Capitalization of delay charges

[Nevermore]

I have been reviewing accounts of an independent power producer and came across an issue for which i seek professional advice of qualified accountants and auditors in this forum..

The required commercial production date was 31 March 2009 as per agreement with Pakistan infrastructure board. The Company had given guarantee of startup of commercial production on that date.. However,it started production on the mid of December.. Due to delay, the Company had to pay delay charges of $1.1 million..

The issue is that the payment was made on December 2010 and Company capitalized it on December 2010.. Logic behind such capitalization is that it directly pertained to the acquisition of plant etc..

IAS-16 does not specifically mention anywhere about this scenario.. Hence, I need your advice regarding any such practical event in your experience..

Waiting for replies
Thanks

[Schuaeb]

In my opinion the delay charges in the aforesaid case cannot be capitalized.

[awaisaftab]

From the question it is not clear whether or not the asset falls within the definition of Qualified Asset, as defined in IAS-23. It is also not clear whether delayed charges paid against loan or as penalty as per agreement with Pakistan infrastructure board?

[Schuaeb]

<blockquote id="quote"><font size="1" face="Verdana, Arial, Helvetica, san" id="quote">quote<hr height="1" noshade id="quote"><i>Originally posted by awaisaftab</i>
<br />From the question it is not clear whether or not the asset falls within the definition of Qualified Asset, as defined in IAS-23. It is also not clear whether delayed charges paid against loan or as penalty as per agreement with Pakistan infrastructure board?
<hr height="1" noshade id="quote"></font id="quote"></blockquote id="quote">

Nothing in the query asked suggests that the capitalization charges have to do any thing with IAS 23. As far as my understanding is concerned the delay charges are due to non commencement of production at the agreed time. In such situation they should be expensed in the period in which they are incurred.

[kamranACA]

This issue has nothing to do with IAS-23 from any angle of discussion.

The capitalization criteria/logic asks for the future economic benefits that will presumably flow to the enterprise on incurring a cost with reference to PPE item (See Paragraph 7 of IAS-16). These future benefits have to be analyzed with reference to how vital/crucial the cost is for an asset to get ready for operations. Is it enhancing its life or capacity or quality etc? In case of such penalties, these have no crucial bearing on the asset to get ready. These don’t even have any bearing to capacity, quality or life of the asset. Here I must mention that Penalties cannot be misconstrued / mixed up with non-refundable taxes. Non-refundable taxes are unavoidable and have to be borne in all cases so these have a direct bearing with capital expenditure. The penalties are always avoidable and these also don’t give rise to anything which at its own ensures flowing of economic benefits to the enterprise. This drives the basic logic that such penalty cannot be capitalized.

Paragraph 17 of IAS-16 provides examples of costs that can be directly attributed with PPE assets. This does not include any sort of Penalties in its list. Further, paragraph 19 of IAS-16 states that the Administration and General Overheads cannot be capitalized. The penalty imposed is more of an Administration/General Overhead in its nature than a Capital nature expense since it is imposed due to failure at administration part of the project.

If by all means other comments are not accepted then there is a factor which can also create the difference. The poster of the question has not given the reason of delay in start of operations. There can be two scenarios; either the project was under completion; or, the project was complete in all respects but operations were not started due to some administrative or other issues. The succeeding explanation relates to the scenario where the project was complete in all respects but operations were not started.

Paragraph 20 of IAS-16 interalia states………….….”Recognition of costs in the carrying amount of an item of property, plant and equipment ceases when the item is in the location and condition necessary for it to be capable of operating in the manner intended by management”………………

Now if the plant of IPP was completed and only the startup was pending due to any reason; the costs incurred for whatever purpose cannot be capitalized. If this is the scenario then there is altogether no reason to going into deeper details.

On the basis of information provided by the poster of the query; I believe penalties cannot be included in the carrying value of PPE item constructed/acquired.

Regards,

[Schuaeb]

Kamran sb nice to see you around and as elucidative as ever.

I can't think of any situation where penalty can be capitalized. Can there be?

[kamranACA]

Persumably, your view point seems correct. However, I would like to keep the doors open for case to case discussion, as we oftenly see the issues carrying greater level of novelty.

Regards,

[Dard]

Let's change the scenario
What if the project was completed late in December due to a serious and unexpected fault in one of the manufacturing units(not administrative nature)
The late penalty charges had to be paid. Will it not be capitalised now?

[kamranACA]

I have to refer some paragraphs of IAS-16 from which I hope a lot of people can draw reasonable inference on the topic.

Paragraph 15 of IAS-16 requires that an item of property, plant and equipment that qualifies for recognition as an asset shall be measured at its cost.
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Paragraph 16 explains the elements that can constitute the cost of such asset as under

(a) its purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates.

(b) any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management.

(c) the initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located, the obligation for which an entity incurs either when the item is acquired or as a consequence of having used the item during a particular period for purposes other than to produce inventories during that period.
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None of the above elements can infer any possibility of capitalizing delaying penalties etc in the cost of the asset being constructed. However, in above quoted list, the item (b) raises some questions as to what should be considered as DIRECTLY ATTRIBUTABLE when the cost is in question.

To rule out illogical inferences and conclusions we must patiently look at the words ………… “IN THE MANNER INTENDED BY MANAGEMENT”……. .

I believe no management intends to NECESSARILY burden itself with penalties and incur such avoidable expenses intentionally or willfully. Saying that some penalties are directly attributed because there was an intention of delaying the completion and incurring such penalty would be weird.

The (b) element allows the cost that is incurred to bring the asset in location and condition NECESSARY for it to be capable of operating IN THE MANNER INTENDED by the management. Firstly, the penalties are always avoidable, so cannot be termed as “necessary”. Secondly, no management ever originally “intends” to pay them off.

Therefore, whether or not these are due to failure at administrative part, these cannot make part of elements of the cost. This is very important not to forget about; and I hope a careful reading of this point would clear many ambiguities.
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Further to this understanding, Paragraph 17 of IAS-16 has given certain examples of directly attributable costs which do not include any such penalties etc.
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Apart from the above discussion, Paragraph 21 of IAS-16 states

…………..“Some operations occur in connection with the construction or development of an item of property, plant and equipment, BUT ARE NOT NECESSARY TO BRING THE ITEM TO THE LOCATION AND CONDITION NECESSARY for it to be capable of operating IN THE MANNER INTENDED BY MANAGEMENT. These incidental operations may occur before or during the construction or development activities. For example, income may be earned through using a building site as a car park until construction starts. Because incidental operations are not necessary to bring an item to the location and condition necessary for it to be capable of operating in the manner intended by management, the income and related expenses of incidental operations are recognized in profit or loss and included in their respective classifications of income and expense…………………

Although the above paragraph does not specifically talk about penalties, yet, it states that INCIDENTAL operations (I tend to include HAPPENINGS as well) may occur during construction phase but because such incidental HAPPENINGS are not NECESSARY and are not INTENDED by the management, these do not give rise to capitalization.

In fact penalties are always incidental during the construction phase (if there are such conditions) but are never necessary and are never intended. Therefore, this supports the conclusion that these cannot be capitulated.
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Further to this, penalties do not increase life of an asset, do not increase profitability, do not increase working capacity or quality of the asset etc, AND are also originally avoidable, these cannot be capitalized as per my understanding.

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I hope the above discussion would benefit the readers in drawing their own conclusions.

Regards,

[Dard]

I was also thinking the same about "capable of OPERATING in a way INTENDED by management" phrase. Thank you

[Schuaeb]

Additionally capitalizing penalty or any other avoidable cost may require immediate recording of impairment as at least market value will be less than the recorded cost in such case.

[Nevermore]

thanks for all the replies above )