The Hindu Business Line : Income during construction period

Often business entities generate some income, however small during the project stage (or during the construction period) — also known as preoperative period. As the objective of the company is different from the activity which is generating the income, it would not be proper to recognise the income so earned as revenue.

As the entity is still in the construction stage, the question of revenue statement or the profit and loss (P&L) account does not arise. It would be premature to apply the provisions of Accounting Standard (AS) 9. Such incomes are to be treated in accordance with the relevant provisions of the broad framework of accounting as applicable to it from time to time.

Certain of the funds not required immediately might be parked elsewhere for a short period yielding income by way of interest. Such funds could be either out of own funds brought in by way of equity or promoters’ contribution or out of the borrowings disbursed by the lending institutions.

Treatment of such income depends upon the source of funds, that is, equity or borrowings.

OWN FUNDS

When a part of equity funds are converted into a fixed deposit yielding interest, the source of funds for such an investment is not borrowings. Therefore, it falls totally beyond the scope of AS 16. In such a case, the entity would be justified in reducing such interests from the preoperative expenditure. Such interest or other income so earned cannot be treated as revenue nor can it be reduced from the cost of the asset.

Consider a situation where promoters contribute Rs 50 lakh towards their margin for the project costing Rs 200 lakh and raise a loan of Rs 150 lakh (margin of the promoters being 25 per cent of the project cost).

If the promoters have already brought in their margin of Rs 50 lakh into the entity, it makes a lot of sense to keep the money in a fixed deposit with the lending institution itself initially and keep a portion in the current account to be utilised for the project. They would be justified in releasing only 25 per cent of the cost proportionate to the loan disbursed.

If only Rs 75 lakh is drawn towards loan, the promoters’ contribution would only be Rs 25 lakh. The balance Rs 25 lakh is parked in a fixed deposit. Interest generated by such deposit falls outside the scope of AS 16 as the borrowings are not invested.

Interest in this case is to be set off against the preoperative expenditure and not against borrowing costs.

Treatment of interest earned by investing borrowed funds stands on a totally different footing. Provisions of AS 16 become operative.

BORROWING COSTS

AS 16 requires the cost of borrowing to be added to the cost of the asset. The Standard is specific on the interest earned on the borrowings invested for short periods and requires that such income be set off against the borrowing costs. (paragraphs 10 and 11of the standard).

Such income by way of interest does not qualify for setting off against the interests paid on loans for acquiring the assets.

This amount can neither be reduced from the head ‘preliminary expenditure’ under Section 35 D.

Such an interest earned is to be considered as ‘income from other sources’ and tax paid accordingly.

CONSEQUENCES

Cost of an asset for the purposes of depreciation is the expenditure incurred on the asset to bring it to a usable condition less any grants, subsidies, etc., received (AS 6 and Section 32 of the Income-Tax Act).

While the broad accounting framework provides for reduction of certain items, the provisions of the I-T Act are at variance.

Consequently, cost of the asset for the purposes of financial statements would be the net of the borrowing costs as reduced by the interest earned.

But, from the taxation angle, such interest earned cannot be set off against the cost of the asset. Therefore, cost of the asset for calculation of depreciation under income-tax would be more.

Consider the example:

Cost of the asset — Rs 200 lakh

Loan — Rs 150 lakh

Interest on loan during construction period — Rs 25 lakh

Cost of the asset as per AS 16 — Rs 225 lakh.

Considering that the entity invested a part of the loan and generated an income of Rs 2 lakh for the first year and a further Rs 1.5 lakh for the second year, the cost of the asset would stand reduced by Rs 3.5 lakh (being interest earned during the construction period) to be capitalised at Rs 221.5 lakh and charged to depreciation accordingly.

For the purposes of income-tax, the entity has to offer to tax the income generated by way of interest (under the head ‘income from other sources’) in the respective years. Cost of the asset continues to be Rs 225 lakh.

Any income generated by way of sale of scrap, empty containers, etc., resulting from a specific asset is to be deducted from the cost of the asset.

Sale of empty cement bags, end pieces of steel rods, etc., is to be reduced from the cost of construction of the building.

It is possible that the asset generates certain income before it is ready for the purpose for which it is being acquired.

It is possible that the upper floors of the building are under construction. The ground floor might be let out for short durations — for holding exhibitions, as an examination centre, and so on.

As the asset is not yet ready for its intended use, it would not be proper to recognise the revenue from the asset. Such an income cannot be set off against the preoperative expenses either.

Instead, such hire charges, etc., are to be reduced from the cost of the asset under construction.

If an entity generates miscellaneous income during the construction period, it should be reduced from the preoperative expenditure and not from the cost of the asset.

If an entity purchases a truck for transport of its construction materials during the construction period, it would be a viable proposition to earn revenue by hiring out the truck one way of the round trip.

Such an income can be set off against the preoperative expenditure. It is not to be set off against the cost of the asset.

(The author is a Hyderabad-based chartered accountant.)