Query No. 33

Subject:         Accounting treatment of price reduction due to delay in mechanical completion of capital projects.[1]

A. Facts of the Case

1.         A company, a Government of India (GOI) undertaking working under the Department of Fertilizers (DOF) was incorporated on 23rd August, 1974 with two manufacturing units at Bathinda and Panipat in the state of Punjab and Haryana, respectively, having an installed capacity of 5.115 lakh MT urea each. Subsequently, on the reorganisation of fertilizer group of companies in 1978, the Nangal Unit of Fertilizer Corporation of India with an installed capacity of 4.785 lakh MT urea came under the company’s fold. The company expanded its installed capacity in 1988 by 7.26 lakh MT urea after installing and commissioning of its Vijaipur gas based Plant in Madhya Pradesh.  Subsequently, Vijaipur plant doubled its capacity by commissioning Vijaipur Expansion Unit i.e., Vijaipur-II in 1997. The company also implemented capacity enhancement projects at Vijaipur I and II.  Consequently, at present, the company has an installed capacity of 35.68 lakh MT of urea. The plants at Nangal, Panipat and Bhatinda were based on feed stock of Fuel Oil (FO) and Low Sulphur Heavy Stock (LSHS) whereas plant at Vijaipur Unit was set up with feed stock as natural gas (NG). Urea (Fertilizer) is a controlled product and its price is controlled by the Government under its subsidy scheme. 

2.         The GOI, Ministry of Chemicals and Fertilizers, vide its letter dated 6.03.2009 notified policy for conversion of FO/LSHS urea units to natural gas.  The salient features of the policy are given as under:

• Government has approved to recognise cost of conversion through reimbursement of fixed cost for five years after conversion.

• Only FO/LSHS units viz., Bhatinda, Panipat, Nangal and Gujrat Narmada Valley Fertilizers & Chemicals Ltd. (GNVFC) Bharuch covered under the policy.

• Project Development India Limited (PDIL) will evaluate the project report by conducting techno-economic feasibility study.

• The actual project cost for conversion would be admitted after scrutiny by a team comprising representatives of PDIL, DOF, Fertilizers Industry Coordination Committee (FICC) and respective units and will be in accordance with the final PIB approval alongwith exchange rate variation and variation in statutory levies.

• The pre-set energy would be allowed for 5 years and saving in energy with respect to the same would be considered on designed/guaranteed basis and then same would be available to the unit for partially meeting the project cost. Keeping in view the above, the percentage of project cost to be considered for determining special fixed cost will be decided by the PIB while approving the project cost.

• The special fixed cost will be paid only for production till 100% of reassessed capacity.

3.         GOI approval of the company’s proposal for Ammonia Feed Stock Conversion Project (AFCP Project) at Bhatinda, Panipat and Nangal Unit: In terms of aforesaid GOI policy, techno-economic feasibility study of the proposals for AFCP Project through contractors A Ltd. (Bhatinda and Panipat) and B Ltd. (Nangal) was carried out by Project Development India Limited.  The company finalised award of lumpsum turnkey contracts (LSTK) in respect of Bhatinda, Panipat, Nangal Unit and after approval of the company’s Board of Directors, proposals for investment were sent by the company to the Department of Fertilizers for the approval of PIB and Cabinet Committee on Economic Affairs (CCEA).

3.1       PIB considered the proposals and recommended for approval of CCEA, the estimated project cost of Rs. 1294.19 crore for Bhatinda, Rs. 1292.48 crore for Panipat and Rs. 1478.63 crore for Nangal (Rs. 1346.20 crore for urea covered by Government grant and Rs. 132.43 crore for industrial products to be financed by the company out of its own resources).

3.2       As the company has made reference to the Institute of Chartered Accountants of India (ICAI) for its opinion on accounting treatment of price reduction (liquidated damage (LD)) in respect of LSTK contracts pertaining to Nangal and Panipat units only, the brief facts in the matter excluding facts of Bhatinda Unit are mentioned in the following paragraphs.

 3.3      GOI conveyed its approval to the investment proposal of Panipat and Nangal units for AFCP Projects to be implemented on lumpsum turnkey basis (LSTK) as per following details: 

*Rs. 1346.20 crore for urea and Rs. 132.43 crore for industrial products.

4.         DOF conveyed specific approval for Panipat and Nangal units vide its letter dated 8.02.2010 for undertaking conversion projects from FO/LSHS to gas based unit through LSTK contractor i.e., A Ltd. for Panipat unit and B Ltd. for Nangal unit. As per approval, the project cost shall be reimbursed subject to cost ceiling of Rs. 1292.84 crore for Panipat unit and Rs. 1346.20 crore for Nangal unit (subject to exchange rate variation, changes in statutory levies and also escalation/de-escalation on account of nickel price till the issuance of letter of intent on the quoted quantity of nickel). The project cost shall be further adjusted after completion of conversion project for any savings during execution, lower interest rate on loans with reference to SBI’s PLR and sales realisation of redundant front end of existing plant after conversion. The reimbursement of project cost shall be based on the following parameters:

• The actual project cost shall be admitted after scrutiny by a team comprising  representatives of PDIL, DOF, FICC and the company and will be in accordance with the CCEA approval.

• NPS III pre-set energy norm would be allowed for five years and saving in energy with respect to the same would be considered on designed/guaranteed basis and shall be available to unit for partially meeting the project cost.

• Balance project cost shall be paid through special fixed cost component and will be covering (i) interest on borrowed capital (ii) own funds (iii) 12% post tax return on own funds as a part of balance project cost.

• The special fixed cost would be fixed for five years period and would be paid from the date of commercial production after conversion upto the end of five years and shall be withdrawn at the end of five years.

• The special fixed cost shall be paid only for production till 100% of the re-assessed capacity.

• The project cost considered as special additional fixed cost would not be considered/recognised as a capital addition for the purpose of net fixed assets as well as for depreciation during current pricing and future pricing, if any.

• Special fixed cost component and the energy savings to be paid for first five years post conversion based on the production upto 100% of the reassessed capacity is towards reimbursement of capital cost of the project and is a subsidy in the nature covered under explanation 10 to section 43 (1) of Income-tax Act, 1961.

  LSTK Contract for Nangal Unit:

5.         Pursuant to the Government’s approval, contract was awarded on 29.01.2010 to B Ltd. on LSTK basis for AFCP Project of Nangal Unit. Under the contract, mechanical completion of the project was to be completed by 29.10.2012. The mechanical completion of the project was achieved by the contractor on 15.02.2013. There is delay of 108 days on the part of contractor in achieving mechanical completion. Clause No. 11.0 on Price Reduction and Clause No. 11.1.1 on amount of Price Reduction as contained in the contract are as under:

“11.0 Price Reduction Clause

If for reasons not attributable to the Owner or due to conditions not constituting Force Majeure as defined in this Contract, the Work is not completed in accordance with the provisions hereof, within and in accordance with the Time Schedule/time for Completion as indicated in the terms and conditions of the Contract, it is agreed that the Owner shall be entitled to recover and/or the Contractor shall pay to the Owner, without prejudice to any other rights or remedy available to the Owner, the following amount as mutually agreed compensation.

11.1.1 A sum equivalent to 0.5% of the Contract price for every complete week or part thereof, for delay in completion of milestone activities separately for ‘Mechanical Completion’ and ‘Hooking up & Commissioning’ of Plant by the Contractor, subject to a maximum 5% of total Contract Price inclusive of escalation and contingencies, if any.”

In terms of aforesaid provision of the contract, price reduction of Rs. 64.22 crore which is 5% of the contract value is leviable. The amount of price reduction (LD) of Rs. 64.42 crore is clearly identified with the AFCP Project and the same is directly attributable to the delay in achieving mechanical completion of the project. After commissioning on 9.04.2013, commercial production was declared on 18.07.2013. The assets of AFCP project were capitalised with project cost amounting to Rs. 1401.88 crore after reduction of Rs. 64.22 crore towards price reduction as per contract, in the accounts during F.Y. 2013-14. 

LSTK Contract for Panipat Unit:
6.         In respect of Panipat Plant, the contract was awarded on 29.01.2010 to A Ltd. As per the provisions of contract, mechanical completion of the project was to be completed by 28.10.2012. The mechanical completion of the project was achieved by the contractor on 9.11.2012. There is a delay of 12 days on the part of the contractor in achieving mechanical completion in respect of Panipat Unit. Clause No 11.1 on Price Reduction and Clause No. 11.1.1 on amount of Price Reduction as contained in the contracts for Panipat are as under:

“11.0   Price Reduction

 “11.1  If for reasons not attributable to the Owner or due to conditions not constituting Force Majeure as defined in this Contract, the Work is not completed in accordance with the provisions hereof, within and in accordance with the Time Schedule/ time for Completion as indicated in the terms and conditions of the Contract, it is agreed that the Owner shall be entitled to recover and/or the Contractor shall pay to the Owner, without prejudice to any other rights or remedy available to the Owner, the following amount as mutually agreed compensation.”

 

“11.1.1              A sum equivalent to 0.5% of the Contract price for every complete week or part thereof, for delay in completion of milestone activities separately for “Mechanical Completion” and “Hooking up & commissioning” of Plant by the Contractor, subject to a maximum 5% of total contract Price inclusive of escalation and contingencies, if any.”

In terms of aforesaid provision of the contract, price reduction of Rs. 10.99 crore is leviable on A Ltd. The amount of price reduction (LD) of Rs. 10.99 crore is clearly identified with the AFCP Project and the same is directly attributable to the delay in achieving mechanical completion of the project. After commissioning on 24.01.2013, commercial production was declared on 28.03.2013. The assets of AFCP project were capitalised with project cost amounting to Rs. 1232.32 crore after reduction of Rs. 10.99 crore towards price reduction as per contract in the books of account during F.Y. 2012-13. 

7.         Accounting treatment of Government grant in the annual accounts of the company for F.Y. 2012-13 and 2013-14

7.1       The company has adopted ‘Income Approach’ as per Accounting Standard (AS) 12, ‘Accounting for Government Grants’, for accounting treatment of government grant for the purpose of capitalisation of assets of AFCP Project of Nangal and Panipat Unit.  Accordingly, assets of AFCP projects have been shown at their historical cost and government grant relating to assets of AFCP Project is being treated as deferred income (receivable from the Government over a period of 5 years) which is being recognised in the statement of profit and loss and being allocated to income over the periods and in the proportions in which depreciation on AFCP assets is being charged.    

7.2       It may be mentioned that actual project cost of Nangal/Panipat Unit shall be admitted by the Government after scrutiny by a Government appointed team and will be in accordance with the Government’s approval of these projects as per approval letters dated 8.02.2010.  The Government will consider the actual executed cost under the contract.  Therefore, in the executed cost of the project, the amount of price reduction of Rs. 64.42 crore and Rs. 10.99 crore is required to be adjusted by the company in terms of aforesaid contract. 

7.3       As on date, the closure of AFCP contract for Nangal and Panipat is pending. The settlement of matter with LSTK contractor including the issue relating to recovery of price reduction shall be settled at the time of closure of contract.

Government audit observation on the annual accounts for F.Y. 2013-14:

8.         During the course of audit of annual accounts of the company for F.Y. 2013-14, Government audit issued the following half margin (HM) on the accounting treatment of adjustment of price reduction in the capital cost of AFCP project of Nangal and Panipat Unit:  

“As per the Opinion of the Expert Advisory Committee of the Institute of Chartered Accountants of India (ICAI) dated February 7, 1992, liquidated damages are not directly attributable to the acquisition of capital equipment like trade discounts and rebates. They are also not adjustments in the price of the equipment. The damages result from inefficiency on the part of the supplier, i.e., delay in the supply of the equipment. In view of this, the liquidated damages received from the supplier cannot be adjusted in the cost of purchase. Thus the amount of liquidated damages should be shown as income separately, in the profit and loss account, and not adjusted against the cost of the relevant asset acquired.

During the current year the company made recoveries on account of liquidated damages from the lumpsum turnkey (LSTK) contractors (of Ammonia Feed Stock Conversion Project at Nangal and Panipat units) M/s B Ltd. and M/s A Ltd. of Rs. 64.31 crore and Rs. 10.99 crore respectively on account of delay for mechanical completion of projects at Nangal and Panipat units as per terms of contract. In case of Nangal Unit, the LD charges were adjusted from the expenditure during construction period (included in capital work in progress) that were finally capitalised on commissioning of plant during the year. In case of Panipat Unit, the LD charges were adjusted from the capitalised amount of plant and machinery. Thus, the capitalised project costs for Nangal and Panipat units were reduced by Rs. 75.30 crore.

In view of the above opinion, the company cannot adjust the LD charges to reduce its capitalised cost and since this income pertains to the Government, as the asset is being acquired through capital grant, it being a revenue receipt, should be credited to the Government against the current recoverable from the Government.   The above accounting treatment has resulted in understatement of Deferred Government Grant and Tangible Asset (Gross Block) as on 31.03.2014 by Rs. 75.30 crore. Further, the depreciation on fixed assets against Government Grant was under charged by Rs. 2.98 crore.

While confirming facts and figures, the comment of the management may please be furnished within three days from issuance of the HM.”

9.         Reply to Government Audit Half Margin: The company submitted following reply to the aforesaid HM to the Government audit:

“During F.Y. 2010-11, the company has undertaken projects for changeover of Feed Stock from FO to gas based at three FO based units at Nangal, Bathinda and Panipat on Lump-Sum Turn key basis. In terms of Department of Fertilizer Letter No.14016/2/2007-FP (Vol-II) (2) and No.14016/2/2007-FP (Vol-II) (3) dated 8th Feb, 2010, capital cost of the Project shall be reimbursed by the Government of India in a span of 5 years post commercial production.

In respect of Nangal Plant the Ammonia Feedstock Conversion Project (AFCP) contract was awarded on 29.01.2010 to the consortium bid of M/s X Ltd., Italy & M/s Y Ltd., Mumbai on LSTK basis for the work of ‘The Revamp of Ammonia Plant at Nangal for change over of feedstock from Fuel Oil/LSHS to NG/RG’.

As per the provisions of contract, mechanical completion of the project was to be completed by 28.10.2012. The mechanical completion of the project was achieved by the contractor on 15.2.2013. There is a delay of 108 days on the part of the contractor in achieving Mechanical Completion.

In respect of Panipat Plant the contract was awarded on 29-01-2010 to M/s A Ltd. for the work of ‘The Revamp of Ammonia Plant at Panipat for change over of feedstock from Fuel Oil/LSHS to NG/RG’.

As per the provisions of contract, mechanical completion of the project was to be completed by 28.10.2012. The mechanical completion of the project was achieved by the contractor on 9.11.2012. There is a delay of 12 days on the part of the contractor in achieving Mechanical Completion in respect of Panipat.

Clause No 11.1 on Price Reduction and Clause No 11.1.1 on amount of Price Reduction as contained in the contracts for Nangal and Panipat are as under:

Price Reduction

“11.1   If for reasons not attributable to the Owner or due to conditions not constituting Force Majeure as defined in this Contract, the Work is not completed in accordance with the provisions hereof, within and in accordance with the Time Schedule/ time for Completion as indicated in the terms and conditions of the Contract, it is agreed that the Owner shall be entitled to recover and/or the Contractor shall pay to the Owner, without prejudice to any other rights or remedy available to the Owner, the following amount as mutually agreed compensation.”

“11.1.1              A sum equivalent to 0.5% of the Contract price for every complete week or part thereof, for delay in completion of milestone activities separately for “Mechanical Completion” and “Hooking up & commissioning” of Plant by the Contractor, subject to a maximum 5% of total contract Price inclusive of escalation and contingencies, if any.”

In respect of delay in mechanical completion as stated above, price reduction of Rs. 64.31 crore is leviable as per the provisions of the contract in respect of Nangal Unit and Rs. 10.99 crore in respect of Panipat Unit.  In terms of the contract, above amounts pertain to price reduction due to delay in achieving mechanical completion and are not in the nature of liquidated damages.

The total amount of price reduction of Rs. 75.30 crore has been deducted as a reduction in cost of the project and is clearly identified with the AFCP Project and the same is directly attributable to the delay in achieving mechanical completion of the project. Since said levy of price reduction is in accordance with the terms of the contract, price reduction of Rs. 64.31 crore in respect of Nangal and Rs. 10.99 crore in respect of Panipat has been deducted from the respective capital cost of the AFCP Project of unit for the purpose of capitalisation of assets of project in the annual accounts for F.Y. 2013-14.   In terms of the GOI policy dated 8.02.2010 for Nangal and Panipat for conversion of FO based plants to gas based, net cost is to be reimbursed by the Department of Fertilizers.

Further with reference to liquidated damages subsequent to opinion of the Expert Advisory Committee of the ICAI dated February 07, 1992, there are two expert opinions of the EAC of the ICAI dated December 12, 1995 and December 31, 1996 which are as under:

“The Committee is of the view whether or not liquidated damages should be adjusted against the project cost would depend upon whether the liquidated damages are directly identifiable with the project and whether, in fact, they are received in mitigation of the extra project costs incurred and capitalised by the enterprise on account of the same specific events which gave rise to liquidated damages. Where and to the extent the liquidated damages meet the aforesaid stipulations in affirmative, the same should be adjusted in the cost of the project.”

The opinion of Expert Advisory Committee of the ICAI dated December 31, 1996 has reiterated the above opinion and has given opinion in the matter as under:

“If it can be established that the liquidated damages are in fact received in mitigation of the extra project costs incurred and capitalised by the company on account of the same specific events which give rise to liquidated damages and that the said damages can be identified with the project, the Committee is of the opinion that the liquidated damages can be adjusted in  the cost of the project.”

Therefore, in view of embedded terms of AFCP contract of Nangal and Panipat Unit and opinion of Expert Advisory Committee, the accounting treatment is correct and this HM may kindly be dropped by Government Audit.”

 

Government Audit Supplementary Observation:

10.       Government auditors after considering the above reply have further pursued their observation of HM during the course of supplementary audit of the company’s annual accounts for F.Y. 2013-14 and vide their letter dated 28.08.2014 have requested the comapny for needful action in respect of observation made in the subject matter as under:

“The Company made recoveries on account of delay in mechanical completion as per Price Reduction clause of agreement from the lump sum turnkey (LSTK) contractors M/s. B and M/s. A Ltd. of Rs. 64.31 crore and Rs. 10.99 crore respectively at Nangal and Panipat Units. In case of Nangal Unit, the price reduction charges were adjusted from the expenditure during construction period that were finally capitalised on commissioning of plant during the year and in case of Panipat Unit, the price reduction charges were adjusted from the capitalised amount of plant and machinery.  Thus, the capitalised project costs for Nangal and Panipat units were reduced by Rs. 75.30 crore.  The company may refer full facts of the case to the ICAI to seek the opinion for accounting treatment in case of decrease in project cost due to price reduction.”

B.        Query

11.       In the above background, the opinion of the Expert Advisory Committee is requested for the following issues:

(i) Whether the accounting treatment of adjustment of price reduction of Rs. 64.42 crore at Nangal and Rs. 10.99 crore at Panipat in the capital cost is correct.

(ii) In the event the accounting treatment as at (i) above is not found correct, what accounting treatment is to be followed by the company considering the nature of project of reimbursement of capital cost by the GOI?

C.        Points considered by the Committee

12.       The Committee notes that the basic issue raised by the querist relates to accounting treatment of price reduction claimed by the company in respect of a contract from the contractor. The Committee has, therefore, considered only this issue and has not examined any other issue that may be contained in the Facts of the Case, such as, accounting treatment of reimbursement of capital cost of the project and various other costs from the Government, accounting for grants/subsidy received from the Government, etc. The opinion, expressed hereinafter, is purely from accounting perspective and not from the perspective of interpretation of norms for reimbursements of various elements of fixed and other costs as the accounting considerations are different from the considerations of the Government allowing reimbursement/Government grant/subsidy in respect of the Project.

13.       The Committee is of the view that the accounting for price reduction would depend upon the nature of such reduction. In this context, the Committee notes the following paragraphs from the contracts between the LSTK contractor and the company (a copy of which has been supplied by the querist for the perusal of the Committee):

  “11.0   Price Reduction Clause

11.1     If for reasons not attributable to the Owner or due to conditions not constituting Force Majeure as defined in this Contract, the Work is not completed in accordance with the provisions hereof, within and in accordance with the Time Schedule/ time for Completion as indicated in the terms and conditions of the Contract, it is agreed that the Owner shall be entitled to recover and/or the Contractor shall pay to the Owner, without prejudice to any other rights or remedy available to the Owner, the following amount as mutually agreed compensation.

11.1.1  A sum equivalent to 0.5% of the Contract price for every complete week or part thereof, for delay in completion of milestone activities separately for “Mechanical Completion” and “Hooking up & commissioning” of Plant by the Contractor, subject to a maximum 5% of total contract Price inclusive of escalation and contingencies, if any.”

“11.3   The amounts, as set in clause 11.1 is agreed upon and fixed by the parties due to difficulties in ascertaining, on the date hereof, the exact amount that will be actually incurred by the Owner in such event, and parties hereby agreed that amount specified herein are a genuine pre-estimate made by the parties of the loss and damage which the Owner would have suffered and as by way of mutually determined reasonable compensation payable to the Owner and without the Owner required to establish and prove the actual loss/damage suffered by the Owner, not in the nature of penalty and shall be applicable regardless of the amount of such deduction in value actually sustained by the Owner.

11.4     The parties agree and acknowledge that the amount set of  in clause 11.1 above may be recovered by the Owner from the amount to be paid to the Contractor and the Contract Price shall stand reduced by such amount.”

 

From the above, the Committee notes that the price reduction/compensation in the extant case is towards recovery of estimated loss and damages that would be incurred by the company. Further, the Committee notes that the terms of the agreement with the contractors themselves describe the amount to be recovered on account of delay in completion of the Project as ‘Price Reduction’, which indicate that this is merely an adjustment of price in case of delay in the completion of project. The Committee also notes that the amount of compensation would be recovered by the company from the amount to be paid to the contractor and the contract price shall stand reduced by such amount. Accordingly, the Committee is of the view that since the contract price itself would be reduced by the amount of compensation, the price reduction in the extant case is a reduction from the contract price and therefore, is a part of the process for determination of contract price of LSTK contract and, in substance, should be considered as a component of acquisition price of the relevant fixed asset under the LSTK contract. Accordingly, the price reduction in the extant case should be reduced from the cost of the asset/LSTK project concerned and should not be recognised in the statement of profit and loss.

14.       With reference to the earlier opinion of the Committee referred to by the Government auditor in support of his contention, the Committee notes that the facts of the earlier opinion in respect of liquidated damages were different from the facts of the extant case and therefore, the opinion expressed in that case, that the liquidated damages cannot be adjusted in the cost of purchase, cannot be applied in the extant case.

D.        Opinion

15.       On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 11 above:

(i) The accounting treatment of adjustment of price reduction of Rs. 64.42 crore at Nangal and Rs. 10.99 crore at Panipat in the capital cost is correct, as discussed in paragraph 13 above.

(ii) In view of (i) above, answer to this question does not arise.

____________________________

[1]Opinion finalised by the Committee on 7.11.2014.