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Query No. 32
Subject: Capitalisation of borrowing costs under AS 16.
A. Facts of the Case
1. A company is a Government of India Undertaking under the Ministry of Defence (MoD). The company manufactures a wide range of products, like super alloys, titanium alloys, maraging steel, etc. for strategic sectors, like space, defence, nuclear power, etc. The products manufactured are sold in the form of ingots, forged billets, sheets, plates, strips, rods, rings, etc. To enable supply of the material in the form specified by the customers requiring special operations, like machining, rolling, ring forming, etc., for which facilities are not available in-house, such jobs are off-loaded to the sub-contractors in India. The company’s turnover in the year 2011-12 was to the tune of Rs. 509 crore.
2. The Government of India, during the period 2008-09 to 2011-12, has granted a financial assistance of Rs. 100 crore to the company (i.e., Rs. 50 crore as equity contribution and Rs. 50 crore as loan) for procurement of 10 tonne ESR furnace and 6000 tonne forging press. While 10 tonne ESR furnace valued at Rs. 1,384.34 lakh has been commissioned and capitalised during the year 2010-11, the other equipment, 6000 tonne forging press, is still under procurement stage. In respect of loan of Rs. 50 crore, repayable in 5 equal installments after the lapse of one year from the date of withdrawal of loan, the company has repaid a loan of Rs. 2,020.00 lakh along with interest of Rs. 1,014.30 lakh @ 11.50 per cent p.a. on respective due dates.
3. It is observed by the Government auditor during audit of annual accounts of the year 2011-12 that entire interest payment of Rs. 1,014.30 lakh has been charged to revenue between the period 2009-10 to 2011-12 instead of capitalisation of borrowing costs against the ESR furnace commissioned in the year 2010-11 and forging press under acquisition. The query of the C&AG auditors and the reply of the company are placed below:
“Query:
As per significant accounting policy No. 13, read with Accounting Standard (AS) 16, ‘Borrowing Costs’, borrowing costs that are attributable to the acquisition or construction of qualifying assets are to be capitalised as a part of the cost of such assets.
The Government of India, between the year 2008-09 and 2011-12, granted a financial assistance of Rs.100 crore to the company (i.e., Rs. 50 crore as equity contribution and Rs.50 crore as loan) for procurement of 10 tonne ESR furnace and 6000 tonne forging press. While 10 Tonne ESR furnace valued Rs. 1384.34 lakh has been commissioned and capitalised during the year 2010-11, the other equipment, 6000 tonne forging press, is still under procurement stage.
In respect of loan of Rs. 50 crore, repayable in 5 equal installments from the first anniversary after the date of drawl of loan, company has repaid a loan of Rs. 2020.00 lakh along with interest of Rs. 1014.30 lakh @ 11.50 percent p.a. on respective due dates. However, no provision has been made in the books for a liability of Rs. 2.70 lakh towards interest accrued but not due on outstanding loan of Rs. 2980.00 lakh, as on 31st March, 2012.
It is observed that entire interest payment of Rs. 1014.30 lakh has been charged to revenue between 2009-10 to 2011-12 instead of capitalisation of borrowing cost (to the extent admissible) against the ESR furnace commissioned in the year 2010-11 and forging press under acquisition.
The failure to capitalise the borrowing cost in compliance of significant accounting policy No. 13 / AS 16 and failure to recognise a liability towards interest accrued but not due on loan in compliance with Accounting Standard (AS) 29, ‘Provisions, Contingent Liabilities and Contingent Assets’ has resulted in:
Understatement of other current liabilities by Rs. 2.70 lakh (Note No.10)
Understatement of tangible assets (plant and machinery) gross block by Rs. 85.15 lakh and Depreciation by Rs. 4.85 lakh (Note No.12)
Understatement of Capital Work in Progress by Rs. 865.04 lakh (Note No.14)
Overstatement of Finance Cost by Rs. 341.58 lakh (Note No.28)
Overstatement of Prior Period Adjustments by Rs. 605.92 lakh (Note No.29) and
Understatement of Profit by Rs. 942.65 lakh.
Further, non-compliance of AS 16 and AS 29 in preparation of financial statements and impact thereon has not been suitably qualified in the Auditors’ Report dated 05.07.2012 and hence, the opinion vide paragraph 4 (d) of the report is incomplete to that extent.”
“Management reply:
The total funding from Ministry towards ESR furnace and 6000 tonne forge press is as under originally:
| ESR furnace |
Rs.15 crores |
| 6000 tonne forge press |
Rs.85 crores |
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Rs.100 crores
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ESR furnace instead of importing, the company has taken up fabrication in house after procuring mechanical and electrical items and commissioned during 2010-11. Thus, the accounting policy No.13 defines capitalisation of borrowing cost as the amount was very meager and there are no substantial economic benefits going to accrue to the company in future by capitalising the same. Thus, interest of Rs. 85.15 lakh incurred towards ESR furnace was ignored in the year 2010-11 as a tax planning measure.
Out of Rs. 46 crore borrowed from the MoD, the company has already repaid Rs. 11.00 crore by 31.3.2011. The contract for 6000 tonne press on M/s XYZ was signed only in 2011-12. An initial advance and advance on submission of drawings was paid during the year 2011-12. There is already an existing press of 1500 tonne on which the company is carrying out its regular operations. In order to enhance the capacity to handle more load 6000 tonne forge press is ordered. Thus, this is not a new facility but enhancement of existing capacity. The amount was drawn from MoD Rs. 9 crore in 2008-09, Rs. 37 crore in the year 2009-10 and Rs. 4 crore in the year 2011-12.
The original order placed on M/s ABC, South Korea in 2008-09 was not executed as the supplier became bankrupt and the security deposit was encashed and kept under suspense in the year 2010-11. This is also to be considered at the time of capitalisation of 6000 tonne forge press.
While calculating interest during construction related to present order, it is yet to be decided whether interest element on borrowed amount outstanding as on 31.3.2011 is to be considered or even prior to that as the present order is placed only in the year 2011-12.
Thus, taking into consideration of above facts, a definite view will be taken in the year 2012-13 accounts suitably, by which time the press will be commissioned and capitalisation will be done.
In view of the above the audit enquiry may please be dropped.”
4. The querist has stated that the auditor, not satisfied with the management reply, had retained the query. Subsequently, management has replied further which is as under:
(i) ESR furnace
Rs. 1,384.34 lakh was spent on ESR furnace which was capitalised in the year 2010-11 assuming 50% is from equity and 50% is from loan. Borrowing cost is calculated on Rs. 692.0 lakh till the date of capitalization in the year 2010-11 by government audit. As per second paragraph of the audit enquiry, it is clear that the Government of India had granted a financial assistance of Rs. 100 crore to the company, Rs. 50 crore as equity and Rs. 50 crore as loan for procurement of 10 tonne ESR furnace and 6000 tonne forge press. While drawing the loan, the company had given an undertaking confirming that the amount will not be diverted for any other purpose except for using the same towards procurement of specified equipment. As per the undertaking, the amount should be kept identified separately and it should not be diverted for any other purpose.
Attention is invited to Note under Schedule 3 as well as Note under Schedule 8.3 of the year 2010-11 accounts wherein it is clearly published that the amount is received from Ministry of Defence for specific purpose. Attention is also invited to Point No.1 under A. Balance Sheet in Schedule 20 Notes on Accounts attached forming part of Accounts for the year ended 31/3/2011 wherein again it is clearly brought out about the amount received as well as the amount kept separately for meeting capital expenditure.
As per AS 16, the borrowing cost can be applied on qualifying assets.
To qualify the assets for borrowing cost, the asset must necessarily take substantial period of time to get it ready for intended use.
In commercial parlance, one can say that any time over a period of one year may be termed as substantial period.
The period for ESR furnace from the date of contract to date of installation is eight months. Further, interest for the delay period cannot be capitalised as per AS 16.
In view of the above, borrowing cost cannot be allocated on ESR furnace capitalisation as per AS 16.
(ii) Forge press
As per paragraph 17 of AS 16, capitalisation of borrowing cost should be suspended during extended periods to which active development is interrupted. Audit party had been provided with the total document relating to the forge press in the first stage where the amounts were paid but finally the contract was closed under force majeure because of bankruptcy of the supplier but the company earned interest of Rs. 1,043.97 lakh, (interest on encashment of bank guarantees Rs. 392.66 lakh as well as encashment of security deposit Rs. 732.69 lakh).
As the project is closed, the interest earned and the interest paid were both carried to profit and loss account in the respective years and the amount realised towards encashment of security deposit is kept in suspense A/c (being a capital receipt).
Equipment was re-tendered and the contract was finalized with M/s XYZ, Italy in June, 2011 and the advances are paid as under:
First Advance Rs. 6,73,16,345/- on 27/7/2011
Second Advance Rs. 7,18,51,180/- on 29/3/2012
Hence, there is a need to capitalise borrowing cost in the year 2011-12 with effect from June 2011 till the commissioning of the forge press which is likely to take place in July/August 2013.
In the meanwhile the company had repaid two instalments of loan by 31/3/2011 and also earned interest on Rs. 72.22 crore upto 31/3/2012. If the borrowing cost is to be capitalised and kept in capital work in progress as on 31/3/2012 as pointed out by government audit, it is also necessary to consider the interest earned on the specific fund sanctioned and received for specific project which needs to be set off against the borrowing cost.
As per the Guidance Note on Treatment of Expenditure during Construction Period, issued by the Institute of Chartered Accountants of India (ICAI), interest from investments of idle project funds should be adjusted in the capital cost of the project (refer paragraphs 8.1, 15.2, 16.1, 16.2 and 17.11). Accordingly interest earned also need to be set off against borrowing cost.
In addition to this, the amount received towards encashment of security deposit is also to be given treatment while capitalising the forge press which needs to be reduced from the total cost as this being a capital receipt. Paragraph 17.11 of the said Guidance Note closes with an advise “consideration may have to be given to the question of providing for income tax liability on such income (paragraph 8.2).”
Thus, there is a lack of clarity on capitalisation of borrowing cost. In view of this, a conscious view is taken to give appropriate treatment once the plant is commissioned so that it will be a fair treatment of income as well as expenditure relating to the equipment and there will be a clear picture available on the total cost of the project.
5. As the audit had raised enquiry, in order to have the different views, as brought out above, clarified as well as to have back up, it is proposed to refer the issue to the Expert Advisory Committee of the ICAI for its opinion, as this procurement is not a normal one but is having all complications during the execution period as well as due to the undertaking given by the company to the Ministry of Defence, not to divert the funds for any other purpose.
6. Besides taking into consideration the above government audit, enquiries and replies, the following information may also be relied upon to come to appropriate conclusion:
(i) Procurement of forge press is for debottlenecking as the capacity was not sufficient to meet production requirement and therefore it became bottleneck resulting in delayed supplies and getting into liquidated damages.
(ii) While sanctioning the fund, the Ministry insisted for an undertaking from the company that the amount will not be diverted for any other purpose.
(iii) The earlier contract on M/s ABC got terminated under Force Majure condition which qualified for suspended period of operation. As per the Guidance Note on Treatment of Expenditure during Construction Period, issued by ICAI, interest from investments of idle project funds should be adjusted in the capital cost of the project (refer paragraphs 8.1, 15.2, 16.1, 16.2 and 17.11 of the Guidance Note).
(iv) For the purpose of arriving at the net borrowing cost, the amount of interest paid to the Government on the outstanding loan from the date of award of new contract in June 2011 as well as the interest earned on the funds invested in fixed deposits are also considered. Thus, a detailed worksheet bringing out all the facts and figures to know the exact impact of borrowing cost has been provided by the querist for the perusal of the Committee.
(v) To have detailed information on the various notes published in the annual accounts which are duly accepted by statutory auditors as well as government auditors, a summarised sheet bringing out all the notes for ready reference has also been provided by the querist for the perusal of the Committee. Besides, two copies of printed annual reports of 2010-11 and 2011-12 have also been provided.
B. Query
7. In the above background, the querist has sought the opinion of the Expert Advisory Committee on the following issues:
(i) Whether the company is right in not capitalising the interest cost in respect of ESR furnace as the total period of contract execution was eight months only which cannot be treated as substantial period.
(ii) Whether the company is right in not capitalising the net interest cost (i.e., paid so far as well as interest earned on funds invested in short term fixed deposits) for forge press which is yet to be installed and also in view of the fact that net interest cost cannot be capitalised for suspended period of operation as the original contract was not executed due to bankruptcy of the supplier, i.e., M/s ABC, Korea and by refloating the tender, a fresh contract was awarded for supply, installation and commissioning of forge press in June 2011, and thus, operation was suspended till June, 2011.
(iii) Whether the amount of security deposit which was encashed and kept in suspense account is to be reduced from the procurement cost at the time of capitalising the forge press after installation and commissioning in the year 2012-13 or 2013-14.
C. Points considered by the Committee
8. The Committee, while answering the query, has considered only the issues raised in paragraph 7 above viz., (i) considering the time period involved in getting ESR furnace ready for its intended use, whether non-capitalisation of the related borrowing cost during that period is in line with AS 16, (ii) whether non-capitalisation of the borrowing costs incurred in relation to forge press is in line with AS 16 on the grounds that it is not yet installed and that borrowing costs are not eligible for capitalisation for the period when original contract could not be executed due to bankruptcy of supplier, and (iii) whether security deposit encashed on bankruptcy of original supplier should be reduced from the procurement cost of forge press. It has not examined any other issue that may arise from the Facts of the Case, such as, accounting for financial assistance received from the Government, accounting for interest accrued but not due on outstanding loan, accounting for borrowing costs in respect of second contract for forge press, borrowing cost incurred if any between the date when ESR furnace was ready for its intended use and put to use, accounting for various payments made to the contractor under the first contract for forge press, correctness in calculating the interest amount, correctness of impact on financial statements as stated by Government auditors, propriety of keeping the encashed security deposits under suspense account, treatment of any advance given to M/s ABC, Korea and interest thereon, etc. The opinion of the Committee contained hereinafter is from the accounting point of view only, and not from the point of view of income-tax considerations as the latter may be different from accounting considerations. Further, the Committee wishes to point out that the opinion expressed hereinafter provides the principles to be applied while accounting for the issues raised in paragraph 7 above and has not gone into the calculation of various amounts.
9. As regards accounting for borrowing costs in respect of ESR Furnace, the Committee notes the definition of the term ‘qualifying asset’ and paragraph 5 of AS 16, notified under the Companies (Accounting Standards) Rules, 2006 (hereinafter referred to as the ‘Rules’) as reproduced below:
“3.2 A qualifying asset is an asset that necessarily takes a substantial period of time to get ready for its intended use or sale.
Explanation:
What constitutes a substantial period of time primarily depends on the facts and circumstances of each case. However, ordinarily, a period of twelve months is considered as substantial period of time unless a shorter or longer period can be justified on the basis of facts and circumstances of the case. In estimating the period, time which an asset takes, technologically and commercially, to get it ready for its intended use or sale is considered.”
“5. Examples of qualifying assets are manufacturing plants, power generation facilities, inventories that require a substantial period of time to bring them to a saleable condition, and investment properties. Other investments, and those inventories that are routinely manufactured or otherwise produced in large quantities on a repetitive basis over a short period of time, are not qualifying assets. Assets that are ready for their intended use or sale when acquired also are not qualifying assets.”
From the above, the Committee notes that an asset can be considered as qualifying asset only if it takes substantial period of time to get ready for intended use or sale thereof. Ordinarily, 12 months may be considered as a substantial period of time, unless a shorter or longer period can be justified on the basis of facts and circumstances of the case. In this regard, time which an asset takes, technologically and commercially to get ready for its intended use should be considered. The Committee notes from the Facts of the Case (paragraph 4(i) above) that the period of ESR furnace from the date of contract to the date of installation is eight months. Further, it has also been mentioned that the ESR furnace was commissioned and capitalised in the year 2010-11. Accordingly, in the absence of any other related information, the Committee presumes that ESR Furnace takes total time period of eight months to get technologically and commercially ready for its intended use. Further, the Committee is of the view that if the company, based on the facts and circumstances, is of the view that eight months period does not constitute ‘substantial period of time’ in its case, then the company would be correct in not capitalising the interest cost in respect of ESR Furnace.
10. With regard to capitalisation of interest cost incurred on forge press, the Committee notes paragraphs 6, 10, 11 and 14 of AS 16, notified under the ‘Rules’, which are stated below:
“6. Borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset should be capitalised as part of the cost of that asset. The amount of borrowing costs eligible for capitalisation should be determined in accordance with this Standard. Other borrowing costs should be recognised as an expense in the period in which they are incurred.”
“10. To the extent that funds are borrowed specifically for the purpose of obtaining a qualifying asset, the amount of borrowing costs eligible for capitalisation on that asset should be determined as the actual borrowing costs incurred on that borrowing during the period less any income on the temporary investment of those borrowings.
11. The financing arrangements for a qualifying asset may result in an enterprise obtaining borrowed funds and incurring associated borrowing costs before some or all of the funds are used for expenditure on the qualifying asset. In such circumstances, the funds are often temporarily invested pending their expenditure on the qualifying asset. In determining the amount of borrowing costs eligible for capitalisation during a period, any income earned on the temporary investment of those borrowings is deducted from the borrowing costs incurred.”
“14. The capitalisation of borrowing costs as part of the cost of a qualifying asset should commence when all the following conditions are satisfied:
(a) expenditure for the acquisition, construction or production of a qualifying asset is being incurred;
(b) borrowing costs are being incurred; and
(c) activities that are necessary to prepare the asset for its intended use or sale are in progress.”
On the basis of the above, the Committee is of the view that for capitalisation of borrowing costs, it is not sufficient that the funds borrowed are outstanding during the period; it is also essential that the expenditure for construction of the asset is being incurred and the activities necessary to prepare the asset for its intended use are in progress. The Committee notes from the Facts of the Case that the company had entered into contract with M/s ABC, the first supplier of the forge press, which was cancelled due to bankruptcy of the supplier. The Committee is of the view that during the period when the original contract was cancelled and fresh contract to acquire forge press was awarded to another supplier, neither any expenditure was being incurred in construction of the asset nor any activity necessary to prepare the asset for its intended use was in progress, and hence, the question of capitalisation of interest or borrowing costs relating to that period does not arise.
The Committee also notes from paragraph 4 above that decision to capitalise the borrowing costs has been postponed till the commissioning of the plant. In this regard, the Committee wishes to point out that AS 16 prescribes determination of the amount of borrowing costs eligible for capitalisation in each period rather than postponing till the commissioning of the asset. If all the conditions stated in paragraph 14 of AS 16 are satisfied in relation to a qualifying asset, the borrowing costs should be capitalised as and when incurred. As regards accounting for interest earned on the encashed security deposits, the Committee notes from paragraphs 10 and 11 of AS 16 above that borrowing cost to be capitalised is to be adjusted with the income earned from temporary investment of borrowed funds while the project is in the stage of construction. From the Facts of the Case, the Committee is of the view that the interest earned on the encashment of security deposits on the cancellation of first contract is not of the nature of an income earned from investment of borrowed funds. The source of such income is non-performance on the part of supplier originally identified for acquisition of forge press. Hence, such income cannot be adjusted against the interest cost to be capitalised under second contract of forge press, rather it should be recognised in the statement of profit and loss.
11. As regards adjustment of encashed security deposit in the procurement cost of the forge press, the Committee notes paragraphs 69(a) and 91 of the ‘Framework for the Preparation and Presentation of Financial Statements’, issued by the Institute of Chartered Accountants of India, as reproduced below:
“69. …
(a) Income is increase in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contribution from equity participations.”
“91. Income is recognised in the statement of profit and loss when an increase in future economic benefits related to an increase in an asset or a decrease of a liability has arisen that can be measured reliably. This means, in effect, that recognition of income occurs simultaneously with the recognition of increases in assets or decreases in liabilities (for examples, the net increase in assets arising on a sale of goods or services or the decrease in liabilities arising from the waiver of a debt payable).”
From the above, the Committee is of the view that extinguishment/decrease in the liability should be recognised as income in the statement of profit and loss. In the extant case, the Committee notes from the notes to accounts of the company (Note No. 6), as provided by the querist that the security deposit realised from M/s ABC, Korea was disclosed under the head ‘other long-term liabilities’. Accordingly, the Committee is of the view that as and when extinguishment of such liability takes place, the same should be recognised as income in the statement of profit and loss and, therefore, question of adjustment of the same against the cost of the forge press does not arise.
D. Opinion
12. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 7 above:
(i) Subject to the presumption that ESR Furnace takes total time period of eight months to get technologically and commercially ready for its intended use and further, if the company, based on its facts and circumstances, is of the view that eight months period does not constitute ‘substantial period of time’ in its case, the Committee is of the opinion that the company would be correct in not capitalising the interest cost in respect of ESR Furnace.
(ii) The company is correct in not capitalising the interest cost incurred during the period when the original contract was cancelled and fresh contract to acquire forge press was awarded to another supplier, as discussed in paragraph 10 above.
(iii) No, the amount of security deposit which was encashed cannot be reduced from the procurement cost at the time of capitalising the forge press after installation and commissioning in the year 2012-13 or 2013-14, as discussed in paragraph 11 above.
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[1]Opinion finalised by the Committee on 22.1.2014 and 23.1.2014.
[2]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
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