Pre-Operational Expenses treatment

[Muzammil Korai]

One of our audit clients, company ABC was incorporated 4 years ago. This company is not operational yet. It's under development such as machinery is being installed, etc. That company used to charge the operational/admin expenses like Salary of CEO, CFO, project manager,etc. to P/L. However, during current year, they are saying we want to capitalize all of those costs in Capital work in Progress, as the company is not operational yet and most of these costs directly relate to the long term assets. Can they do that? Answer supported by relevant reference will be highly appreciated. Thank you!

(And sorry for long question)

[Ketan Marwah]

Hi,

We can capitalize 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 (IAS 16.16(b)). In the paragraph 17 of IAS 16 there are the examples of what expenses are considered to be directly attributable and therefore, can be capitalized (or included in the cost of an asset). As opposed to that, the paragraph 19 of IAS 16 lists examples of costs that are not costs of an item of PPE and therefore, cannot be capitalized. While this guidance might look clear enough yet in practice, there are many items that require our careful judgment and we are not sure whether to include them in the cost of an asset or not.

Employee benefit expenses arising directly from the construction or acquisition of the PPE/project, such as employee costs of an entity's own employees, workers, laborers, engineers, architects, etc. engaged in the construction activity should only be capitalised and the rest should be charged to the Statement of Profit and Loss.

Generally, a project manager is engaged in the overall management activities and CFO of an organisation is involved in overall finance related activities of the company as a whole. Therefore, normally these activities cannot be considered to be arising directly from the construction or acquisition of PPE/project and the costs thereof cannot be considered to be a directly attributable cost of the project/PPE. Generally, such costs are in the nature of administration and general overheads and should, ordinarily, not be capitalised with the item of PPE.

In certain situations, some of the roles and responsibilities of the project manager could be undertaken in connection with the construction or acquisition of Project/PPE. Examples of such activities could include evaluation of tenders, procurement of various capital equipment, participating in price negotiation with bidders, help in arranging debt financing, etc. that it is a matter of judgement in the specific facts and circumstances whether certain expenses could
be considered as ‘directly attributable’ in the context of IAS 16.

Also, while some of the activities of the Project Manager could be in connection with the construction/acquisition of Project/PPE, the cost incurred might not be completely considered to be arising directly from construction or acquisition of the PPE/project. Therefore, to the extent, such costs are directly attributable to bringing the PPE/project to the location and condition necessary for it to be capable of operating in the manner intended by management,
should be capitalised to the PPE/project by the company and the rest should be charged to the Statement of Profit and Loss.

Similarly, the activities of the CFO would need to be analysed and if they are in the nature of administrative and general overheads then they are not costs of an item of PPE and should be charged to the Statement of Profit and Loss.

In certain exceptional situations if a company is able to clearly demonstrate that the employee costs of the project manager and CFO are directly attributable costs for bringing the PPE/project to the location and condition necessary for it to be capable of operating in the manner intended by the management, then these can be capitalised. However, in order to determine a ratio/proportion of such expenses that could be capitalised, the company would need to consider the nature of expenses/activities and the extent to which these are directly attributable as per the requirements of IAS 16 based on the specific facts and circumstances and using proper rationale.

[JRSB]

also if you did do that, you'd have to restate as it sounds like you're talking about costs from years ago

[Ketan Marwah]

Hi JRSB,

As I read the post it clearly said that "That company used to charge the operational/admin expenses like Salary of CEO, CFO, project manager,etc. to P/L" so basis that I don't think there is historic pile up that requires some sort of clean up. Secondly, restating historic statements is generally an avoidable route for big companies as they have high materiality thresholds. Therefore, I wouldn't advise - "have to restate" until the adjustment is passed through the materiality prism.

[JRSB]

ok, I read 'all of those costs' different to you then!

[Marek Muc]

(And sorry for long question)

That question was the perfect length!

Directly attributable costs must be allocated as a matter of fact. If the involvement of C-level executives remains consistent over the years, and the company decides to include this as part of the PP&E's cost (BTW, excellent guidance, Ketan!), previous years should be restated as error corrections IMO. Actually, the involvement of C-level executives in operational work tends to decrease as the company grows, so it's hard to justify including their remuneration as part of PP&E's cost from the current year only.

[Muzammil Korai]

Thank you Ketan, JRSB, and Marek. Summarizing your answers, I can say that if company somehow proves that CEO, CFO, and project managers are currently involved only in this project (Capital work in progress) , then their salaries can also be capitalized. Am I right?

[Ketan Marwah]

In certain exceptional situations if a company is able to clearly demonstrate that the employee costs of the project manager and CFO are directly attributable costs for bringing the PPE/project to the location and condition necessary for it to be capable of operating in the manner intended by the management, then these can be capitalised. However, in order to determine a ratio/proportion of such expenses that could be capitalised, the company would need to consider the nature of expenses/activities and the extent to which these are directly attributable as per the requirements of IAS 16 based on the specific facts and circumstances and using proper rationale.