Query no. 36
Subject:           Accounting treatment of finished goods produced which are used for internal capital expansion.[1]
A.        Facts of the Case
1.         A Limited is an Indian multi-national in the manufacture of iron and steel products, such as, structural steel, plates & coils, wire rods etc. It has manufacturing units across India particularly in the central and eastern part of the country. It has subsidiaries, joint ventures and associates in India and abroad. The company is also into expansion mode and is establishing an integrated steel plant at a new location. For the construction of this plant, the company besides, external purchases, shall also be consuming its own manufactured products.
2.         The querist has stated that the primary issue is whether finished products manufactured internally by a unit and consumed for capital consumption by another unit / same unit can be regarded as ‘revenue’ in the statement of profit and loss. It may be noted that these manufactured finished products are also sold to external customers in the ordinary course of business in substantial volumes. Internal captive consumption is not material.
3.         Secondary issues involve its (a) treatment when sold to related entities (b) cost of capitalisation in accordance with Accounting standard (AS) 10, ‘Accounting for Fixed Assets’ and (c) valuation when carried in inventories in accordance with Accounting Standard (AS) 2, ‘Valuation of Inventories’. 
4.         The querist, while raising the issue has referred to the following literature:

- Accounting Standard – 1        Disclosure of Accounting Policies;

- Accounting Standard – 2        Valuation of Inventories;

- Accounting Standard – 9        Revenue Recognition;

- Accounting Standard – 10      Accounting for Fixed Assets;

- Accounting Standard – 21      Consolidated Financial Statements;

- Accounting Standard – 23      Accounting for Investments in Associates in Consolidated Financial Statements; 

- Accounting Standard – 27      Financial Reporting of Interests in Joint Ventures;

- Announcement of the Institute of Chartered Accountants of India (ICAI) on ‘Inter-divisional transfer’ published in ‘The Chartered Accountant’, May 2005, pp 1531;

The following opinions of the Expert Advisory Committee of the ICAI:

5.         The querist has stated that in respect of the issue involved, three options could be considered:
Option 1: Goods capitalised are recognised as revenue with full disclosures in terms of quantity and value:

- This option is simple;

- The ratios could be analysed properly from a perusal of the published accounts which are general purpose financial statements;

- The company desires and is willing to disclose this treatment in the notes to the financial statements and to provide comprehensive quantitative details, such as, installed capacity, production of various products and products consumed internally for capital consumption  in its published results  even though not required by Schedule III to the Companies Act, 2013; 

- It may be noted that the finished goods that are capitalized cannot be further processed by the company. There will be no value-add to these finished products.

- Had the company not consumed these goods for capital consumption, these would have been sold to external customers. Thus, by not following this method, the company would be understating its revenue;

- The market of these goods exists and the company is able to sell these goods without any problem. The objective is to ensure that the project cost is relatively lower. The material purchased from third parties will be more costlier than the internal cost. The goods are not specifically manufactured for capital consumption;

- Alternatively, the company can sell these goods to outsiders and then purchase from these outsiders these very goods for capital consumption. This methodology will give the same results as also given in option 1;

- Also, the opinions referred above and the ICAI announcement under ‘Literature’ above have been given in the perspective that:

• Goods are ultimately sold to external customers; and
• Due to inter-divisional transfer of goods, double recognition of revenue should be avoided;

- The Announcement and EAC opinions are not applicable to the present matter where goods are not ultimately sold to external customers but are consumed internally for capitalisation. Further, the opinions are given in cases and are primarily applicable to ‘intermediate’ goods and not the ‘finished’ product;

- In this treatment:

• There is a change in the character of goods – from ‘sale’ to ‘use’;
• Thus, there is a change in the risk and reward profile of the goods;
• The ultimate collection is through ‘use’ embedded in the sale price of further goods manufactured through ‘use’ of capitalised products;

- It may be noted that the goods that are consumed are not a single item of a self-constructed asset. But it may also go in the construction of an asset that is being constructed by a third party.  For example, in the cement industry, the cement manufacturer may be supplying cement to a building contractor constructing the office building for the cement manufacturer. The cement is either supplied free of cost or may be deducted from the running bill of the contractor.  

- The company believes this treatment is in accordance with ‘Substance over Form’ as mentioned in paragraph 17 of Accounting Standard (AS) 1, ‘Disclosure of Accounting Policies’;

- That this option, as per the querist, is also supported by law (refer page 760 – 761 of Sampat Iyenger’s Law of Income-tax, 10th edition), which states that “In this context, the issue, as to the manner of taxation where stock in trade of the assessee is converted into capital asset or is merely withdrawn from the stock for personal use, would require a differential treatment as found in Sir Kikabhai Premchand v CIT (as held by Hon’ble SC in 1953 and reported in 24 ITR 506). It was held that if the stocks are valued at cost from year to year, the stocks that are withdrawn from the business would be treated as having been sold at cost for the purposes of computation from business and not at market value”.  (Emphasis supplied by the querist.)

- That paragraph 4.1 of Preface to the Statements of Accounting Standards, issued by the ICAI states, “Efforts will be made to issue Accounting Standards which are in conformity with the provisions of the applicable laws, customs, usages and business environment in India. However, if a particular Accounting Standard is found to be not in conformity with law, the provisions of the said law will prevail and the financial statements should be prepared in conformity with such law”. (Emphasis supplied by the querist.)

- This option facilitates the reconciliation of published data with various returns filed under various Acts such as excise, sales-tax and VAT;   

- The querist has also observed that certain listed enterprises are following this practice.

Option 2: The value of goods capitalised is deducted from the cost of raw materials consumed and adequate disclosures are made:

- This follows the approach enunciated in the ICAI’s Announcement and other literature referred above;

- But this option needs to appreciate that:

• There could be distortion of ratios over years within the enterprise and when compared with other entities, as ‘revenue’ is one of the indicators of enterprise growth;
• The value of goods capitalised consists of various components of costs, reducing only from cost of raw materials consumed will lead to understatement of ‘cost of raw materials consumed’ and overstatement of other expenses such as salaries, production and other overheads, interest, depreciation etc.;
• Schedule III to the Companies Act, 2013 requires total recognition and presentation of various items of cost;
• Enterprises are required to disclose ‘indirect expenditure treated as part of capital work-in-progress’ in the notes to the financial statements. Thus, to understand, for example, how much an enterprise has spent on say ‘salaries & wages’, a reader would be required to add figures from 3 data sources (a) statement of profit and loss (b) statement of indirect expenditure treated as capital work in progress and (c) statement of components of indirect cost embedded in the finished goods capitalised but data related to all components may not be disclosed;
• Also, this presentation will not lead to complete recognition of all expenses of similar nature as a single item (It may be noted that the statement of profit and loss is now based on ‘nature of expense’ approach method); 

- An alternative to this option is not to make any disclosures. Is this alternative view acceptable?

Option 3: As the goods consist of various components of cost, deduction is made from each component of cost and adequate disclosures are made:

- This option has a merit over option 2 as the costs are reduced from the correct head;

- However, generation of data for each component of cost could be a very complex, time consuming and expensive exercise and inconsistent with cost-benefit approach;

- But this approach will make the entire process of preparation and presentation of statement of profit and loss extremely complex and perhaps incomprehensible;

- An alternative to this option is not to make any disclosures, but this clearly is not advisable.

6.         The querist has stated that the company presently measures the goods capitalised as a part of capital expansion project in accordance with Cost Accounting Standard 4 (CAS 4), ‘Cost of Production for Captive Consumption’ read with Rule 8 of the Central Excise Valuation Rules which, inter alia, provides that where the excisable goods are not sold but are used for consumption of the assessee or on his behalf in the production or manufacture of other articles, the value shall be 110% of the cost of production or manufacture of such goods to be determined as per CAS 4, as required by circular dated 13th February, 2003, issued by Department of Revenue, Ministry of Finance and Company Affairs, Government of India.  The querist pointed out that as per paragraph 4.1 of CAS 4, “cost of production shall consist of material consumed, direct wages and salaries, direct expenses, works overheads, quality control cost, research and development cost, packing cost, administrative overheads relating to production. To arrive at cost of production of goods dispatched for captive consumption, adjustment for stock of work-in-process, finished goods, recoveries for sales of scrap, wastage etc shall be made”.

7.         The querist drew the attention of the Committee to the requirements of paragraph 10 of Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, which states 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. Included in the gross book value are cost of construction that relate directly to the specific asset and costs that are attributable to the construction activity in general and can be allocated to the specific asset. Any internal profits are eliminated in arriving at such costs”.

8.         The querist also noted the requirements of paragraph 6 of Accounting Standard (AS) 2, ‘Valuation of Inventories’, which provides that “the cost of inventories should comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition”.

9.         The querist pointed out that one of the costs that is included under AS 10 is borrowing cost, which is not included either under CAS 4 or AS 2.

B.        Query

10.       On the basis of the above, the querist has sought the opinion of the Expert Advisory Committee on the following issues:

(a) Whether goods manufactured internally (which can also be sold to external customers) and capitalised as a part of capital work-in-progress or tangible fixed assets can be considered as ‘revenue’ in the statement of profit and loss.  If yes, whether the treatment and disclosures proposed in option 1 (refer paragraph 5 above) shall be in conformity with the accounting principles and accounting standards. If not, what is the correct treatment and requisite disclosures?      

(b)If answer to query (a) above is ‘no’, then, which of the options out of options 2 and 3 (refer paragraph 5 above) should be adopted and what should be the accounting and disclosures requirement? If neither option 2 nor option 3 is acceptable, what is the correct methodology for accounting and presentation in general purpose financial statements.

(c) The company will be selling the goods manufactured by it to its subsidiaries, step-down subsidiaries, joint ventures and associates and the transactions will be at ‘arm’s length’. Further, these enterprises shall be capitalising these goods as part of tangible fixed assets. In such a case, how should these transactions be recognised, measured, presented and disclosed in the consolidated financial statements prepared by the holding company so that these are in compliance with Accounting Standard (AS) 21, ‘Consolidated Financial Statements’, Accounting Standard (AS) 23, ‘Accounting for Investments in Associates in Consolidated Financial Statements’, and Accounting Standard (AS) 27,  ‘Financial Reporting of Interests in Joint Ventures’?                                                                       

(d) When capitalising an internally manufactured finished product, whether the value of capitalised item to be adopted should be as per (a) Cost Accounting Standard 4, ‘Cost of Production for Captive Consumption’ read with relevant excise law circulars (refer paragraph 6 above), (b) AS 2, ‘Valuation of Inventories’ (refer paragraph 8 above), or (c) AS 10, ‘Accounting for Fixed Assets’ (refer paragraph 7 above). If neither of these alternatives are acceptable, suggest the correct valuation methodology.

(e) Presently, the company is valuing its inventory in accordance with AS 2, i.e., lower of cost or net realisable value. As per the querist, the issue is that the company may not be aware as on the reporting date whether the goods carried in inventory shall be used for capital consumption in subsequent years. In case the company is not aware whether the goods carried in inventory shall be used for capital consumption in subsequent years:

- Will it be appropriate to value the said goods in accordance with the present practice, i.e., lower of cost or net realisable value?;

- If so, if such valuation differs from the valuation determined in accordance with paragraph 10 of AS 10, how should the differential in two values be recognised and disclosed in the annual results when these products are used for capital consumption in a subsequent year?

In case the company is aware that the goods, as identified, carried in inventory shall be used for capital consumption in subsequent years, what should be the basis of valuation of such goods? 

C.        Points considered by the Committee

11.       The Committee has examined the issues raised in paragraph 10 above, purely from accounting point of view and has not evaluated the compliance or otherwise of this matter with the applicable laws and regulations including excise rules, requirements relating to cost accounting records etc. since as per Rule 2 of the Advisory Service Rules of the Committee, the Committee does not answer issues that involve purely interpretation of legal enactments.  Similarly, the Committee has not evaluated any tax implications of the matters under consideration.  Further, the opinion expressed below does not deal with the associated presentation and disclosure matters, such as segment reporting, related party disclosures, disclosures required by Schedule III of the Companies Act, 2013 etc., which should be carried out in accordance with the relevant requirements, as applicable.

12.       The Committee notes that, as per the querist, internal captive consumption is not material (refer to paragraph 2 above).  The Committee has examined the matter from the perspective of accounting principles. However, as per the ‘Preface to the Statements of Accounting Standards, issued by the Council of the Institute of Chartered Accountants of India (ICAI), “the Accounting Standards are intended to apply only to items which are material”.  Further, the Committee notes that with regard to the amount at which the finished product should be capitalised, the querist has referred to Cost Accounting Standards. The Committee is of the view that these are not relevant for the measurement of an item for the purpose of preparation of general purpose financial statements since the objective and purpose of such standards are different.

13.       The Committee notes the following definition of ‘revenue’ as per Accounting Standard (AS) 9, Revenue Recognition:

“4.1 Revenue is the gross inflow of cash, receivables or other consideration arising in the course of the ordinary activities of an enterprise from the sale of goods, from the rendering of services, and from the use by others of enterprise resources yielding interest, royalties and dividends. Revenue is measured by the charges made to customers or clients for goods supplied and services rendered to them and by the charges and rewards arising from the use of resources by them. In an agency relationship, the revenue is the amount of commission and not the gross inflow of cash, receivables or other consideration.”

The Committee also notes the following paragraphs from the Announcement on Treatment of Inter-divisional Transfers, issued by the ICAI in May 2005 (referred to as the ‘Announcement’):

“The use of the word ‘enterprise’ in the definition of the term ‘revenue’ clearly implies that the transfers within the enterprise cannot be considered as fulfilling the definition of the term ‘revenue’.  Thus, the recognition of inter-divisional transfers as sales is an inappropriate accounting treatment and is inconsistent with Accounting Standard (AS) 9, Revenue Recognition. …”

“Since in case of inter-divisional transfers, risks and rewards remain within the enterprise and also there is no consideration from the point of view of the enterprise as a whole, the recognition criteria for revenue recognition are also not fulfilled in respect of inter-divisional transfers.” 

14.       Considering the above, the Committee is of the view that goods manufactured internally, which are used for the purpose of capital expansion project of the company, cannot be considered as revenue of the company.   The Committee notes that this view is also consistent with the EAC opinions referred to by the querist in paragraph 4 above.

15.       The Committee also considers the querist’s view that the earlier EAC opinions and the Announcement are not applicable to the present situation since ultimately goods are not sold to external customers but are consumed internally for capitalisation and hence, there is no double recognition of revenue, and also that the earlier opinions were primarily applicable to ‘intermediate’ goods and not to the ‘finished’ product.   The Committee is of the view that these aspects do not have an impact on the matter under consideration since in both the cases, i.e., where the goods are transferred to other divisions for onward processing and sale and, where the goods are transferred for capital expansion project within the company, no sale of goods to external customers is involved. Therefore, recognition of revenue is not appropriate.  

16.       The Committee notes that the cost of finished goods capitalised comprise various components, such as, raw materials, production and other overheads, depreciation etc.   In view of this, it would not be appropriate to deduct the entire cost of goods capitalised from the cost of raw materials consumed, as suggested by the querist as Option 2 (refer paragraph 5 above).     The various components of cost of finished goods should be reduced from the relevant heads.  This position is similar to the situation where a company uses its internal department, say engineering department, for capitalisation activity, and the salary of the personnel of that department is capitalised as a part of the capital work-in-progress.   The company should make suitable disclosures by way of a note to explain the above.

17.       With regard to the situation where the goods manufactured by the company are sold to its subsidiary, joint venture and associate companies and these companies capitalise these goods as a part of capital work-in progress or tangible fixed assets, in the context of consolidated financial statements, the Committee is of the view that in such cases, the general principles laid down in AS 21, ‘Consolidated Financial Statements’, AS 23, ‘Accounting for Investments in Associates in Consolidated Financial Statements’ and AS 27, ‘Financial Reporting of Interests in Joint Ventures’, notified under the Companies (Accounting Standards) Rules, 2006, (hereinafter referred to as the ‘Rules’) as reproduced below, should be applied:

AS 21, Consolidated Financial Statements:
“16.     Intragroup balances and intragroup transactions and resulting unrealised profits should be eliminated in full. Unrealised losses resulting from intragroup transactions should also be eliminated unless cost cannot be recovered.

17.       Intragroup balances and intragroup transactions, including sales, expenses and dividends, are eliminated in full. Unrealised profits resulting from intragroup transactions that are included in the carrying amount of assets, such as inventory and fixed assets, are eliminated in full. Unrealised losses resulting from intragroup transactions that are deducted in arriving at the carrying amount of assets are also eliminated unless cost cannot be recovered.”

In view of the above, while preparing the consolidated financial statements, the company would eliminate the intragroup transaction of sale of finished products and unrealised profit, if any, included in the carrying amount of tangible fixed assets.   The overall impact from the perspective of the consolidated financial statements, would be the same as if the financial statements of a single enterprise are prepared considering the subsidiary as a division.  Therefore, the accounting treatment explained in the above paragraphs would be equally relevant in the context of consolidated financial statements when the goods manufactured are sold to a subsidiary company.

AS 23, Accounting for Investments in Associates in Consolidated Financial Statements
13.       In using equity method for accounting for investment in an associate, unrealised profits and losses resulting from transactions between the investor (or its consolidated subsidiaries) and the associate should be eliminated to the extent of the investor’s interest in the associate. Unrealised losses should not be eliminated if and to the extent the cost of the transferred asset cannot be recovered.

Considering the above requirements of AS 23, the company, in its consolidated financial statements, in effect, should eliminate unrealised profits and losses to the extent of the company’s interest in the associate entity (assuming that the cost of the transferred asset can be recovered).  

AS 27, Financial Reporting of Interests in Joint Ventures:
“40.     When a venturer contributes or sells assets to a joint venture, recognition of any portion of a gain or loss from the transaction should reflect the substance of the transaction. While the assets are retained by the joint venture, and provided the venturer has transferred the significant risks and rewards of ownership, the venturer should recognise only that portion of the gain or loss which is attributable to the interests of the other venturers. The venturer should recognise the full amount of any loss when the contribution or sale provides evidence of a reduction in the net realisable value of current assets or an impairment loss.”

44.       In the separate financial statements of the venturer, the full amount of gain or loss on the transactions taking place between the venturer and the jointly controlled entity is recognised. However, while preparing the consolidated financial statements, the venturer's share of the unrealised gain or loss is eliminated. Unrealised losses are not eliminated, if and to the extent they represent a reduction in the net realisable value of current assets or an impairment loss. The venturer, in effect, recognises, in consolidated financial statements, only that portion of gain or loss which is attributable to the interests of other venturers.”

 

Considering the above requirements of AS 27, the company, in its consolidated financial statements, in effect, should recognise only that portion of the gain or loss which is attributable to the interests of the other venturers (assuming unrealised losses do not represent a reduction in the net realisable value of current assets or an impairment loss).  

18.       The Committee is of the view that till the change in intention of the company to transfer the inventory item (finished goods) to capital work-in progress or tangible fixed assets, the company needs to follow the measurement principles of AS 2, Valuation of Inventories, since till that time, the intention was to sell the inventory item in the ordinary course of business.   Once there is a change in intention of the company from ‘sale in the ordinary course of business’ to ‘use in internal capital project’, the question arises with regard to the value at which the transfer should be made. In this regard, the Committee notes the requirements of Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, notified under the Rules, as follows:

“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.”

“10.1 In arriving at the gross book value of self-constructed fixed assets, the same principles apply as those described in paragraphs 9.1 to 9.4. Included in the gross book value are costs of construction that relate directly to the specific asset and costs that are attributable to the construction activity in general and can be allocated to the specific asset. Any internal profits are eliminated in arriving at such costs.”

From the above, the Committee notes that the cost of an item of fixed assets comprises the cost of various items/elements that are directly attributable to bringing the asset to its working condition for its intended use. Accordingly, the Committee is of the view that the transfer should be made at cost. In case, such items of inventories are being carried in the books at ‘net realisable value’ as per the principles of AS 2, the Committee is of the view that inventories should be brought back to their cost through the statement of profit and loss, as per the requirements of AS 2.

19.       With regard to capitalisation of ‘borrowing costs’, the Committee is of the view that as per AS 16, borrowing costs should be capitalised (subject to fulfilment of other criteria prescribed therein) only if these are directly attributable to the acquisition, construction or production of a qualifying asset.  In the present case, till the time, the finished goods are held by the company for sale in the ordinary course of business, it would not meet the definition of a qualifying asset and, hence, borrowing costs cannot be capitalised.  Once these assets are classified as a part of capital work-in progress, the relevant costs would be considered for capitalisation of borrowing costs (provided the underlying capital expansion project meets the definition of ‘qualifying asset’ and other criteria laid down in AS 16 are met).   The Committee is of the view that change in the expected usage of finished goods from ‘sale in the ordinary course of business’ to ‘use in the internal capital project’ is the trigger point for determining its classification and subsequent accounting thereof.

20.       With regard to the accounting as at the reporting date, the Committee notes the difficulty expressed by the querist that the company may not be aware as on the reporting date whether the goods carried as inventory shall be used for capital expansion in subsequent years. However, the Committee is of the view that such a situation may not arise due to reasons stated in paragraphs 18 and 19 above. Till the time, the finished goods are held by the company for sale in the ordinary course of business and not identified for use in the fixed asset, they would meet the definition of inventory and would continue to be classified as such. Change in the expected usage of finished goods from ‘sale in the ordinary course of business’ to ‘use in the internal capital project’ should be the trigger point for determining its classification and subsequent accounting thereof.

D.        Opinion

21.       On the basis of the above, the Committee is of the following opinion on the issues raised by the querist in paragraph 10 above:

(a) The goods manufactured internally and capitalised as a part of capital work-in-progress or tangible fixed assets, should not be considered as revenue.

(b)  Various components of the cost of finished goods produced should be deducted from the respective heads. The company should make suitable disclosures by way of a note to explain the above as stated in paragraph 16 above.
(c)  In case the finished products are sold to subsidiaries/ step subsidiaries, joint ventures and associates and are capitalised by these entities as a part of capital work-in progress or tangible fixed assets, the querist should apply the principles laid down in AS 21, AS 23 and AS 27, referred to in paragraph 17 above, for the purpose of preparing consolidated financial statements.
(d) Till the change in intention of the company to transfer the inventory item (finished goods) to capital work-in progress or tangible fixed assets, the company needs to follow the measurement principles of AS 2, Valuation of Inventories. The transfer from inventory to capital work-in-progress or tangible fixed asset should be made at its cost and, subsequent measurement should be in accordance with requirements of AS 10, Accounting for Fixed Assets, as discussed in paragraphs 18 to 20 above.

(e) Till the time, the finished goods are held by the company for sale in the ordinary course of business and not identified for use in the fixed asset, they would meet the definition of inventory and would continue to be classified as such. Change in the expected usage of finished goods from ‘sale in the ordinary course of business’ to ‘use in the internal capital project’ should be the trigger point for determining its classification and subsequent accounting thereof.

_____________

[1]Opinion finalised by the Committee on 11.12.2014.