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Volume XXVI
Volume
XXVI
Volume XXVI Expert Advisory Committee The Institute of Chartered Accountants of India (Set up by an

Expert Advisory Committee The Institute of Chartered Accountants of India

(Set up by an Act of Parliament)

New Delhi

Compendium of Opinions

(Volume XXVI)

of the

Expert Advisory Committee

of Opinions (Volume XXVI) of the Expert Advisory Committee THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA (Set up by an Act of Parliament) NEW DELHI

COPYRIGHT © THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA

All rights reserved. No part of this publication may be translated, reprinted or reproduced or utilised in any form either in whole or in part or by any electronic, mechanical or other means, including photocopying and recording, or in any information storage and retrieval system, without prior permission in writing from the publisher.

(This twenty sixth volume contains opinions finalised between February 2006 and January 2007. The opinions finalised upto September 1981 are contained in Volume I. The opinions finalised thereafter upto January 2006, are contained in Volumes II to XXV)

Published in 2009

Price

:

Rs. 200

Committee/

Department

:

Expert Advisory Committee

ISBN

:

978-81-8441-064-8 (Volume XXVI)

ISBN

:

81-85868-05-0 (Set)

Published by

:

The Publication Department on behalf of The Institute of Chartered Accountants of India, ICAI Bhawan, Indraprastha Marg, New Delhi-110 002

Printed at

:

Sahitya Bhawan Publications, Hospital Road, Agra-282 003

November/2009/1000 copies

Foreword

Today’s ever-changing economic climate is pushing enterprises to adopt new business models incorporating multiple business transactions, and forcing financial executives to address complex and intricate management issues. As the complexity in business grows, so do generally accepted accounting principles (GAAPs) as these principles attempt to measure the economic impacts of intricate business transactions. These GAAPs cover in their ambit various relevant legal requirements, accounting standards, guidance notes, and other authoritative pronouncements of the Institute of Chartered Accountants of India.

The complexities and intricacies involved in business transactions also sometimes make the application and implementation of the GAAPs difficult. To address these issues, the Expert Advisory Committee has been constituted to provide its independent and objective opinion on such issues. The opinions provide an insight to various accounting and auditing related real life practical problems faced by the industry and members in practice.

I am pleased to note that the Committee has brought out this new volume of the Compendium of Opinions which is twenty-sixth in its series and contains the opinions finalised by the Committee between February 2006 and January 2007. I am sure that like other volumes, this volume would be of great significance and use for all concerned.

New Delhi February 4, 2007

CA. T.N. Manoharan President

Preface

This volume of the Compendium of Opinions, which is twenty-sixth in its series, contains opinions finalised by the Expert Advisory Committee between February 2006 and January 2007. During this period, the Committee provided opinions on various matters involving accounting and/or auditing principles and allied aspects as enunciated in the applicable accounting, auditing and assurance standards and guidance notes, relevant statutory requirements, and also taking into account the international literature available on the concerned issues.

The various subjects on which the Expert Advisory Committee expressed its opinion include accounting treatment in respect of revenue recognition, prior period items, depreciation, segment reporting, inventory valuation, foreign exchange forward contracts, intangible assets, deferred tax assets/liabilities, borrowing costs, etc. As in the preceding volumes of the Compendium of Opinions, this volume also contains a composite index, which provides ready reference of all the opinions published in all the preceeding twenty- five volumes and this volume. The date on which the Committee finalises its opinion is indicated as a footnote to every opinion in the Compendium. While making a reference to an opinion, any subsequent changes in the relevant law(s)/pronouncements, etc., must be kept in mind.

The Advisory Service Rules, in accordance with which the Committee expresses its opinion, is included in the Compendium. The Rules also make it clear that although the Committee has been appointed by the Council, an opinion given or a view expressed by the Committee would represent nothing more than the opinion or the view of the members of the Committee and not the official opinion of the Council of the Institute.

I would like to thank my learned colleagues on the Expert Advisory Committee, namely, CA. S. Gopalakrishnan (Vice-Chairman), CA. T.N. Manoharan (President), CA. Sunil Talati (Vice-President), CA.

Anuj Goyal, CA. Charanjot Singh Nanda, CA. J.P. Gokhale, CA. Manoj Fadnis, CA. Sunil Goyal, Shri Jitesh Khosla, CA. S.C. Vasudeva, CA. H.N. Motiwalla, CA. Prem Prakash Pareek, CA. Gautam M. Mehra, CA. P.G. Sadguru Das, CA. R. Sivakumar, CA. V. Krishnan, CA. Seshagiri Rao, CA. Anil Mathur, CA. Aseem Chawla and Ms. Gurveen S. Chophy. I would also like to thank Dr. Avinash Chander, Technical Director, Ms. Anuradha Jain, Secretary, Expert Advisory Committee and CA. Parul Gupta, Executive Officer of the Technical Directorate for their untiring efforts and support in the process of finalisation of the opinions.

I firmly believe that this volume will be of much significance and value to not only the members of the institute but also to the industry as a whole.

New Delhi February 4, 2007

CA. K.P. Khandelwal Chairman Expert Advisory Committee

Contents

Foreword

Preface

1. Treatment of engineering fee paid to a lumpsum turn key contractor.

2. Accounting treatment of expenditure incurred on licence fee (including user licences) for SAP software. 6

1

3. Accounting treatment of lease premium received on lease of industrial plots as industrial estates.

12

4. Depreciation

of

Water

Treatment

Plant (WTP) and

Effluent Treatment Plant (ETP).

 

22

5. Determination of net selling price of a cash generating unit incurring losses.

28

6. Treatment of deferred tax asset in respect

of

excess

provision for doubtful advances and doubtful claims.

 

37

7. Rates of depreciation on various mass rapid transport system.

assets

involved

in

42

8. Segment reporting for sale of power to the State grid.

49

9. Disclosure of partly secured Bonds.

 

55

10. Applicability of AS 3 and AS 18.

58

11. Accounting for Minimum Alternative Tax (MAT) under section 115JB and credit available in respect thereof.

 

64

12. Recognition of revenue in respect of long production cycle items.

72

13. Segment reporting by a finance company.

 

79

14. Booking of export sales/purchases of wheat and rice under subsidised quota of the Government of India, purchased from another government undertaking.

88

15. Overhead allocation for the purpose of inventory valuation at quarter/year end.

 

96

16. Accounting

treatment

in

respect

of

side-tracking

 

costs of wells.

 

109

17. Creation of provision for contingencies.

 

119

18. Creation of deferred

tax liability on special reserve

created u/s 36(1)(viii) of the Income-tax Act, 1961.

 

124

19. Capitalisation

of

certain

expenses

related

to

acquisition of an investment.

 

140

20. Accounting

treatment

on

cancellation

of

foreign

exchange forward contract.

 

142

21. Accounting

treatment

of

Duty

Credit Entitlement

under the Target Plus Scheme.

 

148

22. Treatment of spares.

 

161

23. Disclosure of interest on shortfall in payment of advance income-tax in the financial statements. 166

24. Accounting for conversion of membership rights of

erstwhile BSE (AOP) into and shares.

trading rights of BSEL

172

25. Recognition of duty credit entitlement under ‘Served from India Scheme’.

181

26. Accounting for expenditure on distribution of mementos to employees during construction period.

187

27. Books

of

account

of

franchise

business

and

accounting implications thereof.

 

190

28. Capitalisation

of

establishment

expenses

of

Rehabilitation & Resettlement office after commissi- oning of the project.

198

29. Accounting

and

reporting

of

interest

in

jointly

controlled entity.

 

209

30. Accounting for fixed assets held for sale.

 

217

31. Treatment

of

conversion

rights

for calculation

of

diluted EPS.

 

220

32. Recognition of Duty Credit Entitlement Certificates issued under the ‘Served from India Scheme’.

225

Advisory Service Rules

 

234

Compendium of Opinions — Vol. XXVI

Query No. 1

Treatment of engineering fee paid to a lumpsum turn key contractor. 1

A. Facts of the Case

1. A public sector undertaking is engaged in refining and

marketing of petroleum products. The company has entered into a

lumpsum turn key (LSTK) agreement with a contractor for procurement, supply, commissioning, test run, etc., of a petrochemical plant at one of its refineries.

2. The querist has stated that the LSTK agreement with the

contractor provides for residual process design, detailed engineering, procurement, supply, transportation, storage, fabrication, construction, installation, testing, pre-commissioning, commissioning and performance guarantee test run, and handing over of the plant to the company in lieu of one lumpsum amount agreed to by both the parties.

3. According to the querist, in order to facilitate payments, the

LSTK agreement segregates the lumpsum price in the following categories:

Subject:

(a)

Price

for

residual

process

design

and

detailed

engineering,

 

(b)

Price for supply portion, and

 

(c)

Price for construction/installation portion.

 

4. The querist has stated that the contractor carries out all the

jobs necessary to complete the project as per the agreement. As soon as all the works have been completed in all respects to the satisfaction of the engineer-in-charge of the company, final tests and commissioning of the complete system plant(s), equipment(s), vessels and machinery, and associated system, etc., as required in the specifications, are undertaken by the contractor at the risk and cost of the contractor under the overall supervision of the

1 Opinion finalised by the Committee on 27.3.2006

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Compendium of Opinions — Vol. XXVI

engineer-in-charge of the company. Upon satisfactory conclusion of the final tests and commissioning of the system, the engineer- in-charge issues a final tests and commissioning certificate, which certifies the date on which the final tests and commissioning of the system have been completed. As and from the date of the issue of final tests and commissioning certificate, the company is deemed to have taken over the work(s).

5. As per the querist, advance payments are being made to the

contractor based on different stages of performance as agreed in the LSTK contract on account of all the three categories (residual process design and detailed engineering, supply, and construction/ installation). After completion of the contract, the contractor raises the final invoice and the company makes the final payment. Till the date of completion of the project, as mentioned in the above paragraph, all the advance payments made to the contractor are accounted for as capital advance and, accordingly, disclosed as capital work-in-progress in the financial statements. The querist has further clarified that the payment terms, as mentioned at paragraph 3 above are only in the nature of milestones for making payment under the LSTK contract and the ownership of the full project under such LSTK contract passes to the company only after satisfactory completion of the complete project.

6. On final completion of the project, capitalisation of assets

under various heads, i.e., plant and machinery, equipments and appliances, buildings, furniture and fixtures, etc., is carried out in the books of the company based on the information provided by

the contractor.

7. In this connection, the querist has mentioned that one of the

elements of cost indicated in paragraph 3 above claimed by the contractor relates to detailed engineering and design of the plant. The examples of such process design and detailed engineering are designing layout of the equipments, ensuring that the length, size, thickness of equipments, pipes, etc., adheres to the safety

norms, etc.

8. The querist has also drawn the attention of the Committee to

paragraphs 9.1 and 10.1 of Accounting Standard (AS) 10,

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Compendium of Opinions — Vol. XXVI

‘Accounting for Fixed Assets’, issued by the Institute of Chartered Accountants of India, which state as under:

“9.1 The cost of an item of fixed asset comprises its purchase price, including import duties and other non-refundable taxes or levies and any directly attributable cost of bringing the asset to its working condition for its intended use; any trade discounts and rebates are deducted in arriving at the purchase price. Examples of directly attributable costs are:

(i)

site preparation;

(ii)

initial delivery and handling costs;

(iii)

installation cost, such as special foundations for plant; and

(iv)

professional fees, for example fees of architects and engineers.

The cost of a fixed asset may undergo changes subsequent to its acquisition or construction on account of exchange fluctuations, price adjustments, changes in duties or similar factors.” (Emphasis supplied by the querist.)

“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.”

According to the querist, considering the above provisions of AS 10, the expenses incurred towards process design and engineering fees under the LSTK agreement are accounted for as a component of the cost of the fixed assets and, accordingly, apportioned among the various categories of the fixed assets.

3

Compendium of Opinions — Vol. XXVI

B.

Query

9.

The querist has sought the opinion of the Expert Advisory

Committee on the following issues in respect of accounting for expenses incurred towards engineering and design of the plant under the LSTK agreement:

 

(a)

Whether the accounting treatment of capitalising the expenditure incurred on process design and engineering cost as a component of the total asset is in order.

(b)

If the answer to (a) above is in the negative, whether the expenditure incurred on process design and engineering cost is to be separately accounted for as an intangible asset.

(c)

If the answer to (b) above is also in the negative, the suggested accounting treatment to be followed in this regard may be given.

C.

Points Considered by the Committee

10.

The Committee notes that the basic issue raised in the query

relates to the treatment of expenditure incurred on process design

and engineering cost in respect of various assets under the LSTK agreement. The Committee has, therefore, answered only this issue and has not touched upon any other issue arising from the Facts of the Case, such as, accounting treatment of payments made to contractor based on stages of completion.

11. As far as the expenditure relating to detailed engineering and

design of the plant is concerned, the Committee notes paragraph 20 of AS 10 and paragraph 10 of AS 26, which state, respectively,

as follows:

AS 10

“20. The cost of a fixed asset should comprise its purchase price and any attributable cost of bringing the asset to its working condition for its intended use.”

4

Compendium of Opinions — Vol. XXVI

AS 26

“10. In some cases, an asset may incorporate both intangible and tangible elements that are, in practice, inseparable. In determining whether such an asset should be treated under AS 10, Accounting for Fixed Assets, or as an intangible asset under this Statement, judgement is required to assess as to which element is predominant. For example, computer software for a computer controlled machine tool that cannot operate without that specific software is an integral part of the related hardware and it is treated as a fixed asset. The same applies to the operating system of a computer. Where the software is not an integral part of the related hardware, computer software is treated as an intangible asset.”

12. From the above, the Committee is of the view that the

expenditure on detailed engineering and process design consisting of layout of the equipments is an integral part of the related fixed asset and is also attributable to the cost of bringing the related asset to its working condition for its intended use. Hence, the expenditure on detailed engineering and process design should be allocated to various related fixed assets on the basis of benefit derived by these assets in this regard.

D. Opinion

13. On the basis of the above, the Committee is of the following

opinion on the issues raised in paragraph 9 above:

(a)

Yes, the accounting treatment of capitalising the expenditure incurred on process design and engineering cost as a component of the total asset is correct.

(b)

Since the answer to (a) above is not in the negative, this question does not arise.

(c)

The accounting treatment should be as stated at (a) above.

5

Compendium of Opinions — Vol. XXVI

Query No. 2

Accounting treatment of expenditure incurred on licence fee (including user licences) for SAP software. 1

A. Facts of the Case

1. A public sector undertaking is engaged in refining and

marketing of petroleum products having its marketing network spread throughout the country. During the year 1999-2000, the company decided to implement SAP ERP system in a phased manner so as to cover all its units spread throughout the country over an expected period of 5 to 6 years.

2. Accordingly, the company budgeted for the estimated total

expenditure likely to be incurred for implementation of SAP system throughout the company and actions were initiated in this regard.

3. Prior to Accounting Standard (AS) 26, ‘Intangible Assets’,

issued by the Institute of Chartered Accountants of India, becoming

mandatory w.e.f. 1.4.2003, the expenditure incurred by the company on implementation of SAP software including user licences separately procured under agreement with SAP India (other than the hardware portion) has been charged off as expenditure in the year of incurrence. The querist has also informed that the payment made to SAP India is only towards the user licence fees for the right to use the SAP software and nothing has been paid on account of the cost of the SAP software.

4. The company continued to incur expenditure after 1.4.2003

on consultancy charges and user licences in line with its plan for implementation of SAP system throughout the company in a phased

Subject:

manner as was envisaged at the time of deciding and initialising the implementation of SAP system in the company. The querist has also informed that the payment of consultancy charges is over and above the payment made on account of user licence fees of SAP software to the supplier company. The Annual Maintenance Charges (AMC) being paid to the supplier company is towards

1 Opinion finalised by the Committee on 27.3.2006

6

Compendium of Opinions — Vol. XXVI

maintenance of the software, right to use the latest version of the software and minor upgradation in the software from time to time. Such expenditure incurred after 1.4.2003 was continued to be charged to revenue since the original cost incurred on SAP user licences for the software were already charged to revenue prior to 1.4.2003 as explained in paragraph 3 above. According to the querist, this is in line with the understanding conveyed by paragraphs 58 and 59 of AS 26, which envisage that subsequent expenditure on an intangible asset can be recognised as intangible asset only if the original expenditure has been treated as an intangible asset subject to satisfying the conditions laid down for determining the test of admissibility as an intangible asset. Paragraphs 58 and 59 are reproduced by the querist as below:

“Past Expenses not to be Recognised as an Asset

58. Expenditure on an intangible item that was initially

recognised as an expense by a reporting enterprise in previous annual financial statements or interim financial

reports should not be recognised as part of the cost of an intangible asset at a later date.

Subsequent Expenditure

59. Subsequent expenditure on an intangible asset after

its purchase or its completion should be recognised as an expense when it is incurred unless:

(a) it is probable that the expenditure will enable the asset to generate future economic benefits in excess of its originally assessed standard of performance; and

(b) the expenditure can be measured and attributed to the asset reliably.

If these conditions are met, the subsequent expenditure should be added to the cost of the intangible asset.”

5. The querist has stated that in addition to the expenditure

stated in paragraph 4 above, the expenditure incurred on or after

7

Compendium of Opinions — Vol. XXVI

1.4.2003 and also further expected to be incurred for total stabilisation of SAP system in the company is mainly for procuring additional user licences for operating the software as was originally envisaged by the company and the same is required to achieve the originally assessed optimal utilisation envisaged while deciding to implement the SAP system.

B. Query

6. The querist has sought the opinion of the Expert Advisory

Committee with respect to the expenditure incurred for acquiring the user licences for right to use of the SAP software, on the following issues:

(a)

Whether the accounting treatment of charging subsequent expenditure on SAP licence fee (including user licences) incurred on or after 1.4.2003 to the profit and loss account is correct in view of the fact that the initial expenditure incurred on SAP software including licence fee prior to 1.4.2003 (i.e., before AS 26 became mandatory) has already been charged to revenue in the year of incurrence.

(b)

In case the answer to (a) above is in the negative, what is the suggested accounting treatment for the following:

(i)

Expenditure incurred on licence fee for SAP software prior to 1.4.2003 (i.e., before AS 26 became mandatory).

(ii)

Subsequent expenditure on user licence fee for the SAP software incurred on or after 1.4.2003, which has already been charged to revenue.

(iii)

Whether the adjustments, if any, required to be carried out for the accounting periods prior to 31 st March, 2005 are to be reflected as prior year adjustment as per Accounting Standard (AS) 5, ‘Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies’.

8

Compendium of Opinions — Vol. XXVI

C.

Points considered by the Committee

7.

The Committee notes that the issue raised in the query relates

to accounting for the expenditure incurred on purchase of user licences for SAP software. The Committee has, therefore, restricted the opinion only to this issue and has not considered any other issue arising from the Facts of the Case, for example, accounting treatment for Annual Maintenance Contract of the software.

8. The Committee is of the view that prior to Accounting Standard

(AS) 26, ‘Intangible Assets’, becoming mandatory, i.e., before 01.04.2003, all fixed assets, whether tangible or intangible, were covered by Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’. AS 10 dealt with assets such as know how, patents, etc., the relevant paragraphs in respect of which were withdrawn when AS 26 became mandatory. In this context, the definition of the term ‘fixed asset’ as per AS 10, contained in paragraph 6.1, is reproduced below:

“6.1 Fixed asset is an asset held with the intention of being used for the purpose of producing or providing goods or services and is not held for sale in the normal course of business.”

9. The Committee notes from the Facts of the Case that the

company has purchased the user licences for SAP software for the purpose of use in the business and not for sale. Therefore, in the view of the Committee, since the user licences have a life longer than one year, the expenditure on purchase of user licences, before AS 26 becoming mandatory, i.e., before 01.04.2003, should have been capitalised as per AS 10 and should have been depreciated/amortised as per the requirements of Accounting Standard (AS) 6, ‘Depreciation Accounting’, over the estimated useful life of the user licences. Since this was not done, this amounts to an error and, accordingly, it comes within the purview of the definition of ‘prior period items’ under Accounting Standard (AS) 5, ‘Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies’. The definition of the term ‘prior period items’ as contained in paragraph 4 of AS 5, is reproduced below:

9

Compendium of Opinions — Vol. XXVI

“Prior period items are income or expenses which arise in the current period as a result of errors or omissions in the preparation of the financial statements of one or more prior periods.”

10. In view of the above, if the assets (user licences) are existing

on the date of the balance sheet, the company needs to capitalise the above-said asset at a value arrived at by capitalising the expenditure incurred with retrospective effect and amortising the same for the past accounting years. The value of the asset so arrived at should be brought into books in the current year by a corresponding credit to the profit and loss account as a prior period item.

11. The Committee further notes the definition of the term

‘intangible asset’, provided in paragraph 6 of Accounting Standard (AS) 26, ‘Intangible Assets’, which is reproduced below:

“An intangible asset is an indentifiable non-monetary asset, without physical substance, held for use in the production or supply of goods or services, for rental to others, or for administrative purposes.”

The Committee is of the view, on the basis of the above definition, that the user licences purchased are intangible assets. Therefore, the expenditure incurred on the purchase of user licences for SAP software on or after 01.04.2003, should have been capitalised and amortised over their estimated useful life as per AS 26. Since this was not done as above, the company is required to make adjustments as suggested in paragraph 10 above.

12. The Committee does not agree with the contention of the

querist that previous expenditure which should have been capitalised but which was expensed can not be capitalised in view of the requirements of paragraph 58 of AS 26 reproduced in paragraph 4 of the Facts of the Case. In the view of the Committee, paragraph 58 of AS 26 is related only to that expenditure which could not qualify to be recognised as an intangible asset as per the requirements of the said Standard, at the time of incurrence and, therefore, was charged as an expense, but later it qualified to

10

Compendium of Opinions — Vol. XXVI

be recognised as an intangible asset. Paragraph 58 of AS 26 provides that the expenditure so expensed can not be capitalised as an intangible asset in a later year. Thus, this paragraph does not relate to an expenditure which fulfilled all the conditions for recognition as an intangible asset but was erroneously expensed. Therefore, in the view of the Committee, paragraph 58 is not relevant in the present case.

13. The Committee also does not agree with the contention of the

querist that as per paragraph 59 of AS 26, reproduced in paragraph 4 of the Facts of the Case, the subsequent expenditure can not be capitalised as the original expenditure on acquisition was not capitalised. In the view of the Committee, the subsequent expenditure dealt with in paragraph 59 is that expenditure which is incurred on those items which were recognised as assets as per AS 10 or AS 26 in earlier years. Thus, simply because the expenditure incurred initially on acquisition of user licences for SAP software was not capitalised, cannot be an argument for not capitalising user licences acquired subsequently as they meet the recognition criteria for capitalising the user licences as an intangible asset. Accordingly, the Committee is of the view that the further purchase of user licences does not amount to be a subsequent expenditure as contemplated in paragraph 59, as this expenditure amounts to creation of an intangible asset.

14. The Committee notes paragraph 4.3 of the ‘Preface to the

Statements of Accounting Standards’ which states that “The Accounting Standards are intended to apply only to items which

are material….”. Therefore, the above suggestions are only applicable if the amounts involved are material.

D. Opinion

15. On the basis of the above, the Committee is of the following

opinion on the issues raised in paragraph 6 above, subject to the consideration of materiality stated in paragraph 14 above:

The accounting treatment of charging expenditure, on purchase of user licences on or after 1.4.2003, to the profit and loss account is not correct.

(a)

11

Compendium of Opinions — Vol. XXVI

(b) Subject to the condition that the user licences exist on the date of the balance sheet, i.e., the user licences have a useful life on the balance sheet date,

(i)

expenditure incurred on purchase of SAP software user licences prior to 1.4.2003 should be capitalised as suggested in paragraph 10 above;

(ii)

expenditure incurred on SAP user licences, on or after 1.4.2003, should be recognised as an intangible asset as suggested in paragraph 11 above; and

(iii)

adjustments required to be carried out for the accounting periods prior to 31 st March, 2005, should be reflected as prior period item as suggested in paragraph 10 above.

Query No. 3

Subject:

Accounting treatment of lease premium received on lease of industrial plots as industrial estates. 1

A. Facts of the Case

1. A government company, registered under the Companies Act,

1956, is engaged in the business of developing industrial plots, leasing them to industrial units and meeting their financial needs.

2. The company has developed various industrial plots, which

were acquired through the Government. The company provides adequate infrastructure facilities like construction of roads, drainage system, sewerage system, water distribution network, maintenance of the plots, etc. The said plots are then leased out to various industrial units who construct buildings/sheds etc. The lease is given for a period of 99 years and a non-refundable lease premium

1 Opinion finalised by the Committee on 27.3.2006

12

Compendium of Opinions — Vol. XXVI

amount is collected towards 100% of the estimated development expenditure besides a yearly rental of Re 1/-.

3. The querist has stated that till 1988-89, the following accounting

practice was followed:

(i)

the acquisition cost of land as well as the development expenditure of the industrial estates were shown as ‘Current Assets’ and the lease premium received on allotment of the corresponding developed plots was shown as “Current Liabilities” in the balance sheet.

(ii)

The resultant profit or loss on such activity was ascertained on completion of the development of the industrial complex.

4. According to the querist, the above accounting treatment was

changed in the financial year 1988-89, as per the advice of the

Accountant General (Commercial), to the understated method, which has been followed upto and including the year 2005-06:

(a)

accounting for the cost of land as well as the development expenditure of the industrial estates as ‘Fixed Assets’,

(b)

proportionate amount of the lease premium is accounted for as income of the concerned financial year,

(c)

the balance of the lease premium is presented under ‘current liabilities’, and

(d)

depreciation is charged to the profit and loss account at the relevant rates on the concerned assets.

5. During the supplementary audit for the financial year 2002-

03, the Accountant General (Commercial) commented that the company was not following the accounting practice as per an Opinion given by the Expert Advisory Committee of the Institute of Chartered Accountants of India (Query No. 22 of Compendium of Opinions – Volume No. XX), wherein it was opined that in such cases, the cost of acquisition of land and the relevant development expenditure should be treated as current assets till the plots are leased and after leasing of the plots, the lease premium received

13

Compendium of Opinions — Vol. XXVI

should be recognised as income in the profit and loss account in the year in which the recognition conditions as laid down in Accounting Standard (AS) 9, ‘Revenue Recognition’, issued by the Institute of Chartered Accountants of India are fulfilled and the costs of acquisition of land and the development expenditure thereon should also be expensed in the same year.

6. The Accountant General (Commercial) had commented on

the same issue for the accounting year 2003-04 and had stated that the current liabilities and fixed assets were being overstated.

7. The Board of Directors of the company has discussed the

issue and decided as below:

(i)

That the matter regarding accounting treatment to be given in the books of account in respect of the plots/land allotted by the corporation under the lease premium scheme for the period of 99 years be referred to the Expert Advisory Committee of the Institute of Chartered Accountants of India for expert opinion.

(ii)

That the matter be brought to the Board after receipt of the expert opinion.

(iii)

That till such time, the present accounting treatment be continued in order to have consistency.

8. The querist has reproduced below the gist of the Opinion of

the Expert Advisory Committee referred to in paragraph 5 above, for immediate reference:

(a) The query was regarding a government company, which was in the business of developing industrial estates and housing plots, including provision of amenities and infrastructure just like the company under consideration. The developed industrial estates were given out on lease for 60 years for which the company was receiving a lease premium at the beginning of the lease period. The lease premium was not refundable during the period of lease. However, the lease was transferable to any other entrepreneur with the consent of the company. A nominal

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Compendium of Opinions — Vol. XXVI

lease rent of Re. 1/- per annum was charged from the lessees besides recovery of service and maintenance charges towards maintenance of the industrial estate.

(b)

The lease premium was accounted as income at 1/60 th each year and the balance lease premium was shown as ‘lease premium received in advance’ under the head ‘current liabilities’. The leasehold land, and the land development expenditure were shown as ‘Fixed Assets’. On objections raised by statutory auditors, the company started amortising the proportionate land development expenditure during the operative period of lease and included the same under the head ‘Depreciation’.

(c)

Considering the above basic facts, the Expert Advisory Committee was of the view that in respect of the lease agreements for long periods, e.g., 60 years and 99 years, it is generally expected that on the expiry of the lease term, either the lease period would be extended or the title will pass to the lessee at some agreed amount. This amounts to passing of the significant rights of ownership in the land to the lessee. Thus, it would be in the nature of sale of plots and should be accounted for, accordingly. This requirement, according to the Committee, is recognition of the principle of ‘substance over form’.

(d)

The cost of land along with development expenditure should be reflected as a current asset and should be expensed in the same year in which the revenue from the lease of plots is recognised as income keeping in view the matching principle.

(e)

Also, as per Accounting Standard (AS) 9, ‘Revenue Recognition’, issued by the Institute of Chartered Accountants of India (ICAI), the following three conditions are laid down for recognition of revenue:

(i)

Performance of the act giving rise to revenue

(ii)

Measurability of the revenue

(iii)

Collectability of the revenue

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Compendium of Opinions — Vol. XXVI

(f) In the light of the above considerations, the Expert Advisory Committee opined that the lease of land should be treated as sale. Thus, whole of the lease premium should be recognised as revenue in the year in which the three conditions as laid down in AS 9 are fulfilled and the related costs of acquisition of land and development expenditure thereon should be expensed in the same period.

9. The querist has further stated that perusal of the lease deed

of the company reveals certain important provisions which are enumerated below (a copy of the deed has been separately provided by the querist for the perusal of the Committee):

(i)

In fulfillment of one of its principal objects, the company has laid out the land into various plots, drains and for other commercial betterment schemes for the benefit of the occupants of the plots so laid out. The company proposes to have control over the amenities so created, such as roads, water supply, drainage, etc., so that these are distributed to the industrialists in a reasonable and equitable manner. The company also proposes to allot the land on long lease for 99 years inasmuch as it is felt that the characteristic and homogeneity of the industrial estate should not be destroyed. Also, the intention of the company is that the leased land should be put to the exclusive use for industrial purposes and thereby facilitating the implementation of the pattern of industrialisation that was envisaged. (Emphasis supplied by the querist.)

(ii)

The lessee shall pay 100% of the estimated development expenditure as non-refundable premium in addition to paying rent of Rs. 100/- for 99 years (Re. 1 p.a. for 98 years and Rs. 2 for 99 th year) and service and maintenance charges as may be intimated on a monthly basis.

(iii)

In case the lessee violates any conditions of the lease deed, the company may determine the lease during the

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Compendium of Opinions — Vol. XXVI

period of lease and take possession of the said allotted plot together with the factory buildings and other buildings located on the same and the lessee shall not be entitled to any compensation for any of the construction on the allotted plot or any refund of any amount paid by the lessee by virtue of this deed. (Emphasis supplied by the querist.)

(iv)

If the lessee, by any of his action, causes the land to be sold or attached, then the company may determine the lease and take possession of the said property along with the buildings thereon as mentioned in the above paragraph. (Emphasis supplied by the querist.)

(v)

If any portion of land allotted to the lessee is found unutilised or in excess of the lessee’s requirements, then the company may take over the unutilised or excess land and the proportionate non-refundable premium paid by the lessee for such land shall be refunded to the lessee. (Emphasis supplied by the querist.)

(vi)

On expiry of the lease term laid down in the lease deed, the new lease of the said plot for a similar period of 99 years shall be entered into on such covenants and provisions, as contained in the original lease deed.

10. The querist has stated that the above clauses reveal the

intention of the company to hold the said plots as its own fixed assets and the agreement reveals that no significant rights of ownership pass on to the lessee, inasmuch as that the company retains the right to take over the land with its buildings thereon, upon certain events taking place, even without compensation being payable to the lessee.

11. According to the querist, the condition, “performance of the

act giving rise to revenue” is not absolutely fulfilled in this instance,

as the company retains the right of ownership and even eviction and repossession, and also the company retains the power to extend the lease for another 99 years. Hence, in substance, it cannot be said that the significant rights of ownership have passed on to the lessee.

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Compendium of Opinions — Vol. XXVI

12. Besides, as per the querist, if the cost of acquisition of land

and development cost thereon, are treated as current assets and expensed in the same year in which the revenue from sale of plots is recognised, it leads to the anomaly that the fixed assets of the company are written off, while the company retains the ownership rights on such assets which are only leased. According to the querist, this is not in accordance with Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, issued by the Institute of Chartered Accountants of India, or generally accepted accounting principles. This accounting treatment will not reflect a true and fair view of the financial statements and would invite a qualification thereon by the auditors.

13. The querist has further stated that accounting of the lease

income fully in the year of receipt will also not be in accordance with the principles of recognition of revenue laid down in AS 9, viz., measurability of revenue, as the lease income is paid in advance for 99 years and if accounted in one year, will lead to lopsided presentation of income and non-matching of income with relevant expenditure like depreciation on amenities and other infrastructure. In the view of the querist, this accounting treatment will not reflect a true and fair view of the financial statements and would invite a qualification thereon by the auditors.

14. The querist has reproduced the professional opinion of the

statutory auditors on this issue which is as follows:

“(i) … we are of the professional opinion that the accounting

system followed by the company, i.e., accounting for the cost of acquisition of land and development costs thereon and other infrastructure costs as fixed assets and accounting for the lease premium received in advance as current liabilities and proportionate lease premium (1/99 th ) as income for the financial year and charging off depreciation for the relevant assets to profit and loss account, is as per the generally accepted accounting principles and relevant accounting standards.

(ii) Besides, we are of the professional opinion, that the

opinion of the Expert Advisory Committee of the ICAI should

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Compendium of Opinions — Vol. XXVI

be taken into consideration with all other relevant factors and that it is specifically mentioned that the opinion of the Expert Advisory Committee is only that of the Expert Advisory Committee and does not necessarily represent the opinion of the Council of the Institute of Chartered Accountants of India, which is binding on all institutions and members of the ICAI.”

B.

Query

15.

Considering the above factors, the querist has sought the

opinion of the Expert Advisory Committee as to whether, on consideration of the facts and circumstances of the case concerned, it is right for the company to continue its accounting practice of:

 

(a)

recognising the cost of land as well as the development expenditure of the industrial estates as ‘Fixed Assets’,

(b)

recognising the lease premium under ‘Current Liabilities’,

(c)

recognising the proportionate amount of lease premium as income of the concerned financial year, and

(d)

charging the depreciation to the profit and loss account at the relevant rates on the concerned assets.

C.

Points considered by the Committee

16.

The Committee notes paragraph 17(b) of Accounting Standard

(AS) 1, ‘Disclosure of Accounting Policies’, issued by the ICAI, which states as follows:

“17(b) Substance over Form

The accounting treatment and presentation in financial statements of transactions and events should be governed by their substance and not merely by the legal form.”

17. The Committee notes from the above that the transactions

and events are accounted for and presented in accordance with their substance, i.e., the economic reality of events and transactions and not merely with their legal form. The Committee notes from the ‘Facts of the Case’ that the plots of land are given by the company on lease for a period of 99 years, which is renewable for

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Compendium of Opinions — Vol. XXVI

a similar period. The Committee is of the view that taking into

account the long period of lease with renewability clause, and the prevalent commercial practices in India in this regard, in substance, the lease of land in this case amounts to passing of significant rights of ownership to the parties concerned. Thus, such a lease would be in the nature of sale of plots and should be accounted

for accordingly. In this regard, the Committee notes that the principle of substance over form is also recognised in Schedule VI to the Companies Act, 1956, which requires leaseholds to be shown as fixed assets of the lessee and not of the lessor. The Committee further notes from the ‘Facts of the Case’ that the leasing of industrial plots constitutes an ordinary activity of the company; hence, land along with the development expenditure incurred thereon should be accounted for as ‘Current Assets’ rather than ‘Fixed Assets’. Accordingly, no depreciation should be charged on such assets. These current assets should be expensed in the year

in which revenue from the leasehold premium is recognised, as

discussed in the following paragraphs.

18. The Committee also notes that the querist has argued in paragraph 9(iii) above that the company can take back the possession of the leased land, in case the lessee violates the conditions of the lease deed, or causes the land to be sold or attached, or keeps the land unutilised, etc. The Committee is of the view that such terms and conditions under the lease deed are generally inserted so as to regulate the use of industrial plots for specified purposes only and for their optimum utilisation. The Committee also notes that the company also reserves the right of taking the possession of factory buildings and other construction on land, which are not even owned by the lessors. In the view of the Committee, this does not represent the intention of the company

to hold them as its fixed assets. Similarly, the Committee is of the

view that the above-mentioned conditions in case of lease of land,

in no way, represent the intention of the company to hold the plots

as its own fixed assets as defined in Accounting Standard (AS) 10, Accounting for Fixed Assets, issued by the Institute of Chartered Accountants of India. Accordingly, the contentions of the querist, as stated in paragraphs 11 and 12 above are also not tenable as

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Compendium of Opinions — Vol. XXVI

the significant rights of economic ownership of the land leased for a long period of 99 years, do not vest with the company.

19. Regarding the recognition of revenue, the Committee notes

from the lease deed supplied by the querist, separately that the upfront lease premium comprises upfront leasehold premium on account of the acquisition of land and on account of development expenditure, which is collectively referred to as ‘estimated development expenditure’. As far as premium in respect of land is concerned, it should be recognised as revenue in the profit and loss account in the year in which the recognition conditions laid down in paragraph 11 of AS 9 are met. The revenue from development expenditure such as expenditure on construction of roads, drainage system, sewerage system, etc., should be recognised proportionately over the term during which the development activity is carried on, on the basis of stage of completion, every year. The Committee is of the view that this manner of recognition of revenue on account of upfront lease premiums related to estimated development expenditure would lead to matching of revenue with the cost. As far as the expenditure incurred in future on services and maintenance of land is concerned, the same will be matched with the services and maintenance charges obtained by the company.

D. Opinion

20. On the basis of the above, the Committee is of the opinion

that it is not right for the company to continue its accounting

practice of:

(a)

recognising the cost of land as well as the development expenditure of the industrial estates as ‘Fixed Assets’,

(b)

recognising the lease premium under ‘Current Liabilities’,

(c)

recognising the proportionate amount of lease premium as income of the concerned financial year, and

(d)

charging the depreciation to the profit and loss account at the relevant rates on the concerned assets.

The company should follow the accounting policy as suggested by the Committee in paragraphs 17 and 19 above.

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Compendium of Opinions — Vol. XXVI

Query No.4

Subject:

Depreciation of Water Treatment Plant (WTP) and Effluent Treatment Plant (ETP). 1

A. Facts of the Case

1. A public sector company with majority shareholding by a state

government, manufactures paper for newsprint, printing and writing. The company has a water treatment plant and an effluent treatment plant.

Water Treatment Plant (WTP)

2. The company constructed a WTP in 1985 to treat raw water

drawn from a river to carry out various production activities. The capacity of WTP was augmented in 1995. WTP consists of the following:

(i)

Clarifiers

(ii)

De-mineralisation plants (DM plants)

(iii)

Neutralisation pit and drain

(iv)

Pipelines

3. The querist has stated that the machineries installed in the

WTP, including civil foundation works to install the machinery, were capitalised as ‘plant and machinery’. The other civil works were capitalised as ‘Factory Buildings’. The assets are still in use.

4. The querist has further stated that the company has

constructed three water storage reservoirs during the years 2000, 2003 and 2005 to store water pumped from a river and use the same for the requirements of the factory. The life of these storage reservoirs is expected to be very long. These water storage

reservoirs and connected pipelines have been capitalised as ‘Factory Buildings’ by considering the nature of works.

1 Opinion finalised by the Committee on 27.3.2006

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Compendium of Opinions — Vol. XXVI

Effluent Treatment Plant (ETP)

5. The company constructed ETP to treat the effluent in 1985

and augmented the capacity in 1995. ETP consists of the following:

(i)

Effluent clarifiers (primary and secondary clarifiers)

(ii)

Effluent filter house and clarifiers

(iii)

Drains

(iv)

Effluent/anaerobic lagoon

6. According to the querist, the machineries installed in the

effluent clarifiers, effluent filter house and clarifiers, and lagoon including civil foundation works to install the machineries were

capitalised as ‘Plant and Machinery’. The other civil works were capitalised as ‘Factory Buildings’. These assets are still under use.

7. The querist has provided the following tables containing the

processes/activities carried on by using various civil works involved

in WTP and ETP, respectively, along with the remarks of the company:

CIVIL WORKS IN WATER TREATMENT PLANT (WTP)

S.

Description

Nature of civil

Process

Remarks

No.

work involved

activity

1

Intake well

Reinforced ce- ment concrete (RCC) structure at ground level.

Water is being pumped from the sump for entire plant.

Not directly in- volved in treat- ment.

sumps

2

Clariflocula-

RCC circular tank at ground level.

To treat water with chemicals for clarifying the water.

Directly involved

tor 1 and 2 (Clarifiers)

in pre-treatment

of water.

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Compendium of Opinions — Vol. XXVI

3

Reservoirs

RCC circular tank at ground level.

For storing clari- fied water being pumped for plant use.

Directly involved

at WTP

in treatment.

(Reservoir 1

 

and 2)

4

De-minerali-

RCC

framed

To house equip- ments involved in de-mineralisation activity.

Not directly in- volved in treat- ment of water

sation plant

structure building.

5

Neutralisa-

RCC rectangular ground level tank.

Water is being neutralised by adding chemi- cals.

Directly involved

tion Pit and drains

in treatment.

6

Softening

RCC

framed

To house equip- ments involved in softening activity.

Not directly in- volved in treat- ment of water

plant

structure building.

 

CIVIL WORKS IN EFFLUENT TREATMENT PLANT (ETP)

 

S.

Description

Nature of civil

 

Process

Remarks

No.

work involved

activity

1

Primary

RCC circular tank at ground level.

To

clarify

the

Directly involved

clarifiers

effluent with

in treatment.

 

chemicals.

 

2

Anaerobic

Rectangular earth-en lagoon with stone pitch- ing.

For

anaerobic

Directly involved

lagoon

treatment

for

in treatment.

reducing COD.

3

Aeration

Rectangular pond with RCC lining and walkways at ground level.

For treatment of effluent with aerobic action.

Directly involved

pond

in treatment.

4

Secondary

RCC circular tank at ground level.

For settlement of sludge.

Directly involved

clarifier and

in treatment.

drains

   

5

Sludge

RCC circular tank at ground level.

For removal of sludge.

Directly involved

thickener

in treatment.

6

Filter House

RCC

framed

To house ETP filters for sludge removal.

Not

directly

building

structure building.

involved

in

treatment.

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Compendium of Opinions — Vol. XXVI

B.

Query

8.

The querist has sought the opinion of the Expert Advisory

Committee on the following issues:

 

(i)

Whether the capitalisation of civil works in Water Treatment Plant (WTP) and Effluent Treatment Plant (ETP) as ‘Factory Buildings’ is correct? If not, what should be the treatment for the above civil works?

(ii)

Whether the capitalisation of raw water storage reservoir as ‘Factory Buildings’ is correct? If not, what should be the treatment?

(iii)

If the above items are to be capitalised as ‘Plant and Machinery’, whether the revised depreciation rates are applicable prospectively or retrospectively.

(iv)

If the revised depreciation rates are to be applied retrospectively, whether the depreciation pertaining to prior periods should be presented under ‘prior period items’.

C.

Points considered by the Committee

9.

The Committee is of the view that in the absence of the

definitions of the terms ‘Factory Buildings’ and ‘Plant and Machinery’, under the Companies Act, 1956, a functional test has to be applied to determine whether a structure is ‘plant’ or not. The functional test requires to examine various aspects of the structure to determine whether it is an apparatus with which the activity or activities is/are carried on or it is a mere setting of or part of the premises in which the activity is/activities are carried on.

10. The Committee notes from the Facts of the Case that the civil

works of WTP and ETP consisting of reservoirs, drains, lagoons, various clarifiers, neutralisation pit, aeration pond, and sludge thickener are directly involved in the process of treatment of water and effluent. On this basis, the Committee is of the view that the civil works involved in the Water Treatment Plant and Effluent Treatment Plant, excluding intake well sumps, de-mineralisation plant, softening plant and filter house building, are not merely the

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Compendium of Opinions — Vol. XXVI

premises in which the work is carried on; these are rather the means with which and through which the activities of treatment of water and effluent are carried on. Hence, in the view of the Committee, the civil works directly involved in the treatment of

water and effluent should be capitalised as ‘Plant and Machinery’ instead of ‘Factory Buildings’ and accordingly, depreciation as per

the rates applicable to ‘Plant and Machinery’ should be provided

on these items, taking into account the rates given in Schedule

XIV

to the Companies Act, 1956.

11.

As far as depreciation on other civil works, i.e., which are not

directly involved in the process of treatment of water and effluent,

such as, intake well sumps, de-mineralisation plant, softening plant

and filter house building is concerned, the Committee notes from

the Facts of the Case that these civil works only act as the setting

or structure containing various equipments and are not directly involved in the process of water treatment and effluent treatment. Hence, the Committee is of the view that these civil works should be classified as ‘Factory Buildings’ and accordingly, depreciation on these items should be provided as per the rates applicable to ‘Factory Buildings’ under Schedule XIV.

12. The Committee notes that the information provided by the

querist in tables (paragraph 7 above), explaining the nature of civil works involved and the process activities carried on by them, does not specifically mention raw water storage reservoir. Hence, if the nature of the reservoir is such that it is not directly involved in the treatment of water and effluent, it should be treated as ‘Factory

Building’.

13. Regarding the revision of the rates of depreciation to be applied

on civil works directly involved in WTP and ETP, the Committee is of the view that the practice followed by the company of providing depreciation on these civil works, at the rates applicable to ‘Factory Buildings’, is an error as depreciation on these items should have been provided as per the rates applicable to ‘Plant and Machinery’,

from the very beginning. In view of this, depreciation on the said items should now be provided with retrospective effect. The deficiency or surplus arising from retrospective recomputation of

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Compendium of Opinions — Vol. XXVI

depreciation in accordance with the changed rates due to change in classification of assets should be adjusted in the accounts in the year in which change is given effect to as a prior period item as discussed in the following paragraphs.

14. The Committee notes the definition of the term ‘prior period

items’ and paragraphs 15 and 19 of Accounting Standard (AS) 5, ‘Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies’, issued by the Institute of Chartered Accountants of India, which state as follows:

“Prior period items are income or expenses which arise in the current period as a result of errors or omissions in the preparation of the financial statements of one or more prior periods.”

15. The nature and amount of prior period items should be separately disclosed in the statement of profit and loss in a manner that their impact on the current profit or loss can be perceived.”

“19. Prior period items are normally included in the determination of net profit or loss for the current period. An alternative approach is to show such items in the statement of profit and loss after determination of current net profit or loss. In either case, the objective is to indicate the effect of such items on the current profit or loss.”

15. From the above, the Committee is of the view that the change

in the depreciation rates due to change in the classification of assets arising from an error, as discussed in paragraph 13 above, is a prior period item and, therefore, excess/short depreciation charge pertaining to prior periods should be disclosed separately in the current year’s profit and loss account in a manner that its impact on the current year’s profit or loss can be perceived.

D. Opinion

16. On the basis of the above, the Committee is of the following

opinion on the issues raised in paragraph 8 above:

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Compendium of Opinions — Vol. XXVI

(i)

No, capitalisation of civil works directly involved in water treatment and effluent treatment, as ‘Factory Buildings’ is not correct. These civil works should be treated as ‘Plant and Machinery’.

(ii)

Capitalisation of raw water storage reservoir as ‘Factory Buildings’ would be correct only if it is not directly involved in the process of treatment of water and effluent as discussed in paragraph 12 above.

(iii)

The

revised

depreciation

rates are applicable

retrospectively.

 

(iv)

Depreciation pertaining to prior period due to retrospective application of depreciation rates is a prior period item, which should be separately disclosed.

Query No. 5

Determination of net selling price of a cash generating unit incurring losses. 1

A. Facts of the Case

1. The accounts of a public sector company are audited by the

Office of the Principal Director of Commercial Audit & Ex- Officio

Member, Audit Board. During the audit of the accounts of the company for the financial year 2004-05, certain differences of opinion had arisen in respect of Accounting Standard (AS) 28, ‘Impairment of Assets’, issued by the Institute of Chartered Accountants of India. The auditors, however, had cleared the accounts for the year 2004-05, on the commitment made by the company to take opinion from the Expert Advisory Committee of the Institute of Chartered Accountants of India.

Subject:

1 Opinion finalised by the Committee on 27.3.2006

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Compendium of Opinions — Vol. XXVI

2. The querist has stated that the company has mainly three

different businesses controlled by three separate business groups as under:

(i) Business Group (Petroleum) – It is engaged in storage and distribution of high speed diesel, motor spirit (petrol), kerosene oil, naphtha, aviation turbine fuel, etc., and manufacture and marketing of automotive lubes and grease, etc. Turnover of this business group (B.G.) in the financial year 2004-05 was Rs. 13,364 crore. Under the B.G. (Petroleum), there are 3,272 petrol pumps as on 31.03.2005, 17 depot terminals (for storing and distribution of petroleum products), 27 divisional offices, 4 regional offices, one marketing head office at Mumbai and one corporate head office at Kolkata. For budget and MIS reporting purpose, B.G. (Petroleum) as a whole has been considered as a separate unit and budgeted profitability is being prepared for the B.G. (Petroleum) separately.

For the purpose of accounting, all transactions (cash/ bank/journal) at the divisional office level and depot level are consolidated at the concerned region. Except some major adjustments pertaining to margin updation, Government subsidy is being controlled and accounted for at marketing head office for petroleum at Mumbai. Considering 4 regional final accounts and separate final accounts for LPG business, marketing head office for petroleum prepares consolidated final accounts for the petroleum business which is ultimately consolidated at corporate head office at Kolkata along with the final accounts of B.G. (Explosives) and B.G. (Cryogenics).

Considering various provisions of AS 28 and the industry practice on the issue, the company has considered business group (petroleum) as ‘cash generating unit (CGU)’ instead of considering each regional offices and LPG business as separate CGUs. Reason being that individual regions and LPG business are not independent

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Compendium of Opinions — Vol. XXVI

of cash inflows from the other assets or group of assets of the B.G. (Petroleum). The statutory auditors of the company and C&AG have agreed to consider the B.G. (Petroleum) as a separate CGU.

(ii) Business Group (Explosives) – It is engaged in manufacture and marketing of site mixed explosives, re- pumpable bulk emulsion explosives, cartridged explosives, detonating fuses, cast boosters, etc. Turnover of this group in the financial year 2004-05 was Rs. 92 crore. Under B.G. (Explosives), there are 14 manufacturing plants, two marketing offices at Delhi and Nagpur and one divisional head office at Kolkata. Individual plants are maintaining accounts and making all payments except for majority of the raw material payment which is procured centrally from the divisional head office (DHO) at Kolkata. Sundry creditors for raw material and debtors are also being maintained centrally at divisional head office.

For the purpose of Budget and MIS, overall profitability of the B.G. (Explosives) is being prepared. However, plant-wise profitability is also prepared as per the requirement of the management from time to time. Trial balances of each plant, after getting audited, are sent to DHO for consolidation and preparation of final accounts of B.G (Explosives) which subsequently get consolidated at corporate head office, Kolkata along with B.G. (Cryogenics) and B.G. (Petroleum) accounts. The final accounts get audited at regional level, Mumbai Head office level for B.G. (Petroleum) and at DHO level for B.G. (Cryogenics) and B.G. (Explosives).

Considering various provisions of AS 28, the company has considered the Business Group (Explosives) as a separate ‘cash generating unit’ (CGU). Reasons being:

(a) The sales allocation of principal customer of B.G. (Explosives) is being made from DHO, Kolkata. (b) All the major raw materials are being procured centrally at DHO and then placed with the plants as per the requirements. (c) The overall control of the plants with

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Compendium of Opinions — Vol. XXVI

respect to finance, human resource, marketing issues are being centrally controlled at DHO. The statutory auditors of the company and C&AG have agreed to consider the B.G. (Explosives) as a separate CGU.

(iii) Business Group (Cryogenics) - It is engaged in manufacture and marketing of aluminium cryogenic containers, stainless steel industrial cryovessels, etc. Turnover of this group in the financial year 2004-05 was Rs. 23 crore. Under B.G. (Cryogenics), there is one plant at Nasik and one cryogenics head office at Mumbai. Final accounts of B.G. (Cryogenics) are prepared at Mumbai and finally consolidated at Kolkata corporate office along with B.G. (Petroleum) and B.G. (Explosives) accounts. For the purpose of budget and MIS, overall profitability of the B.G. (Cryogenics) is being prepared. Considering various provisions of AS 28, the company has considered Business Group (Cryogenics) as a separate ‘Cash Generating Unit’.

3. According to the querist, as stated above, in line with the

various paragraphs of AS 28, the company has identified three cash generating units (CGUs), i.e., B.G. (Petroleum), B.G. (Explosives) and B.G. (Cryogenics). For the purpose of testing the impairment of the three CGUs of the company, while calculating the recoverable amount, value in use has been considered for B. G. (Petroleum) as it was possible to forecast the future cash flows for the next 10 years (emphasis supplied by the querist). However, according to the querist, to calculate the recoverable amount of B.G. (Explosives) and B.G. (Cryogenics), assets’ net selling price has been considered in line with paragraph 15 of AS 28 as it was not possible to forecast the future cash flows nearest to actual due to volatile conditions in the market. The querist has also mentioned that these two business groups have been suffering losses for the last five years. While calculating the net selling price of the above two business groups, since the company was unable to make reliable estimate of the amount obtainable from the sale of the assets in an arm’s length transaction between knowledgeable and willing parties, the company had appointed chartered valuers to

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Compendium of Opinions — Vol. XXVI

arrive at the net realisable value of the assets. On the basis of the valuers’ reports, the company had tested the impairment of assets of the B.G. (Explosives) and B.G. (Cryogenics) and found that the carrying amounts of the assets are less than the recoverable amount (net realisable value) of the assets. Hence, as per the querist, no impairment of assets was warranted.

4. The querist has further stated that while considering the net

selling price as recoverable amount of the above two business groups, the company has placed reliance on the following: (a) definition of recoverable amount as per paragraph 4 of AS 28 – since these two business groups are making losses, net selling price of the assets will always be higher than the value in use. (b) paragraph 15 of AS 28, which, inter alia, states that it is not always necessary to determine both assets’ net selling price and value in use.

B.

Query

5.

The querist has sought the opinion of the Expert Advisory

Committee on the following issues:

(a)

In the absence of a binding sale agreement in an arm’s length transaction, or if the assets are not traded in the active market, or in the absence of the current bid prices of the assets, or if the prices of the most recent transaction are not available,

(i)

Whether the assets can be valued by a chartered valuer for accounting at net selling price/ net realisable value, and

(ii)

If yes, whether such value can be considered for the purpose of testing impairment.

(b)

If a CGU is incurring losses, whether the carrying amount should not be more than its value in use.

C.

Points considered by the Committee

6.

The Committee notes that the basic issue raised in the query

relates to the calculation of impairment loss in case of B.G.

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(Explosives) and B.G. (Cryogenics). The Committee has, therefore, considered only this issue and has not touched upon any other issue arising from the Facts of the Case, such as, identification of CGUs, testing of impairment in case of B.G. (Petroleum), etc.

7. The Committee notes that the basic objective of providing

impairment loss is to ensure that the assets of an enterprise are carried at no more than their recoverable amount. Recoverable amount, according to AS 28, “is the higher of an asset’s net selling price and its value in use.” Hence, the company has to compare the net selling price and value in use of an asset and the higher of these two, which is the recoverable amount, is then compared with the carrying amount of the asset, and if an asset is carried at more than its recoverable amount, i.e., the asset is impaired, then the impairment loss is recognised.

8. Insofar as the calculation of value in use is concerned, the

Committee notes the definition of the term ‘value in use’, as contained in paragraph 4 of AS 28 and paragraphs 26 to 30 of AS 28, which state as follows:

“Value in use is the present value of estimated future cash flows expected to arise from the continuing use of an asset and from its disposal at the end of its useful life.”

“26. In measuring value in use:

(a)

cash flow projections should be based on reasonable and supportable assumptions that represent management’s best estimate of the set of economic con ditions that will exist over the remaining useful life of the asset. Greater weight should be given to external evidence;

(b)

cash flow projections should be based on the most recent financial budgets/forecasts that have been approved by management. Projections based on these budgets/forecasts should cover a maximum period of five years, unless a longer period can be justified; and

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(c) cash flow projections beyond the period covered by the most recent budgets/forecasts should be estimated by extrapolating the projections based on the budgets/forecasts using a steady or declining growth rate for subsequent years, unless an increasing rate can be justified. This growth rate should not exceed the long-term average growth rate for the products, industries, or country or countries in which the enterprise operates, or for the market in which the asset is used, unless a higher rate can be justified.

27. Detailed, explicit and reliable financial budgets/forecasts

of future cash flows for periods longer than five years are generally not available. For this reason, management’s estimates of future cash flows are based on the most recent budgets/forecasts for a maximum of five years. Management may use cash flow projections based on financial budgets/ forecasts over a period longer than five years if management is confident that these projections are reliable and it can demonstrate its ability, based on past experience, to forecast cash flows accurately over that longer period.

28. Cash flow projections until the end of an asset’s useful

life are estimated by extrapolating the cash flow projections based on the financial budgets/ forecasts using a growth rate for subsequent years. This rate is steady or declining, unless an increase in the rate matches objective information about patterns over a product or industry lifecycle. If appropriate, the growth rate is zero or negative.

29. Where conditions are very favourable, competitors are

likely to enter the market and restrict growth. Therefore, enterprises will have difficulty in exceeding the average historical growth rate over the long term (say, twenty years) for the products, industries, or country or countries in which the enterprise operates, or for the market in which the asset is used.

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30. In using information from financial budgets/forecasts, an

enterprise considers whether the information reflects reasonable and supportable assumptions and represents management’s best estimate of the set of economic conditions that will exist over the remaining useful life of the asset.”

9. Regarding the determination of net selling price of the two

business groups, the Committee notes the definition of the term ‘net selling price’ as contained in paragraph 4 of AS 28, and paragraphs 16 and 20 to 22 of AS 28, which, state as follows:

“Net selling price is the amount obtainable from the sale of an asset in an arm’s length transaction between knowledgeable, willing parties, less the costs of disposal.”

“16. It may be possible to determine net selling price, even if an asset is not traded in an active market. However, sometimes it will not be possible to determine net selling price because there is no basis for making a reliable estimate of the amount obtainable from the sale of the asset in an arm’s length transaction between knowledgeable and willing parties. In this case, the recoverable amount of the asset may be taken to be its value in use.”

“20. The best evidence of an asset’s net selling price is a price in a binding sale agreement in an arm’s length transaction, adjusted for incremental costs that would be directly attributable to the disposal of the asset.

21. If there is no binding sale agreement but an asset is

traded in an active market, net selling price is the asset’s market price less the costs of disposal. The appropriate market price is usually the current bid price. When current bid prices are unavailable, the price of the most recent transaction may provide a basis from which to estimate net selling price, provided that there has not been a significant change in economic circumstances between the transaction date and the date at which the estimate is made.

22. If there is no binding sale agreement or active market

for an asset, net selling price is based on the best information

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available to reflect the amount that an enterprise could obtain, at the balance sheet date, for the disposal of the asset in an arm’s length transaction between knowledgeable, willing parties, after deducting the costs of disposal. In determining this amount, an enterprise considers the outcome of recent transactions for similar assets within the same industry. Net selling price does not reflect a forced sale, unless management is compelled to sell immediately.”

10. The Committee notes from the above that while AS 28 does

not exempt any enterprise from calculating value in use under any condition, it exempts calculation of net selling price under paragraph 16 reproduced above, where net selling price cannot be arrived at in accordance with the requirements of the Standard. The Standard does not contemplate that in case the net selling price cannot be arrived at as per its requirements, such a price can be arrived at on the basis of the valuation made by a chartered valuer. The said paragraph provides that in such a case the enterprise should, instead, use the value in use. Thus, in the view of the Committee, the company should compute its value in use even though there are volatile conditions in the market, on the basis of the reasonable projections supported by the existing conditions and assumptions over the remaining useful life of the asset as stated in paragraphs 26 to 30 of AS 28. The Committee does not agree with the conclusion given by the querist that in case a CGU is incurring losses, its value in use will always be lower than that of its net selling price. In any case, as stated in paragraph 16 of AS 28, in case the net selling price cannot be computed, the value in use is

to be considered by the company. The underlying reason for this requirement is that the fixed assets are held by the company for use in the business rather than for the purpose of their sale. Thus, computation of value in use is paramount.

D. Opinion

11. The Committee is of the following opinion on the issues raised

in paragraph 5 above:

(a) In the absence of a binding sale agreement in an arm’s length transaction, or if the assets are not traded in the

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active market, or in the absence of the current bid prices of the assets, or if the prices of the most recent transaction are not available,

(i)

the values provided by a chartered valuer can not form basis for determining the net selling price/net realisable value of the assets.

(ii)

No, such value can also not be considered for the purpose of testing impairment.

(b) For the purpose of testing impairment, the carrying amount has to be compared with the recoverable amount (higher of an asset’s net selling price and its value in use). In case net selling price cannot be determined in accordance with principles of AS 28, value in use may be taken as recoverable amount, which then should be compared with the carrying amount of the asset. In such a case, carrying amount of the asset should not be more than its value in use, irrespective of the fact that CGU is incurring losses.

Query No. 6

Subject: Treatment of deferred tax asset in respect of excess provision for doubtful advances and doubtful claims. 1

A. Facts of the Case

1. The accounts of a public sector company are audited by the

office of the Principal Director of Commercial Audit and Ex-officio

Member, Audit Board. During the audit of the accounts of the company for the financial year 2004-05, certain differences of opinion had arisen between the company and the auditors in respect

1 Opinion finalised by the Committee on 27.3.2006

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of Accounting Standard (AS) 22, ‘Accounting for Taxes on Income’, issued by the Institute of Chartered Accountants of India. The auditors, however, cleared the accounts for the year 2004-05, giving the benefit of doubt and on the commitment made by the company to take opinion of the Expert Advisory Committee of the Institute of Chartered Accountants of India.

2. The company has mainly three different businesses controlled

by three separate business groups, namely, Petroleum, Explosives

and Cryogenics.

3. The querist has separately provided detailed calculation of

deferred tax assets/liabilities of the company for the last two years and a copy of the balance sheet as on 31.03.2005 for the perusal of the Committee. According to the querist, the computations show that the company has considered only the provision for doubtful debts against sundry debtors for the purpose of creating deferred tax assets and has not considered provision for doubtful advances, provision for doubtful claims and provision for doubtful deposits for this purpose. The reason given by the querist for the aforesaid treatment is that, from its past experience, the company is reasonably certain in respect of provisions for doubtful advances and doubtful claims that there are remote chances of these resulting into bad debts. The querist has also emphasised that there were no bad debts against these two provisions for the years 2001-02 to 2003-04. As per the querist, the company is consistently following the same method while calculating the deferred tax assets/liability.

B.

Query

4.

The querist has sought the opinion of the Expert Advisory

Committee as to whether while calculating deferred tax assets/ liability for the company as a whole, provision for doubtful advances and provision for doubtful claims need to be considered for

calculation of deferred tax assets.

C.

Points considered by the Committee

5.

The Committee notes that the basic issue raised by the querist

relates to creation of deferred tax asset/liability in respect of provision for doubtful advances and doubtful claims. Hence, the

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Committee has considered only this issue and has not examined any other issue arising from the Facts of the Case, for example, creation of provision in respect of doubtful debts against sundry debtors and treatment of deferred tax assets/liabilities in respect thereof, etc.

6. The Committee notes that Part III of Schedule VI to the

Companies Act, 1956 states in paragraph 7(2) as below:

“(2) Where –

(a)

any amount written off or retained by way of providing for depreciation, renewals or diminution in value of assets, not being an amount written off in relation to fixed assets before the commencement of this Act; or

(b)

any amount retained by way of providing for any known liability;

is in excess of the amount which in the opinion of the directors is reasonably necessary for the purpose, the excess shall be treated for the purposes of this Schedule as a reserve and not as a provision.”

7. The Committee also notes that Schedule VI to the Companies

Act, 1956, under ‘Instructions in accordance with which assets should be made out’ in respect of ‘sundry debtors’ provides that “The provisions to be shown under this head should not exceed the amount of debts stated to be considered doubtful or bad and any surplus of such provision, if already created, should be shown

at every closing under “Reserves and Surplus” (in the Liabilities side) under a separate sub-head “Reserve for Doubtful or Bad Debts”.”

8. The Committee further notes that the provision for bad and

doubtful claims and advances represents impairment of receivables which is covered by Accounting Standard (AS) 4, ‘Contingencies and Events Occurring After the Balance Sheet Date’, issued by the Institute of Chartered Accountants of India. In this context, the Committee notes paragraph 10 of AS 4, which states as follows:

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“10. The amount of a contingent loss should be provided for by a charge in the statement of profit and loss if:

(a)

it is probable that future events will confirm that, after taking into account any related probable recovery, an asset has been impaired or a liability has been incurred as at the balance sheet date, and

(b)

a reasonable estimate of the amount of the resulting loss can be made.”

The Committee notes that an event is regarded as ‘probable’ if the event is more likely than not to occur, i.e., the probability that the event will occur is greater than the probability that it will not.

9. The Committee notes that the querist has stated in paragraph

3 of the Facts of the Case that the chances of advances/claims (against which provisions have been created) becoming bad are very remote and from its past experience, the company is reasonably certain that these debts will be recovered in the future. The Committee also notes from the said paragraph that there were no bad debts against these two provisions during the last two years.

10. From the above paragraphs, the Committee is of the view

that creation of provision by the company against advances/claims that are considered to be recoverable is an error in view of the requirements of the Companies Act, 1956, and AS 4. Hence, the excess amount of provision should be written-back in the financial statements as a ‘prior period item’. In this regard, the Committee notes the definition of the term ‘prior period items’ and paragraphs 15 and 19 of Accounting Standard (AS) 5, ‘Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies’,

issued by the Institute of Chartered Accountants of India, which state as follows:

“Prior period items are income or expenses which arise in the current period as a result of errors or omissions in the preparation of the financial statements of one or more prior periods.”

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“15. The nature and amount of prior period items should be separately disclosed in the statement of profit and loss in a manner that their impact on the current profit or loss can be perceived.”

“19. Prior period items are normally included in the determination of net profit or loss for the current period. An alternative approach is to show such items in the statement of profit and loss after determination of current net profit or loss. In either case, the objective is to indicate the effect of such items on the current profit or loss.”

11. On the basis of the above, the Committee is of the view that

since the creation of provision for doubtful claims and advances was on account of an error in the past years, as discussed in paragraphs 9 and 10 above, it should be written-back in the financial statements of the year in which such a correction is made and should be shown separately in a manner that its impact on the current profit or loss can be perceived. Accordingly, the question of creation of deferred tax assets/liability in respect of provision for doubtful claims and advances would not arise. The Committee is, however, of the view that if the company so desires, the company may create reserve for doubtful claims and doubtful advances as an appropriation of profits.

D. Opinion

12. On the basis of the above, the Committee is of the opinion,

on the issue raised in paragraph 4, that in the present case, the provision for doubtful advances and provision for doubtful claims should be written back in the financial statements as a ‘prior period

item’ as explained in paragraph 11 above and hence, the question of treatment of deferred tax asset/liability against such provisions does not arise.

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Query No. 7

Rates of depreciation on various assets involved in mass rapid transport system. 1

A Facts of the Case

1. A government company has been incorporated to construct

and operate a mass rapid transport system (i.e., metro trains) in the National Capital Region. While some phases of the system have already become operational, others are at various stages of construction or conceptualisation. The construction of a mass rapid transport system involves incurrence of huge capital expenditure. Consequently, depreciation constitutes a significant element of cost of operations.

2. According to the querist, three major types of fixed assets,

each of which accounts for a substantial capital expenditure and

are quite unique to the company in the Indian context are as follows:

Subject:

(a)

Rolling stock

(b)

Escalators and elevators

(c)

Track work

3. The querist has stated that Schedule XIV to the Companies

Act, 1956, does not specifically lay down any rates of depreciation in respect of the above categories of fixed assets. In the absence of a specific rate, if the company applies the general rate applicable to plant and machinery, it would be totally un-representative of the useful lives of these assets. According to the querist, this general rate applicable to plant and machinery (i.e., 4.75 percent on straightline basis) assumes that the useful life of general items of plant and machinery is 20 years whereas, the estimated lives of Rolling Stock, Escalators and Elevators, and Trackwork are much longer than 20 years. The special features of these items are as below:

1 Opinion finalised by the Committee on 27.3.2006

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(i)

Rolling Stock The trains are of modern design and are light weight made of stainless steel with three phase AC drive having VVVF control regenerative braking and suitable for automatic train protection and operation system. The coaches are provided with automatic door closing mechanism to ensure passenger safety. The coaches have been built, meeting international standards of safety, reliability and maintainability. They are designed and constructed for a service life of at least 30 years of normal usage, without major repair.

(ii)

Escalators and elevators – They are provided at elevated and underground stations for passenger transportation. These heavy duty public escalators comply with international and national standards. The design, manufacture, supply, installation, testing and commissioning of the escalators meet the state of the technology in the area. The life of these escalators and elevators is estimated at a minimum of 30 years.

(iii)

Trackwork – With a view to obtain optimum life for various components, a sturdy track structure has been selected, such as 60 kg. head hardened rails, ballast less track on viaduct/tunnel and structurally strong turnouts. A life of 58 years is estimated for the same.

4. As per the querist, the estimates made by the company are

based on technical evaluation and suppliers’ assertions. These estimates are prudent and would represent true and fair commercial depreciation. The querist has separately provided technical evaluation reports of suppliers in this regard for the perusal of the Committee. Comparative depreciation rates/lives of assets adopted by the companies carrying similar operations, along with the corresponding lives under the Companies Act, 1956 and that as estimated by the company, are also provided separately by the querist for the perusal of the Committee. According to the querist, a perusal of the comparative analysis of depreciation rates/useful lives highlights the following in respect of the said assets:

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(a)

Rolling stock: All the companies carrying similar operations have estimated life of Rolling Stock much higher (at 35-40 years) than 20 years which is the life worked out on the basis of the general rate applicable to plant and machinery as per the Companies Act, 1956. According to the data given by the management, the suppliers of the company have estimated the life at 30 years. The life of 30 years, according to the querist, therefore, seems a prudent estimate.

(b)

Escalators and elevators: The useful life has been estimated around 30 years by various other companies (except one company). However, the general rate as prescribed in Schedule XIV to the Companies Act, 1956 envisages a life of 20 years. The life of 30 years as estimated by the management may, therefore, be adopted.

(c)

Trackwork: The management’s estimate of 58 years is supported by the estimates of other railway companies.

5. The querist has stated that the company applied for

concurrence to the aforesaid special rates of depreciation to the Ministry of Urban Development (Administrative Ministry) and the Ministry of Company Affairs. In response, the Ministry of Urban Development, vide its Office Memorandum No. 14011/73/2003/ MRTS dated 22.3.2004, communicated its concurrence. The Ministry of Company Affairs vide its letter dated 22.8.2005 asked the company to seek the expert opinion from the Institute of Chartered Accountants of India.

6. The querist has stated that as per Accounting Standard (AS)

6, ‘Depreciation Accounting’ issued by the Institute of Chartered Accountants of India, useful life is “…the period over which a depreciable asset is expected to be used by the enterprise…” (emphasis supplied by the querist). Further, paragraph 8 of AS 6, inter alia, states that “determination of the useful life of a depreciable

asset is a matter of estimation and is normally based on various factors including experience with similar types of assets” (emphasis

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supplied by the querist). The querist has also drawn the attention of the Committee to paragraph 22 of AS 6, which states as follows:

“22. The useful life of a depreciable asset should be estimated after considering the following factors:

(i)

expected physical wear and tear;

(ii)

obsolescence;

(iii)

legal or other limits on the use of the asset.”

7. The querist has further stated that AS 6 also recognises in

paragraph 13 that “the statute governing an enterprise may provide the basis for computation of the depreciation. For example, the Companies Act, 1956 lays down the rates of depreciation in respect of various assets. Where the management’s estimate of the useful life of an asset of the enterprise is shorter than that envisaged under the provisions of the relevant statute, the depreciation provision is appropriately computed by applying a higher rate. If the management’s estimate of the useful life of the asset is longer than that envisaged under the statute, depreciation rate lower than that envisaged by the statute can be applied only in accordance with requirements of the statute.” (Emphasis supplied by the querist.) According to the querist, it is clear from the aforementioned provisions that one has to:

(a)

estimate the useful life of the specified categories of fixed assets, and

(b)

consider the position under the Companies Act, 1956.

8. According to the querist, as far as the estimate of the useful

life is concerned, technical estimates and past experience are important indicators. The practice followed by the companies using similar assets is another useful indicator (provided those companies are not covered by any specific legal stipulations). As per the querist, in the present case,

(a) the technical specifications agreed to between the company and the suppliers of rolling stock, escalators

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and elevators clearly stipulate a life of a minimum of 30 years;

(b)

other entities using similar assets are also charging depreciation at rates based on estimates of useful lives which are generally higher than those estimated by the company; and

(c)

the Ministry of Urban Development has independently concurred with the useful life as envisaged above.

9. On the basis of the above, the querist has argued that there

is a strong logic for the Ministry of Company Affairs to specifically allow ‘rolling stock’ and ‘escalators and elevators’ of the company being depreciated at 3.17% (SLM) and trackwork being depreciated at 1.63% (SLM) based on technical life of the relevant assets. Also, since the above estimates already take into account the extent of likely usage of the assets (which will be almost on a continuous basis round the clock except for a few hours around mid-night), it may also be specifically provided that there would be no extra shift depreciation on those assets.

B. Query

10. The querist has sought the opinion of the Expert Advisory

Committee on the following issues:

(a)

Assuming that (i) it can be demonstrated that the useful life of rolling stock and escalators and elevators is 30 years and that of track work is 58 years and (ii) there are no legal stipulations as to rate of depreciation, whether charging depreciation at 3.17% and 1.63% (respectively) per annum as per straight line method (SLM) would result in a true and fair view.

(b)

Since the company, as per the querist, has been able to adduce sufficient evidence regarding the above estimates of useful life, whether depreciation at 3.17% and 1.63% (SLM) per annum would be a proper charge, if this rate is allowed by the Ministry of Company Affairs under section 205(2) of the Companies Act, 1956.

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C.

Points considered by the Committee

11.

The Committee notes that the basic objective of providing

depreciation is to allocate the depreciable amount of an asset over its useful life so as to exhibit a true and fair view of the financial statements of an enterprise. In this regard, the Committee notes the definition of the term ‘useful life’ as contained in paragraph 3.3 of AS 6 and paragraph 20 of AS 6, which state as follows:

“Useful life is either (i) the period over which a depreciable asset is expected to be used by the enterprise; or (ii) the number of production or similar units expected to be obtained from the use of the asset by the enterprise.”

“20. The depreciable amount of a depreciable asset should be allocated on a systematic basis to each accounting period during the useful life of the asset.”

12. The Committee further notes paragraphs 7 and 8 of AS 6,

explaining the term ‘useful life’, as follows:

“7.

physical life and is:

The useful life of a depreciable asset is shorter than its

(i)

pre-determined by legal or contractual limits, such as the expiry dates of related leases;

(ii)

directly governed by extraction or consumption;

(iii)

dependent on the extent of use and physical deterioration on account of wear and tear which again depends on operational factors, such as, the number of shifts for which the asset is to be used, repair and maintenance policy of the enterprise etc.; and

(iv)

reduced by obsolescence arising from such factors as:

(a)

technological changes;

(b)

improvement in production methods;

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(c)

change in market demand for the product or service output of the asset; or

(d)

legal or other restrictions.

8. Determination of the useful life of a depreciable asset is

a matter of estimation and is normally based on various factors including experience with similar types of assets. Such estimation is more difficult for an asset using new technology or used in the production of a new product or in the provision of a new service but is nevertheless required on some reasonable basis.”

13. The Committee also notes paragraph 13 of AS 6, which

recognises the linkage between charge of depreciation under a statute and that as per the generally accepted accounting principles, as reproduced in paragraph 7 above.

14. On the basis of the above, the Committee is of the view that

in arriving at the rates at which depreciation should be provided, the company should consider the true commercial depreciation, i.e., the rate which is adequate to write off the asset over its useful life based on the technological estimates of the management. In case the useful life so worked out is less than the life arrived at as per the rates prescribed in Schedule XIV to the Companies Act, 1956 (in case of companies), the higher rate of depreciation, so arrived at is applied. However, in case the useful life works out to

be longer, i.e., the rate so arrived at is lower than the rate prescribed by the statute, the rates prescribed in the relevant statute (Schedule

XIV in case of companies) should be applied. In the concerned

case, since Schedule XIV prescribes no specific rates of

depreciation in respect of rolling stock, escalators and elevators, and track work involved in mass rapid transport system, the general rates applicable to ‘plant and machinery’ would be relevant. Accordingly, the useful life of 20 years (as arrived at from the general rate of depreciation as per Schedule XIV to the Companies

Act, 1956), which is much shorter than the lives of the assets, as

estimated by the management, should be considered for the purpose of calculating depreciation in the present case.

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D.

Opinion

15.

The Committee is of the following opinion on the issues raised

in paragraph 10 above:

(a)

Assuming that (i) the useful life of rolling stock and escalators and elevators is 30 years and that of track work is 58 years determined in accordance with the provisions of AS 6 and (ii) there are no legal stipulations as to the rate of depreciation, charging depreciation as per SLM at the rates determined on the basis of the afore-mentioned lives of the respective assets would result in a true and fair view, provided provisions of section 205(2) of the Companies Act, 1956 are complied with.

(b)

Charging of depreciation as per the SLM rates, based on estimated useful lives of the assets as per the provisions of AS 6 would be a proper charge, provided such rates are allowed by the Ministry of Company Affairs under section 205(2).

Query No. 8

Segment reporting for sale of power to the State grid. 1

A. Facts of the Case

1. A listed company is engaged in the business of manufacturing

paper for newsprint, printing and writing. The turnover from the sale of newsprint, printing and writing paper during 2004-05 was Rs. 671.29 crore.

2. The querist has stated that the company has installed four

turbo generators. The entire power requirement is met through captive generation. Surplus power is sold to the State grid. In

Subject:

1 Opinion finalised by the Committee on 27.3.2006

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addition, the company is having a wind farm. The wind power is also sold to the State grid. The proceeds from sale of power during the financial year 2004-05 were Rs. 29.27 crore.

3. The querist has reproduced paragraph 27 of Accounting

Standard (AS) 17, ‘Segment Reporting’, issued by the Institute of

Chartered Accountants of India, which states as follows:

“27. A business segment or geographical segment should be identified as a reportable segment if:

(a)

its revenue from sales to external customers and from transactions with other segments is 10 per cent or more of the total revenue, external and internal, of all segments; or

(b)

its segment result, whether profit or loss, is 10 per cent or more of-

(i)

the combined result of all segments in profit, or

(ii)

the combined result of all segments in loss,

whichever is greater in absolute amount; or

(c)

its segment assets are 10 per cent or more of the total assets of all segments.”

4. According to the querist, sale from power works out to 4.36 %

of the total turnover. The profit from sale of power is less than

10% of the combined result of the manufacturing activities and sale of power. The segment assets are also less than10% of the total assets of the company.

5. The querist has stated that in the above circumstances, the

company has considered that sale of power is not a reportable segment. However, during the audit, the statutory auditors have opined as below:

“Segment Reporting vis-à-vis, the company, after applying the above norms, we are of the opinion that the company has two business segments viz. 1) paper and Paper products and

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2) wind farm or power sector. Both are subject to different risks and returns and further have different organisational structure and internal reporting.

As far as reportable segment is concerned, paper and paper products individually meet the criteria laid down in AS 17 (paragraph 27) (i.e., more than 10%) and hence to be reported as a separate business segment.

As wind farm or power sector is regarded as a different undertaking for the purpose of claiming deduction u/s 80-IA of the Income-tax Act, for reckoning the threshold limits ‘internal transfer/utilisation’ (i.e., the transaction with other segments) shall also be taken into account as AS 17 (paragraph 27) is very clear in this regard.

Therefore, disclosing of the power sector as a reportable segment has to be arrived at by taking into consideration the transactions with other segments. In case the threshold limits are lower than the percentage stipulated, it is the discretion of the management to consider it as a separate ‘reportable segment’ or as a ‘residual segment’ (as ‘others’).”

B.

Query

6.

The querist has sought the opinion of the Expert Advisory

Committee as to whether the sale of power to the State grid should be considered as a separate reportable segment even though the activity does not fall within the threshold limits stipulated under paragraph 27 of AS 17.

C.

Points considered by the Committee

7.

The Committee notes from paragraph 6 above that the querist

has raised the query only in the context of ‘power’ segment. In the absence of the relevant information, the Committee presumes that

there is only one segment other than ‘power’, viz., ‘paper’.

8. The Committee notes that as per the provisions of Accounting

Standard (AS) 17, ‘Segment Reporting’, issued by the Institute of

Chartered Accountants of India, the components of an enterprise

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have to first fall within the definitions of the term ‘business segment’ or ‘geographical segment’ before being considered as ‘reportable segment’. In this context, the Committee notes the definitions of the terms ‘business segment’ and ‘geographical segment’ as per paragraph 5 of AS 17, which are reproduced below:

“A business segment is a distinguishable component of an enterprise that is engaged in providing an individual product or service or a group of related products or services and that is subject to risks and returns that are different from those of other business segments. Factors that should be considered in determining whether products or services are related include:

(a)

the nature of the products or services;

(b)

the nature of the production processes;

(c)

the type or class of customers for the products or services;

(d)

the methods used to distribute the products or provide the services; and

(e)

if applicable, the nature of the regulatory environment, for example, banking, insurance, or public utilities.

A geographical segment is a distinguishable component of an enterprise that is engaged in providing products or services within a particular economic environment and that is subject to risks and returns that are different from those of components operating in other economic environments. Factors that should be considered in identifying geographical segments include:

(a)

similarity of economic and political conditions;

(b)

relationships between operations in different geographical areas;

(c)

proximity of operations;

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(d)

special risks associated with operations in a particular area;

(e)

exchange control regulations; and

(f)

the underlying current risks.”

9. The Committee further notes paragraphs 7 and 12 of AS 17

which provide as below:

“7. A single business segment does not include products and services with significantly differing risks and returns. While there may be dissimilarities with respect to one or several of the factors listed in the definition of business segment, the products and services included in a single business segment are expected to be similar with respect to a majority of the factors.”

“12. The predominant sources of risks affect how most enterprises are organised and managed. Therefore, the organisational structure of an enterprise and its internal financial reporting system are normally the basis for identifying its segments.”

10. The Committee notes from the above that to identify business

and geographical segments, the undertaking needs to evaluate whether the risks and returns of various components of an enterprise are different as per the factors stated in the definitions of the terms ‘business segment’ and ‘geographical segment’. Where the organisational structure and internal financial reporting system of various components are different, it suggests that the risks and returns are different. The Committee presumes from the Facts of the Case that the company has two business segments, viz., paper and power, as the two have different risks and returns particularly, in view of the fact that they have different organisational structure and internal financial reporting systems.

11. The Committee also notes the requirements of paragraph 27

of AS 17 reproduced in paragraph 3 above with respect to identification of a reportable segment that for the purpose of determination of the threshold limit of 10% with regard to revenue,

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the revenue from sales to external customers and from transactions with other segments is to be taken into account. Accordingly, the Committee is of the view that for the purpose of determining whether paper and power qualify as reportable segments, the revenue from external sales as well as internal sales should be taken into account. In case the segment revenue so determined, is equal to or exceeds 10% of the total revenue of the company, external and internal, that segment would qualify as a separate reportable segment. The Committee further notes that for the purpose of identification of reportable segments, not only the threshold limit with respect to segment revenue, but also with respect to segment result and segment assets should be considered as stipulated in paragraph 27 of AS 17.

12. In the above context, the Committee notes paragraph 28 of

AS 17, reproduced as below:

“28. A business segment or a geographical segment which is not a reportable segment as per paragraph 27, may be designated as a reportable segment despite its size at the discretion of the management of the enterprise. If that segment is not designated as a reportable segment, it should be included as an unallocated reconciling item.”

Therefore, if the segment is not designated as a reportable segment either on the basis of the consideration of paragraph 27 of AS 17, or the management’s discretion as per paragraph 28 of AS 17, it should be included as an unallocated reconciling item. In other words, in the context of the company under consideration even if one of the segments does not qualify as a reportable segment as per the threshold requirements of paragraph 27 of AS 17, the same would have to be reported separately as a residual segment.

D. Opinion

13. On the basis of the above, the Committee is of the opinion

that the company needs to recalculate the threshold limits in accordance with paragraph 27 of AS 17 as stated in paragraph 11 above. In case the threshold limit is not met, it is the discretion of the management to consider power as a separate ‘reportable

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segment’. However, in case the management does not do so, it has to be reported as a ‘residual segment’.

Query No. 9

Subject: Disclosure of partly secured Bonds. 1

A. Facts of the Case

1. A company is a wholly-owned, Government of India enterprise

under the Ministry of Power. The company is a public financial institution and is also registered as a non-banking financial company (NBFC) with the Reserve Bank of India (RBI). The main activity of the company is to fund the various power sector projects in the country.

2. The querist has stated that the company, for meeting its

financial needs, has been raising money through various sources. One of them is bonds. Some of the bonds raised by the company are guaranteed by the Government of India, some bonds are secured by mortgage of immovable property and hypothecation of book debts, and some are unsecured against which no security has been provided.

3. The company, for meeting its financial requirements, has also

been permitted to raise Capital Gains Tax Exemption Bonds and Infrastructure Bonds under section 54EC and section 88 of the Income-tax Act, 1961. These bonds have a lock-in period as per the requirements of the Income-tax Act, 1961 and have been secured by providing mortgage of immovable properties, the value of which is less than the funds borrowed. As per the practice adopted by various companies, the company has been disclosing these bonds as ‘secured borrowings’ with a disclosure of the extent of the security provided. A point has arisen that since the value of the security provided is not commensurate to quantum raised,

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whether these borrowings should be disclosed as ‘unsecured loan’ or ‘secured loans’. Prima facie, the borrowings are neither fully secured nor unsecured. A copy of the annual report of the company for the financial year 2004-05 has also been provided by the querist for the perusal of the Committee. The querist has stated that Schedule ‘C’ on page 52 of the annual report indicates disclosure being made by the company in the balance sheet about factual position. The querist has provided the following extracts from the said Schedule:

“Capital Gains Tax Exemption Bonds are issued for a tenure

of 5/7 years at different interest rates varying from 5.15% to

8.70% payable with 3 options, viz., semi-annual, annual and cumulative. These bonds have put option at par at any time and in case of Capital Gains Tax Exemption Bonds – Series-

IV at the end of 3/5 years. Infrastructure Bonds are issued for

a tenure of 3/5 years at different interest rates varying between 5.60% to 9.00% payable annually. These Bonds have put option at par at the end of 36 months from the date of allotment and in case of Infrastructure Bonds – Series-IV at par at the end of 3/5 years. The Capital Gains Tax Exemption Bonds and Infrastructure Bonds are secured by a legal mortgage respectively over the company’s immovable properties and receivable to the satisfaction of the trustees. The book value

of these immovable properties and receivables is Rs.38.50

lakh. However, charge to the extent of amount borrowed has been created with the Registrar of Companies (ROC ) in

favour of trustees.”

4. According to the querist, the company has raised Capital Gains

Tax Exemption Bonds to the extent of Rs. 7,750 crore as on

31.03.2005.

B. Query

5. The querist has sought the opinion of the Expert Advisory

Committee as to whether such borrowings should be disclosed as

‘secured’ or ‘unsecured’ in the balance sheet of the company.

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C.

Points considered by the Committee

6.

The Committee notes that the basic issue raised in the query

relates to the disclosure of partly secured Capital Gains Tax Exemption Bonds as ‘secured’ or ‘unsecured’ loans as per the requirements of Schedule VI to the Companies Act, 1956, in the

financial statements of the company. The Committee has, therefore, considered only this issue and has not examined any other issue that may arise from the ‘Facts of the Case’, for example, disclosure required by NBFC Prudential Norms (Reserve Bank) Directions,

1998.

7. The Committee notes the definition of the term ‘secured loan’,

as provided by paragraph 15.02 of the Guidance Note on Terms Used in Financial Statements, issued by the Institute of Chartered Accountants of India, which states as follows:

15.02 Secured Loan

Loan secured wholly or partly against an asset.”

8. The Committee further notes from paragraph 3 of the Facts

of the Case that the Capital Gains Tax Exemption Bonds have been partly secured by mortgage of immovable properties. Hence, the Committee is of the view that these bonds should be classified under ‘secured loans’, for the purpose of disclosure in the balance sheet as per the requirements of Schedule VI to the Companies Act, 1956. However, the nature of security should be clearly specified, as required by ‘Instructions in accordance with which liabilities should be made out’ of the said Schedule.

D.

Opinion

9.

On the basis of the above, the Committee is of the opinion,

read with paragraph 6 above, that partly secured Capital Gains Tax Exemption Bonds should be disclosed under ‘secured loans’ along with a proper disclosure of the nature of security, as stated in paragraph 8 above.

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Query No. 10

Subject: Applicability of AS 3 and AS 18. 1

A. Facts of the Case

1. A not-for-profit company was incorporated on 13 th January,

1992 under section 25 of the Companies Act, 1956. Its authorised capital is Rs.700 crore and paid up capital is Rs. 425.35 crore as on 31 st March, 2005. It is a Government company within the

meaning of section 617 of the Companies Act, 1956. Its shares are not listed and its turnover (interest income) during the year 2004-05 was Rs. 20.39 crore. The company is exempted from payment of income-tax under section 10(26 B) of the Income-tax Act, 1961.

2. The main objects to be pursued by the company, as per its

memorandum and articles of association, are reproduced

hereunder:

(i)

To promote economic and developmental activities for the benefit of backward classes;

(ii)

To assist, subject to such income and/or economic criteria as may be prescribed by the Government from time to time, individuals or groups of individuals belonging to backward classes by way of loans and advances for economically and financially viable schemes and projects. Under micro-financing schemes, self help groups having members of target groups to the extent of at least 75% could be considered for financial support. The groups of the individuals belonging to the backward classes will include such groups in which predominantly (75% and above) members belong to backward classes provided other members belong to weaker sections (as per income and/or economic criteria prescribed by the Government) including scheduled castes/scheduled tribes, minorities and disabled persons;

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(iii)

To promote self-employment and other ventures for the benefit of backward classes;

(iv)

To grant concessional financial assistance in selected cases for persons belonging to backward classes below the poverty line in the country in collaboration with Government Ministries/Departments at the national and state level to the extent of the budgetary assistance granted by the Government of India to the company;

(v)

To extend loans to the backward classes for pursuing general /professional/technical education or training at graduate and higher levels;

(vi)

To assist in the upgradation of technical and entrepreneurial skills of backward classes for proper and efficient management of production units;

(vii)

To assist the state level organisations dealing with the development of the backward classes by way of providing financial assistance and in obtaining commercial funding or by way of refinancing;

(viii)

To work as an apex institution for coordinating and monitoring the work of all corporations/Boards set up by the State Government/Union Territory Administrations for schedule castes, schedule tribes, backward classes and minorities insofar as it relates to the economic development of the backward classes;

(ix)

To help in furthering the Government policies and programmes for the development of backward classes.

3. In order to achieve its objects as outlined above, the company

is providing finances at concessional rate of interest (4% p.a. to 6% p.a.) to persons belonging to backward classes (OBCs - notified by the State Government/Central Government) living below the poverty line/double the poverty line in the country. The loans are provided to the eligible target groups through state level companies/ corporations/cooperatives (wholly owned/controlled by the State Governments). These are referred to as state channelising agencies

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(SCAs). The loans are provided to the SCAs after obtaining guarantee from the State Government. The individual borrowers obtain financial assistance from SCAs. The loans are provided for setting-up small business, agricultural activities, viz. STD, PCO shop, electric repair shop, barber shop, minor irrigation, tailoring shop, carpentry, blacksmithy shop, pottery, general store, vegetable vendors or other self employment ventures etc. The loan limit per beneficiary is Rs. 5 lakh, out of which generally 85% to 95% is financed by the company and the balance by the SCAs/individual borrowers. The company also provides educational loans at concessional rates, to the target group for pursuing higher studies. As part of its developmental activities, the company is also providing grants-in-aid to the target group for the upgradation of their technical and entrepreneurial skills.

4. The querist has informed that the company was initially

classified as an investment company (Industrial Classification Code No. 803.1) by the Registrar of Companies. Therefore, the Reserve Bank of India had initially directed the company to file ‘First Schedule’ returns, which are applicable to non-banking financial companies. Consequent to the company’s representation dated 8 th January 1996, on the basis of its objects and nature of activities, the Department of Company Affairs, vide its letter dated 1 st February, 1996, decided to change the Industrial Activity Code number of the company from 803.1 to 94 (Community Services). Thereafter, on submission of the revised industrial classification code on 20 th August, 1998, the Reserve Bank of India, vide its letter dated 2 nd September, 1998, informed that it has deleted the name of the company from the mailing list w.e.f. 15 th February, 1996. Further, vide the company’s representation to the Reserve Bank of India on 7 th April, 1999, the company sought a clarification from the RBI, as to whether RBI directives and prudential norms etc., applicable to NBFCs, are applicable to the company. On July 23, 1999, the RBI informed and “certified that the company is not an NBFC and as such no RBI directives and prudential norms etc. are applicable to the company”. Copies of the relevant correspondence have been provided by the querist separately for the perusal of the Committee. The querist has also drawn the

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attention of the Committee to the fact that the company is also not covered under the definition of ‘Public Financial Institution’ as per the Companies Act, 1956.

5. The querist has reiterated that the main objects of the

company, as mentioned in paragraph 2 above, are to promote economic and developmental activities to help the poor persons belonging to other backward classes. The query pertains to the applicability of Accounting Standard (AS) 3, ‘Cash Flow Statements’ and Accounting Standard (AS) 18, ‘Related Party Disclosures’, issued by the Institute of Chartered Accountants of India. AS 3 and AS 18 are applicable to ‘financial institutions’ and certain other institutions/organisations. The querist has stated that in view of the objects of the company and the background note given above, in the opinion of the company, it is neither a financial institution nor falls under any category of the other institutions/organisations within the scope of AS 3 and AS 18. Therefore, the company did not make disclosures required as per AS 3 and AS 18 in the annual accounts for the year ending 31 st March, 2005. However, the government auditors representing the Office of the C&AG, during the course of the supplementary audit u/s 619(4) of the Companies Act, 1956, for the said year had issued two half margins (copies supplied separately for the perusal of the Committee) to the company stating that though being a financial institution, it has not complied with the aforesaid accounting standards. The company in its reply (copy supplied separately for the perusal of the Committee) had submitted the aforesaid facts and had also given an assurance to the government auditors that it shall seek clarification/ opinion from the Institute of Chartered Accountants of India on this subject. Consequently, the Office of the C&AG agreed

to drop the half margins issued to the company and therefore, no audit qualification was issued by them on this account.

B. Query

6. The querist has sought the opinion of the Expert Advisory

Committee on the following issues:

(a) Whether AS 3 and AS 18 are applicable to the company.

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(b) If yes, whether the company can claim exemption from the applicability of AS 3 and AS 18 and how.

C.

Points considered by the Committee

7.

The Committee notes that the term ‘financial institution’ is not

defined in the applicability paragraphs of Accounting Standard (AS) 3, ‘Cash Flow Statements’, and Accounting Standard (AS) 18, ‘Related Party Disclosures’, issued by the Institute of Chartered Accountants of India (ICAI). The Committee is, therefore, of the view that the term ‘financial institutions’ for the purpose of applicability of Accounting Standards, in the absence of a specific definition thereof in the Accounting Standards, should be construed to have its meaning in the general commercial parlance, which may be different from that given in various legislations. In the view of the Committee, any enterprise engaged in the activities of providing loans and advances and/or providing financial services and/or engaged in financial transactions involving financial products, etc., is considered to be a financial institution in terms of the general commercial parlance. Keeping in view the aforesaid, the company in question should be considered as a financial institution. Accordingly, AS 3 and AS 18 apply to the company.

8. The Committee notes the contention of the querist stated in

paragraph 5 of the ‘Facts of the Case’ that in view of the objects of

the company being primarily for the development of backward classes, AS 3 and AS 18 should not be applied to it. In this context, the Committee notes paragraph 3.3 of the ‘Preface to the Statements of Accounting Standards’, issued by the ICAI, reproduced below:

“3.3 Accounting Standards are designed to apply to the general purpose financial statements and other financial reporting, which are subject to the attest function of the members of the ICAI. Accounting Standards apply in respect of any enterprise (whether organised in corporate, co-operative or other forms) engaged in commercial, industrial or business activities, irrespective of whether it is profit oriented or it is established for charitable or religious purposes. Accounting

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Standards will not, however, apply to enterprises only carrying on the activities which are not of commercial, industrial or business nature, (e.g., an activity of collecting donations and giving them to flood affected people). Exclusion of an enterprise from the applicability of the Accounting Standards would be permissible only if no part of the activity of such enterprise is commercial, industrial or business in nature. Even if a very small proportion of the activities of an enterprise is considered to be commercial, industrial or business in nature, the Accounting Standards would apply to all its activities including those which are not commercial, industrial or business in nature”.

9. On the basis of the above, the Committee is of the view that

for the purpose of applicability of the Accounting Standards to an enterprise, the objective of setting up the enterprise is not relevant;

what is of relevance is the nature of the activities carried on by it. Since the company in question is carrying on the activities of providing loans and advances on which it earns income by way of interest, in the view of the Committee, the activities carried on by the company are of commercial nature. Accordingly, Accounting Standards issued by the Institute of Chartered Accountants of India are applicable to the company, subject to specific exemptions/ relaxations available in the Standards.

10. With regard to disclosure of related party information by the

company, the Committee notes paragraph 9 of AS 18, reproduced

below:

“9. No disclosure is required in the financial statements of state-controlled enterprises as regards related party relationships with other state-controlled enterprises and transactions with such enterprises.”

11. The Committee notes from the Facts of the Case that the

company in question is a state controlled enterprise. In view of this, no disclosure is required in its financial statements in respect

of related party relationships and related party transactions with other state controlled enterprises.

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D.

Opinion

12.

On the basis of the above, the Committee is of the following

opinion on the issues raised in paragraph 6 above:

(a)

AS 3 and AS 18 are applicable to the company.

(b)

The company is exempted from disclosures under AS 18 only to the extent stated in paragraph 11 above. There are no exemptions from AS 3.

Query No. 11

Accounting for Minimum Alternative Tax (MAT) under section 115JB and credit available in respect thereof. 1

A. Facts of the Case

1. A company is a public sector undertaking engaged in refining

of crude oil. The company was earning profits till the financial year 1998-99. Due to withdrawal of Administrative Pricing Mechanism (APM), additional interest, and depreciation burden on account of substantial capacity expansion of the refinery from 3 million metric ton per annum (MMTPA) to 9 MMTPA in April 2001, coupled with drop in refinery margins, the company incurred losses till the financial year ending 31 st March, 2003. This has resulted into substantial carried forward losses and unabsorbed depreciation under the Income-tax Act, 1961.

2. The querist has stated that another public sector undertaking

Subject:

acquired 52% stake in the company through acquisition of 37.50% stake of one of the private promoter group company and infusion of additional equity capital. Further, it acquired equity shares allotted to banks and financial institutions on debt restructuring, thereby increasing its stake to 72%. The company’s debts were restructured,

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which has resulted into substantial reduction in the interest cost of the company.

3. According to the querist, the company made a turn-around in

the year 2003-04, earned substantial profit in the year 2004-05 and declared maiden dividend. This has resulted in wiping-off of the entire carried forward business loss and substantial reduction in unabsorbed depreciation.

4. The company had paid Minimum Alternative Tax (MAT) for

the year 2004-05 and as the company is earning profit for the year 2005-06 also, the company is liable to pay MAT under section 115JB of the Income-tax Act, 1961.

5. The querist has mentioned that with effect from assessment

year commencing on 1 st April, 2006, by virtue of insertion of sub- section (1A) in section 115JAA of the Income-tax Act, tax credit in respect of tax paid under provisions of section 115JB of the Act is allowable. The sub-section (1A) of section 115JAA of the Income- tax Act provides that “where any amount of tax is paid under sub- section (1) of section 115JB by an assessee, being a company for the assessment year commencing on the 1 st day of April, 2006 and any subsequent assessment year, then, credit in respect of tax so paid shall be allowed to him in accordance with the provisions of this section”. Further, sub-section (4) of section 115JAA provides as under:

“The tax credit shall be allowed set-off in a year when tax becomes payable on the total income computed in accordance with the provisions of this Act other than section 115JA or section 115JB, as the case may be.”

6. This position, according to the querist, implies that the MAT

paid in the financial year 2005-06 is eligible for set-off by reduction in the tax liability of subsequent year(s) where the company becomes liable to pay tax under regular computation provisions. In other words, the company needs to pay lower tax in a subsequent year, in which the credit is available for MAT paid in the current year. As per the querist, in view of the company’s present/projected levels of profits, the company is virtually certain that taxes paid

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under MAT will be available for set-off against tax liability in subsequent year(s).

7. The querist has given the following options in respect of

accounting for MAT paid in the year 2005-06:

(a)

Tax paid under MAT to be accounted for as advance tax instead of tax expense of the year; or

(b)

Treat MAT paid as a timing difference resulting in deferred tax asset and reduce the same from the deferred tax liability, to the extent of credit available; or

(c)

Treat MAT paid as current tax and also provide deferred tax without considering such MAT paid as timing difference, for the purpose of deferred tax calculation, in the year.

8. The querist has further stated that Accounting Standard (AS)

22, ‘Accounting for Taxes on Income’, issued by the Institute of Chartered Accountants of India, does not specifically provide for timing differences arising out of tax credits. However, this standard envisages recognition of tax on the book profit. The current tax provision and deferred tax provision shall be equal to tax computed on book profit (excluding permanent difference) at the enacted tax rates. Hence, according to the querist, in case of virtual certainty of absorption of tax credit, if either of the accounting treatments (a) or (b) stated in paragraph 7 above, is not followed, it may result in excess provision to the extent of MAT paid in the current year and also under provision to the extent of set-off/absorption of tax credit in the subsequent year(s). The querist has also stated that Accounting Standards Interpretation (ASI) 6, ‘Accounting for Taxes on Income in the context of Section 115JB of the Income- tax Act, 1961’ was issued by the Institute before the introduction of sub-section (1A) of section 115JAA with effect from 1 st April, 2005, i.e., when credit in respect of MAT paid was not available, meaning thereby that tax paid under MAT was not allowed to be set-off against regular tax payable in later years.

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B.

Query

9.

Considering the Facts of the Case as explained above, the

querist has sought the opinion of the Expert Advisory Committee on the following issues:

 

(i)

Whether MAT paid under section 115JB of the Act for the year ending 31 st March, 2006, is to be considered as current tax to be absorbed as tax expense in the profit and loss account for the year or treat the same as advance tax under current assets.

(ii)

Whether MAT paid under section 115JB of the Act is to be considered as timing difference resulting in deferred tax asset for deferred tax computation purposes under AS 22 and reduce the same from the deferred tax liability in the current year, to the extent of tax credit available.

(iii)

Whether MAT payable under section 115JB of the Act needs to be considered as current tax but should not be considered for the purpose of deferred tax calculation inspite of it being eligible for carry forward and set-off in the subsequent year.

C.

Points considered by the Committee

10.

The Committee notes that the basic issue raised in the query

relates to the accounting treatment of MAT paid under section 115JB of the Income-tax Act, 1961 and credit available in respect thereof. The Committee has, therefore, considered only this issue and has not touched upon any other issue arising from the Facts of the Case.

11. The Committee notes that the issue raised by the querist has

been dealt with in the Guidance Note on Accounting for Credit Available in respect of Minimum Alternative Tax under the Income-

tax Act, 1961, issued recently by the Institute of Chartered Accountants of India. Paragraphs 4 to 15 of the said Guidance Note suggest the accounting treatment in respect of MAT and credit available in respect of MAT, as follows:

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“Whether MAT credit is a deferred tax asset

4. An issue has been raised whether the MAT credit can

be considered as a deferred tax asset within the meaning of Accounting Standard (AS) 22, Accounting for Taxes on Income, issued by the Institute of Chartered Accountants of India. In this context, the following definitions given in AS 22 are noted:

“Timing differences are the differences between taxable income and accounting income for a period that originate in one period and are capable of reversal in one or more subsequent periods.”

“Accounting income (loss) is the net profit or loss for a period, as reported in the statement of profit and loss, before deducting income tax expense or adding income tax saving.”

“Taxable income (tax loss) is the amount of the income (loss) for a period, determined in accordance with the tax laws, based upon which income tax payable (recoverable) is determined.”

5. From the above, it is noted that payment of MAT, does

not by itself, result in any timing difference since it does not give rise to any difference between the accounting income and the taxable income which are arrived at before adjusting the tax expense, namely, MAT. In other words, under AS 22, deferred tax asset and deferred tax liability arise on account of differences in the items of income and expenses credited or charged in the profit and loss account as compared to the items of income that are taxed or items of expense that are allowed as deduction, for the purposes of the Act. Thus, deferred tax assets and deferred tax liabilities do not arise on account of the amount of the tax expense itself. In view of this, it is not appropriate to consider MAT credit as a deferred tax asset for the purposes of AS 22.

Whether MAT credit can be considered as an ‘asset’

6. Although MAT credit is not a deferred tax asset under

AS 22 as discussed above, yet it gives rise to expected future economic benefit in the form of adjustment of future income

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tax liability arising within the specified period. A question, therefore, arises whether the MAT credit can be considered as an ‘asset’ and in case it can be considered as an asset whether it should be so recognised in the financial statements.

7. The Framework for the Preparation and Presentation of

Financial Statements, issued by the Institute of Chartered Accountants of India, defines the term ‘asset’ as follows:

“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.”

8. MAT paid in a year in respect of which the credit is

allowed during the specified period under the Act is a resource controlled by the company as a result of past event, namely, the payment of MAT. MAT credit has expected future economic benefits in the form of its adjustment against the discharge of the normal tax liability if the same arises during the specified period. Accordingly, MAT credit is an ‘asset’.

9. According to the Framework, once an item meets the

definition of the term ‘asset’, it has to meet the criteria for recognition of an asset so that it may be recognised as such

in the financial statements. Paragraph 88 of the Framework provides the following criteria for recognition of an asset:

“88. An asset is recognised in the balance sheet when it is probable that the future economic benefits associated with it will flow to the enterprise and the asset has a cost or value that can be measured reliably.”

10. In order to decide when it is ‘probable’ that the future

economic benefits associated with the asset will flow to the enterprise, paragraph 84 of the Framework, inter alia, provides as below:

“84. The concept of probability is used in the recognition criteria to refer to the degree of uncertainty that the future economic benefits associated with the item will flow to or from the enterprise. The concept is in keeping with the uncertainty that characterises the environment

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in which an enterprise operates. Assessments of the degree of uncertainty attaching to the flow of future economic benefits are made on the basis of the evidence available when the financial statements are prepared.”

11. The concept of probability as contemplated in paragraph

84 of the Framework relates to both items of assets and liabilities and, therefore, the degree of uncertainty for recognition of assets and liabilities may vary keeping in view the consideration of ‘prudence’. Accordingly, while for recognition of a liability the degree of uncertainty to be considered ‘probable’ can be ‘more likely than not’ (as in paragraph 22 of Accounting Standard (AS) 29, ‘Provisions, Contingent Liabilities and Contingent Assets’) for recognition of an asset, in appropriate conditions, the degree may have to be higher than that. Thus, for the purpose of consideration of the probability of expected future economic benefits in respect of MAT credit, the fact that a company is paying MAT and not the normal income tax, provides a prima facie evidence that normal income tax liability may not arise within the specified period to avail MAT credit. In view of this, MAT credit should be recognised as an asset only when and to the extent there is convincing evidence that the company will pay normal income tax during the specified period. Such evidence may exist, for example, where a company has, in the current year, a deferred tax liability because its depreciation for the income-tax purposes is higher than the depreciation for accounting purposes, but from the next year onwards, the depreciation for accounting purposes would be higher than the depreciation for income-tax purposes, thereby resulting in the reversal of the deferred tax liability to an extent that the company becomes liable to pay normal income tax.

12. Where MAT credit is recognised as an asset in

accordance with paragraph 11 above, the same should be reviewed at each balance sheet date. A company should write down the carrying amount of the MAT credit asset to the extent there is no longer a convincing evidence to the effect that the company will pay normal income tax during the

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specified period.

Presentation of MAT credit in the financial statements

Balance Sheet

13. Where a company recognises MAT credit as an asset

on the basis of the considerations specified in paragraph 11 above, the same should be presented under the head ‘Loans and Advances’ since, there being a convincing evidence of realisation of the asset, it is of the nature of a pre-paid tax which would be adjusted against the normal income tax during the specified period. The asset may be reflected as ‘MAT credit entitlement’.

14. In the year of set-off of credit, the amount of credit

availed should be shown as a deduction from the ‘Provision for Taxation’ on the liabilities side of the balance sheet. The unavailed amount of MAT credit entitlement , if any, should continue to be presented under the head ‘Loans and Advances’ if it continues to meet the considerations stated in paragraph 11 above.

Profit and Loss Account

15. According to paragraph 6 of Accounting Standards

Interpretation (ASI) 6, ‘Accounting for Taxes on Income in the context of Section 115JB of the Income-tax Act, 1961’, issued by the Institute of Chartered Accountants of India, MAT is the current tax. Accordingly, the tax expense arising on account of payment of MAT should be charged at the gross amount, in the normal way, to the profit and loss account in the year of payment of MAT. In the year in which the MAT credit becomes eligible to be recognised as an asset in accordance with the recommendations contained in this Guidance Note, the said asset should be created by way of a credit to the profit and loss account and presented as a separate line item therein.”

D. Opinion

12. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 9 above:

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(i)

MAT paid under section 115JB of the Income-tax Act, 1961 should be considered as current tax for the year in which it arises. MAT Credit should, however, be treated as an asset to be shown under the head ‘Loans and Advances’ in the year in which it becomes eligible to be recognised as an asset as discussed in paragraph 11 of the Guidance Note.

(ii)

No, MAT should not be considered as ‘timing difference’, as stated in paragraph 5 of the Guidance Note.

(iii)

MAT should be considered as current tax but should not be considered for the purpose of deferred tax calculation. Instead, MAT credit can be recognised as an asset, in case it meets the requirements of paragraph 11 of the Guidance Note.

Query No. 12

Recognition of revenue in respect of long production cycle items. 1

A. Facts of the Case

1. A company is a leading engineering product company catering

to the vital sectors of the economy such as infrastructure, surface

transportation, mining and defence. The company is a public sector enterprise under the administrative control of the Ministry of Defence. With a turnover of Rs.1857 crore for the financial year 2004-05, the company is the market leader in earthmoving and mining products. The company is making profits consistently right from its inception. For the year 2004-05, the profit before tax of Rs. 272.80 crore registered a growth of 444% compared to the previous year. The shares of the company are listed on Mumbai and Bangalore Stock Exchanges and are actively traded scrips with a market price of Rs. 1473 per share (as on date) with face

Subject:

1 Opinion finalised by the Committee on 27.3.2006

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value of Rs. 10. The company is a fast growing engineering product company with export presence in as many as ten countries spanning over Asia, Africa and South American continents. For the year 2004-05, the export turnover of the company was Rs. 59 crore and according to the querist, it is expected to increase manifold in the future.

2. The company has three manufacturing units located at Kolar

Gold Fields (KGF), Bangalore and Mysore. It has marketing and service centres spread all over India. The KGF unit manufactures dozers, excavators, loaders, walking draglines, rope shovels and sophisticated aggregates catering to the needs of the mining and defence sectors. The Bangalore unit manufactures rail coaches, EMU’s, wagons, overhead inspection vehicles for Indian Railways and also logistics vehicles (Tatra variants) for usage by the Ministry of Defence. In addition, Bangalore unit is manufacturing, for the first time in India, metro rail coaches under license from M/s Rotem of Korea. The Mysore unit manufactures highly sophisticated dumpers, graders, aircraft towing tractors, weapon loading systems and high powered internal combustion engines. All these products are highly technology intensive and call for an array of manufacturing technologies. Some of these products have a long production cycle time extending beyond one accounting year.

3. The querist has stated that the accounting policy of the

company, as far as revenue recognition is concerned, is as under:

“(i)

Sales set up for products, viz., equipments, aggregates, attachments and ancillary products is made when these are unconditionally appropriated to the valid sales contract after pre-despatch inspection by the specified authority.

(ii)

Sales setup for long production cycle items, is reckoned based on technical estimates when the percentage of completion of each identifiable unit of contract including despatches with customers is 30% or more of the total realisable value of such contract or estimate. Such revenue recognition is restricted to 97.5% of the reckoned realisable value and the balance 2.5% is accounted on completion of the contract.”

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According to the querist, these policies are being consistently followed by the company. Further, these policies have been validated by both the statutory auditors and the Comptroller and Auditor General of India (C&AG) (government auditors). However, during the meeting of the Audit Committee held on 06.01.06, the statutory auditors were of the opinion that the accounting policy propounded in paragraph 3 (ii) is not in line with Accounting Standard (AS) 9, ‘Revenue Recognition’, issued by the Institute of Chartered Accountants of India (ICAI). As per the querist, as the views of the statutory auditors are at variance with the stated policy of the company regarding revenue recognition, a need is felt to seek the opinion of the Expert Advisory Committee of the ICAI.

4. The querist has further stated that the marketing policy of the

company is in line with the accounting policies being pursued. For instance, the revenue from sale of equipments, aggregates, components and attachments are recognised based on valid sales contracts. Further, the revenue is recognised in respect of these products only on the basis of pre-despatch inspection. This is applicable in the case of products and aggregates having a production cycle time of less than one year. Some of the products, like Walking Draglines are highly import intensive coupled with multiple manufacturing technologies. Further, the manufacturing of these equipments warrant fabrication and manufacture of heavy duty steel structures, integrating the multiple electrical and electronic assemblies, sub-assemblies and transporting them in dis- aggregated structures to customer site for erection and commissioning. All these activities, right from commencement of production to final erection take more than one year. Recognising the long production cycle time as well as assembling the structures at site, the company has evolved a specific marketing policy in respect of such products. The policy calls for production of these goods only on firm sale orders. Further, in case of these products, invariably advances are received from the customers before the commencement of production. In addition, the customer order provides for billing details, with respect to pre-identified and mutually agreed modules, assemblies and structures. Based on the billing details, invoices are raised as and when the modules, assemblies,

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structures, as the case may be, are despatched as per the terms of the sale order and payments are also received as agreed.

5. According to the querist, it may be seen from paragraph 4

above, that revenue is recognised based on reliable data regarding physical completion. Both the parties to the contract agree to the terms of sale and also payment in respect of modules despatched. Further, both the parties are clear in understanding the rights, obligations, risks and rewards as well as the terms of payment. In fact, in many of the transactions of this kind, the buyer pays not only advance but also to the extent of agreed percentage of value of invoices raised at the point of delivery at site or ex-works, as the case may be.

6. The querist has stated that considering the nature of business,

the type of product and the long production cycle time involved, the method adopted by the company is in order. This also synchronizes the revenue recognition with occurrence of performance or event and is well within the realm of the principle of matching concept (emphasis supplied by the querist). According to the querist, US GAAPs also recognise revenue on the basis of percentage of completion method in respect of long production cycle items/products (the querist has referred to US GAAP 2002 by Siegel, Levine, Qureshi and Shim published by Prentice Hall). On the other hand, if revenue is recognised only after the final delivery of such equipment, it will lead to distortion of the financial performance and position of the company for earlier years.

7. The querist has further stated that AS 9 recognises revenue

both from the sale of products and rendering of services. However, in the case of services, it reckons the applicability of percentage of completion method but not so in the case of sale of goods. The querist has further stated that in this regard, it may be worthwhile to note that revenue recognition irrespective of the fact whether it

is revenue generation from rendering of service or from sale of goods, is well within the purview of the framework of matching concept of revenue with expenditure. Therefore, what is explicitly stated as applicable to rendering of services will be equally applicable for sale of goods. Further, as per the querist, in the

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case of goods having long production cycle time, as long as there

is a valid contract and the parties to the contract agree regarding

billing details, contractual obligations and payment terms, there is

no need to apply the rule of explicit statement in the Standard. On the other hand, the strict interpretation of the Standard based on the literal meaning instead of the spirit behind it would adversely affect the financial performance of the companies having such

products (emphasis supplied by the querist). This, in turn, according

to the querist, would have significant impact on the perception of

economic agencies, like stock exchanges, creditors, bankers, investors and other stakeholders.

8. The querist has also mentioned that an attempt was made by

the company to find out the accounting policies pursued by other companies manufacturing engineering products having long production cycle time. The querist has observed that another

company, having similar product profile as that of the company under construction in respect of products having long production cycle time, has similar accounting policy in respect of these items.

It is requested by the querist that the Committee may also take cognizance of the other company’s accounting policy while expressing its considered opinion.

B.

Query

9.

The querist has sought the opinion of the Committee as to

whether the accounting policy of the company, particularly, with regard to sale of products having long production cycle time is in line with AS 9. If not, what modifications, in the opinion of the Committee are desirable to conform to AS 9?

C.

Points considered by the Committee

10.

The Committee notes that the basic issue raised in the query

relates to whether as per the provisions of AS 9, the revenue from sale of products having long production cycle time, produced under

a contract with the customer, can be recognised following the

principles of percentage of completion method. The Committee has, therefore, considered only this issue and has not touched upon any other issue arising from the Facts of the Case, such as

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accounting treatment of products having production cycle time less than a year, etc.

11. With regard to long production cycle items taking more than a

year to complete, the Committee notes the ‘Objective’ paragraph, definition of the term ‘construction contract’, and paragraph 3 of Accounting Standard (AS) 7 (revised 2002), ‘Construction Contracts’, issued by the Institute of Chartered Accountants of India, which inter alia, state as follows:

“Objective

The objective of this Statement is to prescribe the accounting treatment of revenue and costs associated with construction contracts. Because of the nature of the activity undertaken in construction contracts, the date at which the contract activity is entered into and the date when the activity is completed usually fall into different accounting periods.”

“A construction contract is a contract specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use.”

“3. A construction contract may be negotiated for the construction of a single asset such as a bridge, building, dam, pipeline, road, ship or tunnel. A construction contract may also deal with the construction of a number of assets which are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use; examples of such contracts include those for the construction of refineries and other complex pieces of plant or equipment.”

12. On the basis of the above, the Committee is of the view that

in case of contracts of manufacture and supply of long production cycle items which are complex pieces of equipment and which are manufactured under a contract with the customer, AS 7 (revised 2002) is applicable because the date on which the contract is secured and the date when the contract activity is completed fall into different accounting periods. In view of this, the principles of

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recognition of revenue in respect of sale of goods, as enunciated in AS 9, as being argued by the statutory auditor, are not applicable in this case. In this regard, the Committee also notes paragraph 2 of AS 9, which, inter alia, states as follows:

This Statement does not deal with the following aspects

of revenue recognition to which special considerations apply:

“2.

(i) Revenue arising from construction contracts”.

13. With regard to method of recognition of revenue prescribed in

AS 7, the Committee notes paragraph 21 of the Standard as

reproduced below:

“21. When the outcome of a construction contract can be estimated reliably, contract revenue and contract costs associated with the construction contract should be recognised as revenue and expenses respectively by reference to the stage of completion of the contract activity at the reporting date. An expected loss on the construction contract should be recognised as an expense immediately in accordance with paragraph 35.”

14. On the basis of the above, the Committee is of the opinion

that in the present case, the company should recognise revenue from sale of long production cycle items manufactured under a contract with the customer, on the basis of stage of completion of the product, i.e., percentage of completion method, provided other conditions and provisions of AS 7 (revised 2002) are also complied with.

D. Opinion

15. The Committee is of the opinion on the issues raised in

paragraph 9 above that in the present case, AS 7 (revised 2002) is applicable rather than AS 9. Accordingly, the revenue of the company from sale of products having long production cycle time, i.e., more than a year, that are manufactured under a contract with the customer, should be recognised following the percentage of completion method as per the provisions of AS 7 (revised 2002).

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Query No. 13

Subject: Segment reporting by a finance company. 1

A. Facts of the Case

1. A public sector undertaking is registered under the Companies