If a member of the group uses accounting policies other than those adopted in the consolidated financial statements for like transactions and events in similar circumstances, appropriate adjustments are made to its financial statements when they are used in preparing the consolidated financial statements.”

From the above, the Committee is of the view that the company in the extant case should follow uniform accounting policy for the treatment of development expenditure in the consolidated financial statements unless it is impracticable to do so.  Further, the parent company, being an Indian company, is required to prepare its consolidated financial statements in accordance with the Indian GAAPs.  In case there is any difference in the two laws for the accounting treatment of development expenditure, then necessary adjustments should be made to the expenditure incurred in subsidiary so that the same is in line with the Indian GAAPs. In case it is not practicable to do so, disclosures as required under paragraph 20 of AS 21 should be made.

7.         In the extant case, the Committee notes that the foreign subsidiary has capitalised the development expenses as per the laws prevailing in that country.  However, for the purpose of consolidation, the Committee is of the view that uniform accounting policies have to be followed as discussed above and accordingly, the said expenditure should be capitalised only if it is in accordance with AS 26.  The Committee notes paragraph 44 of AS 26, which is stated as below:

“44. An intangible asset arising from development (or from the development phase of an internal project) should be recognised if, and only if, an enterprise can demonstrate all of the following:
(a)   the technical feasibility of completing the intangible asset so that it will be available for use or sale;
(b)   its intention to complete the intangible asset and use or sell it;
(c)   its ability to use or sell the intangible asset;
(d) how the intangible asset will generate probable future economic benefits. Among other things, the enterprise should demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset;
(e)   the availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset; and
(f)    its ability to measure the expenditure attributable to the intangible asset during its development reliably.”

From the above, the Committee is of the view that the expenses incurred in development phase of an internal project should be recognised as an intangible asset if, and only if, an enterprise can demonstrate that all the conditions mentioned in paragraph 44 of AS 26 above are fulfilled. In the extant case, since the querist has stated that the conditions of paragraph 44 of AS 26 were satisfied at the time of initial recognition, the Committee is of the view that initial capitalisation of the expenses incurred in the development phase as ‘capital work in progress’ under ‘Intangible Assets’ is in line with AS 26.

8.         As regards subsequent accounting for development expenditure in the consolidated financial statements, the Committee notes that extra-ordinary depreciation was charged in the books of the Hungarian subsidiary under sections 53(1)(b) and 53(2) of the Hungarian Accounting Law when the conditions of paragraphs 44(d) and (e) of AS 26 were not being met. The Committee notes the aforesaid sections of Hungarian Accounting Law as reproduced below:

“53(1)  Extraordinary depreciation shall apply in connection with intangible and tangible assets, if:
a)         the book value of the intangible or tangible asset (not including assets in course of construction) remains permanently and substantially higher than the market value of such asset;
b)         the value of intellectual property and tangible assets (including assets in course of construction) drops permanently because such intellectual property or tangible assets (including assets in course of construction) have become unnecessary due to a change in the entrepreneurial activities, or cannot be used for the original purpose thereof as a consequence of damage or destruction, or cannot be used at all; (emphasis supplied by the Committee)
…”
“53(2)  Depreciation as defined in Subsection (1) shall be carried out to an extent that the intangible assets, tangible assets and assets in course of construction be shown in the balance sheet at the known market value corresponding to the utility thereof, in effect on the balance sheet date. If an intangible or tangible asset, or an asset in the course of construction cannot be used for its intended purposes, or if its unusable, destroyed or is missing, it shall be removed from the list of intangible assets, tangible assets, or assets in course of construction after extraordinary depreciation is claimed and deducted. Any extraordinary depreciation on the basis of market value shall be claimed as on the balance sheet date; whereas extraordinary depreciation upon derecognition shall be accounted for as at the date when the asset is derecognized.”

From the above, it is apparent that the extraordinary depreciation could have been provided only if the conditions prescribed as above in the law had been fulfilled, viz., permanent drop in the value of intangible asset because it could not be used at all or if the company could not use the intangible asset for its intended purposes, then it is to be removed from the asset register. Accordingly, the company had written off the development expenditure recognised as intangible asset in progress to zero. The Committee is of the view that writing off the intangible asset to zero itself indicates that at that point of time, intangible asset had neither value-in-use nor any disposal value. In other words, no future economic benefits were expected either from its use or disposal, which is also evident from the fact that at that point of time, neither of the conditions stated in paragraphs 44(d) and (e) of AS 26 were met, as stated by the querist in paragraph 1 above. In other words, the intangible asset had became virtually infructuous having no future economic benefit. Accordingly, in the view of the Committee, the said intangible asset should have been derecognised in accordance with paragraph 87 of AS 26 which is reproduced as below:

“87. An  intangible  asset should be derecognised (eliminated  from  the balance  sheet)  on  disposal  or  when  no  future  economic  benefits  are expected from its use and subsequent disposal.”

In view of the above, the question of charging of impairment loss on such intangible assets under Indian GAAPs or reversal thereof does not arise.

9.         On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 4 above:

(i) The capitalisation of development expenses as per the Hungarian Accounting Law is in line with Indian GAAPs assuming that the conditions of paragraph 44 of AS 26 as discussed in paragraph 7 above are fulfilled.

(ii)  Since in the extant case, the company had no future use of that intangible asset resulting into any future economic benefits, the intangible asset (CWIP) recognised should have been derecognised rather than being considered as impairment loss in the consolidated financial statements as discussed in paragraph 8 above.

(iii) Since the answer to (ii) above is in the negative, the question of reversal of impairment does not arise.

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