Query

1. A Government of India undertaking, registered under the Companies Act 1956, is engaged in the activities of refining and marketing of petroleum products and is having its refineries in Mumbai and Visakh and various marketing locations spread throughout the country.



2. In the course of carrying out its business, the company places purchase orders for supply of materials/services, plant and equipment and also enters into various contracts for carrying out activities of erection and repairs/maintenance through turnaround jobs at its refineries which are highly specialised in nature. While entering into such contracts, timely completion, supply and/or erection of material/equipment are of prime importance, as any delay in such supply/erection/construction would have an adverse impact on the cost of the projects. In view of this, suitable liquidated damages clause is included in the relevant purchase orders/contracts.



3. During the year 1995-96, the company’s Visakh refinery recovered Rs. 357.30 lakhs towards liquidated damages, levied on the contractor for delay in supply and erection of gas turbine generators and heat recovery steam generators. Since the delay caused by the contractor had resulted in increase in the cost of acquiring the assets by way of exchange rate variations and increase in interest cost, the amount recovered is directly attributable and relates to the project. Accordingly, the amount of liquidated damages of Rs. 357.30 lakhs has been adjusted to the cost of the assets.



4. In this context, the querist has given below relevant extracts from Para 15 of the Guidance Note on Treatment of Expenditure During Construction Period, issued by the Institute of Chartered Accountants of India:



“15.1 …………..attention is drawn to the undernoted paragraphs which deal with different items of indirect expenditure which may be capitalised as part of the cost of construction: -



15.2 From the total of the aforesaid items of indirect expenditure would be deducted the income, if any, earned during the period of construction, provided it can be identified with the project.”



5. As per the above, income earned during the period of construction, if identified with the project, should be deducted from the indirect expenditure such as interest charges, that are capitalised as part of the cost of construction of the project. The liquidated damages levied constitute income which is clearly identified with the project/assets under reference and is also directly attributable to the delay in execution of the project.



6. The querist has noted the opinions of the Expert Advisory Committee of the Institute of Chartered Accountants of India, published against Query No. 1.54 of Volume XI and Query No. 1.15 of Volume XIII of the Compendium of Opinions. It has been opined in both the cases that liquidated damages should be shown as income on the ground that the same cannot be regarded as an adjustment in the price of the equipments.



7. The querist is of the view that the instant case referred herein is distinct from the cases referred to earlier as specified in para 6 above. The differences are detailed below:



(i) The purchase order in the instant case had a specific stipulation that liquidated damages would be deducted from the contract price. This, in other words, would result in reduced cost of acquisition of an identifiable asset. Further, the increase in the cost due to the delays would be mitigated partly or fully by deducting liquidated damages from the project cost.



(ii) Liquidated damages, being in the nature of income identified with the project, needs to be deducted from the indirect expenditure capitalised as a part of the cost of acquisition of an asset in line with the provisions of the Guidance Note on Treatment of Expenditure During Construction Period, issued by the Institute of Chartered Accountants of India, as mentioned above.



8. Opinion of the Expert Advisory Committee of the Institute of Chartered Accountants of India is hereby sought as to whether crediting of liquidated damages to the capital expenditure and capitalisation of costs net of liquidated damages is in order in the light of the special provision in the purchase order for treating liquidated damages as price reduction and also the provision of adjusting related income against indirect expenditure as envisaged in the Guidance Note on Treatment of Expenditure During Construction Period as followed consistently by the company, constitute the correct accounting treatment.




Opinion December 31, 1996



1. The Committee refers to its earlier opinion on a similar query, dated December 12, 1995, published in the Compendium of Opinions, Volume XV, page XV-57, which is as below:



“The Committee is of the view that whether or not the liquidated damages should be adjusted against the project cost would depend upon whether the liquidated damages are directly identifiable with the project and whether, in fact, they are received in mitigation of the extra project costs incurred and capitalised by the enterprise on account of the same specific events which gave rise to liquidated damages. Where and to the extent the liquidated damages meet the aforesaid stipulations in affirmative, the same should be adjusted in the cost of the project.”



2. The Committee notes that the querist has, inter alia, stated in para 7 of the query, as below:



“Further, the increase in the costs due to the delays would be mitigated partly or fully by deducting liquidated damages from the project cost.”



3. On the basis of the above, if it can be established that the liquidated damages are in fact received in mitigation of the extra project costs incurred and capitalised by the company on account of the same specific events which gave rise to liquidated damages and that the said damages can be identified with the project, the Committee is of the opinion that the liquidated damages can be adjusted in the cost of the project.