I have tried to get the following articles on accounting of “ Expenditure during construction period” .
01.
Many times, we see that many companies which are in startup stage i.e. during construction period and before it is ready for commencing commercial operations do not prepare Profit and Loss Account for the year / period and the total expenditure incurred during such year / period is kept under the head "Pre-Operative Expenditure, pending allocation" - Whether this treatment is correct as per Companies Act, 1956 and whether it complies with the Accounting Standards and Guidance notes issued by the ICAI?
Let us have a glance on the various relevant statutory provisions relating to the same.
Under the Companies Act, 1956:
Section 210(1) states: "At every annual general meeting of a company held in pursuance of Section 166, the Board of Directors of the company shall lay before the company - (a) a balance sheet as at the end of the period specified in sub-section (3); and (b) a profit and loss account for that period."
Section 210(3) states: "The profit and loss account shall relate - (a) in the case of the first annual general meeting of the company, to the period beginning with the incorporation of the company and ending with a day which shall not precede the day of the of the meeting by more than nine months..."
Hence, from the above, every company is required to prepare a profit and loss account from the date of incorporation of the company.
DCA Circular (Letter No.2/17/64-PR, dated 29-1-1964) states: "The intention underlying Section 210 is that every company should render to its shareholders an account of its expenditure, and income even though they may have been incurred or received during the period of construction. It is no doubt true that a company does not really commence its business operations till the period of construction is over. There will, of course be no objection if such account is called “Development Account”, Expenditure during construction account” or by any other suitable name so long as these accounts, give details of the revenue expenditure and income during the period covered, in the manner required by Part II of Schedule VI. Subsection (3) of section 210 makes it quite clear that it is mandatory for every company to prepare a “profit and loss account” from the date of its incorporation."
As per Schedule VI, Part II, "The profit and loss account shall be so made out as clearly to disclose the result of the working of the company during the period covered by the account". It cannot be regarded as only Commencement of commercial operations reflects the 'result of the working' of the company rather other activities like construction or winding up activities also denote the working of the company.
Under the Companies (Accounting Standards) Rules 2006:
Now, the accounting pronouncements applicable to capitalisation of assets are AS 10: Accounting for Fixed Assets and AS 26: Intangible Assets and the Guidance Note on Treatment of Expenditure during Construction Period has been withdrawn by the ICAI. Hence, now there is no concept of accumulating all the expenditure incurred into one account and then charging it off to revenue once the Commercial Operations are commenced.
As per para 9.3 of AS 10 Accounting for Fixed Assets, 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. Hence, all the general expenses cannot be capitalized and should be charged off profit and loss account i.e. Profit and loss account has to be prepared.
From the above, it is mandatory for each and every company to prepare Profit and loss account
Let us have a glance on the various relevant statutory provisions relating to the same.
Under the Companies Act, 1956:
Section 210(1) states: "At every annual general meeting of a company held in pursuance of Section 166, the Board of Directors of the company shall lay before the company - (a) a balance sheet as at the end of the period specified in sub-section (3); and (b) a profit and loss account for that period."
Section 210(3) states: "The profit and loss account shall relate - (a) in the case of the first annual general meeting of the company, to the period beginning with the incorporation of the company and ending with a day which shall not precede the day of the of the meeting by more than nine months..."
Hence, from the above, every company is required to prepare a profit and loss account from the date of incorporation of the company.
DCA Circular (Letter No.2/17/64-PR, dated 29-1-1964) states: "The intention underlying Section 210 is that every company should render to its shareholders an account of its expenditure, and income even though they may have been incurred or received during the period of construction. It is no doubt true that a company does not really commence its business operations till the period of construction is over. There will, of course be no objection if such account is called “Development Account”, Expenditure during construction account” or by any other suitable name so long as these accounts, give details of the revenue expenditure and income during the period covered, in the manner required by Part II of Schedule VI. Subsection (3) of section 210 makes it quite clear that it is mandatory for every company to prepare a “profit and loss account” from the date of its incorporation."
As per Schedule VI, Part II, "The profit and loss account shall be so made out as clearly to disclose the result of the working of the company during the period covered by the account". It cannot be regarded as only Commencement of commercial operations reflects the 'result of the working' of the company rather other activities like construction or winding up activities also denote the working of the company.
Under the Companies (Accounting Standards) Rules 2006:
Now, the accounting pronouncements applicable to capitalisation of assets are AS 10: Accounting for Fixed Assets and AS 26: Intangible Assets and the Guidance Note on Treatment of Expenditure during Construction Period has been withdrawn by the ICAI. Hence, now there is no concept of accumulating all the expenditure incurred into one account and then charging it off to revenue once the Commercial Operations are commenced.
As per para 9.3 of AS 10 Accounting for Fixed Assets, 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. Hence, all the general expenses cannot be capitalized and should be charged off profit and loss account i.e. Profit and loss account has to be prepared.
From the above, it is mandatory for each and every company to prepare Profit and loss account
02. Treatment of capital expenditure on assets not owned by the company. (File attached)
A. Facts of the Case
1. A government company is engaged in the construction and operation of thermal power plants in the country. The company has also diversified into hydro power generation, coal mining and oil & gas exploration, etc. The company is registered under the Companies Act, 1956 and being an electricity generating company, is governed by the provisions of the Electricity Act, 2003. The company prepares its annual financial statements as per the provisions of the Companies Act, 1956. The company is listed with the Bombay Stock Exchange and the National Stock Exchange.
2. The company has a three-tier organisation structure consisting of projects/stations, regional headquarters and corporate office. The company has six regions with the regional headquarters located across the country and also a hydro region headquarter located centrally. The projects/stations are grouped under different regions and report to the corporate office through the regional headquarters. The regional headquarters provide various services to the projects under construction and the operating stations under their jurisdiction. The company has also established two transport and customs clearance (T&CC) offices to facilitate the timely receipt of imported goods for the projects/stations.
3. The company is undertaking construction of a number of new power projects at the greenfield sites as well as expansion of existing projects. Some of the key activities related to the construction projects, such as, design & engineering, award of major contracts, post-award contract management, project monitoring, etc., are performed centrally at the corporate office. The company has seven coal mining blocks and similar activities for the development of these mines are also performed centrally at corporate office. The company has established departments mainly for performing these activities for the construction/expansion of power projects and development of mining projects at its corporate office with a view to benefit from the pooling of highly skilled manpower in these areas and also to achieve economy in expenditure. As a result, according to the querist, certain expenditures required for construction/expansion of the projects are incurred centrally instead of at individual project locations.
4. The querist has stated that till the financial year 2007-08, in accordance with paragraph 5 read with paragraph 7 of the Guidance Note on Treatment of Expenditure during Construction Period (See Note- 1), issued by the Institute of Chartered Accountants of India (ICAI), expenses of the corporate office, regional headquarters and T&CC offices were allocated to the operating stations and projects under construction in the proportion of sales to annual capital outlay. The amounts allocated to the operating stations were recognised in the profit and loss account. The amounts allocated to the projects under construction, along with the project’s expenses considered as ‘incidental expenditure during construction’, were apportioned to different assets in the proportion of accretion to capital work-in-progress during the year and capitalised. The accounting policies of the company in this regard for the year 2007-08 were as under:
“Expenses common to operation and construction activities are allocated to profit and loss account and incidental expenditure during construction in proportion of sales to annual capital outlay in the case of corporate office and sales to accretion to capital work-in-progress in the case of projects.”
“Incidental expenditure during construction (net) including corporate office expenses (allocated to the projects prorata to the annual capital expenditure) for the year, is apportioned to capital work-in-progress on the basis of accretions thereto.”
5. The querist has also stated that consequent to the withdrawal of Guidance Note on Treatment of Expenditure during Construction Period by the Institute of Chartered Accountants of India (ICAI) during the year 2008-09, the company constituted a committee comprising members from cross functional areas to:
(a) identify the expenditures of the related departments of corporate office, regional headquarters (RHQs) and T&CC offices whose services are specifically attributable to construction of projects considering the provisions of Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, notified under the Companies (Accounting Standards) Rules, 2006, and
(b) allocate such expenses to the projects under construction/expansion.
As per the querist, the said committee was guided by the provisions of paragraph 9.2 of AS 10 which states that expenses which are specifically attributable to the construction of a project or incurred for acquisition of a fixed asset or incurred for bringing the asset to its working condition, can only be included as a part of the cost of construction project or as a part of the cost of the fixed asset. Paragraph 9.2 of AS 10 is reproduced as below:
“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.”
6. Considering the above mentioned provisions, the said committee reviewed the services rendered by various departments located at the corporate office to the construction/ expansion projects. Based on such review, the committee identified that the following departments provide services mainly for construction/execution activities of the projects:
(a) Corporate Monitoring Group (CMG)
(b) Corporate Engineering Department
(c) Corporate Contract Services Department
(d) Finance Concurrence Department
(e) Hydro Region Headquarter for construction of hydro projects; and
(f) Coal mining department rendering services to coal mining projects.
According to the querist, the committee recommended that the expenditure of the above departments be allocated to the projects under construction/expansion on the basis of annual capital expenditure for the period considering the following principles:
Sl
|
Name of the Department
|
Allocated to
|
1
|
CMG, Engineering,
Contracts and finance Concurrence Group |
Thermal, Gas, Hydro &
Coal Mining Units |
2
|
Hydro Region
|
Hydro Units
|
3.
|
Coal Mining
|
Coal Mining Units
|
As regards other departments, the committee noted that other departments are either providing common services to projects under construction/expansion and projects in operation or providing services for operating stations only and hence, the committee recommended that expenses of these departments may be charged to the statement of profit and loss. Accordingly, the expenditure of engineering, contracting, project monitoring, hydro region headquarter, coal mining and finance concurrence departments were considered as expenditure during construction and for allocation to the projects under construction/expansion on a systematic basis, i.e., capital expenditure incurred during the year at these projects. Expenses of other departments providing common services were charged to the statement of profit and loss. Further, accounting policy of the company for allocation of administration and general overhead expenses to the units for the financial year 2008-09 was as under:
“Administration and general overhead expenses attributable to construction of fixed assets incurred till they are ready for their intended use are identified and allocated on a systematic basis to the cost of related assets.”
7. During supplementary audit of accounts under section 619(3)(b) of the Companies Act, 1956, the government auditor observed as below:
“With the withdrawal of Guidance Note on Treatment of Expenditure During Construction Period by the ICAI, the accounting is to be done as per AS 10, which stipulates that administration and other general overhead expenses are usually excluded from the cost of fixed assets since they do not relate to a specific fixed asset. 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.
The company has allocated expenses relating to five divisions on the ground that they perform functions relating to construction only. However, the expenses do not pertain to any one project. Hence, allocation of the expenses was not in accordance with AS 10.”
8. The company is of the view that the employees posted in engineering, contracts, project monitoring, hydro region headquarters, coal mining and finance concurrence departments at corporate centre are engaged in the activities of project engineering and design, procurement, contract management and project monitoring, etc. which are essential activities for the construction of projects/coal mine development. Since the activities of the identified departments were directly related to the construction of projects, capitalisation of these expenses is in accordance with the requirements of AS 10. The fact that these activities are performed centrally at the corporate centre does not change their basic character which is that such expenditure is incurred for the construction of fixed assets. The allocation to the individual projects based on the capital expenditure incurred during the year is a reasonable basis and is not prohibited under AS 10. Charging of the expenditure of the departments engaged in project engineering, design, procurement, contract management and project monitoring activities, etc. to profit and loss account merely because they are involved with more than one project would not be in accordance with paragraph 9.2 of AS 10.
B. Query
9. Considering the above facts, the querist has sought the opinion of the Expert Advisory Committee as to whether allocation and capitalisation of expenses related to the identified departments of corporate office and the regional headquarters which are engaged in project engineering, designing, contract management and project monitoring activities etc. to/at the projects under construction/expansion is correct.
C. Points considered by the Committee
10. The Committee notes that the basic issue raised in the query relates to the accounting treatment of expenditure incurred at various departments performing centralised functions identified by the company for the construction/expansion of power projects. The Committee has, therefore, considered only this issue and has not examined any other issue that may arise from the Facts of the Case, such as, specific basis of allocation of the common expenditures incurred at these departments over various projects/assets, propriety of accounting treatment followed by the company before financial year 2008-09, accounting for expenditure incurred by other departments providing common services to projects under construction/expansion and projects in operation, etc. The Committee has also not considered the issue with respect to the development of mining projects as special considerations may apply to those projects. Further, as the querist has referred to only AS 10 in the context of construction/expansion and development of power projects, the Committee presumes that the underlying assets in all cases are ‘fixed assets’ covered under the provisions of AS 10. As the exact nature of the activities being performed by various departments is not clear from the nomenclature of the departments, the Committee’s opinion contained hereinafter is based on the general principles to be followed while accounting for expenditure incurred at departments engaged in providing services to the construction/expansion of power projects. The exact expenditures that are to be capitalised will have to be determined on the basis of the said principles. The Committee also notes that while the querist has enumerated six departments that are stated by the querist to be engaged in the functions relating to construction activities, the government auditor has made his observation in respect of allocation of expenses relating to five divisions. However, that does not affect the opinion of the Committee expressed hereinafter.
11. The Committee notes that the accounting principles for determination of the cost of a self-constructed fixed asset, have been laid down, inter alia, in paragraph 10.1 of AS 10 which provides as follows:
“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 9.5. 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.”
The Committee further notes paragraphs 9.1 and 9.2 of AS 10 reproduced below:
“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.”
From a wholesome reading of the above paragraphs of AS 10, the Committee is of the view that the basic principle to be applied while capitalising an item of cost to a fixed asset/project under construction/expansion is that it should be directly attributable to the construction of the project/fixed asset for bringing it to its working condition for its intended use. The costs that are directly attributable to the construction/acquisition of a fixed asset/project for bringing it to its working condition are those costs that would have been avoided if the construction/acquisition had not been made. These are the expenditures without the incurrence of which, the construction of project/asset could not have taken place and the project/asset could not be brought to its working condition, such as, site preparation costs, installation costs, salaries of engineers engaged in construction activities, etc. The avoidance of costs as the basis of identifying directly attributable cost for the purpose of capitalisation is also supported by Accounting Standard (AS) 16, ‘Borrowing Costs’. In the extant case, the Committee is of the view that it should be seen that whether the expenses incurred on the activities of the various departments are directly attributable to the construction as discussed above. Accordingly, if the expenses incurred at the various departments are directly attributable to construction, these can be capitalised with the cost of the concerned fixed asset(s)/ project(s).
12. As regards basis of allocation of the expenses of these departments that can be allocated and capitalised to various projects or assets under construction, the Committee is of the view that the same should be allocated selecting an appropriate basis that reflects the extent of usage of service rendered by the department to the construction of the project.
D. Opinion
13. On the basis of the above and subject to the considerations contained in paragraph 10 above, the Committee is of the opinion on the issue raised in paragraph 9 above that capitalisation of expenses related to various departments of corporate office and the regional headquarters to the projects/assets under construction/expansion would be correct provided the expenses incurred on the activities of these departments can be considered to be directly attributable to the construction of project(s)/ fixed asset(s) for bringing it(them) to its(their) working condition as discussed in paragraph 11 above.
Note to above:-
1. The Guidance Note on Treatment of Expenditure during Construction Period has since been withdrawn pursuant to the decision of the Council at its 280th meeting held on August 7-9, 2008
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