Liquidated Damages & Asset Cost Recognition Under Ind AS

1. Question

Alpha Industries Limited (hereinafter referred to as “the Company”) is purchasing a specialised manufacturing machine from Beta Engineering Private Limited (hereinafter referred to as “the Supplier”). The purchase order includes a clause for liquidated damages for delayed supply. The supplier failed to meet the agreed delivery date, and the Company invoked the liquidated damages clause, deducting Rs. 500,000 from the invoice price of Rs. 10,000,000. The machine was subsequently delivered and installed. The Company’s accounting team is unsure how to account for this deduction.

Should the machine be recorded at its original invoice price of Rs. 10,000,000 with the liquidated damages recognised as other income, or should the machine be recorded at the net cost of Rs. 9,500,000 after deducting the liquidated damages?

2. Relevant Provisions

Ind AS 16, Property, Plant and Equipment:

Para 7 – The cost of an item of property, plant and equipment shall be recognised as an asset if, and only if:

(a) it is probable that future economic benefits associated with the item will flow to the entity; and

(b) the cost of the item can be measured reliably.

Para 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; and

(c) the initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located……

3. Analysis

In this case, the central issue revolves around the interpretation of the liquidated damages and their impact on the cost of the PPE. There are two possible scenarios to consider:

(a) Liquidated damages as a price reduction – The liquidated damages represent a pre-agreed adjustment to the purchase price, effectively reducing the cost of the asset due to the delayed delivery. This scenario views the delay as directly impacting the value of the asset received.

If the liquidated damages clause acts as a pre-agreed price reduction for late delivery, akin to a retrospective rebate or discount, it should be deducted from the invoice price to arrive at the net cost of the asset. This aligns with Ind AS 16, Para 16(a), which requires deducting trade discounts and rebates from the purchase price. The delay is considered to directly affect the asset’s value upon receipt.

(b) Liquidated damages as compensation for consequential losses – The liquidated damages compensate the Company for losses incurred because of the delay, such as lost production, penalties to third parties, or other costs arising from the late delivery. In this scenario, the damages are unrelated to the inherent value of the asset itself.

If the liquidated damages are intended to compensate the Company for losses resulting from the delay, such as lost production or contractual penalties, they should be treated as other income and recognized separately from the cost of the asset. This is because these damages relate to consequential losses stemming from the delay, not a reduction in the cost of the PPE itself. This treatment would align with Ind AS 37 if the conditions for recognizing a reimbursement are met.

In the given case, the provided information doesn’t explicitly clarify the nature of the liquidated damages clause in Alpha Industries’ contract. To determine the correct treatment, it is crucial to examine the contract’s wording and ascertain whether the Rs. 500,000 relates directly to a reduction in the asset’s value due to the delay or represents compensation for other consequential losses arising from the late delivery.

Click Here To Read The Full Story