BACKGROUND The accounting for cost of test runs raises some very interesting questions both under Indian GAAP and IFRS. Paragraph 16 of IAS 16 states that the cost of an item of plant and equipment includes any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management. Paragraph 17 enumerates examples of directly attributable cost and includes cost of testing whether the asset is functioning properly, after deducting the net proceeds from selling any items produced while bringing the asset to that location and condition; such as samples produced when testing equipment. However, it does not clearly state what the treatment should be when the net proceeds are greater than the cost of testing. Now consider the following two scenarios.
Scenario 1
The cost of test run is Rs. 100. The samples produced are sold at Rs. 80. Theoretically, two answers are possible. The first answer is to capitalise Rs. 100 and consider Rs. 80 as revenue (P&L). The second answer is to capitalise net, i.e., Rs 20. Nothing is taken to P&L.
Scenario 2
The cost of test run is Rs 100. The samples produced are sold at Rs. 130. Theoretically, the following three possibilities exist.
1. Capitalise Rs.100. Take Rs. 130 to revenue (P&L)
2. Capitalise a negative amount of Rs. 30. Nothing is taken to P&L.
3. Capitalise zero amount. Take Rs. 30 to revenue (P&L).
Interpretation under IFRS
This matter was discussed in the IFRS Interpretation committee. They felt that the way paragraph 17 is written, it is only the costs of testing that are permitted to be included in the cost of the plant and equipment. These costs are reduced by the net proceeds from selling items produced during testing. It is self-evident that if the net proceeds exceed the cost of testing, then those excess net proceeds cannot be included in the cost of the asset. Those excess net proceeds must therefore be included in the P&L.
IFRS Interpretation Committee also relied upon paragraph 21 of IAS 16, which indicates that proceeds and related costs arising from an operation, which is not necessary to bring the item to the location and condition necessary for it to be capable of operating in the manner intended by management, should be recognised in P&L and cannot be capitalised. Paragraph 21 is reproduced below.
“Some operations occur in connection with the construction or development of an item of property, plant and equipment, but are not necessary to bring the item to the location and condition necessary for it to be capable of operating in the manner intended by management. These incidental operations may occur before or during the construction or development activities. For example, income may be earned through using a building site as a car park until construction starts. Because incidental operations are not necessary to bring an item to the location and condition necessary for it to be capable of operating in the manner intended by management, the income and related expenses of incidental operations are recognised in profit or loss and included in their respective classifications of income and expense.”
Based on the above discussion, in Scenario 1, a net amount of Rs. 20 is capitalised. In Scenario 2, zero amount is capitalised, and Rs. 30 is taken to revenue (P&L).
Interpretation under Indian GAAP
The following guidance is available in Indian GAAP. It may be noted that the below mentioned Guidance Note on Treatment of Expenditure During Construction Period is withdrawn, but nonetheless relevant for our assessment, since it does not conflict with any accounting standard with respect to the principle that is being debated.
Paragraph 9.1 of AS 10 Accounting for Fixed Assets
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.
Paragraph 9.3 of AS 10 Accounting for Fixed Assets
The expenditure incurred on start-up and commissioning of the project, including the expenditure incurred on test runs and experimental production, is usually capitalised as an indirect element of the construction cost.
Paragraph 8.1 of Guidance Note on Treatment of Expenditure During Construction Period
It is possible that a new project may earn some income from miscellaneous sources during its construction or preproduction period. Such income may be earned by way of interest from the temporary investment of surplus funds prior to their utilisation for capital or other expenditure or from sale of products manufactured during the period of test runs and experimental production. Such items of income should be disclosed separately either in the profit and loss account, where this account is prepared during construction period, or in the account/statement prepared in lieu of the profit and loss account, i.e., Development Account/Incidental Expenditure During Construction Period Account/Statement on Incidental Expenditure During Construction. The treatment of such incomes for arriving at the amount of expenditure to be capitalised/deferred, has been dealt with in para 15.2.
Paragraph 11.4 of Guidance Note on Treatment of Expenditure During Construction Period
During the period of test runs and experimental production it is quite possible that some income will be earned through the sale of the merchandise produced or manufactured during this period. The sale revenue should be set off against the indirect expenditure incurred during the period of test runs as suggested in para 15.2.
Paragraph 15.2 of Guidance Note on Treatment of Expenditure During Construction Period
From the total of the aforesaid items of indirect expenditure (one of the aforesaid items included expenditure relating to expenditure on test runs) would be deducted the income, if any, earned during the period of construction, provided it can be identified with the project.
Paragraph 14.5 of Guidance Note on Treatment of Expenditure During Construction Period
Income during the construction or pre-production period should be shown separately in the financial statements (see paragraph 8.1 of this Note).
Conclusion
Based upon the above guidance, it is clear in Scenario 1, that a net amount of Rs. 20 is capitalised and nothing is taken to the P&L. However, in the case of Scenario 2, when the corresponding income is greater than the cost of trial run, neither the guidance note nor the standard are absolutely clear on what should be done. However, the author believes that based on similar arguments produced above in the context of IFRS interpretation, a net amount of zero is capitalised and Rs. 30 is taken to revenue (P&L).
