An article on Project Expenditure and the Consequences that arise on its Scrapping

 

Many existing companies undertake new projects to survive in this competitive age. It often happens that the decision of the management to undertake the project changes and it decides to scrap it in view of technological advancements, market constraints, governmental policy etc.

 

The article discusses some of the issues relating to the expenditure on expansion projects incurred by existing companies. The treatment for expenditure incurred on new capital projects while they are in the stage of construction may be different. Also, please note that, the issues discussed and the treatments suggested, except where separate references have been made, are my personal views. There may be alternative treatment possible.

 

The major considerations that arises in one’s mind would be:

 

1.      Treatment of the expenditure, whether revenue or capital.

2.      When can the project be treated as Research and Development Project?

3.      Disclosure of the expenditure.

4.      Whether events occurring after the balance sheet date should be considered while finalizing the accounts.

5.      Treatment of carried forward expense on scrapping of the project

6.      Whether the expenditure results in a prior period item on it’s scrapping.

7.      Disclosure of expenditure on its scrapping.

8.      Valuation of Assets that can be used elsewhere and those that cannot be used.

 

ISSUES:

 

1.   Treatment of the expenditure, whether revenue or capital:

 

Ø      As per the Guidance Note on Treatment of Expenditure Incurred during construction period, the cost of preparing the project report, conducting feasibility studies, location studies, expenditure incurred in connection with preliminary financial studies as well as in connection with preliminary negotiations with foreign collaborators and with the Government for the purposes of obtaining various permits/licenses are incurred directly in connection with the project and are to be regarded as an addition to the total construction cost of the project.

Ø      The expenses such as interest charges and commitment fees on loans specially taken for the purpose of the project are indirect construction expenditure and should be added to the total cost of the project. However, these charges incurred after the commencement of commercial production are to be treated as revenue expenditure in the normal way.

Ø      Accounting Standard (AS) 16 on ‘Borrowing Costs’ issued by the Institute of Chartered Accountants of India, in Para 6, states that “Borrowing Costs that are directly attributable to the acquisition, construction or production of a qualifying asset should be capitalized as part of the cost of that asset.” However, Para 7 of the same AS, states that the “Borrowing costs are capitalized as part of the cost of a qualifying asset when it is probable that they will result in future economic benefits to the enterprise and the costs can be measured reliably otherwise they are to be expensed in the period in which they are incurred. Thus in this case, for an auditor, management representation becomes very important and should invariably be obtained as per SAP-11 “Management Representation”.

Ø      Interest charges on loans not taken specially for the purpose of the project but a portion of which is used for the project should be capitalized by applying a capitalization rate to the expenditure on that asset. The capitalization rate should be the weighted average of the borrowing costs applicable to the borrowings of the enterprise that are outstanding during the period other than borrowings made specifically for the purpose of the project as per Para 12 of AS-16.

Ø      Some indirect expenditure is also incurred while the expansion activity is on. Such expenditure should be capitalized only to that extent by which the expenditure has increased due to the concurrence of the project.

Ø      Any income earned during the expansion activity because of the project should be deducted from the total of the indirect expenditure so that only the net amount is capitalized. This would also show a true gross book value of the assets when the project is over.

Ø      Expenditure on assets purchased for the project would be a capital expenditure.

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2.   Can the project be treated as Research and Development Project:

 

Ø     To decide whether the project can be treated as research and development project one has to refer to AS-8 “Accounting for Research and Development”. According to Para 3 of AS-8, “Research is original and planned investigation undertaken with the hope of gaining new scientific or technical knowledge or understanding”. While, “Development is the translation of research findings or other knowledge into a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services prior to the commencement of commercial production”.

Ø     Thus, to treat the project as an R & D project, it is necessary that the project would lead to production of a new material or would result in some new technical know-how. If the project satisfies the above criteria, it can be treated as R & D project and accounted as per AS-8.

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3.    Disclosure of the Expenditure in Final Accounts:

 

Ø      All assets acquired during the construction period should be grouped under and should be added to Net Block of Fixed Assets as Construction Work-in-Progress a/c. or under similar head. Expenditure directly related to the purchase of an asset should be added to its cost.

Ø      Other expenditure should be grouped as pre-operative expenditure and shown under the head Miscellaneous Expenditure. These expenses are apportioned based on the project’s assets’ cost when the project is ready for commercial production.

Ø      Depreciation should be charged on assets used during the period of construction for the construction. However, the same is an indirect expenditure and should be treated accordingly.

Ø      The above treatment would continue until the project is ready for commercial use.

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4.    Events occurring after the balance sheet date:

 

Ø      According to AS-4, “Contingencies and Events occurring after the Balance Sheet date”, “Events occurring after the balance sheet date are those significant events, both favourable and unfavourable, that occur between the balance sheet date and the date on which the financial statement are approved by the Board of Directors in the case of a company, and, by the corresponding approving authority in the case of any other entity.”

Ø      As per AS-4, adjustments to assets and liabilities are required for events occurring after the balance sheet date that provide additional information materially affecting the determination of the amounts relating to conditions existing at the balance sheet date.

Ø      Thus, events occurring after the balance sheet date should be considered before finalizing the accounts. Adjustments should be made in case the events show that the viability of the project is itself in question.

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5.   Treatment of expenditure on Scrapping of the Project:

 

Ø     According to Para 5 of AS-5, “Net Profit or loss for the Period, Prior period items and Changes in Accounting Policies”, all items of income and expense which are recognized in a period should be included in the determination of net profit or loss for the period unless an Accounting Standard requires or permits otherwise.

Ø     Expenses of project, which have been brought forward from the previous year, should be expensed in the period in which the project is scrapped.

Ø     According to Para 12 of AS-5, “Net Profit or loss for the Period, Prior period items and Changes in Accounting Policies”, when items of income and expense within profit or loss from ordinary activities are of such size, nature or incidence that their disclosure is relevant to explain the performance of the enterprise for the period, the nature and amount of such items should be disclosed separately.

Ø     Thus, as per the above Para, the whole of the expenses should be disclosed separately and, for transparency, on the face of the profit and loss account.

Ø     One may take the view that if whole of expenses are expensed in one year, it may adversely affect the profitability of the enterprise for that year. Hence, it should be treated as deferred revenue expenditure and written off in 3 to 5 years. In my view, this sort of treatment is not proper. Such a treatment is not in accordance with the basic concepts of accounting such as conservative concept and matching concept. An expense can be treated as deferred revenue expenditure only when it is probable that the enterprise is going to receive some benefit out of the expenditure in future. The expenses of a project, which is scrapped, therefore, should not be treated as deferred revenue expenditure.

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6.   Prior period considerations on scrapping of the project next year:

 

Ø    According to AS-5, “Net Profit or loss for the period, Prior period items and Changes in Accounting Policies”, “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”.

Ø    IAS-8 (Revised) requires separate disclosures about discontinued operations that help the users to project the future performance of the reporting entity. A discontinued operation means sale or abandonment of a major line of business of which assets; net profit or loss and activities can be distinguished. The disclosures to be made in this respect are:

 

1.   Nature of discontinued business;

2.   Industry and geographic segment to which the discontinued business belonged;

3.   Effective date of discontinuation;

4.   Manner of discontinuation;

5.   Gain or loss of discontinuation and accounting policies for treatment thereof; and

6.   Revenue, profit and loss of such discontinued business along with corresponding prior period figures.

 

AS-5 (Revised) has not touched upon the issue. However, for transparency, these data should be given at least by way of notes.

Ø    The loss occurring on scrapping of a project cannot be considered as prior period as it does not result from errors or omissions in the preparation of the financial statements of one or more prior periods. The decision to scrap the project is taken in the current year and hence it is a loss of current year. However, one may take a contrary view on the basis of the following justification: if the decision to scrap the project was taken before the approval of final accounts and no adjustment is made in the accounts and the whole expenditure is carried forward to the next year under the respective heads, the same should be treated as prior period items. This is because, as per AS-4, the expenditure should have been expensed in the first year itself.

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7.    Disclosure of Expenditure on its scrapping:

 

Ø    According to AS-5, “The net profit or loss for the period should comprise the following components, each of which should be disclosed on the face of the statement of profit and loss:

(a)       Profit or loss from ordinary activities; and

(b)       Extraordinary items

Ø    Ordinary activities have been defined as any activities which are undertaken by an enterprise as part of its business and such related activities in which the enterprise engage in furtherance of, incidental to, or arising from, these activities.

Ø    Extraordinary items have been defined as those incomes or expenses that arise from events or transactions that are clearly distinct from the ordinary activities of the enterprise and therefore, are not expected to recur frequently or regularly.

Ø    In my view, the loss occurring on scrapping of a project is a loss arising from ordinary activity. This is because; enterprises normally do undertake the activity of expansion and diversification. Thus, the activity is an ordinary activity and the loss arising on such activity would also be from ordinary activity.

Ø    If the expenses are treated as a prior period item, then the same should be disclosed, in my view, below the line as the expenses are disallowed by Income Tax Authorities. Disclosure of the same below the line shows that the expenditure has not been considered for provision of tax.

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8.    Valuation of Assets on scrapping:

 

Ø    When a project is scrapped, there arises a question of the valuation of assets, that can be used elsewhere and those that cannot be used elsewhere and therefore remain idle.

Ø    In case of assets that can be used elsewhere, the valuation does not pose any problem. These assets should be added to the block of assets where they can be used. If these assets can be used after incurring certain expenses for modification, these should be added to the historical cost of the asset.

Ø    The problem is mainly of those assets which remain idle on the balance sheet date and cannot be used anywhere else. These assets are held for disposal. These should be valued at the lower of the net book value and net realizable value and shown separately in the financial statements. Any loss being recognized in the profit and loss account immediately.

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