1.38     Query

Capitalization of interest during construction period.

1. A paper manufacturing company has undertaken a renovation, modernization and expansion scheme at an estimated cost of about Rs. 60.75 crores. The work is being carried on along with the normal operations of the business. The project cost is to be financed by the Government in equal proportion of equity and loan. The scheme is under implementation since 1980-81. The company drew the funds from the Government, first, in the form of equity up to 50% of the project cost, and the balance thereafter as loan. The scheme covers a number of individual assets which are being commissioned on completion from time to time. However, with this pattern of withdrawal of funds, the assets under construction/commissioned during the period were difficult to be earmarked as financed out of equity or loan.

2. The querist has submitted a statement containing details regarding receipt of equity and loan, year-wise, vis-à-vis, cost of assets in progress and those capitalized. According to the statement, so far, the funds received are more in the form of equity. In other words, the ratio of equity to loan is not 50:50.

3. Till 1985-86, the total interest paid/accrued on loans was apportioned between capital work-in-progress and assets capitalized on pro rata basis irrespective of the date of actual commissioning of the assets. Thus, no portion of interest was charged to revenue. In the year 1986-87, this method was changed and interest on 50% cost of the assets capitalized was considered to have been financed out of loan. The interest at the current rate on this portion was charged to fixed assets with respect to the date of commissioning of the assets and balance was charged to revenue. This method was followed on the basis that the project cost was to be financed in equal proportion of equity and loan. Accordingly, following Note appeared in the Accounts for the year 1986-87:

            “Interest on borrowed funds

The Scheme of modernization and expansion financed by the Government of India through equity and loan in equal proportion is under execution since 1980-81. Up to the year 1985-86, the interest on loan was allocated pro rata between work-in-progress and works commissioned during the year irrespective of the date of commissioning. During the year 1986-87 the interest on one-half of the cost of works commissioned has been charged to revenue after the date of commissioning. As a result of this change in the basis of allocation of interest the impact on profit during the year amounts to Rs.27.10 lakhs.”

4. The querist has sought the opinion of the Expert Advisory Committee on the following issues arising from the above:

(a) Whether, in the circumstances of the query, the method followed by the company in the year 1986-87 can be considered as an appropriate accounting policy.

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(b) What should be the method if the proportion of equity and loan is distorted?

(c) Whether the interest earned by the company on the borrowed funds on short term investment should be given credit to the project cost or be treated as revenue receipt.

5. The querist has further informed that the difference between total interest accrued and the interest charged to assets commissioned during the year together with the interest charged to revenue is carried forward as part of the capital work-in-progress.

                                               Opinion                  December 15, 1988

1. The Committee notes that as per the accepted accounting principles, only the interest related to pre-production period should be capitalized as part of the cost of the asset and the interest related to the period subsequent to commencement of commercial production should be charged to revenue. The Committee notes that this treatment is recommended in the various publications of the Institute viz., Statement on Treatment of Interest on Deferred Payments, Guidance Note on Treatment of Expenditure During Construction Period, and Statement on Auditing Practices.

2. With regard to the treatment of interest income earned during construction period out of the funds borrowed for the purpose of expansion, the Committee notes that para 15 of the Guidance Note on Treatment of Expenditure During Construction Period, recommends allocation of indirect capital expenditure, incurred during construction period, to specific asset heads. Para 15.2, which deals with treatment of income earned during that period, is reproduced below:

“From the total of the aforesaid items of indirect expenditure [of which interest is one of the items] would be deducted the income (which can be directly related to the particular item of indirect expenditure), if any, earned during the period of construction.”

3. The Committee also notes from para 16.1 of the above mentioned Guidance Note that its recommendations are also applicable in case of capital expansion.

4. The Committee notes from the Statement mentioned in para 2 of the query that, so far, equity and loan are not in the proportion of 1:1, but the proportion of equity to loan is higher. Thus, in the view of the Committee, in case the assets commissioned during the period are charged with interest accrued/paid assuming that their cost comprised 50% loan and 50% equity and the balance portion charged to revenue on the same premise, it would amount to recognition of higher interest charge as a consequence of which higher amount will be capitalized and higher interest would be charged to revenue. In view of this, in the facts and circumstances of the present case, the Committee feels that instead of presuming 1:1 ratio of loan to equity it would be appropriate that actual ratio of equity and loan should be used for the said purpose.

5. On the basis of above, the opinion of the Committee on the various issues raised by the querist in para 4 of the query, is as below:

(a) As a matter of principle of accounting, interest on borrowings should be capitalised only in respect of period(s) prior to the commencement of commercial production by the asset(s) concerned.

(b) Where proportion of equity to loan is not in accordance with the terms stipulated in the agreement, the actual proportion of equity to loan should be considered and interest portion capitalised to the extent the same relates to pre-production period.

(c) The Committee is of the opinion that the interest earned on the short term loans given out of borrowings made for the purpose of expansion/modernisation, related to the period under expansion/modernisation, should be adjusted against the project cost.

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