Query No. 42

Subject:           Accounting treatment of borrowing cost for oil & gas assets acquired directly and through overseas subsidiary companies.[1]

A. Facts of the Case

1.         A public limited company, which is a wholly owned subsidiary of a listed Government company (hereinafter referred to as the ‘company’), is in the business of exploration and production of oil and gas and other hydrocarbon related activities outside India.The company acquires oil and gas properties/blocks by way of acquisition of Participating Interest (PI) 100% or less, therein either directly or through acquisition of the legal entity owning the right in the oil and gas properties/blocks. The overseas oil and gas operations are generally conducted in joint ventures with other partners. The company has PI in these joint ventures either directly or through acquisition of a company holding PI in the asset or through its wholly owned overseas subsidiary companies. Main consideration for holding PI through subsidiary companies is because of tax or host country’s regulations or risk management point of view.

2.         The company compiles standalone financial statements as well as consolidated financial statements including the overseas subsidiaries denominated in INR, following the requirements of the Companies Act and the accounting standards and relevant guidance notes issued by the Institute of Chartered Accountants of India (ICAI).

3.         The querist has stated that recently, the company has acquired PIs in the same oil and gas assets as under:

(i)X% PI in an overseas oil and gas joint venture project directly by the company as an asset transaction, and

(ii)Another Y% PI by way of acquiring shares of an overseas subsidiary company which ultimately holds the PI in the same overseas oil and gas joint venture project. (Emphasis supplied by the querist).

The company had financed both the above acquisitions in the oil and gas joint venture project partly by external borrowings and partly by internal accruals. The project is currently under development and would be taking substantial time for commencement of oil and gas production. The borrowing costs incurred for the acquisition of the PIs in the oil and gas joint venture project was accounted for in the books of account as per the following:

 (i) The borrowing cost related to the acquisition of X% PI directly by the company by way of asset acquisition was capitalised to the eligible assets following the provisions of Accounting Standard (AS) 16, ‘Borrowing Costs’, notified under the Companies (Accounting Standards) Rules, 2006.

(ii) The borrowing cost related to the acquisition of Y% PI by way of acquiring shares of the overseas subsidiary company which ultimately holds the PI in the same overseas oil and gas joint venture has been charged off following the provisions of AS 16 since the investment in shares is not a qualifying asset.

4.         The querist has observed that though the company has acquired PI in the same oil and gas joint venture project through two different legal structures to optimize the taxation or host country’s regulations etc., which are quite similar in substance but different in form, the accounting treatment for borrowing costs differs significantly. This does not reflect the true economic value of the acquisition of the underlying oil and gas asset. In view of the above, the company believes that the borrowing cost incurred by the company for both the transactions to ultimately acquire PI interest in the same oil and gas assets should be capitalised to the underlying eligible assets of the project.

5.         The querist has further stated that paragraph 35 of the Framework for the Preparation and Presentation of Financial Statements, issued by the ICAI deals with the issue of ‘substance over form’ as one of the principles for reliability of financial statements.  If information is to represent faithfully the transactions and other events that it purports to represent, it is necessary that these are accounted for and presented in accordance with their substance and economic reality and not merely their legal form. The substance of transactions or other events is not always consistent with that which is apparent from their legal or contrived form. The principle of ‘substance over form’ is used “to ensure that financial statements give a complete, relevant, and accurate picture of transactions and events”. If an entity practices the ‘substance over form’ concept, then the financial statements will show the overall financial reality of the entity (economic substance), rather than the legal form of transactions. In accounting for business transactions and other events, the measurement and reporting is for the economic impact of an event, instead of its legal form.

6.         According to the querist, the principle of ‘substance over form’ is relevant in the instant case as the company in essence has acquired the PI in the assets in different forms only. So considering the ‘substance over form’, the borrowing costs incurred in both cases should be capitalised to the underlying eligible assets.   

Suggested accounting treatment of borrowing costs for acquiring PI in oil and gas assets through acquiring shares of subsidiary company 

7.         As per the querist, considering the above facts, to uniformly record and present the true economic value of the above two transactions which are same in substance but different in form, the borrowing costs incurred by the company related to acquiring shares in the overseas subsidiary company ultimately holding the participating interest in the joint venture should also be capitalised to the respective eligible assets. In the standalone books, the borrowing cost related to acquisition of PI through the subsidiary company would be charged off to the statement of profit and loss. However, in the consolidated financial statements of the company, the borrowing cost incurred by the company relating to acquisition of PI through the subsidiary company will be capitalised to the respective eligible assets by necessary adjustment to the statement of profit and loss.

B.        Query

8.   In view of the above facts, the opinion of the Expert Advisory Committee (EAC) of the ICAI is sought on the following issues:

(i) Considering ‘substance over form’, whether the suggested accounting treatment of capitalising the borrowing cost related to acquiring PI in the oil and gas project through the overseas subsidiary company to the respective eligible assets held by the subsidiary company  in the underlying oil and gas project as per paragraph 7 above is appropriate.

(ii) Is there any other accounting treatment to bring in uniformity in the accounting for borrowing costs for both the transactions in the extant case?

(iii) Whether there is any need for addition to the relevant Accounting Standards to provide for the extant situation of capitalising the borrowing cost.

C.        Points considered by the Committee

9. The Committee notes that the basic issue relates to accounting for borrowing costs incurred on acquisition of participating interest in oil and gas assets through participating interest in joint operations with other partners through acquisition of shares in overseas subsidiary. The Committee has, therefore, considered only this issue and has not considered any other issue that may arise from the Facts of the Case, such as, accounting for joint venture as per AS 27, whether the ‘oil and gas assets’ acquired directly in the joint venture can be considered as ‘qualifying assets’ as per the principles of AS 16, accounting in the books of subsidiary company, consolidation of financial statements of subsidiary companies as per AS 21, etc. Further, it is presumed from the Facts of the Case that joint venture referred in the extant case is not a jointly controlled entity since acquisition of oil and gas assets through a jointly controlled entity cannot be considered as a qualifying asset for the company.

10. With regard to the issue of accounting treatment of borrowing costs incurred on acquisition of participating interest in joint venture by way of asset (oil and gas assets) acquisition through overseas subsidiary, the Committee notes the definition of ‘qualifying asset’ and paragraphs 5, 6, 14 and 16 of Accounting Standard (AS) 16, ‘Borrowing Costs’, notified under the Companies (Accounting Standards) Rules, 2006 as follows:

            “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.
            …”

“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.

 

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.”

 

 “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.”

 

“16. The activities necessary to prepare the asset for its intended use or sale encompass more than the physical construction of the asset. They include technical and administrative work prior to the commencement of physical construction, such as the activities associated with obtaining permits prior to the commencement of the physical construction. However, such activities exclude the holding of an asset when no production or development that changes the asset’s condition is taking place. For example, borrowing costs incurred while land is under development are capitalised during the period in which activities related to the development are being undertaken. However, borrowing costs incurred while land acquired for building purposes is held without any associated development activity do not qualify for capitalisation.”

 

The Committee is of the view that where the company is acquiring the oil and gas assets through subsidiary, the company is acquiring only the investment in overseas subsidiary and not the qualifying asset (viz., oil and gas asset) as such and accordingly, considering the specific requirements of AS 16, borrowing costs incurred on such acquisitions cannot be capitalised in the separate financial statements of the company. Since the capitalised asset itself does not appear in the books of the company, the question of capitalisation of borrowing costs with such asset does not arise in the separate financial statements of the company. The Committee is of the view that as per the above-reproduced principles of AS 16, borrowing costs can be capitalised only when all the conditions as per paragraph 14 of AS 16, are satisfied. Accordingly, even in the first situation where the company directly acquires the oil and gas assets, if these conditions are not met, for example, the expenditure for the acquisition, construction or production of a qualifying asset is not being incurred, the borrowing costs cannot be capitalised. Similarly, in the second situation also, the borrowing costs can be capitalised in the subsidiary company’s separate financial statements and consolidated financial statements only when the above-mentioned conditions of AS 16 are satisfied.

D.        Opinion

11.       On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 8 above:

(i) and (ii)        No, the suggested accounting treatment of capitalising the borrowing cost related to acquiring PI in the oil and gas project through the overseas subsidiary company to the respective eligible assets held by the subsidiary company  in the underlying oil and gas project in the consolidated financial statements as per paragraph 7 above is not appropriate.

(iii)    As per the terms of reference of the Committee, it answers issues only from the perspective of existing accounting standards and other pronouncements.

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[1]Opinion finalised by the Committee on 16.1.2015.