Sometimes, circumstances force an entity to incur capital expenditure which is not represented by any specific or tangible assets. For example, an entity may agree with a local authority to pay the cost or part of the cost of roads to be built by the authority. In this case also, the roads will remain the property of the Municipal body. Whether such expenditure should be capitalised or not, is a matter of debate and the solution will depend on facts and circumstances of each case. Consider two scenario’s as given below. The discussion is based on Indian GAAP, but would be equally relevant for Ind-AS purposes as well.
Scenario 1
The Company had to incur expenditure on the construction/ development of certain assets, like electricity transmission lines, railway sidings, roads, culverts, bridges, etc. (hereinafter referred to as enabling assets) for setting up a new refinery. This was required in order to facilitate construction of project and subsequently to facilitate its operations. The ownership of these enabling assets does not vest with the company. The moot question is whether such expenditure can be capitalised or has to be charged to the profit and loss account immediately. This question was raised in 2011 with the Expert Advisory Committee (EAC), and its view and the basis of conclusion was as follows:
View of EAC along with the basis of conclusion [published in CA Journal January 2011]
The expenditure on enabling assets should be expensed by way of charge to the profit and loss account of the period in which the same is incurred. As per the Committee, an expenditure incurred by an enterprise can be recognised as an asset only if it is a resource controlled by an enterprise. For example, the entity having control of an asset can exchange it for other assets, employ it to produce goods or services, charge a price for others to use it, use it to settle liabilities, hold it, or distribute it to owners.
Further, an indicator of control of an item of fixed asset would be that the entity can restrict the access of others to the benefits derived from that asset. In the given case the entity does not have control over the enabling assets and should therefore charge the same as an expense in the profit and loss account.
Author’s comments
In the author’s view, there is sufficient justification in existing literature to support capitalisation of the enabling assets as part of the overall cost of the refinery. This is discussed below.
As per paragraph 9.1 of AS-10, “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: (a) site preparation; (b) initial delivery and handling costs; (c) installation cost, such as special foundations for plant; and (d) professional fees, for example fees of architects and engineers. Further paragraph 10.1 states, “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.”
Paragraph 8 of AS-16 states, “The borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset are those borrowing costs that would have been avoided if the expenditure on the qualifying asset had not been made. When an enterprise borrows funds specifically for the purpose of obtaining a particular qualifying asset, the borrowing costs that directly relate to that qualifying asset can be readily identified.” In the given case, the costs incurred on the enabling assets is directly related to the construction of the refinery. The expenses on the enabling assets are required solely for the purpose of bringing the refinery to its working condition for its intended use. For example, without the electricity transmission lines, the refinery will not be ready for its intended purpose.
Interestingly, the EAC [Volume 24 – Query no. 9] had dealt with a similar issue in 2004 with regards to the expenditure incurred on the catchment area of a hydroelectric power project. In the said matter, a dam was being constructed across a river for the purpose of creation of a reservoir so that water is stored and used for the purpose of generating electricity. The reservoir is dependent upon the catchment area for water. Continuous soil erosion results in sedimentation, and reduces the capacity of the reservoir and efficiency of the project (emphasised). Substantial expenditure was incurred towards extensive catchment area treatment measures. In the said matter, EAC opined that the expenditure on the catchment area treatment is capitalised with the cost of the dam. For determining which expenditure is directly attributable to bring the asset to its working condition for its intended use, factors such as whether the concerned expenditure directly benefits or is related to that asset may be considered. In other words, there has to be some nexus between the expenditure and the benefit/relationship with the asset.
The ‘unit of account’ (should not be confused with component accounting) concept is another interesting concept in accounting. Under this concept, it would be argued that what is being constructed is the refinery, and not the roads, culverts, etc. which are all required to construct the refinery. The enabling assets are required not for their own individual purposes but for the purposes of the refinery. The expenditure on the enabling assets is required as part of the cost of constructing the refinery. Therefore the entire project cost including those incurred on the enabling assets will be captured as cost of constructing the refinery. Once that is done, the refinery itself will be bifurcated into various components, so that component accounting can be applied.
In the EAC opinion it is argued that, the entity having control of an asset can exchange it for other assets, employ it to produce goods or services, charge a price for others to use it, use it to settle liabilities, hold it, or distribute it to owners. Further, an indicator of control of an item of fixed asset would be that the entity can restrict the access of others to the benefits derived from that asset. Unfortunately, the argument presupposes the refinery and enabling assets as separate unit of accounts (should not be confused with component accounting). In the author’s view, the unit of account or the asset under construction is the refinery (and not the enabling assets), and all the costs (including on the enabling assets) are related to constructing the refinery. The entity has control over the refinery and restrict the access of others to the benefits derived from the refinery. Thus by looking at the refinery as the unit of account, it is argued that all expenses directly related to constructing the refinery (including costs on enabling assets) should be capitalised.
The EAC opinion will have significant implications for a lot of companies that are in the process of constructing huge projects. In light of the various submissions above, the EAC may reconsider its position. The author is aware that this gap is likely to be plugged in the revised AS 10 under Indian GAAP.
Scenario 2
A mining company has to transport coal through road transport to the nearest railway siding which is around 40 k.m. away from the mines. The existing two lane road is also extensively used by local villagers causing inconvenience, traffic jams and accidents due to which blockage of roads and delay in delivery is a common phenomena. Hence, there was a business necessity and compulsion to widen this road to liquidate the coal stock and to maintain continuity of production. To find a solution to the management problem of transporting the coal, the company widened the two lane road to four lane. The road belongs to and is owned by the State Government. The question is whether expenses incurred for widening of two lanes road to four lanes which is not owned by the company can be recognised as intangible asset.
The appropriate standard would be AS 26 Intangible Assets. As per paragraph 14 of AS 26, an enterprise controls an asset if the enterprise has the power to obtain the future economic benefits flowing from the underlying resource and also can restrict the access of others to those benefits. From the facts of the case neither the land to be acquired for widening the road nor the road will be the property of the company. These will remain the property of the State Government. Further, it is noted that the nearby villagers will also be beneficiaries. From this, it appears that although the work of widening the road will facilitate unrestricted movement of coal for the company, the company does not enjoy control in terms of restriction of access of others to the benefits arising from the widened road facility. Therefore, one may argue that the ex penditure incurred on widening and construction of road on the land which is not owned by the company does not meet the definitions of the terms ‘asset’ and ‘intangible asset’. Accordingly, some may argue that such expenditure cannot be capitalised as an intangible asset.
However the author believes, similar to Scenario 1, the unit of account is not the road but the mine. Hence the above argument of control is not a valid argument. Nonetheless, this fact pattern is different from the one in Scenario 1. In Scenario 1, the expenditure was incurred for and incidental to the construction of an asset (the refinery). The company controls the refinery and hence the capital expenditure including the incidental expenditure incurred for construction should be capitalised as cost of refinery. In Scenario 2, no new asset is created and the expenditure incurred on widening the lane is with respect to an already functioning mine. Paragraph 60 of AS 26 is relevant here, which states “Subsequent expenditure on a recognised intangible asset is recognised as an expense if the expenditure is required to maintain the asset at its originally assessed standard of performance.” This is a matter of judgement. The company should carefully evaluate whether the expenditure incurred on widening the road has increased the originally assessed standard of performance of the mine. If for example, substantially more coal can be produced and transported, because transportation bottlenecks have been removed, one may argue that the originally assessed standard of performance of the mine is increased, and therefore the cost of widening the road will be capitalised as an intangible asset. One will have to make this assessment very carefully.
