Enquiry:

Following are the two enquiries pertaining to liquidated damages:

Query 1:

A company is engaged in telecommunication. It awards contracts for jobs of capital nature which involve purchase of equipment and its installation. The equipment is normally handed over to the company after the trail runs and final acceptance. The equipment is normally capitalised once the final acceptance is signed off. The price of the equipment is governed mainly in line with the price book agreed with the vendor and the company’s parent company group frame work agreement.

The purchase agreements generally contain following type of penalties:

– Penalties for delayed installation.
– Actual revenue loss during installation prior to final acceptance based on estimate.
– Actual revenue loss after acceptance and capitalization of the equipment caused by any issue relating to equipment.

IFRS is not very clear about the treatment of these damages/ penalties. We will appreciate if guidance is provided, how each such type of penalties should be treated. Company is currently booking all the above as other revenue.

Query 2:

A telecommunication company has outsourced its network maintenance job. The maintenance contract has performance bench marks. The contract contains bonus or additional payment for performance better than the set bench marks and penalties for the performance below the set targets.

The company is currently charging the normal payment and additional bonus to cost and booking penalties for under performance as other income. Is the mentioned treatment correct? Will the situation /treatment would be different if the underperformance penalty is calculated based on the actual revenue loss resulting from the underperformance.

Opinion:

Committees response to the queries is as follows:

Query 1:

The Committee would like to refer following paragraphs of IAS 16 ‘Property plant & Equipment’ (underline is ours):

“15 An item of property, plant and equipment that qualifies for recognition as an asset shall be measured at its cost.”

“Cost as defined in IAS 16 is the amount of cash or cash equivalents paid or the fair value of the other consideration given to acquire an asset at the time of its acquisition or construction or, where applicable, the amount attributed to that asset when initially recognised in accordance with the specific requirements of other IFRSs, e.g. IFRS 2, Share-based Payment.”

The paras of IAS 16 relating to the elements of cost are reproduced as under:

“16 The cost of an item of property, plant and equipment comprises:
(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.”

“17 Examples of directly attributable costs are:
(a) costs of employee benefits (as defined in IAS 19 Employee Benefits) arising directly from the construction or acquisition of the item of property, plant and equipment;
(b) costs of site preparation;
(c) initial delivery and handling costs;
(d) installation and assembly costs;
(e) costs of testing whether the asset is functioning properly, after deducting the net proceeds from selling any items produced while bringing the asset to that location and condition (such as samples produced when testing equipment); and
(f) Professional fees.”

“21 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.”

The Committee’s response to the enquired scenarios is as follows:

a) Penalties/ liquidated damages for delayed installation

Purchasing fixed assets does not give rise to income. Therefore, in the absence of specific reference to compensating for losses in a liquidated damage clause, the liquidated damages received are deducted from the cost of the related assets.

The rationale for this approach is consistent with the conclusion that, rather than damages for delay, the contract provides for an additional payment in the event of early completion.

For example, if rather than a Rs. 100 penalty for late delivery on a Rs. 1,000 contract after 1 January 200X, as the contract had a value of Rs. 900 but provided for an additional payment of Rs. 100 for an early completion before 1 January 200X. Therefore, the cost of the asset is the total price paid to acquire it, including the premium for early completion (i.e., Rs. 1,000 if finished before 1 January 200X and Rs. 900 if finished after 1 January 200X). This gives the same result as with liquidated damages.

b) Penalties for actual revenue loss during installation prior to final acceptance based on estimate

However, when the liquidated damages clause in a contract refers to compensating the affected party for any revenue lost or reimbursement of specific costs incurred because of delay in the completion of the project, then recognizing as revenue or deducting against specifically reimbursed costs is more consistent with the purpose of the liquidated damages clause.

c) Penalties for actual revenue loss after acceptance and capitalization of the equipment caused by any issue relating to equipment

At the date of acceptance, the Company has determined that the asset capable of operating in the manner intended by management and accordingly has also estimated the amount payable to vendor. If, however, this estimate is revised, subsequent to the yearend, the effect of revision in amount payable to vendor will be taken to profit and loss account, as an adjustment in estimate, in accordance with IAS 8.

Query 2:

The Committee is of the view that additional payment made by the Company in case of better performance than the set benchmark, should be part of the maintenance cost. Further, the penalties imposed on the vendor due to performance below the set benchmark should be adjusted against the maintenance cost as these refers the compensation for the below standard maintenance job.

(May 19, 2017)