Construction period is the time taken by an entity to complete the civil works, install plant and machinery and be ready to commence commercial production. The entity would incur expenditure during this construction period, both for acquiring the new assets as well as on administration.
Direct and administrative expenses: Cost of tendering for plant and machinery, travel related to inspection and sourcing of equipment, etc., are incidental to acquiring the assets,
While expenditure such as office rent, communication costs, staff costs, etc., which cannot be directly related to acquiring the fixed asset, would constitute administrative expenses.
Guidance note on expenditure during construction: The ICAI has issued a guidance note on treatment of expenditure during construction period.
The guidance note requires all such administrative expenditure during the construction period to be capitalised and apportioned to the fixed assets proportionately. It has been the practice to club all the expenditure as preoperative and disclose it as miscellaneous expenditure on the asset side of the balance-sheet.
Accounting for fixed assets (AS 10): AS 10, dealing with fixed assets, requires all the expenditure incurred in connection with acquiring the fixed assets and incidental to acquiring such fixed assets to be added to the cost of the respective asset. (Paragraph 9 of AS 10). Paragraph 9.3 of AS 10 reads: “Administration and other general overhead expenses are usually excluded from the cost of fixed assets because they do not relate to a specific fixed asset….”
Accounting for borrowing costs (AS 16): AS 16, on borrowing costs, requires the interest attributable to acquiring the qualifying asset to be capitalised and added to the cost of the asset till such time the asset is brought to a usable condition, subject, however, to certain terms and conditions for suspension of such borrowing costs.
Accounting for intangible assets (AS 26): Subsequently, the ICAI came out with AS 26 on intangible assets, effective for financial statements commencing from periods beginning on or after April 1, 2003. This standard requires that the expenditure which does not result in any enduring future economic benefit be written off in the year of incurring the expenditure.
Withdrawal of guidance note
All these years, the guidance note continued to exist. One after the other, the expenditure during construction period formed part of the respective Accounting Standards. The guidance note on expenditure during construction period was finally withdrawn in August 2008.
Implications and changes: Pre-incorporation and preliminary expenditure were amortised over a period of time. Such expenditure, to the extent not written off, was disclosed in the financial statements as miscellaneous expenditure.
All the expenditure, whether incidental to acquiring the assets or administrative in nature, was grouped under preoperative expenditure to be apportioned to the assets on commissioning of the project.
After the issue AS 10, all the expenditure related to acquiring the asset got shifted out from preoperative expenditure and formed part of capital work-in-progress.
Preoperative expenditure was shrunk further with the issue of AS 16, requiring the interest on loans and borrowing costs to be capitalised to the respective asset.
Consequent to the issue of AS 26, the preliminary expenditure is written off totally in the year of incorporation of the company and does not appear in the balance-sheet any more.
The residual portion of preoperative expenditure consisted purely of administrative costs.
AS 26 requires all that expenditure which does not result in future economic benefits be expensed out in the year in which it is incurred. This requirement rendered the guidance note redundant and it was finally withdrawn in August 2008. Expensing out through the profit and loss (P&L) account is understandable if the entity is an existing entity and is going in for expansion.
However, where the entity is setting up the first unit and not gone into operations, it does not have a profit and loss account. The point of contention is, whether the administrative expenditure incurred during the period of construction is to be treated as expenditure incurred and is of the nature of a future economic benefit.
Consolidation of accounts
There is no particular reference to the treatment of expenditure during construction in the Accounting Standards for consolidation, in AS 21.
Paragraph 13 of AS 21 reads as under:
“13. In preparing consolidated financial statements, the financial statements of the parent and its subsidiaries should be combined on a line by line basis by adding together like items of assets, liabilities, income and expenses.”
It requires consolidation on a line by line basis, by adding together like items of assets, liabilities and expenses.
Administrative cost of an entity under construction continues to be a preoperative expense. The nature does not change when it is combined for consolidation purposes.
Though administrative in nature, the salary paid during the period of construction is not a like item of expenditure in consolidation with other entities which have already gone on stream.
If one of the entities does not have a profit and loss account and treats the expenditure as preoperative expenditure, treating the same expenditure as revenue and setting it off against the revenues generated by other operating entities may not be justifiable. Such expenditure should be continued to be shown as preoperative expenditure.
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