Query No. 6                    

Subject:           Capitalisation of expenditures in respect of projects under construction.[1]

A. Facts of the Case

1.         A company (hereinafter referred to as ‘the company’) has been created as an undertaking of a State Government for implementing the Metro Rail Project (hereinafter referred to as ‘the project’). The company has entered into an agreement with A Ltd. for construction of phase IA of the project.

2.         The querist has stated that for the construction of phase IA, A Ltd. has agreed to charge 6% on the total estimated value (as per Detailed Project Report (DPR)) of the works carried out by A Ltd. as overhead charges/fees to cover their establishment and administrative overheads. It is worth to note here that rate of fees normally charged on the deposit works is 12.5%. The company, during the preparation of books of account for the year ended on 31/03/2012, has charged the fees paid to A Ltd. to revenue instead of capitalising the same on the premise that A Ltd. is providing administrative/management support to the company by undertaking on behalf of the company, the appointment of contractors and consultants and management thereof and procurement of equipments and installation thereof; virtually this is as an extension of the administrative wing of the company. If A Ltd. would not have agreed to do it, the company would have directly incurred the establishment cost. According to the querist, as per Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’ also, the cost which is not specifically attributable to a specific asset is not to be capitalised. The expression "may be included as part of the cost of the construction" has been used in paragraph 9.2 of AS 10, which indicates that those expenses which are not specifically attributable to specific fixed asset, may not be capitalised (emphasis supplied by the querist).

3.         The querist has also stated that the administrative charges payable to A Ltd. are on the total cost even if the actual expenditure is lower. Further, it is not attributable to a specific asset group whereas the assets proposed to be created may fall under the following asset groups:

(i) Civil works (All building, depot, station etc.)

(ii) Plant & Machinery

(iii) Rolling stock

(iv) Power sub-station

(v) Other fixed assets

 

In view of this also, the capitalisation is not covered under the spirit of AS 10.

4.         During the supplementary audit under section 619(3)(b) of the Companies Act, 1956, of the company's accounts for the year ending on 31/03/2012, the Principal Accountant General of the State, has stated this treatment to be in contravention to AS 10.

5.         However, the company differs on this interpretation of AS 10 due to the fact that the spirit of AS 10 is not to ensure that all expenditure that may be classified as capital expenditure must be so classified. Instead, it is to ensure that no expenditure that may not be classified as capital expenditure is not so classified. This spirit of AS 10 has been followed by the company only to avoid unnecessary capitalisation of the expenses in question.

The querist has further mentioned that the establishment expenses incurred by the company on its employees including Chairman-cum-Managing Director (CMD), finance department, technical department and the administrative expenses incurred by the company have been accounted for as revenue expenses, the accounting of which has been duly accepted by the Comptroller and Accountant General (C&AG).

B. Query

6.         The querist has sought the opinion of the Expert Advisory Committee of the Institute of Chartered Accountants of India (ICAI) on the application of AS 10 particularly paragraph 9, ‘components of costs’, of which sub-paragraph 9.2 clearly states that administrative and general overhead expenses are usually excluded from the cost of fixed assets because they do not relate to a specific fixed asset. Accordingly, whether the establishment and administrative overheads etc. paid by the company to A Ltd. is capital or revenue expenditure (allowable under the provisions of the Income-tax Act, 1961) and therefore, whether the treatment given in the accounts by the company is the violation of AS 10.

C. Points considered by the Committee

7.         The Committee notes that the basic issue raised in the query relates to accounting treatment of fees paid to A Ltd. which is providing administrative and management support to the company relating to the appointment of contractors and consultants, procurement and installation of equipments for the construction of the project. The Committee has, therefore, considered only this issue and has not touched upon any other issue arising from the Facts of the Case, such as, correctness in the treatment of establishment expenses incurred by the company and other administrative expenses, which are accounted as revenue expenses and also accepted by the C&AG, etc. Further, the Committee has presumed that various assets under the project or the project itself are controlled by the company and have been appropriately capitalised in the books of the company. The Committee also wishes to point out that its opinion is expressed purely from accounting point of view and not from the angle of legal interpretation of any legal enactment, such as, Income-tax Act, 1961, i.e., whether any expense is allowable or disallowable under the Income-tax Act as the Committee is prohibited from answering such issues as per its Advisory Service Rules.

8.         The Committee notes paragraphs 9.1, 9.2, 20 and 21 of AS 10 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. 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.
…”

“9.2 Administration and other general overhead expenses are usually excluded from the cost of fixed assets because they do not relate to a specific fixed asset. However, in some circumstances, such expenses as are specifically attributable to construction of a project or to the acquisition of a fixed asset or bringing it to its working condition, may be included as part of the cost of the construction project or as a part of the cost of the fixed asset.”

“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.”

From the above paragraphs of AS 10, the Committee is of the view that the basic principle to be applied while capitalising an item of cost (including administration and other general overhead expenditure) to a fixed asset under construction is that it should be directly attributable to the construction of the fixed asset for bringing it to its working condition for its intended use. These are the expenditures without the incurrence of which, the construction of fixed asset could not have taken place and the asset could not be brought to its working condition, such as, site preparation costs, installation costs, professional fees, etc. The Committee is further of the view that the above principles of capitalisation relating to a fixed asset are equally applicable to a group of assets including a project.

9.         The Committee notes that in the extant case the company has entered into the agreement with A Ltd. for the appointment of contractors and consultants and management thereof and for procurement and installation of equipments for the purpose of the construction of the project which the company has argued to be administrative overheads by nature. The Committee further notes from AS 10 that if expenses are directly attributable to the construction of a project or to the acquisition of any fixed asset or bringing it to its working condition, these may be included as part of the cost of the project or as a part of the cost of the fixed asset. The Committee is of the view that the fees paid to A Ltd. is being specifically incurred for the project and therefore, should be regarded as directly attributable to the project or fixed asset(s) constructed or acquired for the project and therefore should be capitalised in the cost of the project or fixed asset.

10.       As regards the querist's argument in the context of phrase, ‘may be included as part of the cost of the construction’, used in paragraph 9.2 of AS 10, the Committee is of the view that paragraph 9.2 explains only the application of the ‘Main Principles’ as given in paragraph 20 of AS 10 (reproduced in paragraph 8 above), which states that the cost of fixed asset should comprise any attributable cost of bringing the asset to its working condition for its intended use. Accordingly, since the expenses incurred in the extant case are specifically incurred for the project and are directly attributable to it, these ‘should be’ capitalised as discussed in paragraph 9 above.

11.       As regards the querist's argument that the principles of AS 10 is to avoid unnecessary capitalisation of the expenses, the Committee does not agree with the querist as there are specific principles for capitalising an expenditure as an asset or for expensing it as the decision to capitalise/expense can have a material effect on the company’s reported results.

D.        Opinion

12.       On the basis of the above, the Committee is of the opinion that the treatment made by the company on the expenses incurred as establishment and administrative expenses in the form of fees to A Ltd. as revenue expenditure is not in accordance with AS 10 and these should be capitalised to the project/asset(s) concerned as discussed in paragraphs 8 and 9 above.

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