Executive Summary:
Plant setup has just completed and is ready to start production against a potential customer order.
There would be certain expenses which the entity
would incur as a pre-requisite activity costs to get ready itself to start with
the commercial production of deliverable goods. These costs would be in the
nature of design and engineering which involves deployment of dedicated
manpower, process testing etc. and other related costs associated with this
pre-requisite activity. These expenses are substantial both in terms of outlay
required and the time to perform necessary activities. Therefore, it is important
to examine and evaluate how these expenses are to be accounted for to achieve
fair presentation and to evaluate periodic profitability.
Evaluating Costs to Decide What Should be the Accounting Treatment:
The subjected expenses would be incurred by the entity as part of fulfilling the performance obligation outlined in the contract with the customer. Though the control over design of the core product (finished goods) is not held by the entity, without the production design and completion of related pre-requisite activities, it is not possible for the entity to reap the economic benefits from the installed production facilities.
Costs to Fulfill a Customer Contract: Indian Accounting Standard (Ind AS 115) is a reference guide to draw an inference to deal with the given situation.
In accordance with Para 95: If the costs incurred in fulfilling a contract with a customer are not falling within the ambit of another Accounting Standard, an entity shall recognize an asset from the costs incurred to fulfill a contract only if those costs meet ALL of the below mentioned criteria.
(i). The costs relate directly to a contract or to an anticipated contract that the entity can specifically identify (for example – costs relating to services to be provided under renewal of an existing contract or costs of designing an asset to be transferred under a specific contract that has not yet been approved); and
(ii). The costs generate or enhance resources of the entity that will be used in satisfying (or in continuing to satisfy) performance obligations in the future; and
(iii). The costs are expected to be recoverable in nature
For costs incurred in fulfilling a contract with a customer and if that costs are within the ambit of another Accounting Standard, an entity shall account for those costs with reference to those other Standards as relevant.
In accordance
with Para 97: Costs that relate directly to a
contract (or a specific anticipated contract) include any of the following.
(a). Direct labour such as salaries and wages of employees who provide the promised services directly to the customer;
(b). Direct materials such as supplies used in
providing the promised services to the customer;
(c). Allocation of costs that relate directly to the
contract or to the contract activities such as costs of contract management and
supervision, insurance and depreciation of tools and equipment used in
fulfilling the contract;
(d). Costs that are explicitly chargable to the customer
under the contract; and
(e). Other costs that are incurred only because an entity entered into the contract – such as payments to sub-contractors.
In accordance
with Para 98: An entity shall recognize the
following costs as expense when incurred:
(i). General and administrative costs (unless those
costs are explicitly chargable to the customer under the contract, in which
case an entity shall evaluate those costs in accordance with Para 97.
(ii). Costs of wasted materials, labour or other
resources to fulfill the contract that were not reflected in the price of the
contract;
(iii). Costs that relate to satisfied performance
obligations or partially satisfied performance obligations in the contract
(i.e. costs that relate to past performance obligations); and
(iv). Costs for which an entity can not distinguish whether the costs relate to unsatisfied performance obligations or to satisfied performance obligations or partially satisfied performance obligations.
In summary, it appears from the above evaluation that those costs that are incurred to fulfill a contract and where there is no specific guidance from other Ind AS, it is essential to recognize such expenses as an asset (to be deferred) and amortised in the pattern of transferring the goods or services related to those costs. It is also necessary to take note of expenses that are generic in nature such as general and administrative expenses etc., which are not explicitly recoverable from the contract price need to be recognized as expense as and when incurred.
