5

Query No. 35

Subject:

Recognition of free of cost equipment provided by a contractee to the contractor.1

A.Facts of the Case

1.A company (hereinafter referred to as ‘the company’) is a defence public sector undertaking under the Ministry of Defence and is engaged in the construction of Warships and Submarines. For a particular class of ship construction, the company entered into an agreement with the buyer for the construction and delivery of 3 ships.

2.The company has agreed for construction of 3 ships on ‘Fixed Price’ basis with variable component in respect to certain items.

(i)The break-up of the contract price is as under:

Sr No

Cost Element

1st

2nd

3rd

Total

ship

ship

ship

1

Material

xx

xx

xx

xxx

2

Yard efforts

xx

xx

xx

xxx

(A)

Fixed cost element on not exceeding basis (1+2)

xxx

xxx

xxx

xxx

(B)

Variable cost items on not exceeding basis

xxx

xxx

xxx

xxxx

(C)

Base and Depot (B & D) spares (Budgetary) (With FE

xxxx

Content xx crore) on not exceeding basis

(D)

Grand Total (a+b+c)

xxxxx

Note: The above cost is exclusive of duties and other statutory levies applicable at the time of delivery of the vessel(s) and will be paid at actual.

(ii) Payment Terms:

(a) Fixed price element:

The payment will be made by the buyer against the completion of particular stage.

(b) Variable price element:

1 Opinion finalised by the Expert Advisory Committee on 21.5.2013 and 22.5.2013.

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The payment will be made at actual with % of profit against the documentary evidence.

3.Base and depot (B&D) spares for all 3 ships of this class shall be procured through the company and X % remuneration will be paid on the cost of the item.

4.The contract states that variable cost items indicated as a part of contract price are budgetary and will be paid based on finalised specifications and source of supply nominated by the buyer at actual. Later, the buyer intimated to the querist that certain equipments out of variable cost items, will be supplied by him at ‘free of costfor installation on board of ship. It is, therefore, to be noted that the variable cost items mentioned at paragraph 2(i) (B) in the table above consists of 2 parts as under:

(i)The purchase orders of some equipments are placed by the company in the presence of the buyer’s representative for technical scrutiny as well as negotiating the prices. The vendors of the equipment are paid by the company. The cost of the equipment alongwith the cost of installation and profit thereon is claimed and reimbursed by the buyer to the company.

(ii)There are certain equipments for which orders are directly placed and also paid by the buyer. These equipments are known as ‘Buyer Furnished Equipment (BFE)’ and are delivered to the company ‘free of cost’ for installing in the ship. The labour cost of installation is included in the fixed price component of the contract.

5.Sale on delivery of the ship to customer is reflected in that financial year. During the construction period, work-in-progress (WIP) is valued as under:

a.Where profits can be reliably measured:

“At costs incurred upto the reporting date plus profits recognised under the percentage of completion method in the proportion of the actual costs incurred bear to the estimated total cost to completion as on that date.”

b.Where loss is anticipated:

“When it is probable that total contract costs will exceed the total contract revenue, the expected loss is fully recognised as an expense immediately, irrespective of physical progress achieved on the reporting date.”

(A copy of annual accounts for the financial year (F.Y) 2011-12 has been supplied by the querist for the perusal of the Committee.)

B.Query

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6. From the above, the querist has sought the opinion of the Expert Advisory Committee on the following issues:

(i)Whether the Buyer Furnished Equipment’s (BFE’s) cost can be considered as inventory (simultaneously creating liability to the buyer) and then on issue to ship can be taken in WIP, so that accretion to WIP will be recognised as revenue.

(ii)Whether BFE’s value can be considered as a part of sale value in the year of delivery.

C.Points considered by the Committee

7.The Committee notes that the basic issue raised by the querist relates to whether the Buyer Furnished Equipment (BFE) can be considered as inventory/WIP by the contractor and whether that value can be considered as part of sales value in the year of delivery. The Committee has, therefore, considered only this issue and has not examined any other issue that may arise from the Facts of the Case, such as, accounting treatment of equipments purchased by the company whose value is reimbursed by the buyer, accounting treatment of installation cost on BFE, recognition of contract costs and revenue, method of valuing work-in-progress during the construction period, etc. Further, it is also presumed by the Committee that the risks and rewards of ownership relating to BFEs do not vest with the company.

8.The Committee notes that before any item can be recognised as an inventory, it should meet the definition of ‘asset’ as given in paragraph 49 of the Framework for the Preparation and Presentation of Financial Statements (hereinafter referred to as ‘the Framework’), issued by the Institute of Chartered Accountants of India as follows:

“(a) 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.”

The Committee notes from the Facts of the Case that orders in respect of BFEs are directly placed by the buyer and also payment in respect of them is made by the buyer. These are then supplied to the company for installing in the ship and the buyer pays installation charges which are included in the contract price. Thus, the company has neither incurred any cost on BFEs nor any amount is recoverable on account of such equipments except installation charges. Accordingly, the Committee is of the view that such equipments are not ‘assets’ that may be a considered as a part of its contract work-in progress. In fact, after installation in the ship, BFEs are returned to the buyer after completion of the ship. Thus, these are only held by the company in the capacity of a bailee. Since, these cannot be considered as ‘asset’, therefore, these can neither be considered as ‘inventory’ nor as work-in-progress.

Accordingly, these cannot also be considered as a part of sale value or revenue of the company as no consideration would be receivable in respect of the cost of such equipments.

D.Opinion

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9. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 6 above:

(i)No, the BFEs cannot be considered as inventories/WIP, as discussed in paragraph 8 above.

(ii)No, the BFE’s cost cannot be considered as part of sales value/contract revenue, as discussed in paragraph 8 above.

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4

Query No. 34

Subject:

Accounting treatment of share application money pending for allotment

invested by holding company in subsidiaries.1

A.Facts of the Case

1. Consequent to State Electricity Reforms Transfer Scheme 2000, the erstwhile State Electricity Board (SEB) was reorganised into three corporations namely State Power Corporation Ltd. (SPCL), State Vidyut Utpadan Nigam Ltd. and State Jal Vidyut Nigam Ltd. w. e. f. January 14, 2000. The City Electricity Supply Area was separated as a subsidiary company of SPCL and christened as the City Electricity Supply Company Limited (CESCO) vide State Transfer of K Zone Electricity Distribution Undertaking Scheme, 2000.

The State Power Corporation Ltd. (hereinafter referred to as ‘the company’) is dealing with bulk purchase and sale of electrical power in the State and had a turnover of Rs. 12,197.66 crore in the financial year (F.Y.) 2007-08. It purchases electricity from central generation utilities, state power generation utilities, independent power producers and also from private traders through bilateral purchases, etc. Further, it sells the electrical power to its wholly owned subsidiary companies holding distribution license under the Electricity Act, 2003. These distribution companies were created pursuant to the Transfer Scheme Notification passed by the State Government on August 12, 2003, wherein the distribution business of the company was vested in them.

2. The company is a Government company within the meaning of section 617 of the Companies Act, 1956 and is holding 100% shares in its subsidiaries, which are also

1 Opinion finalised by the Expert Advisory Committee on 21.5.2013 and 22.5.2013.

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Government companies (within the meaning of section 617 of the Companies Act, 1956), as ‘Investments’. The company’s 100% shareholding is with the Governor of the State.

3.The State Government infuses funds by way of equity contribution in the holding company, i.e., the company. These funds are used by the company as per the instructions of the State Government for investing in the shares of its subsidiary distribution companies for creation of capital assets, etc.

4.The funds received from the State Government are invested by the company in the subsidiary distribution companies as ‘share application money’. The allotment process from share application money to share capital rests with the respective subsidiary distribution companies. Pending allotment of share application money, these subsidiary distribution companies have utilised such amounts in the creation of capital assets.

5.The auditors in the course of the audit observed that the subsidiary distribution companies have negative net worth and, accordingly, advised the company to make suitable provisions in the annual accounts for diminution in the value of investments in accordance with Accounting Standard (AS) 13, ‘Accounting for Investments’, considering that such investments in subsidiary distribution companies was made as long- term investment.

6.As per the advice of the auditors, the company made a provision for diminution in the value of investment upto the level of equity shares actually allotted by the subsidiary distribution companies subsequent to the close of the financial year till the date of approval of the accounts of the holding company.

7.The querist has stated that considering that till such time the allotment is made, the contract of contribution to share capital is not complete and the application money is therefore only a liability in the books of subsidiary companies, the provision for

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diminution in the value of investments has not been made for the amount invested in subsidiary distribution companies which has not been allotted by the subsidiaries as equity in the name of the company till the date of approval of accounts.

8.The querist has also stated that the allotment of share application money by the subsidiary companies is pending as their accounts are in arrears and are yet to be audited.

9.At the time of organisation of the SEB in January, 2000 and then at the time of creation of successor distribution companies in August, 2003, the capital assets were allocated on historical cost basis. Such assets of subsidiary distribution companies have not been revalued since their inception. The company and the subsidiary distribution companies have undertaken the revaluation of their assets and this exercise is in progress.

10.According to the querist, considering that the revaluation of assets was in progress till the date of approval of accounts, the fair value of assets of the subsidiaries cannot be determined until and unless the revaluation process is completed and restated balance sheet is prepared. It was contended that since the real value of assets of subsidiary distribution companies is much higher than the book value, the diminution can be worked out only after a fair valuation of shares of distribution companies.

11.In view of the foregoing contentions, the company has made a provision for diminution in the value of investments made in subsidiary distribution companies upto the level of equity allotted by the subsidiary companies.

12.The company’s accounting policy discloses the accounting treatment of investment as under:

“Investments:

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4. Long-term investments in subsidiaries are valued at cost and provision is made for diminution, other than temporary, in the value of such investments.”

13. In the above context, Accountant General, the State under his Review Audit for the F.Y. 2007-08, has commented that the company should consider the amount of share application money (which has not been allotted till the approval of accounts of the company) also while making provisions for diminution in the value of investments.

(Emphasis supplied by the querist.)

B.Query

14. On the basis of the above, the querist has sought the opinion of the Expert Advisory Committee on the following issues:

(i)Whether share application money is to be considered for making provision for diminution in the value of investments even though the shares for the same are yet to be allotted.

(ii)Whether share application money, in respect of which shares are allotted subsequent to the end of the financial year but before the adoption of accounts of the company, should be considered as share capital for the purpose of making the provision for diminution in the value of investments.

(iii)For making provision for diminution in the value of investments, whether the company can consider the fact that the revaluation of assets is under progress and that the fair market value of assets would be higher than the historical value/cost of assets?

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C.Points considered by the Committee

15.The Committee, while answering the query, has considered only the issues raised in paragraph 14 above and has not examined any other issue that may arise from the Facts of the Case, such as, recognition of share application money pending allotment in the financial statements of subsidiary companies, etc. Further, the Committee has presumed that the money has been given to the subsidiary companies as equity contribution and not as grant.

16.The Committee notes that the erstwhile SEB was restructured into three corporations one of which is the company. Further, its electricity distribution business has been divested to wholly owned subsidiary companies of the company. The company as well as its subsidiary companies are Government companies. The State Government infuses funds in the company, which the company uses as per the instructions of the State Government for investing in the shares of subsidiaries. Accordingly, the company has invested the funds received from the State Government as share application money in subsidiary companies some of which is pending for allotment. In this regard, the issue raised is that whether the provision for diminution in the value of investments should be made against the share application money even though the shares for the same are yet to be allotted as on the balance sheet date. The Committee notes the definition of the term ‘Investments’ as defined in AS 13, notified under the Companies (Accounting Standards) Rules, 2006 (hereinafter referred to as the ‘Rules’) and ‘Advance’ as defined in the ‘Guidance Note on Terms Used in Financial Statements’, issued by the Institute of Chartered Accountants of India, as below:

AS 13

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“3.1 Investments are assets held by an enterprise for earning income by way of dividends, interest, and rentals, for capital appreciation, or for other benefits to the investing enterprise. Assets held as stock-in-trade are not ‘investments’.”

Guidance Note on Terms Used in Financial Statements

“1.17 Advance

Payment made on account of, but before completion of, a contract, or before acquisition of goods or receipt of services.”

From the above, the Committee is of the view that although the share application money pending for allotment may not give any benefits to the company (neither dividend, interest, rentals nor capital appreciation) till shares are allotted against it to the company, however, since in the extant case, the money has been given to the subsidiary companies, this application money for shares may be considered to be held ‘for other benefits’. Further, the Committee notes that the money so provided has been utilised by the companies for acquisition of capital assets and all the companies being State Government companies operate as per the instructions of the State Government. Also, paragraph 7 above indicates existence of a ‘contract of contribution to share capital’ against which shares have been allotted after the balance sheet date but before the approval of accounts. The Committee is of the view that all this indicates that irrespective of the fact that whether shares are allotted to the company or not, the money given as share application money would not be refundable to the company. Therefore, considering ‘substance over form’, the Committee is of the view that these are of the nature of long-term investments. Accordingly, provision for diminution in the value of investments other than temporary should be considered against the same. Further, the Committee is the view that it should be disclosed in the financial statements with an appropriate nomenclature and notes to accounts so as to give the correct picture of the situation, viz., shares are yet to be allotted against these investments. The Committee is also of the view that even if shares are

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allotted against such application money after the balance sheet date, but before the adoption of accounts, there is no need for disclosing it as ‘shares’ till the date of allotment, as it is taking place in the subsequent year. However, additional disclosures regarding allotment (which takes place in subsequent year before adoption of accounts) may be made in the financial statements. The Committee is further of the view that had the subsidiary companies reserved the right to simply refund the money without allotting the shares then it should have been treated as an ‘advance’ rather than ‘investment’ till such shares are allotted to the company. The Committee is of the view that in that case also, the company should examine the recoverability of the said advance and, accordingly, an appropriate provision should be made against such advance as per the Generally Accepted Accounting Principles.

17. As regards making provision for diminution in the value of investments, the Committee notes paragraphs 17 and 32 of Accounting Standard (AS) 13, ‘Accounting for Investments’, notified under the Rules, as reproduced below:

“17. Long-term investments are usually carried at cost. However, when there is a decline, other than temporary, in the value of a long term investment, the carrying amount is reduced to recognise the decline. Indicators of the value of an investment are obtained by reference to its market value, the investee’s assets and results and the expected cash flows from the investment. The type and extent of the investor’s stake in the investee are also taken into account. Restrictions on distributions by the investee or on disposal by the investor may affect the value attributed to the investment.”

“32. Investments classified as long term investments should be carried in the financial statements at cost. However, provision for diminution shall be made to recognise a decline, other than temporary, in the value of the investments, such reduction being determined and made for each investment individually.”

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On the basis of the above, the Committee is of the view that in the case of long-terminvestments, only where there is a decline, other than temporary, in the value of investments, the carrying amount is reduced to recognise the decline. The Committee is further of the view that to determine whether there is a decline other than temporary, in the value of investments, an assessment should be made keeping in view the value of the assets of the subsidiaries, its results, the expected cash flows from the investment, etc. Such an assessment should be made on an individual investment basis. In determining the value of investment, fair value of the underlying assets of the subsidiaries may also be considered.

D.Opinion

18. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 14 above:

(i)Yes, in the extant case, as discussed in paragraph 16 above, since the money would not be refundable to the company, share application money pending for allotment should be considered as long-term investment while making provision for diminution in the value of investments. Even if the share application money would have been refundable and as such, shown as ‘advances’, an appropriate provision should be made based on their recoverability as discussed in paragraph 16 above.

(ii)and (iii) Refer to paragraphs 16 and 17 above.

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3

Query No. 31

Subject:

Adjustment of losses on sale of fixed assets, writing-off inventory and

doubtful receivables against capital reserves arising out of acquisition of

business, capital redemption reserves and revaluation reserves.1

A.Facts of the Case

1. A company (hereinafter referred to as ‘the company’) is a 50:50 joint venture between two companies. The company is in the business of manufacture and sale of power/telecom cable joining kits, transformers, gas meters, energy meters & corrosion protection products and providing services. During the financial year 2010-11 (i.e., w. e. f. September 24, 2010), the company acquired the energy business, consisting of manufacture and sale of connectors, fittings and insulation products from another company, ‘A’ Pvt. Ltd, Bangalore, on going concern basis under slump sale agreement. Based on valuation report from an independent valuer, the company has recognised fixed assets, inventories and liabilities at fair value and a capital reserve of Rs. 1476.72 lakh being excess of assets acquired over purchase consideration paid. A detailed working of the same has been supplied by the querist for the perusal of the Committee. Apart from theabove-mentioned capital reserve, the company also has capital redemption reserve and revaluation reserve in its books as on 31.03.2011. The break-up is as follows:

Rs. in lakh

Capital reserve created as above

1476.72

Revaluation reserve

82.17

Capital redemption reserve

250.00

1808.89

2. During the financial year 2012-13, the company has passed the following two entries by debiting the above capital reserve:

1 Opinion finalised by the Expert Advisory Committee on 7.2.2013.

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(i)Non-moving inventory acquired out of the above acquisition amounting to Rs. 1,06,813.10 written off by debiting the above capital reserve.

(ii)Fixed assets acquired out of the above acquisition have been scrapped and loss amounting to Rs. 1,04,117.81 has been debited to the above capital reserve.

From the above, it can be summarised that the company has adjusted the following losses against the above reserves:

(i)Any loss/likely loss on sale/disposal of some of the fixed assets acquired from ‘A’ Pvt. Ltd.

(ii)Any shortages/write-off in inventory taken over from ‘A’ Pvt. Ltd. and transferred to Baroda (new manufacturing facility) from Bangalore on acquisition of business.

(iii)Old and doubtful receivables pertaining to any of the business of the company.

B. Query

3. In this context, the querist has sought the opinion of the Expert Advisory Committee as to whether the correct accounting treatment has been applied by the company by debiting the above-mentioned reserves as per the provisions of the Accounting Standards and the Companies Act or any other law.

C.Points considered by the Committee

4. The Committee notes that the basic issue raised by the querist relates to adjustment of losses on sale/disposal of fixed assets, writing-off inventories and old and doubtful receivables against capital reserves created from business acquisition, and capital redemption reserves and revaluation reserves already standing in the books 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, such as, valuation of assets and liabilities acquired

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by the company, detailed aspects of accounting for acquisition of energy business by the company, recognition of capital reserves, recognition of impairment loss on assets as per AS 28, etc. The Committee wishes to point out that as per Rule 2 of the Advisory Service Rules, the Committee has answered the issue only from accounting point of view and not from the angle of interpretation of any legal enactments, etc. The Committee notes that the Companies Act, 1956 does not specifically contain any provision for utilisation of capital reserve and revaluation reserve. Further, Companies Act, 1956 does not envisage utilisation of capital redemption reserve for writing off losses on sale of fixed assets as well as for writing-off inventory and doubtful receivables. Accordingly, the relevant accounting standards as applicable to the circumstances mentioned above have been considered for expressing the opinion given hereinafter.

5. As regards accounting for loss/likely loss on sale of fixed assets, the Committee notes paragraphs 24 to 26 and paragraph 32 of Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, notified under the Companies (Accounting Standards) Rules, 2006 (hereinafter referred to as ‘the Rules’) which are reproduced below:

“24. Material items retired from active use and held for disposal should be stated at the lower of their net book value and net realisable value and shown separately in the financial statements.

25.Fixed asset should be eliminated from the financial statements on disposal or when no further benefit is expected from its use and disposal.

26.Losses arising from the retirement or gains or losses arising from disposal of fixed asset which is carried at cost should be recognised in the profit and loss statement.”

“32. On disposal of a previously revalued item of fixed asset, the difference between net disposal proceeds and the net book value should be charged or credited to the profit and loss statement except that to the extent that such a loss is related to an increase which was previously recorded as a credit to revaluation reserve and

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which has not been subsequently reversed or utilised, it may be charged directly to that account.”

From the above, the Committee notes that losses arising on sale or disposal of fixed assets should be recognised in the statement of profit and loss. However, in case of a previously revalued item, the loss to the extent it is related to an increase which was previously recorded as a credit to revaluation reserve and which has not been subsequently reversed or utilised, is charged directly to that account (revaluation reserve). From the Facts of the Case, the Committee presumes that revaluation reserve which stands in the books of the company does not pertain to the transferor company. In other words, revaluation reserve does not pertain to the assets acquired by the company in business acquisition. Thus, the losses arising on sale or disposal of fixed assets cannot be adjusted against revaluation reserve of the company. Accordingly, the the losses arising on sale of fixed assets acquired by the company in business acquisition should be recognised in the statement of profit and loss. Further, as regards likely/expected loss on sale of fixed assets, the Committee is of the view that as per the existing accounting framework, only ‘incurred’ losses are recognised. However, in the context of assets retired from active use and held for disposal, there is possibility that the company may expect loss on their disposal due to difference between their net realisable value and net book value, which again as per AS 10 should be recognised in the statement of profit and loss. On the basis of the above, since the losses on sale or retirement of fixed assets are to be recognised in the statement of profit and loss, the question of their adjustment against capital reserves and capital redemption reserves does not arise.

6. As regards accounting for non-moving inventories, the Committee is of the view that these represent obsolescence of inventories which would be reflected in the determination of net realisable value of the inventories. In the context of writing down the inventories to their net realisable value, the Committee notes the following paragraphs of Accounting Standard (AS) 5, ‘Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies’, notified under the ‘Rules’:

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“5. All items of income and expense which are recognised 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.”

“12. 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.”

“14. Circumstances which may give rise to the separate disclosure of items of income and expense in accordance with paragraph 12 include:

(a) the write-down of inventories to net realisable value as well as the reversal of such write-downs;

…” (emphasis supplied by the Committee)

From the above, the Committee is of the view that write-off of non-moving inventory should be included in the statement of profit and loss.

7. Further, as regards write-off of inventories due to shortages observed in the acquisition of business and writing off of old and doubtful receivables, the Committee is of the view that these represent losses. In this regard, the Committee notes the following paragraphs of the Framework for the Preparation and Presentation of Financial Statements, issued by the Institute of Chartered Accountants of India:

“77. The definition of expenses encompasses those expenses that arise in the course of the ordinary activities of the enterprise, as well as losses. Expenses that arise in the course of the ordinary activities of the enterprise include, for example, cost of goods sold, wages, and depreciation. They take the form of an outflow or depletion of assets or enhancement of liabilities.

78. Losses represent other items that meet the definition of expenses and may, or may not, arise in the course of the ordinary activities of the enterprise. Losses represent

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decreases in economic benefits and as such they are no different in nature from other expenses. Hence, they are not regarded as a separate element in this Framework.

79. Losses include, for example, those resulting from disasters such as fire and flood, as well as those arising on the disposal of fixed assets. The definition of expenses also includes unrealised losses. When losses are recognised in the statement of profit and loss, they are usually displayed separately because knowledge of them is useful for the purpose of making economic decisions.”

From the above, the Committee is of the view that losses also represent expenses and accordingly, these should be charged to the statement of profit and loss as per the requirements of paragraph 5 of AS 5. Accordingly, the Committee is of the view that anywrite-off of inventories and receivables cannot be adjusted against capital reserves, capital redemption reserves and revaluation reserves.

D.Opinion

8. On the basis of the above, the Committee is of the opinion that accounting treatment followed by the company of debiting capital reserves, capital redemption reserves and revaluation reserves in respect of losses arising on (i) retirement or sale or disposal of fixed assets, (ii) writing-off of inventory, and (iii) writing-off of doubtful receivables is not correct as per the provisions of the Accounting Standards as discussed in paragraphs 5, 6 and 7 above.

________

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2

Query No. 15

Subject:

Revenue recognition in case of project managers.1

A.Facts of the Case

1.A public sector company (hereinafter referred to as ‘the company’) registered under the

Companies Act, 1956, is engaged in construction and operation of Hydro Electric Power Projects. In addition to construction and operation of Hydro Electric Power Projects, being a central public sector undertaking, the company is also engaged in project management/consultancy and other construction contracts on behalf of other agencies on deposit work basis generally not on profit and loss basis. These assignments are either related to own projects of the company or work has been entrusted to the company by the Government of India (GoI). None of the assignments as aforesaid is taken up by the company by bidding like a contractor (emphasis provided by the querist). For carrying out these assignments, the company acts as an agent of the agency on whose behalf said deposit work is done and there is no principal to principal relation between the company and the said agency. One of such assignments is for formulation and implementation of Rajiv Gandhi Gramin Vidyutikaran Yojna

(hereinafter referred to as the ‘RGGVY’). The company is carrying out these assignments in a

number of states on behalf of respective states. The brief background as well as the modus

operandi for carrying out these assignments are as under:

Under the Bharat Nirman programme of the Government of India, the Ministry of Power (MoP) has been entrusted with the formulation and implementation of the RGGVY. The RGGVY aimed at electrifying all villages and habitations and

providing access to electricity to all rural households of the country through

Central Public Sector Undertakings (CPSUs), since the CPSUs have the

1 Opinion finalised by the Committee on 16.7.2013

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technical and professional competence and expertise to implement such a scheme

on a massive scale.

A Memorandum of Understanding (MoU) was signed on 14th July, 2004 between a funding company and the company with the objective to be associated in the formulation and implementation of projects under the programme in association with the concerned State Government/power utility. In accordance with the said MOU, the company entered into agreements with the GoI, State Governments and State Power Utilities (SPUs) for implementation of projects in those states on behalf of the State Governments/SPUs. Under the said MOU, the funds required for the execution of the project are released directly to the company by the GoI through the funding company including 12% service charges. The company is responsible for selecting executing agencies (contractors) through open tenders.Project-wise separate contracts namely ‘Supply Contracts’ and ‘Erection Contracts’ are entered into between the company and the selected contractors, for execution of the work. At no point of time, GoI, State Government or SPU enters into any kind of contract with the contractors. The contractor company furnishes a performance bank guarantee in favour of the company for executing the work. Further, the responsibility of levying and collecting the liquidated damages, if any, from the contractors is that of the company and, the amount so recovered will be adjusted in the project cost. Relevant extracts of MOU entered between funding company and the company are given hereinbelow by the querist for ready reference:

“Clause 4: Role of the company:

4.1

(a)The company shall undertake these projects on deposit work basis (in suitable installments) on behalf of the borrower/owner of the project after a separate multilateral agreement is entered into as stated hereinabove.

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(b)The company shall be responsible for formulation, development and implementation of the projects in the identified area involving systemplanning, design, engineering (in accordance with the GoI’sguidelines, specifications and construction standards, wherever applicable) and procurement in accordance with agreed competitive bidding procedures.

(c)The projects shall be implemented by the company in a time bound manner as scheduled in the approved projects and projects so implemented by the company will be taken over immediately after their completion by the concerned State Government/State Power Utility, who will be responsible for proper operation and maintenance thereafter.

(d)If the State Government/State Power Utility so desires, the company may consider taking up operation and maintenance of the completed projects on mutually agreed terms and conditions under a separate agreement with that State Government/State Power Utility.

4.2 If the State Government/State Power Utility so desires, the role of the company may be limited to:

(a)Project monitoring and supervision of quality of works during construction, or

(b)Formulation and preparation of project reports based on the details provided by the concerned State Government/State Power Utility, arranging project approvals, providing advisory support during procurement, if required, and project monitoring and supervision ofquality of works during construction. …”

Clause 5: Project Execution and Development Expenditure

5.1

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(a)The projects to be implemented by the company under this agreement shall be funded by the GoI from the funds sanctioned to the State Government/ State Power Utility under Accelerated Electrification of Villages and Households Programme.

(b)The funds for the execution of the projects shall be released by the GoI directly to the company, including service charges as per agreement to be executed with the borrower/owner of the project under suitable multilateral arrangements, which shall be legally enforceable.

(c)Separate accounts for development and implementation of such GoI funded projects shall be maintained by the company.

(d)the company shall be entitled to service charges of 12% of project cost on pro-rata basis and the same may be included in the project cost. Further, additional statutory taxes payable by the company shall also be reimbursed.

5.2 Service charges payable to the company shall be 2% and 5% of the project cost on pro-rata basis for the scope of services as defined against clauses 4.2 (a) and 4.2 (b) respectively and the same may be included in

the project’s cost. Further, additional statutory taxes payable by the company shall be reimbursed. …”

Relevant extracts of Agreement between the funding company, State Government, SPU and the company entered separately for each state have been provided by the querist as under:

“3.0 Construction / Implementation

3.1The company shall make all possible efforts to complete the project(s) within the approved time frame starting from the date of release of the first installment of funds by the GoI.

3.2The company shall specify quarterly milestones, and progress shall be reviewed with reference to these milestones jointly by the GoI, authorised

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representative of State Government, State Electricity Board and the company in quarterly Performance Review Meetings.

3.3The company shall suitably incorporate the provisions towards levy of liquidated damages in their agreements with contractors for delay in completion of the project(s) and also other relevant contractual provisions pertaining to the procurement of goods and works. Declaration in this regard shall be furnished by the company before setting the actual expenditure on the project in line with the provisions under clause 1.3 (g) of this agreement. All amounts towards liquidated damages, if any, as may be recovered by the company under this provision, shall be suitably adjusted in the project cost.

3.4(a) The company shall ensure that its own quality control systems and inspection are adopted in the implementation of these projects.

(b) The best cost control measures shall be enforced by the company during implementation through appropriate management and control systems.

(c) On behalf of the project authority (State Government and SEB), the company shall ensure that the equipment & material specifications and

construction practices & standards are as those approved/stipulated by the

Funding Company. …”

2. Accounting treatment being followed by the company in respect of the above type of work is described as under:

The company is recognising revenue in the statement of profit and loss to the extent of agency fees proportionate to the work executed in the year and establishment and administration expenses actually incurred are charged to the statement of profit and loss. The direct work cost (executed by the contractor) is directly adjusted against the advance / funds received from the funding company on behalf of the State Power Utilities / State Government. Accounting on net basis is being done because of the following:

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As per the MOU, it is clear that the ownership of the entire work shall vest with the various State Governments/State Power Utilities. The company works only as an agent on their behalf and the funds are provided by the Government of India under a fiduciary relationship of principal and agent. This definition ofownership is contained in clause 1.0 of ‘Funding Company Guidelines for procurement of goods and services’ under the chapter ‘Invitation to Bids’,

which is reproduced below:

“______ *** has been entrusted by ____** with the concurrence of Government of ____* for execution of XYZ Ltd. for electrification of villages and rural households in the _______ district(s) of ______*. The execution of the project shall be funded out of the proceeds of the financial assistance to be received by Government of ___* from XYZ Ltd. and all

eligible payments for the execution of the project under the intended contract shall be made by the _____*** under suitable arrangement with

___**. The ownership of the project shall remain vested with ___**.”

(*** stands for ‘the company’, ** stands for ‘name of SPU’ and * stands for ‘the State Government’.)

The company is to utilise the funds as per the terms and conditions of the MOU and after meeting the actual expenses on the work, the balance is to be refunded.

The statutory deduction of taxes and duties at source related to these works shall be done by the company on behalf of the State Power Utilities and TDS so deducted shall be deposited with the relevant tax authorities on their behalf. TDS certificates shall also be issued on their behalf by utilising PAN/TAN/TIN of the State Power Utilities.

All invoices under the construction contracts, awarded by the company, shall be raised by the contractor on “State Power Utilities acting through the company” and all payments shall be made to the contractor by the company onbehalf of State Power Utilities.

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The way-bills/road-permits are also being issued by the owner, i.e., the State Power Utilities.

Liquidated damages recovered by the company from contracting company, to whom the work has been awarded by the company on behalf of SPU, is also to be passed on to the respective SPU/State Government.

The company works as agent on behalf of the concerned SPU / State Government, thereby having no risk and reward of its own, so far as directwork cost on the assignment is concerned. The company’s reward is only to theextent of its agency fees and only risk associated in this assignment is incurring of loss in case expenditure incurred on establishment and administration (indirect expenditure) happens to be more than the agency fees. It clearly shows that the company acts as an agent of the State Government and is not a contractor.

As such, the company is performing these services as an implementing agency on nomination basis and not as a contractor as ownership of the assets always vests with the State Power Utilities. Therefore, Accounting Standard (AS) 7,

‘Construction Contracts’, is not applicable. However, for the purpose of measurement of revenue as aforesaid, proportionate completion method asstipulated in Accounting Standard (AS) 9, ‘Revenue Recognition’/AS 7 is beingfollowed. Disclosure as regard to advance received, work done and revenue earned during the reporting period is given in the financial statements.

3.The querist has stated that the above accounting treatment is in conformity to the recent opinion of Expert Advisory Committee (EAC) given in respect of one of the subsidiaries of a power sector company executing the rural electrification work under RGGVY. The querist has also provided the relevant extracts of the opinion referred to by it.

4.Significant accounting policy of the company in respect of accounting of aforesaid assignment is reproduced below:

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“10.2 In respect of Project Management/Consultancy Contracts/Cost plus Contract, revenue

is recognised based on the terms of agreement and the quantum of work done under the

contract.”

5.For such assignments, revenue recognition principle i.e., proportionate completion method as enunciated in AS 9 / AS 7 is being followed for the computation of revenue only. However, other disclosures warranted by AS 7 were not given in the financial statements in view of the explanation given in paragraph 2 above read with the EAC opinion referred in paragraph

3above (emphasis supplied by the querist).

6.During the audit of accounts for the financial year (F.Y.) 2011-12 of the company, the Government auditor had raised an observation on the accounting treatment being followed by the company in respect of aforesaid assignment. The observation of the audit is reproduced below:

“In terms of the Accounting Policy No. 10.2 in respect of revenue, the Company has

recognized the revenue in respect of Project Management / Consultancy / Construction Contracts on the basis of Contract Agreement and quantum of work done under the contract. During review of the Profit & Loss Account, it has been observed that the company has recognized the revenue of Rs. 131.42 crore on account of Rural Electrification / Construction Contracts and other different works assigned by different agencies having long terms cycle contracts falling under the category of Accounting Standard 7 in terms of different opinions of Expert Advisory Committee of the ICAI. As such, the provisions of the Accounting Standard 7, i.e., Construction Contracts should have been followed and accordingly, an accounting policy with other treatment as required in compliance of AS 7 should have been followed with following disclosures at the reporting date:

1.the amount of contract revenue recognised as revenue in the period;

2.the methods used to determine the contract revenue recognised in the period;

3.the method used to determine the stage of completion of contract in progress;

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4.the aggregate amount of cost incurred and recognised profits (less recognised losses) upto the reporting date;

5.the amount of advances received and

6.the amount of retentions.

As such, accounts are deficient to that extent and needs to revisit the treatment given in

the Profit and Loss Account and Balance Sheet.”

However, after referring to the aforesaid opinion of EAC, the auditors did not press further the observation as far as recognition of revenue is concerned. But they insisted on the following disclosures in the accounts:

(a)Accounting policy of the company should be modified so as to disclose that revenue is being recognised on proportionate completion method and the method used to determine the stage of completion;

(b)Disclosure as required in AS 7 should invariably be given in respect of all the assignments.

In view of the above audit observation, Accounting Policy No.10.2 of the company has been re-

worded during F.Y. 2012-13 as under:

“Revenue on Project Management / Construction Contracts / consultancy assignments is

recognised on percentage of completion method. The percentage of completion is determined

as proportion of “cost incurred up to reporting date” to “estimated cost to complete the concerned Project Management / Construction Contracts and consultancy assignment”.

B.Query

7. On the basis of the above, it is contended by the company that AS 7 is not applicable in case of such assignments, though the revenue is being recognised on proportionate completion method. The company is of the view that the recent EAC opinion referred to above is quite clear and supports the accounting treatment of the company in respect of such assignments. However, since the above referred EAC opinion is silent on the issue of disclosure requirements as per AS

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7, which has been pointed out by the Government auditors at paragraph 6 above, opinion of EAC

has been sought by the querist on the following issues:

(i)Whether AS 7 is attracted to such assignment.

(ii)In case AS 7 is attracted, whether its application is limited to recognition of revenue only, as opined by EAC in its above referred opinion, or all disclosures as given in AS 7 are also warranted.

(iii)In case disclosures are to be given, whether disclosure related to aggregate amount of cost incurred and recognised profit (less recognised losses) upto the reporting date should be given for the entire project cost i.e., (sum of direct work cost and establishment & administrative cost) or the cost relating to agency fees, i.e., establishment & administrative cost only.

C.Points considered by the Committee

8. The Committee notes that the basic issues raised by the querist are related to applicability of AS 7 in the extant case in relation to recognition of revenue in the context of RGGVY assignment undertaken by the company and its disclosure requirements. Therefore, the Committee has examined only these issues and has not examined any other issue that may arise from the Facts of the Case, such as, revenue recognition policy to be followed for other projects viz., owned projects and other construction contracts, accounting policy to be followed for operation and maintenance of the project after its implementation, propriety of arrangement for compliance of provisions of income-tax/deduction of TDS on payments as per the provisions ofIncome-tax Act, 1961, or interpretation of the terms of the agreements or MoUs entered into with the State Government or State Power Utilities, or sub-contractors or funding company, treatment of establishment and administrative expenses incurred by the company as direct or indirect cost in the books of the company, etc. Further, the Committee wishes to point out that its opinion is expressed purely from the accounting point of view. The Committee notes that while varioussub-clauses of clause 4 of MoU between the funding company and the company indicate that SPU is one of the project authority, clauses 3.2 and 3.4 (c) of the Agreement between funding company, State Government, SPUs and the company indicate SEB to be the project authority.

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Accordingly, the Committee presumes that SPUs and/or SEBs are project authorities along with the State Government.

9. With regard to recognition of revenue, the Committee notes paragraph 17(b) of

Accounting Standard (AS) 1, ‘Disclosure of Accounting Policies’, notified under the Companies (Accounting Standards) Rules, 2006 (hereinafter referred to as the ‘Rules’), which is reproduced

below:

“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.”

In view of the above, 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 in

accordance with their legal form. In other words, it is the ‘economic reality’ that is important in accounting and not only the ‘legal reality’. In the extant case, the Committee notes from the

Facts of the Case that while the company is responsible for formulation and implementation of the projects in accordance with the agreed procedures, the actual execution is being done through other agencies/parties. Further, the Committee notes that while the legal form is that all the documents, such as, bidding documents, notification to executing agencies, contract and letter of award or even the guarantees given by the executing agencies etc., are in the name of the company, the substance of the transaction is that the company is acting only as an agent of the State Government/SPU/ SEB as significant risks and rewards related to the project vest with the State Government/SPU/SEB which is clear from the following facts:

(a)It has been specifically stated in clause 4.1 (a) of MOU between the funding company and the company that the company shall undertake these projects on deposit work basis on behalf of the borrower/ owner of the project.

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(b)Clause 3.4 of Agreement between the funding company, State Government, SPU and the company clearly reflects that the company is just acting under the instructions/ specifications of the funding company, the nodal agency appointed by the Government of India.

(c)It is clearly stated that the State Governments / SPUs would be the owner of the project.

(d)It is stated that the company gets only a fixed percentage of income as service charges depending on the nature of contract awarded to it and the only risk associated in this assignment is incurring of loss in case expenditure incurred on establishment and administration happens to be more than the agency fee. From this, it appears that the company is not incurring any cost directly related to the project.

(e)Although the company has the right to recover liquidated damages from the executing agencies but the same are adjustable against the project cost. Thus, neither such cost is borne by the company nor such recovery benefits the company. In other words, all significant risks and rewards related to the business are assumed either by the owner (State Government/SPU/SEB) or executing agencies.

10.On the basis of the above, the Committee is of the view that since the significant risks and rewards related to the ownership of project do not vest with the company, the costs and revenues related to the construction of the project and the procurement of products as per the project should not be recognised in the books of account of the company. The Committee is further of the view that as the company is merely providing services in relation to construction/procurement to the State Governments/ SPUs for which it is receiving fixed service charges, keeping in view the consideration of substance over form as explained above, the company should recognise only the service charges received in consideration of its services as its

revenue. In this regard, the Committee also notes paragraphs 10 and 11 of Accounting Standard

(AS) 7, ‘Construction Contracts’, notified under the ‘Rules’, which provide as follows:

“10. Contract revenue should comprise:

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(a)the initial amount of revenue agreed in the contract; and

…”

“11. Contract revenue is measured at the consideration received or receivable. …”

On the basis of the above, the Committee is of the view that since the consideration being received by the company out of its contract for rendering of services is a fixed percentage of the project cost, the same should be considered as contract revenue of the company in the extant case.

11. As regards application of AS 7 in the extract case, the Committee notes that for execution

of the projects, the company enters into ‘supply’ and ‘erection’ contracts with the selected

contracting companies (sub-contractors/executing agencies). Thus, the company is rendering services directly related to the construction as in case of project managers and accordingly, AS 7 is applicable in the extant case. In this connection, the Committee notes paragraph 4 of AS 7,

notified under the ‘Rules’, which is reproduced below:

“4. For the purposes of this Standard, construction contracts include:

(a)contracts for the rendering of services which are directly related to the construction of the asset, for example, those for the services of project managers and architects; and

(b)…”

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Accordingly, the Committee is of the view that the principles of AS 7 should be applied while recognising revenue (viz., service charges) from the services rendered as well as while considering disclosures as per AS 7. The Committee is further of the view that since, in the extant case, contract revenue is the service charges, same should be considered while providing disclosures as per AS 7. Similarly, contract cost would be restricted to the cost incurred in relation to its service contract, as per the principles of AS 7.

D.Opinion

12. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 7 above:

(i)AS 7 is applicable to the assignments in the extant case, as discussed in paragraph 11 above.

(ii)Application of AS 7 is not limited to recognition of revenue only and accordingly, all disclosures as per AS 7 are also warranted.

(iii)Since, in the extant case, contract revenue is the service charges, same should be considered while providing disclosures as per AS 7. Similarly, contract cost would be restricted to the cost incurred in relation to its service contract, as per the principles of AS 7.

_________

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1

Query No. 13

Subject:

Treatment of disputed elements of cost in valuation of inventory of raw

material.1

A.Facts of the Case

1.A company (hereinafter referred to as ‘A Refinery Ltd.’ or ‘A Ltd.’), a Government of

India undertaking, is engaged in refining of crude oil having a refining capacity of 3 MMTPA. A Ltd. is jointly-owned by other public sector undertakings and a State Government (SG). It is engaged in production of petroleum products, i.e., high speed diesel, motor spirit, aviation turbine fuel, superior kerosene oil, liquified petroleum gas, naphtha, sulfur, raw petroleum coke and calcined petroleum coke. The refinery is the fourth refinery in the State.

2.A Ltd. has stated that it shares transportation cost on crude with X Refinery and

Petrochemicals Limited (hereinafter referred to as ‘X Refinery Ltd.’ or ‘X Ltd.’) and certain

elements of this transportation cost are disputed. The company has accounted for these disputed elements as a part of its raw material cost and considers the same also for closing inventory valuation. There is a difference of opinion on the present accounting treatment as to whether such disputed elements should be considered for inventory valuation or not.

3. There are four refineries located in the North East (NE) having an overall refining capacity of 7 MMTPA as detailed below:

1 Opinion finalised by the Committee on 21.5.2013 and 22.5.2013

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Refinery

Company

Refinery Capacity

B Refinery

Z Ltd.

0.65 MMT per annum

C Refinery

Z Ltd.

1.00 MMT per annum

X Refinery

Z Ltd.

2.35 MMT per annum

A Refinery

A Refinery Ltd.

3.00 MMT per annum

Against crude oil refining capacity of 7 MMTPA, crude oil availability in the State is only around 4.50 MMTPA which is delivered to the 4 NE Refineries from the crude oil fields owned by Z Ltd./D Ltd. in the State. In view of low availability of State crude at 4.50 MMTPA, the overall refining capacity of the North East is not fully utilised and, therefore, with a view of optimising the refining capacity in the North East, the Ministry of Petroleum &

Natural Gas (hereinafter referred to as MOP&NG or ‘the Ministry’) allocated 1.5 MMTPA of

Ravva PSC crude effective from 1st April, 2003 to X Refinery Ltd. MOP&NG vide letter

reference no. P-20029/67/02 PP dated 18th February, 2003 stated that consequent upon the allocation of 1.5 MMTPA of Ravva PSC crude oil to X Refinery Ltd., the total crude oil availability for the North East refineries for the financial year 2003-04 would go up by 1.5 MMTPA over and above the State crude oil quantity. This additional 1.5 MMTPA Ravva crude along with the State crude would be re-apportioned among the four North East refineries in proportion to their installed capacities and in case of X Refinery Ltd., quantity re- apportioned above would comprise of 1.5 MMTPA of Ravva crude oil and the balance quantity would be made up by the State crude oil. It was also decided that the additional transportation cost of Ravva crude over the State crude would be shared by all the North East refineries in the proportion in which crude availability to the North East refineries is individually augmented on account of the enhanced reallocation.

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4.Thus, crude oil transported in two sectors is as follows:

a)Haldia to Barauni through pipeline owned by Z Ltd.

b)Barauni to X Refinery through pipeline owned by another company, E Limited.

As per MOP&NG instructions, the additional transportation cost of Ravva crude over the State crude would be shared by all the North East refineries in the proportion in which crude availability to the North East refineries is individually augmented. This additional transportation cost is to be shared by the 4 NE Refineries, as transportation cost of Ravva crude is higher than the transportation cost of the State crude which is available locally and X Refinery Ltd. is foregoing its share of the State crude to the other 3 NE Refineries as it processes both Ravva crude (1.50 MTPA) and balance State crude.

5. The querist has further stated that X Refinery Ltd. is debiting the additional transportation cost incurred for Ravva crude to the other 3 NE Refineries on a year to year basis from the financial year 2003-04 on the quantity of augmented crude received by each refinery. Transportation cost consists of elements like service tax, entry tax, terminalling charges, marine insurance, agency fee, etc. As the MOP&NG instructions did not indicate the elements of additional transportation cost, the same was discussed with X Refinery Ltd. and certain elements were agreed to between the two main parties i.e., X Refinery Ltd. and A Refinery Ltd. Although A Refinery Ltd. is not agreeable to some of the elements of this additional transportation cost debited by X Refinery Ltd., provisions are being made in the books of account based on the debits raised by X Refinery Ltd.; however, payments have been

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released only for the agreed items. The elements of additional transportation cost agreed and

not agreed to by A Refinery Ltd. are as under:

6.Elements of additional transportation cost agreed to by A Refinery Ltd. for which payments are regularly made to X Refinery Ltd.:

(a)Ocean freight, bunker charges, insurance upto port and other import related costs,

(b)Pipeline freight for movement from port to X Refinery Ltd.,

(c)Pipeline consumption and ocean loss,

(d)Entry tax payable on the additional transportation cost on entry of Ravva crude into the State.

7.However, some elements of additional transportation cost debited by X Refinery Ltd. have not been agreed to by A Refinery Ltd. and the same are currently under dispute as detailed below:

(a)The State Freight Savings adjustment – All the 4 NE refineries have to pay crude oil pipeline transportation cost to Z Ltd./D Ltd. on the State crude oil received at each refinery. As the other 3 NE refineries are receiving higher quantity of the State crude through this exercise, they have already incurred the State crude transportation cost and this cost should be reduced from the additional transportation cost of Ravva augmented crude to be borne by each refinery. The calculation methodology of this State freight savings is under dispute.

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(b)Entry Tax element – Further, on account of the difference in opinion of the State freight savings, A Refinery Ltd. is also settling the entry tax on a lower net transportation cost.

(c)Other issues Disputes are also towards quantity of loss on elements such as ocean loss, pipeline loss incurred on Ravva crude transportation.

8. The differential on account of the above differences, i.e., difference in opinion on the State Freight Savings cost and the entry tax on the same, and high element of ocean and transportation loss on Ravva crude movement through ship and pipeline, is accounted for as a

liability in A Refinery Ltd.’s books of account and debited to raw material cost, i.e., part of

the crude cost, though no payment is being made to X Refinery Ltd. for these differentials. Further, as these items are being accounted for as a part of the raw material cost, the same are also considered for the purpose of closing inventory valuation. Though the amount is disputed, negotiations are going on against the disputed elements.

9.A Refinery Ltd. is considering all the elements as part of inventory cost in line with

paragraph 6 of Accounting Standard (AS) 2, ‘Valuation of Inventories’, which states, “The

cost of inventories should comprise all costs of purchase, costs of conversion and other

costs incurred in bringing the inventories to their present location and condition.”

10. A Refinery Ltd. has included the disputed amount of Ravva crude transportation cost as a part of crude oil cost and the closing inventory valuation of crude oil and provision for the same has been made in the books of account following a conservative approach. The

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querist has separately clarified that the disputed amount has been provided for as a liability

and disclosed in its balance sheet under ‘sundry creditors’ and not as a provision.

11.A Refinery Ltd.’s auditors, during the audit for the financial year 2011-12, have raised an objection for inclusion of disputed amount of Ravva crude transportation cost in crude inventory valuation. In the opinion of the auditors, as per AS 2, no abnormal (disputed) amount should be considered for valuation of closing stock. Thus, inclusion of disputed amount of liability has resulted in inflation of closing stock with corresponding overstatement of profit.

12.A Refinery Ltd. is of the view that amount that is disputed by it is not an abnormal item but a difference in calculating the net amount (rate) payable on account of Ravva crude

transportation. Again, as per paragraph 13 of AS 2, following costs are to be excluded:

“(a) abnormal amounts of wasted materials, labour, or other production costs;

(b)storage costs, unless those costs are necessary in the production process prior to a further production stage;

(c)administrative overheads that do not contribute to bringing the inventories to their

present location and condition; and

(d) selling and distribution costs.” (Emphasis supplied by the querist.)

As disputed amounts are not abnormal items and the disputes are purely commercial in nature, A Refinery Ltd. has been considering the same as part of inventory cost.

B.Query

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13. On the basis of the above, the querist has sought the opinion of the Expert Advisory Committee as to whether the procedure followed by A Refinery Ltd. for valuation of inventory with inclusion of disputed items of additional transportation cost for which no agreement has yet been reached between two parties as a part of cost of crude oil is correct or not.

C.Points considered by the Committee

14.The Committee notes that the basic issue raised in the query relates to the inclusion of additional transportation cost which is under dispute in the aggregate cost of inventory. The Committee has, therefore, considered only this issue and has not examined any other issue that may arise from the Facts of the Case, such as, appropriateness of inclusion of various components of the additional transportation costs in the cost of inventories, appropriateness of creation of liability/provision in respect of transportation cost which is under dispute, etc. Further, the opinion expressed hereinafter is purely on the accounting issue raised in the query and not on the legal issues involved.

15. The Committee notes from the Facts of the Case that A Ltd. has recognised transportation cost which is under dispute in the cost of inventories and, therefore, the Committee has presumed from the Facts of the Case that these are the costs necessary for bringing the inventories to their present location and condition. Accordingly, the issue that

arises is that only because these are ‘disputed’, whether these should be considered as

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‘abnormal’ and excluded from the cost of inventories, as contemplated under paragraph 13 of AS 2, as follows:

“13. In determining the cost of inventories in accordance with paragraph 6, it is appropriate to exclude certain costs and recognise them as expenses in the period in which they are incurred. Examples of such costs are:

“(a) abnormal amounts of wasted materials, labour, or other production costs;

…”

(Emphasis supplied by the Committee.)

The Committee is of the view from the above that costs that are excluded from the cost of inventories are abnormal wasted materials, labour or other production costs, etc. The Committee is of the view that just because a cost is under dispute does not make it wasted materials, labour, or other production cost and, therefore, it cannot be considered as an abnormal cost.

D.Opinion

16.On the basis of the above, and subject to the presumptions stated in paragraph 15

above, the Committee is of the view that the procedure followed by ‘A’ Refinery Ltd. for

valuation of inventory with inclusion of additional transportation cost which is under dispute as a part of cost of crude oil is correct.

________________

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