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Accounting Treatment of Spectrum Charges, Promotional Expenses, and R&D Costs related to Project

Question

ABC Limited (hereinafter referred to as "the company") involved in constructing a high-speed rail project incurred various expenses, including spectrum charges, project promotion expenses, and research and development (R&D) costs. The total expenditure amounted to ?80 crore up to 31st March 2022. Details of the same are as given:- Spectrum charges:- ?40 Crores, Project promotion expenses:- ?10 Crores, Research and development expenses:- ?30 Crores. The company adopts the following accounting treatment for recognition of these expenses:

(a) Spectrum charges: The spectrum charges are essential for the successful execution of the high-speed rail project, particularly in the design and construction phases. The company's decision to capitalize these charges as part of the Capital Work in Progress is based on the critical role these frequencies play in ensuring the project's progress and eventual operation. The recurring nature of the payments and the risk of losing the spectrum underscore the importance of maintaining these charges to avoid the risk.

(b) Promotional expenses: The company has incurred substantial expenses related to event sponsorships, and social media promoting the high-speed rail project and engaging with stakeholders. These expenses have been carefully recorded as part of the project's capital work, reflecting their importance in the successful execution of the project by capitalizing on these costs, the company aligns with the practice of treating expenditures that contribute to the development of long-term assets as part of the project's overall value.

(c) Research and development expenses: To understand the technology and alternative methods to be used for construction of the Project, need for specific research were felt. Accordingly, a trust was incorporated i.e., 'H Innovation Centre (HIC)'. This trust works with the various IITs to understand and develop different alternatives for the construction of the Project. Accordingly, payments made to HIC are treated as 'Capital work-in-progress' pending capitalization of assets, i.e., the Project.

As per the auditor's opinion, these expenses are not directly related to the construction of the High-Speed Rail, therefore, the same should have been charged to the profit and loss account in compliance with Ind AS 16, Property, Plant, and Equipment. This has resulted in an overstatement of Capital Work in Progress, an overstatement of "Profit before exceptional items & tax, an overstatement of Other Equity, and an understatement of other expenses.

State whether the company's accounting treatment of expenditure is correct. If not what shall be the correct accounting treatment?

Relevant provisions

Ind AS-38: Intangible Assets

An intangible asset is an identifiable non-monetary asset without physical substance. An asset is a resource:

(a) Controlled by an entity as a result of past events;

(b) And from which future economic benefits are expected to flow to the entity.

Para-13

An entity controls an asset if the entity has the power to obtain the future economic benefits flowing from the underlying resource and to restrict the access of others to those benefits. The capacity of an entity to control the future economic benefits from an intangible asset would normally stem from legal rights that are enforceable in a court of law.

Para-17

The future economic benefits flowing from an intangible asset may include revenue from the sale of products or services, cost savings, or other benefits resulting from the use of the asset by the entity. For example, the use of intellectual property in a production process may reduce future production costs rather than increase future revenues.

Para-54

No intangible asset arising from research (or from the research phase of an internal project) shall be recognized. Expenditure on research (or on the research phase of an internal project) shall be recognized as an expense when it is incurred.

Para-55

In the research phase of an internal project, an entity cannot demonstrate that an intangible asset exists that will generate probable future economic benefits. Therefore, this expenditure is recognized as an expense when it is incurred.

Para-57:

An intangible asset arising from development (or from the development phase of an internal project) shall be recognised if, and only if, an entity can demonstrate all of the following:

(a) The technical feasibility of completing the intangible asset so that it will be available for use or sale.

(b) Its intention to complete the intangible asset and use or sell it.

(c) Its ability to use or sell the intangible asset.

(d) How the intangible asset will generate probable future economic benefits. Among other things, the entity can demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset.

(e) The availability of adequate technical, financial, and other resources to complete the development and to use or sell the intangible asset.

(f) Its ability to measure reliably the expenditure attributable to the intangible asset during its development.

Para-69

In some cases, expenditure is incurred to provide future economic benefits to an entity, but no intangible asset or other asset is acquired or created that can be recognized. In the case of the supply of goods, the entity recognizes such expenditure as an expense when it has a right to access those goods. In the case of the supply of services, the entity recognizes the expenditure as an expense when it receives the services.

Ind AS-16: Property Plant and Equipment

Para-10

An entity evaluates under this recognition principle all its property, plant and equipment costs at the time they are incurred. These costs include costs incurred initially to acquire or construct an item of property, plant and equipment and costs incurred subsequently to add to, replace part of, or service it. The cost of an item of property, plant and equipment may include costs incurred relating to leases of assets that are used to construct, add to, replace part of or service an item of property, plant and equipment, such as depreciation of right-of-use assets.

Para-16(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.

Para-19 (b)

Examples of costs that are not costs of an item of property, plant and equipment are:

(b) Costs of introducing a new product or service (including costs of advertising and promotional activities).

Points Considered by the Expert Advisory Committee (EAC)

A. Accounting treatment of Spectrum Charges

The spectrum charges paid by ABC Limited are essential for securing dedicated frequencies necessary for high-speed communication within the project. These charges include license fees and royalties paid to the Wireless Planning Commission (WPC) for a spectrum license valid for five years, with payments made annually. The EAC noted that the spectrum license is an intangible asset under Ind AS 38, "Intangible Assets." This is based on the license meeting the criteria of identifiability, control over the resource, and the existence of future economic benefits. Since the license provides ABC Limited with a controlled resource that will generate future economic benefits, it qualifies as an intangible asset and should be recognized and accounted for as such.

The EAC further examined whether the amortization of the spectrum license can be capitalized as part of the project costs under Ind AS 16, "Property, Plant, and Equipment" (PPE). Given that the spectrum is critical in the project's design phase, particularly for the development of radio systems, repeaters, and other integral components, it is clear that the spectrum is directly and continuously involved throughout the construction period. The spectrum license ensures the availability of necessary frequencies, which are vital for the proper operation of the project's communication systems.

Consequently, the amortization of the spectrum license during the construction period is deemed a cost directly attributable to bringing the project to a state where it can operate as intended by the management. Therefore, it is appropriate for ABC Limited to capitalize these amortization costs with the overall project costs, in line with Ind AS 16.

B. Accounting for Promotional Expenses

The EAC's analysis focuses on the nature and purpose of the promotional expenses. These costs, including event sponsorships and social media campaigns, primarily aim to create public awareness, manage stakeholder relationships, and promote the project to a broader audience.

The EAC highlighted that these promotional expenses are akin to advertising and marketing activities, which are generally intended to introduce a new product or service rather than directly contribute to the construction or operational readiness of the project. According to Ind AS 16, costs that do not directly contribute to bringing an asset to the location and condition necessary for it to be capable of operating as intended by management should not be capitalized. Instead, these costs should be expensed as incurred.

Even though the social media team expenses may facilitate smoother project execution by preventing public unrest and ensuring timely completion, their core nature remains promotional. As such, these costs do not meet the criteria for capitalization under Ind AS 16 or Ind AS 38, which governs the recognition of intangible assets. The expenses do not directly enhance the physical construction or functionality of the project, nor do they qualify as intangible assets that generate future economic benefits on their own.

C. Accounting for Research and development expenses

The Committee opined that expenses related to research activities, such as those aimed at exploring new knowledge or alternative methods, should be recognized as expenses when incurred. This is because these activities are still exploratory, and it cannot yet be demonstrated that they will result in an intangible asset with future economic benefits. Even if these expenses are connected to a project, they do not meet the criteria for capitalization under Ind AS 16 due to the uncertainty of their outcomes. Therefore, the company's current accounting treatment of these expenses is incorrect and should be adjusted to reflect them as expenses, not assets.

Conclusion

Based on the above facts and opinions provided by the EAC of the ICAI, it can be concluded that the existing accounting treatment of expenses is not correct.

A. The spectrum charges should be treated as an intangible asset under Ind AS 38. Amortization of the spectrum license during the project's construction should be capitalized as part of the project costs in line with Ind AS 16.

B. The promotional expenses incurred related to advertising and promotional activities, should not be capitalized with the project costs but should be expensed when incurred as per Ind AS 16 and Ind AS 38.

C. The Research and Development expenses should be expensed when incurred, as they cannot yet be shown to create an intangible asset with probable future economic benefits, and are not directly necessary for bringing the project to its operational condition under Ind AS 16.

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