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Query No. 5
Subject: 1. Accounting treatment of pre-operative and preliminary expenses incurred on formation and incorporation of the company.
2. Accounting treatment of finance cost and other pre-operative expenses incurred during pre-operative period.
3. Accounting for interest earned on fixed deposits made out of idle funds, interest earned on mobilization advance and other miscellaneous income during pre-operative period. 1
A. Facts of the Case
1. A company (hereinafter referred to as 'the company’) is a special purpose vehicle (SPV) of the Government of India, promoted at the behest of the Ministry of Finance, Govt. of India, jointly by S Limited, A Government of India enterprise and B Limited, a wholly owned subsidiary of the Reserve Bank of India (RBI) as equal partners to implement a greenfield strategic project of national importance of setting up of a bank note paper mill for manufacturing currency paper and other security paper with a capacity of 12000 TPA (two lines of 6000 TPA each) at the existing premises of B Ltd.
2. The company was incorporated in October 2010 as a standalone private limited company as per the provisions of the Companies Act, 1956. It has an independent board of directors nominated equally by the joint venture (JV) partners. As clarified by the Ministry of Corporate Affairs through Ministry of Finance, Government of India, the company is treated as a special purpose vehicle of the Government of India and accordingly, provisions of section 619(B) of the Companies Act, 1956 (corresponding section 139(5) and (7) of the Companies Act, 2013) are attracted. Accordingly, statutory auditor of the company is appointed by the Comptroller and Auditor General of India (C&AG), New Delhi.
3. The estimated capital cost of the project of around Rs. 1500 crore is being funded by equity capital to the extent of Rs. 600 crore and the balance by long term bank finance. The JV partners have already contributed to equity capital in three tranches of Rs. 100 crore each by each of them and as on 31st March, 2014, the paid up capital of the company stands at Rs. 600 crore (contributed @ Rs. 300 crore each by the JV partners). The company has also completed financial closure with the arrangement of long term rupee loan of around Rs. 900 crore in multiple banking arrangement. The project on implementation will substitute import of bank note paper/ currency note paper substantially.
4. The querist has stated that the company has been in the construction phase since its first financial year commencing from the date of incorporation and ending on March 31st, 2011 and the year ended March 31st, 2014 is the 4th accounting period in the construction phase. The company is still in the construction phase as on date and is expected to commence commercial production in the later part of financial year 2015-16.
5. The project of setting up of a bank note paper mill was originally
conceived by B Ltd. (which, later on, became one of the JV promoters of the
company) to be set up at its existing premises of bank note printing press at
Mysore, Karnataka as a strategy of backward integration and accordingly,
preparatory work started much earlier than the date of incorporation of the
company. Subsequently, the Ministry of Finance, Government of India,
decided that the proposed bank note paper/security paper mill would be
implemented by establishing a 50:50 joint venture between S Ltd. and B
Ltd. in the existing premises of B Ltd. Pending incorporation of the company,
at the behest of the Ministry of Finance, Government of India, a Joint
Management Committee (JMC) was formed comprising members from S
Ltd., B Ltd. and the Ministry of Finance to prepare a road map to decide
capacity of production and to take decision on mode of financing, etc.
Accordingly, the JMC started functioning with the assigned tasks to take the project forward. The foundation stone was unveiled ceremoniously on 22nd March, 2010 at the project site by the then Union Finance Minister in the presence of the then Governor, Reserve Bank of India and other dignitaries. Thereafter, the company was formed in October 2010 to take over the project on as is basis for its implementation. On incorporation, the company took over the preliminary and preoperative expenditure of Rs. 8,27,07,706/-partly funded by B Ltd. and partly by S Ltd. and adopted/renewed all existing contracts as was necessary to implement the project.
6. The company formation and registration expenses, share issue expenses towards stamp duty etc. included in the preliminary and preoperative expenses amounting to Rs. 2,57,57,020/- have been charged off to the statement of profit and loss and other expenses relating to the project incurred in the pre-incorporation period have been capitalised under the head ‘preoperative expenses pending allocation'. In the first financial year ended March 31, 2011, the JV promoters contributed @ Rs. 100 crore each net of preliminary and preoperative expenses incurred by them respectively. In the 3rd financial year ended March 31, 2013, the JV promoters contributed Rs. 200 crore each in two tranches towards equity contribution and then, the paid up equity capital stood at Rs. 600 crore as on March 31, 2013, and the paid up capital stood at the same level on March 31, 2014.
7. Pending disbursement of funds towards acquisition and construction of project assets, the company parked the unspent money out of equity capital in fixed deposit with banks and renewed from time to time depending upon the project cash outflow. Thus, the company has earned interest income during construction period upto March 31, 2014 amounting to Rs. 68,08,40,636/-. Besides, the company has also earned interest on mobilisation advance of Rs. 1,54,58,811/- and other miscellaneous receipts of Rs. 25,88,834/-. The stated income and the construction of the project being inextricably linked, the same has been capitalised and adjusted with preoperative expenses. The querist has separately clarified that in order to have a quick start-up of the project, it was proposed and the company paid mobilisation advance to the extent of 10% of the civil & structural value and Effluent Treatment Plant (ETP) value to the civil contractor and ETP construction contractor, respectively with the following conditions:
a.The above advance will carry simple interest of 10% per annum; and
b.The recovery of the advances will be from each running account bill on a pro rata basis.
The querist has also stated that relying on the following favourable judgments, the company has not provided for income tax, if any, on such interest income earned during the construction period:
a. Karnal Co-operative Sugar Mills Limited Vs CIT(SC)
b. CIT Vs Bokaro Steel Ltd (SC)
c. CIT Vs Karnataka Power corporation (SC)
d. Indian Oil Panipat Power Consortium Limited Vs ITO (HC)
e. NTPC Sail Power Company Private Limited Vs CIT (HC)
f. CIT Vs VGR Foundations (HC)
As an abundant precaution, the company has, however, deposited advance tax on self-assessment basis and disclosed the same under the head 'Loans & Advances’ in the balance sheet.
8. The querist has stated that the company has actually started availing of long term bank finance only in the later part of the financial year 2013-14 and incurred an interest expenditure of Rs. 3,40,09,846/- as on March 31, 2014 which is capitalised as it is directly related to acquisition and construction of fixed assets. Since the company is implementing the greenfield project and constructing the same from scratch and the only business activity being related to construction of the project, administrative and general overhead expenses incurred during the construction period being incidental to the construction have been capitalised and accumulated under the head 'Preoperative Expenditure Pending Allocation’. Expenses which are purely general and corporate in nature such as formation expenses, share issue expenses, audit fees, filing fees, directors sitting fees etc. have been charged off to the statement of profit and loss. Expenditure which are directly attributable to the project, such as, project consultancy fees, preparation of DPR cost, various fees for approvals etc. are directly capitalised under the head 'preoperative Expenses’. Upon successful commissioning of the project, the preoperative expenses which are directly identified with an asset will be capitalised along with that particular asset and other preoperative expenses will be apportioned on a suitable basis. A statement of preoperative expenses incurred year wise and the total accumulation as on March 31, 2014 under various heads of accounts has been supplied by the querist as Annexure 1.
9. The company is consistently following the accounting practices as above in terms of Accounting Standards - Accounting Standard (AS) 10, ‘Accounting for Fixed Assets'2, AS 16, ‘Borrowing Costs' and AS 26, ‘Accounting for Intangible Assets' as well as Guidance Note on Treatment of Expenditure During Construction Period3, issued earlier by the Institute of Chartered Accountants of India, to the extent these are not contrary to the provisions of the Accounting Standards. However, the Government auditor raised a preliminary enquiry during the audit of the accounts for the financial year 2013-14 as under:
1. Capital work in progress (CWIP) Rs. 469.68 crore
a. This does not include Rs. 3,25,844 being the expenses relating to directors' sitting fees and auditors' fee (Note -13). As per AS 10, paragraph 9.2, administration and other general overhead expenses as are specifically attributable to construction of a project be included as part of the cost of the construction project or as a part of the cost of the fixed assets.
Non-inclusion of the same under CWIP resulted in understatement of capital WIP, understatement of reserves and surplus by Rs. 3.25 lakh.
b. Further, an amount of Rs. 3.23 crore is appearing as opening balance under reserves and surplus (deficit) which relates to the accumulated loss at the beginning of the year. Since the project is under construction, all the expenditure whether it relates to specific cost identifiable to project or general expenditure should be included under project cost/capital work in progress. The same may be reviewed and necessary adjustments in the books may be carried out.
Not doing so resulted in understatement of capital WIP, understatement of reserves and surplus by Rs. 3.23 crore.
10. The management replied to the preliminary enquiry raised by the Government auditor as under:
The company has charged off to the statement of profit and loss, certain expenses which are of corporate nature, such as, formation expenses, share issue expenses, audit fees, filling fee, directors' sitting fees etc. in the pre-operative period based on the applicable Accounting Standards and various opinions furnished by the Expert Advisory Committee of the Institute of Chartered Accountants of India. The details of such expenses charged off year-wise are given in Part-D of Annexure- 1. After the withdrawal of the Guidance Note on Treatment of Expenditure During Construction Period by the Institute of Chartered Accountants of India and the introduction of AS 26, the concept of accumulation of general overhead expenses which are not related directly/indirectly to the construction under the head ‘deferred revenue expenditure' for charging off to the statement of profit and loss after the commencement of commercial production is no longer a practice recognised under Accounting Standards. As such, these expenses of general overhead in nature are charged off to the statement of profit and loss even in the pre-operative period. This practice of accounting is in line with the provisions of AS 10 and AS 26.
The company has been consistently following this practice since its inception and accordingly, a sum of Rs 3.27 crore is appearing as a negative balance under the head ‘Reserves and Surplus' in the balance sheet as on March 31, 2014.
The accounts of the company have been prepared and presented as per the applicable Accounting Standards notified by the Central Government giving due regard to various opinions/clarifications furnished by the Expert Advisory Committee of the Institute of Chartered Accountants of India (refer Query No. 25 of Volume 32, Query No. 1.25 of Volume 14, Query No. 8 of Volume 30 and Query No. 29 of Volume 29).
Since the preparation of accounts of the company and presentation thereof are compliant to the standards, there is no understatement of capital work in progress and 'Reserves & Surplus’ as observed by the audit.
11.Subsequently, in supersession of the preliminary enquiry, the Government auditor made the following observations:
1. Capital Work in Progress Rs. 469.68 crore
a. The above is overstated by Rs. 32.89 crore on account of inclusion of preoperative expenses pending allocation. As per paragraph 56 of Accounting Standards (AS) 26 Intangible Assets, the preoperative costs are to be charged off in the year of incurrence as this expenditure is incurred to provide future economic benefits to the enterprise, but no intangible asset or other asset is acquired or created. This has resulted in understatement of expenditure during the current year by Rs. 11.51 crore, prior period expenditure by Rs. 21.38 crore and cumulative loss by Rs. 32.89 crore. This has also resulted in non-adherence to the provisions of Accounting Standard (AS) 26, Intangible Assets.
b. During the period 2010-11 to 2013-14, the company has accounted the interest earned from unutilized /surplus funds and other miscellaneous receipts amounting to Rs. 24.29 crore (for the year 2013-14) as capital receipts as per the accounting policy 3 of the company on income during construction / pre-production period, “interest / dividend earned on investment of funds not immediately required and other miscellaneous receipts during the construction /pre-production period are treated as capital receipts and taken to reduce the pre-operative expenses to arrive at the net expenses to be capitalised”.
However, Audit is of the opinion that income from unutilised/surplus funds is an income from investments and is to be credited to statement of profit and loss as 'Other income’. Adjusting the same to capital WIP is incorrect as the interest income is not earned from fixed assets. Therefore, the accounting policy needs suitable modification.
The above accounting treatment made by the company has resulted in understatement of capital WIP by Rs. 69.88 crore, current year income by Rs. 24.32 crore and prior period income by Rs. 45.56 crore.
The net impact on account of provisional comments (1) and (2) would result in tax liability of Rs. 12.57 crore and cumulative profit of Rs. 24.42 crore.
12 The management reply to the observations of the Government auditors is given below:
a. The company has been incurring various expenses relating to the implementation of the project including administrative and general expenses which are necessary for acquisition and construction of the assets and for bringing those assets to their working condition for intended use. Expenses which are directly related to construction / acquisition of fixed assets and administrative and general overhead expenses which are incidental to construction / acquisition of fixed assets net of income such as interest and miscellaneous receipts have been capitalised and grouped under ‘Pre-operative expenses related to construction' while those which are not specifically related to construction and are mostly of general and corporate nature, such as, company formation expenses for bringing the company as a corporate/ legal entity, share issue expenses, audit fees, director's sitting fees etc. have been grouped under ‘pre-operative expenses not specifically related to construction' and charged off to the statement of profit and loss in the year of incurrence. The above accounting treatments are in compliance with the provisions of applicable Accounting Standards namely AS 10, AS 16 and AS 26 (to the extant applicable), as notified by the Central Government and consistent with the opinions rendered by the Expert Advisory Committee of the Institute of Chartered Accountants of India (ICAI) vide query no. 34, query no. 35 and query no. 36 of Volume 29, query no. 8 of Volume 30 and query no. 25 of Volume 32. Accordingly, financial statements showing Rs. 469.68 crore under the head capital work in progress includes Rs. 32.89 crore as pre-operative expenses pending allocation of which Rs. 11.51 crore pertains to the current year. As such, there is no understatement of the expenditure during the current year and / or in the previous years as also cumulative loss as observed by the audit. Similarly, the accounting treatments given as above do not amount to non-adherence to the provisions of applicable Accounting Standards.
The observations made by the Government audit with reference to Accounting Standard (AS) 26 are relating to intangible assets only which are not relevant in the extant case as the company is engaged in the construction and acquisition of fixed assets for the project which are tangible and future economic benefits will flow to the organisation on implementation of project. Therefore, applicable Accounting Standard for treatment of expenditure during construction period should be Accounting Standard (AS) 10 relating to fixed assets. Paragraph 56(a) of AS 26, inter alia, provides that expenditure on start-up activities which is not included in the cost of fixed asset under AS 10 is only to be recognised as an expense when it is incurred.
In this regard, reference is drawn to paragraphs 9.1, 9.2, 9.3, 9.4 and 10.1 of AS 10 which are applicable to treatment of expenditure during construction period including any internal profits/ income relating to acquisition and construction of fixed assets. Similarly, Accounting Standard (AS) 16 is applied for capitalisation of borrowing cost relating to acquisition and construction of fixed assets.
Thus, from a wholesome reading of above paragraphs of AS 10, it would be clear that expenditures which are directly related or incidental to the construction and acquisition of fixed assets are only to be capitalized. Start-up/preliminary and pre-operative expenditures, such as company formation expenses, expenses on advertisement and promotional activities etc. are to be charged off to the statement of profit and loss in the year of incurrence as provided in paragraph 56 of AS 26. Other expenditure such as share issue expenses, borrowing costs etc. which are of specialised nature and are not covered by AS 26 are to be dealt by specific accounting standards, if any. For example, borrowing cost relating to construction of fixed assets is dealt with under AS 16. Audit fees, filing fees, director’s sitting fees and share issue expenses etc. which are purely general, corporate and statutory in nature are normally charged off to the statement of profit and loss in the year of incurrence as these are not attributable specifically to any fixed asset. Accounting treatment given by the company consistently to the expenditure incurred during the construction period in the financial statements is strictly in compliance with the provisions of the above applicable accounting standards
b. The company has earned interest on investment of funds out of share capital monies held for project, interest on mobilisation advance and other miscellaneous receipts which are inextricably linked to the construction and acquisition of fixed assets and has a direct nexus with the project. As such, these incomes during the construction period are necessarily to be capitalised. Due to its direct nexus with the construction and acquisition of fixed assets, such incomes are to be applied to the pre-operative expenditure to arrive at the net cost to be capitalised. Therefore, the accounting treatment accorded to the interest and other income during construction period is in compliance to paragraphs 9.1, 9.2, 9.3, 9.4 and 10.1 of AS10.
The view taken by the management on the treatment of income earned during the construction period is further corroborated by the favourable observations made by various judiciaries in the cases cited below:
a. Karnal Co-Operative Sugar Mills Limited vs CIT (SC)
b. CIT vs. Bokaro Steel Ltd (SC)
c. CIT vs. Karnal Co-operative Sugar Mills Limited (SC)
d. CIT vs. Karnataka Power Corporation (SC)
e. Indian Oil Panipat Power Consortium Limited Vs ITO (HC)
f. NTPC SAIL Power Company Private Limited Vs CIT (HC)
g. CIT Vs VGR Foundations (HC)
In view of the above, accounting treatment accorded by the company is not resulting in understatement of capital WIP by Rs. 69.88 crore, current year income by Rs. 24.32 crore and prior period income by Rs. 45.56 crore as observed by the audit.
As regards tax liability, if any, on interest income during construction period, the company has preferred an appeal before CIT (Appeal) against the order of assessing officer taxing such income. Pending outcome of the appeal, the company has not recognised the tax demand as liability and consistent with its earlier practices, tax paid by the company is shown as advance tax. The explanations being adequately disclosed in other notes to financial statements no. 16(iii)(a)&(b), there is no tax liability of Rs. 12.57 crore as yet.
It may be reasonable to appreciate that income alone during the construction period cannot be taxed under the head other income in isolation by disallowing the expenditure only to be reduced from reserves and surplus. Therefore, both income and expenditure during construction period which are directly related and/or incidental to construction and acquisition of fixed assets in a project are to be reasonably capitalised as provided in paragraphs 9.1, 9.2, 9.3, 9.4 and 10.1 of AS 10.
As such, there is no understatement of cumulative profit of Rs. 24.42 crore as observed by the audit.
The accounting policies and practices as followed by the company consistently are compliant to applicable accounting standards and read with explanatory notes, the financial statements reflect a true, reasonable and fair view of the accounts and the state of affairs of the company.
13. The querist has stated that the statutory auditor of the company appointed by the Comptroller and Auditor General of India has concurred on the above reply. Finding no consensus, the observation was however dropped by the Government auditor (C&AG) on the assurance of the management that the issues shall be referred to the Expert Advisory Committee of the ICAI for its expert opinion.
B. Query
14. Based on the facts and circumstances of the case and having regard to the fact that the company is implementing a greenfield project from scratch, the querist has sought the opinion of the Expert Advisory Committee on the following issues:
a. Whether the accounting treatment followed consistently by the company of capitalising administrative and general expenses
along with specific expenses as detailed in part- A and part- B of the Annexure -1 is correct and in line with applicable accounting standards. If not, then what should be the accounting treatment for such expenses?
b. Whether it would be in order to capitalise expenses which are purely general and corporate in nature such as auditors’ fee, directors’ sitting fees etc. incurred during the construction period in the light of the fact that, the company’s only business being construction of the project.
c. Whether capitalisation of interest and other income during the construction period being incidental and inextricably linked to the
construction is in order and in accordance with applicable accounting standards and Guidance Note issued by the ICAI. If not, then what should be the accounting treatment for such income?
C Points considered by the Committee
15. The Committee notes that the basic issues raised in the query relate to accounting for various pre-operative expenses incurred before commencement of operations and during construction of the project, and accounting for interest income earned on surplus equity funds, interest on mobilization advance and other miscellaneous income earned before and during construction period. The Committee has, therefore, considered only these issues and has not considered any other issue that may arise from the Facts of the Case, such as, disclosure of advance tax in the financial statements, etc. Further, the Committee has expressed its opinion purely from accounting perspective and not from tax perspective or from the perspective of legal interpretation of various judgments of High Court/ Supreme Court, as referred to by the querist. The Committee also wishes to point out that as the exact nature and details of various expenses as listed by the querist in Annexure 1 are not available, the Committee’s opinion contained hereinafter is based on the general principles to be followed while accounting for such expenses.
16. At the outset, the Committee wishes to point out that various expenses are incurred during construction/pre-operative period before commencement of operations. However, it is not necessary that all expenses incurred during construction are eligible to be capitalised to the project/asset being constructed. The capitalisation of an item of cost to a fixed asset/project depends upon the nature of such expenses in relation to the construction/ acquisition activity in the context of requirements in this regard laid down in the applicable accounting standards.The Committee notes from the Facts of the Case that the company in the extant case has incurred various preoperative expenses before commencement of operations which can be broadly categorised into preliminary and pre-operative expenses on formation/ incorporation of the company and other pre-operative and general and administrative expenses incurred during acquisition/construction of various assets/project (paper mill project) for commencement of its operations. In this context, the Committee notes the following paragraphs from AS 10 and AS 26, notified under the Companies (Accounting Standards) Rules, 2006 (hereinafter referred to as the ‘Rules'):
AS 10
"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.”
"9.3 The expenditure incurred on start-up and commissioning of the project, including the expenditure incurred on test runs and experimental production, is usually capitalised as an indirect element of the construction cost. ...”
"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.”
AS 26
"56. In some cases, expenditure is incurred to provide future economic benefits to an enterprise, but no intangible asset or other asset is acquired or created that can be recognised. In these cases, the expenditure is recognised as an expense when it is incurred. For example, expenditure on research is always recognised as an expense when it is incurred (see paragraph 41). Examples of other expenditure that is recognised as an expense when it is incurred include:
(a) expenditure on start-up activities (start-up costs), unless this expenditure is included in the cost of an item of fixed asset
under AS 10. Start-up costs may consist of preliminary expenses incurred in establishing a legal entity such as legal and secretarial costs, expenditure to open a new facility or business (pre-opening costs) or expenditures for commencing new operations or launching new products or processes (pre-operating costs);
(b) expenditure on training activities;
(c) expenditure on advertising and promotional activities; and
(d) expenditure on relocating or re-organising part or all of an enterprise.”
The Committee notes from the above that as per paragraph 56 of AS 26, start-up costs that relate to the costs of starting up an activity, such as, preliminary expenses incurred in establishing an entity, expenditure to open a new facility or business and expenditure for commencing new operations should be expensed unless such expenditure can be included as an element of cost of a fixed asset. Further, the Committee notes from the abovereproduced paragraphs of AS 10 that the basic principle to be applied while capitalising an item of cost to a fixed asset/project under construction is that it should be directly attributable to the construction/acquisition of a fixed asset/project for bringing it to its working condition for its intended use. Further, as per the principles of AS 10, administration and general overhead expenses should not be included in the cost of a fixed asset/project unless these are specifically attributable to the construction/acquisition of a fixed asset/project or for bringing it to its working condition.
Preliminary and pre-operative expenses on formation/incorporation of the company
17. From the above discussion, the Committee is of the view that incorporation expenses or expenses incurred on incorporation or formation of a company to bring it into legal existence, such as, legal costs in drafting the memorandum and articles of association, fees for registration of the company, cost of printing of the memorandum and articles of association and statutory books of the company, etc. cannot be considered to be attributable to the construction/acquisition of a fixed asset/project for bringing it to its working condition for its intended use. Therefore, these expenses cannot be capitalised and accordingly should be expensed by way of a charge to the statement of profit and loss in the period in which these are incurred. In this regard, the Committee wishes to point out that the abovereproduced paragraph 9.3 of AS 10 refers to those start-up costs which are incurred on the start-up and commissioning of a project before the commencement of commercial production, such as, expenditure on test runs, etc., and not on incorporation of the enterprise. The Committee is further of the view that the auditors fee incurred in connection with the audit of the financial statements of the company and directors’ sitting fee cannot also be considered as directly attributable to the construction of the project/ fixed asset even though the only activity of the company in that period relates to construction activity and, therefore, these cannot also be included as part of the cost of a fixed asset/project. With regard to accounting for share issue expenses, the Committee notes that AS 26 does not deal with such expenses. Accordingly, the Committee notes the definition of the term 'asset’ as provided by the Framework for the Preparation and Presentation of Financial Statements, issued by the ICAI, which states that, "an asset is a resource controlled by the enterprise as a result of past events from which future economic benefits are expected to flow to the enterprise.” The Committee notes that share issue expenses do not meet the definition of the term ‘asset' as no resource controlled by the company comes into existence out of the share issue expenses and, therefore, it cannot be recognised as an asset. Accordingly, the Committee is of the view that it would be appropriate to charge such expenses to the statement of profit and loss. In this regard, the Committee also wishes to point out that, to the extent permitted under the requirements of section 52 (2) of the Companies Act, 2013, the above preliminary expenses can also be adjusted against the securities premium account
Other pre-operative expenses incurred during acquisition/construction of various assets/project
18. Further, with regard to other pre-operative expenses incurred during the acquisition/construction phase other than finance or interest costs incurred on long-term bank finance, the Committee is of the view that the accounting treatment of such expenses would depend upon whether or not such expenses are directly attributable to the construction/acquisition of a fixed asset/project for bringing it to its working condition for its intended use, as discussed above. If the expenses incurred are directly attributable to construction/acquisition, such as, site preparation and installation costs, these can be capitalised with the cost of the concerned fixed asset(s)/ project(s). However, if the expenses are not attributable to construction/ acquisition, as aforesaid, these should be expensed by way of a charge to the statement of profit and loss. The Committee is further of the view that recruitment expenses, advertising and publicity expenses, foundation stone laying expenses, meeting and conference expenses, printing and stationery, newspaper, books, periodicals, subscription and membership expenses, security and other facility management services etc. are not ordinarily directly attributable to construction/acquisition and, therefore, are charged to the statement of profit and loss unless it can be demonstrated that these are directly attributable to construction as aforementioned. Since the facts of the query do not contain sufficient relevant details to establish whether expenses listed in Annexure 1 are directly attributable to construction/ acquisition, the Committee has not dealt specifically with the individual expenses. Accordingly, in the extant case, the company should examine various expenses as listed in Annexure 1 keeping in view the nature and purpose of such expenses as to whether or not these are directly attributable to the construction/acquisition of a fixed asset/project for bringing it to its working condition for its intended use so as to determine the accounting treatment of such expenses. For example, legal and professional charges listed in the Annexure -1 can be capitalised with the cost of the fixed asset/ project only if these are directly attributable to construction of the project, such as, engineer's fees for engineering services related to the project. However, if such charges are not in relation to the construction of the project, e.g., consultant's fees related to formation of the company, such charges should be charged to the statement of profit and loss. Similarly, there are various other expenses, such as, employee benefits expenses, travelling and conveyance expenses, communication charges, rent, rates and taxes, insurance expenses, etc. which need to be examined keeping in view the nature and purpose of such expenses so as to determine the accounting treatment of such expenses. These expenses can be capitalized with the cost of a fixed asset/project only to the extent these are directly attributable to the construction/acquisition of a fixed asset/project for bringing it to its working condition for its intended use.
19. With regard to interest cost incurred on long term bank finance, the Committee notes the following relevant accounting principles related to borrowing costs as provided under Accounting Standard (AS) 16, ‘Borrowing Costs', notified under the Rules, 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.”
“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.”
From the above, the Committee notes that the borrowing costs can be capitalised as a part of the cost of a qualifying asset only when expenditure for the acquisition, construction or production of qualifying asset is being incurred and other conditions of paragraph 14 of AS 16, as reproduced above are fulfilled.
Interest income earned on surplus funds and mobilisation advance and miscellaneous income
20. With regard to issue raised relating to interest earned on fixed deposits made out of surplus funds, interest earned on mobilisation advance and other miscellaneous receipts during the construction phase, the Committee notes paragraphs 10 and 11 of AS 16, notified under the Rules as follows:
“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.”
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 specific borrowed funds while the project is in the stage of construction. Thus, the income earned from temporary investments of specific borrowed funds during the construction period can be set-off against the borrowing costs to be capitalised as per the principles of AS 16. However, the Committee notes that these paragraphs deal with the investment of specific borrowed funds and not investment made out of equity funds. In this regard, the Committee notes that as per the requirements of AS 10, notified under the Rules, only those items of costs which are directly attributable to bringing the fixed asset to its working condition can be included in the cost of the asset. The Committee is of the view that the same principles can also be extended in respect of an item of income arising during the acquisition/construction of a fixed asset/project. Thus, only those items of income arising from the activities would go on to reduce the fixed asset/project cost, that are directly attributable to the acquisition/ construction of a fixed asset/project for bringing it to its working condition for its intended use. In the extant case, the Committee is of the view that interest earned on fixed deposits made out of equity funds is an income arising out of the company's ancillary activities which are not necessary to bring the project/asset to its working condition for its intended use and therefore, these cannot be considered as directly attributable to the mill project. Accordingly, interest income earned on the deposits made out of equity funds cannot be adjusted against the cost of the asset/project and therefore, should be recognised in the statement of profit and loss.
21. With regard to miscellaneous income earned during the construction period, the Committee is of the view that it should be examined as to whether such income is arising from activities that are directly attributable to the acquisition/construction of a fixed asset/project for bringing it to its working condition for its intended use. In case it is so, the income should be reduced from the cost of activity generating such miscellaneous income, which is to be included in the cost of the fixed asset.
22. As far as interest earned on mobilisation advance is concerned, the Committee notes that in the extant case, the purpose of mobilisation advance to the contractors is to have a quick start-up of the project. The Committee is of the view that since such advance is incidental to construction activity of the mill project and is an integral part of the contract with contractors, interest earned thereon can be considered to be arising from activities that are directly attributable to the acquisition/construction of a fixed asset/project for bringing it to its working condition for its intended use. Accordingly, interest earned on mobilisation advance in the extant case can be adjusted against the cost of the relevant fixed asset/project. Further, since such interest would reduce the payment to be made to the contractor (as it would be recovered from the running account bill), it should be reduced from the cost of the asset/project concerned.
D. Opinion
23. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 13 above:
a. The accounting treatment followed consistently by the company of capitalising administrative and general expenses along with specific expenses as detailed in part - A and part - B of the Annexure -1 would be correct and in line with applicable accounting standards, if these are directly attributable to the construction/acquisition of a fixed asset/project for bringing it to its working condition for its intended use, as discussed in paragraphs 16-18 above. In case these expenses are not directly attributable to the construction/acquisition of a fixed asset/project for bringing it to its working condition for its intended use, these should be expensed by way of a charge to the statement of profit and loss.
b. The incorporation expenses or expenses incurred for formation of a company to bring it into legal existence, auditors fee, director sitting fees etc. cannot be considered as directly attributable to the construction of the project/fixed asset even though these are incurred during construction period and the company's only business being construction of the project. Therefore, these cannot also be included as part of the cost of a fixed asset or project.
c. The interest income earned from temporary investments of specific borrowed funds during the construction period can be set-off against the borrowing costs to be capitalised as per the principles of AS 16. However, interest earned on fixed deposits made out of equity funds is an income arising out of the company's ancillary activities which are not necessary to bring the fixed asset/project to its working condition for its intended use and therefore, these cannot be considered as directly attributable to the mill project. Accordingly, the same cannot be adjusted against the cost of the asset/project and should be recognised in the statement of profit and loss. Since mobilisation advance is incidental to construction activity of the mill project and is an integral part of the contract, interest earned thereon can be considered to be arising from activities that are directly attributable to the acquisition/construction of a fixed asset/project for bringing it to its working condition for its intended use. Accordingly, interest earned on mobilisation advance in the extant case can be adjusted against the cost of the relevant fixed asset/project, as discussed in paragraph 22 above. Other miscellaneous income earned during the construction period can be adjusted against the cost of the relevant fixed asset/project, only if such income is arising from activities that are directly attributable to the acquisition/ construction of the asset/project for bringing it to its working condition for its intended use, as discussed in paragraph 21 above. Further, such income should be reduced from the cost of related activity generating such miscellaneous income, which is to be included in the cost of the fixed asset.
Annexure 1
| Details of Expenditure
during construction
period & its accounting treatment: |
|
|
|
|
Amount in Rs. |
| Particulars |
2010-11 |
2011-12 |
2012-13 |
2013-14 |
Closing
balance as
on March 31,2014 |
| A. Pre-operative expenses pending allocation |
|
|
|
|
|
| Project Consultant’s fees |
34,097,139 |
9,586,185 |
21,854,244 |
17,245,890 |
82,783,458 |
Preparation of DPR Paper
mill fees |
5,233,996 |
- |
- |
- |
5,233,996 |
Preparation of DPR Water
Supply Fees |
981,000 |
- |
- |
- |
981,000 |
| Project Building Plan Sanction fees |
8,317,586 |
- |
- |
- |
8,317,586 |
| Project Insurance |
|
- |
- |
9,753,988 |
9,753,988 |
| Site Audit Fees |
280,804 |
- |
- |
- |
280,804 |
| Site Development Expenses |
- |
1,390,507 |
1,120,000 |
7,738,472 |
10,248,979 |
Technical Advisors - Remun-
eration & Travelling Exp. |
1,871,112 |
1,068,620 |
491,800 |
- |
3,431,532 |
| Topographical Survey Fees |
110,195 |
- |
- |
- |
110,195 |
| Geo-Technical Survey Fees |
416,141 |
- |
- |
- |
416,141 |
| Consent Fee-KSPCB |
400,000 |
- |
- |
- |
400,000 |
| Fee for Power Connection |
31,134 |
- |
50,000 |
- |
81,134 |
| Statutory Clearance fee-Karnataka Udyog Mitra |
300,000 |
- |
- |
- |
300,000 |
| Foundation Stone laying expenses |
2,000,000 |
- |
- |
- |
2,000,000 |
| Sub Total (A) |
54,039,107 |
12,045,312 |
23,516,044 |
34,738,350 |
124,338,813 |
B. Other Administrative
and General Expenses
related to Construction: |
|
|
|
|
|
| |
2010-11 |
2011-12 |
2012-13 |
2013-14 |
Amount
in Rs. |
| Employee Benefits Expenses |
8,817,177 |
16,710,320 |
24,794,450 |
37,817,786 |
88,139,733 |
| Finance Cost |
5,726 |
10,218 |
5,669,440 |
5,364,978 |
11,050,362 |
| Depriciation and Amortization Expenses |
444,954 |
5,567,542 |
6,041,785 |
6,442,978 |
18,497,259 |
Other Administrative &
General Expenses: |
|
|
|
|
|
| Travelling, halting & conveyance expenses |
4,933,036 |
1,891,336 |
3,628,960 |
8,249,094 |
18,702,426 |
| Printing and stationary |
143,522 |
495,087 |
558,947 |
904,997 |
2,102,553 |
| Communication charges |
90,589 |
443,297 |
594,635 |
665,285 |
1,793,806 |
| Power, fuel, light and water |
43,182 |
1,157,319 |
1,321,585 |
1,391,701 |
3,913,787 |
| Rent, rates & taxes |
2,037,696 |
7,963,316 |
8,128,295 |
8,220,185 |
26,349,492 |
| Legal & professional charges |
270,131 |
638,755 |
947,195 |
706,226 |
2,562,307 |
| Advertisement & publicity expenses |
5,454,692 |
398,463 |
2,223,014 |
1,636,875 |
9,713,044 |
| Repairs & maintenance |
- |
947,275 |
1,396,148 |
2,914,583 |
5,258,006 |
| Security & other facility management services |
- |
2,002,009 |
2,925,220 |
3,398,516 |
8,325,745 |
| Insurance expenses |
- |
9,708 |
124,878 |
125,934 |
260,520 |
| Meeting and conference expenses |
- |
410,934 |
496,096 |
627,388 |
1,534,418 |
News paper, books,
periodicals, subscription and
membership fees |
- |
191,648 |
278,784 |
314,841 |
785,273 |
| Recruitment expenses |
- |
547,925 |
2,811,513 |
1,327,431 |
4,686,869 |
| Misc. Expenses |
598,499 |
98,572 |
6,153 |
229,142 |
932,365 |
| |
|
|
|
|
|
| Sub Total (B) |
22,839,204 |
39,483,724 |
61,947,098 |
80,337,940 |
204,607,966 |
| |
|
|
|
|
|
Total Pre-operative
expenses pending
allocation (A+B) |
76,878,311 |
51,529,036 |
85,463,142 |
115,076,290 |
328,946,779 |
Amount in Rs.
| C. |
2010-11 |
2011-12 |
2012-13 |
2013-14 |
Total |
Total Pre-operative
expenses pending
allocation (from above) |
76,878,311 |
51,529,036 |
85,463,142 |
115,076,290 |
328,946,779 |
| Add: |
|
|
|
|
|
Interest on Term Loan
on acquisition &
construction of fixed
assets. |
- |
- |
- |
34,009,846 |
34,009,846 |
Less: Capital Receipts:
Interest on Short
Term Deposits |
55,078,525 |
170,172,084 |
215,281,724 |
240,308,305 |
680,840,636 |
Interest on Mobilisation
advance |
- |
6,740,994 |
6,146,287 |
2,571,530 |
15,458,811 |
Interest on Income
Tax refund |
- |
- |
1,864,395 |
- |
1,864,395 |
| Miscellaneous Receipts |
25,556 |
17,745 |
320,211 |
360,927 |
724,439 |
| Sub Total |
55,104,081 |
176,930,823 |
223,612,617 |
243,240,762 |
698,888,281 |
Net pre-operative
Expenses capitalised
under the head CWIP |
21,774,230 |
-125,401,787 |
-138,149,475 |
-94,154,626 |
-335,931,656 |
Expenses not related to construction and charged off to P&L Statement:
Amount in Rs.
| D. |
2010-11 |
2011-12 |
2012-13 |
2013-14 |
Total |
1. Company registration
and incorporation
expenses |
2,50,07,020 |
- |
- |
- |
2,50,07,020 |
2. Solicitor’s fees in
connection with
registration of company |
7,50,000 |
- |
- |
- |
7,50,000 |
| 3. Share issue expenses |
20,00,000 |
- |
40,00,000 |
- |
60,00,000 |
| 4. Directors sitting fees |
20,000 |
40,000 |
82,416 |
89,888 |
2,32,304 |
| 5. Statutory auditors fees |
27,575 |
56,180 |
1,12,360 |
1,23,596 |
3,19,711 |
| 6. Internal auditors fees |
- |
67,416 |
89,888 |
1,12,360 |
2,69,664 |
| 7. Others |
1,33,332 |
- |
- |
- |
1,33,332 |
Total expenses charged
off to P&L statement |
2,79,37,927 |
1,63,596 |
42,84,664 |
3,25,844 |
3,27,12,031 |
___________
1 Opinion finalised by the Committee on 3.6.2015.
2 The opinion should be read in the context of Accounting Standard (AS) 10, ‘Accounting
for Fixed Assets’, which has been revised as AS 10, ‘Property, Plant and Equipment’ by
the Companies (Accounting Standards) Amendment Rules, 2016 vide Ministry of Corporate
Affairs (MCA) Notification No. G.S.R. 364(E) dated 30.03.2016.
3 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. |