Guidance Note on Audit of Miscellaneous Expenditure [2003]*

INTRODUCTION

1. The following is the text of the Guidance Note on Audit of Miscellaneous Expenditure. This Guidance Note provides guidance on audit procedures to be applied while auditing miscellaneous expenditure. This Guidance Note also provides guidance for audit of items that generally constitute miscellaneous expen­diture when Accounting Standard (AS) 26, Intangible Assets comes into effect or is voluntarily applied by an enterprise in accounting for intangible assets. This Guidance Note, however, does not provide any guid­ance on audit of intangible assets that are recognised in accordance with AS 26. The guidance provided herein is restricted to only those items which were hitherto (before application of AS 26‑whether mandatory or otherwise) being classified as items of miscellaneous expenditure, but because of application of AS 26, accounting treatment of such items would change.
   
    
2. 'Miscellaneous expenditure' shown in the balance sheet of companies (or shown under this or some other appropriate heading in the balance sheet of other enterprises) embraces within its fold a variety of items of expenditure which are not entirely charged to income in the year in which they are incurred, but are carried forward in the balance sheet to be written‑off in subsequent periods. Unless some benefit from the expenditure can reasonably be expected to be received in future and unless the amount of such benefit is reasonably determinable, there is no justification for carrying forward the expenditure for being written‑off in subsequent peri­ods. Also, the amount of expenditure to be carried forward should not exceed the expected future rev­enue/other benefits related to the expenditure.
   
    
3. The Guidance Note deals with the audit considera­tions related to the following items that normally constitute 'miscellaneous expenditure':

(a)    preliminary expenses;

(b)    expenses including commission or brokerage on underwriting or subscription of shares or debentures including discount allowed on the issue of shares or debentures;

(c)     research and development expenditure, etc.

4. The Council of the Institute of Chartered Accountants of India has issued Accounting Standard (AS) 26, 'Intangible Assets'. The objective of this AS 26 is to prescribe the accounting treatment for intangible assets that are not dealt with specifically in another Accounting Standard. AS 26 requires an enterprise to recognise an intangible asset if, and only if, certain criteria are met. The accounting stand also specifies how to measure the carrying amount intangible assets and requires certain disclosures about intangible assets. Consequently, the accounting treatment of some of the items that generally constitute 'miscellaneous expenditure' would change and when an enterprise adopts Accounting Standard 26 'Intangible Assets' to account for intangible assets.
   
    
5. Accounting Standard (AS) 26, 'Intangible Assets' comes into effect in respect of expenditure incurred on intangible items during accounting periods commencing on or after 1‑4‑2003 and is mandatory nature from that date for the following:

(i)                 Enterprises whose equity or debt securities are listed on a recognised stock exchange in India, and enterprises that are in the process of issuing equity or debt securities that will be listed on a recognised stock exchange in India as evidenced by the board of directors' resolution in this regard.

(ii)               All other commercial, industrial and business reporting enterprises, whose turnover for the accounting period exceeds Rs. 50 crores.

In respect of all other enterprises, the Accounting Standard comes into effect in respect of expenditure incurred on intangible items during accounting periods commencing on or after 1‑4‑2004 and is mandatory from that date. The Accounting Standard, however, encourages earlier application.

6. In respect of intangible items appearing in the balance sheet as on the aforesaid date, i.e., 1‑4‑2003 or 1‑4­2004, as the case may be, the Standard has limited its application as stated in paragraph 99 of AS 26. From the date of this Standard becoming mandatory for the concerned enterprises, the following stand withdrawn:

(i)    Accounting Standard (AS) 8, Accounting for Research and Development;

(ii)    Accounting Standard (AS) 6, Depreciation Accounting, with respect to the amortisation (depreciation) of intangible assets; and

(iii)  Accounting Standard (AS) 10, Accounting for Fixed Assets ‑ paragraphs 16.3 to 16.7,37 and 38.

7. Since AS 26, applies to different entity from different dates, it may happen that certain enterprises, till the date the standard becomes mandatory for them may con­tinue to defer the expenditure incurred on items that normally constitute "miscellaneous expenditure". Once an entity applies AS 26 to account for intangible assets, the expenditure incurred on items that normally constitute miscellaneous expenditure shall be governed by the Standard, except in the case of already appearing miscellaneous expenditure in the balance sheet which is to be accounted for using paragraph 99 of AS 26.

8. The following features of miscellaneous expenditure have an impact on the related audit procedures.

(a)               The items of expenditure included under this heading do not represent any tangible asset.

(b)               The expenditure on these items is usually of a non‑recurring nature.

(c)               There is a justification for deferring the expendi­ture on the basis that the benefits from the expenditure can reasonably be expected as flow­ing into the future the amount of such benefits is reasonably determinable, and the amount of deferred expenditure does not exceed the expected future benefits related thereto.

(d)               Unless some fresh expenditure is incurred, the balance in these items reduces each year by the amount written‑off in the year.

9. The auditor's primary objective in audit of items that generally constitute miscellaneous expenditure is to satisfy himself that -

(a)               in case where some items are shown in the balance sheet under the head Miscellaneous Expenditure whether it is proper to defer the expenditure;

(b)               in case where some items are shown in balance sheet under the head 'Miscellaneous Expenditure', the period of amortisation of the expenditure is reasonable;

(c)               the expenditure shown to have been incurred during the year actually occurred during the year and there is proper authority for the expenditure and for its deferral;

(d)               the criteria which previously justified the defer­ral of the expenditure continue to be met and the expected future revenue/other benefits related to the expenditure continue to exceed the amount of unamortised expenditure;

(e)               where the entity has applied AS 26, for account­ing for items that normally constitute miscella­neous expenditure, whether the same has been done in accordance with the Standard and the already appearing items under the head miscellaneous expenditure have been dealt with in accordance with paragraph 99 of AS 26.

INTERNAL CONTROL EVALUATION

10. The auditor should study. and evaluate the system of internal control relating to the various items of mis­cellaneous expenditure to determine the nature, tim­ing and extent of his other audit procedures. He should particularly review the following aspects.

(a)     There should be a system of control over expen­diture incurred on these items. An effective method of exercising such control is budgeting which, apart from ensuring proper authorisation of the expenditure incurred, also shows in general how effectively such expenditure is being con­trolled. This is accomplished through periodical comparisons of actual with budgeted figures.

(b)     Accountability should be established over each item of such expenditure. This can be achieved, inter alia, by up‑to‑date maintenance of proper records.

(c)     The system should ensure that reliable informa­tion (including reports of experts) is available for assessment of the results achieved against the objectives and estimates of the expenditure determined originally.

VERIFICATION 

11. The nature, timing and extent of substantive proce­dures to be performed are matters of professional judgment of the auditor which is based, inter aha, on the auditor's evaluation of the effectiveness of the related internal controls.

12. While verifying an item of miscellaneous expenditure in the year in which the relevant expenditure is incurred, the auditor should satisfy himself regarding the amount of such expenditure and its deferral as also regarding the reasonableness of the period of amorti­sation of the expenditure. Till the amount is fully amortised, the auditor should examine every year that a proper amount is amortised during the year by way of a charge to income for the year (and not as its appro­priation). The auditor should also examine every year that the criteria which previously justified the deferral of the expenditure continue to be met. If those criteria no longer apply, the auditor should examine whether the unamortised balance has been charged as expense immediately. Where the auditor finds that the criteria for deferral continue to be met but the amount of unamortised balance of the expenditure exceeds the expected future revenue/other benefits related thereto, the auditor should examine whether such excess has been charged as an expense immediately.

13. The applicability of AS 26 on items that generally con­stitute miscellaneous expenditure and special consid­erations in audit of various items of miscellaneous expenditure when AS 26 is applied are discussed in subsequent paragraphs of this Guidance Note.

Preliminary Expenses

14. Preliminary expenses are the expenses relating to the formation of an enterprise. For example, in the case of a company, preliminary expenses would normally include the following.

(a)    Legal cost in drafting the memorandum and arti­cles of association.

(b)    Fees for registration of the company.

(c)     Cost of printing of the memorandum and articles of association and statutory books of the company.

(d)    Any other expenses incurred to bring into exis­tence the corporate structure of the company.

15. Paragraph 55 of AS 26 requires that expenditure on an intangible item should be recognised as an expense when it is incurred unless:

(a)    it forms part of the cost of an intangible asset that meets the recognition criteria laid down in para­graphs 19‑54 of AS 26; or

(b)    the item is acquired in an amalgamation in the nature of purchase and cannot be recognised as an intangible asset. If this is the case, this expen­diture (included in the cost of acquisition) should form part of the amount attributed to goodwill (capital reserve) at the date of acquisition.

16. Paragraph 56 ofAS 26 provides some examples where the expenditure is recognised as an expense when it is incurred. The examples given include, expenditure on start‑up of activities (start‑up costs), unless the expenditure is included in the cost of an item of fixed asseet under AS 10. Start-up costs may consist of preliminary expenses incurred in establishing a legal entity such as legal and secretarial costs, expenditure to open a new facility or business (pre‑opening costs) or expenditure for commencing new operations or launching new products or processes (pre‑operating costs).

17. Preliminary expenses, therefore, incurred on or after, the date on which the Standard becomes mandatory for an enterprise or the preliminary expenses incurred on or after the date on which the enterprise opts to apply the Standard in the preparation and presentation of financial statements would be written off in the year in which they are incurred. The expenditure on preliminary expenses shall not be carried forward in the balance sheet to be written off in subsequent accounting periods.

18. Preliminary expenses already shown in the balance sheet on the date the Standard is first applied would be required to be accounted for in accordance with the requirements laid down by paragraph 99 of AS 26.

19. The auditor should verify these expenses with reference to supporting documents such as invoices and contracts relating to these expenses. In the case of a company, auditor should also examine that the reimbursement of such expenses to promoters is in accordance with disclosures made in the prospectus. Compliance with legal provisions regarding reimbursement of the promoters' expenses should he specifically examined. In addition to the audit procedures mentioned above, auditor should also apply the following audit procedures with regard to preliminary expenditure:

(a)     The auditor should verify whether the preliminary expenses incurred on or after the date Standard is applied by the enterprise are entirely charged to the profit and loss account in the year in which they are incurred.

(b)     In the case of preliminary expenses already appearing in the balance sheet on the date the Standard is applied, the auditor should satisfy himself that the estimate made by the management of the enterprise of the useful life preliminary expenses is appropriate.

(c)     The auditor should verify whether the carrying      amount of the preliminary expenses appearing in the balance sheet is eliminated with a corresponding adjustment to the opening bal­ance of the revenue reserve in case the amortisa­tion period determined under paragraph 63 of AS 26 has already expired.

(d)     The auditor should satisfy himself that the pre­liminary expenses already appearing in the bal­ance sheet are being amortised in accordance with the requirements of AS 26 in case the amor­tisation period determined under paragraph 63 of AS 26 has not expired.

Expenses Related to Subscription or Issue of Shares

20. Expenses related to subscription or issue of shares include commission or brokerage on underwriting or subscription of shares or debentures, discount allowed on issue of shares or debentures. AS 26 excludes from its scope certain activities or transac­tions which are so specialised that they give rise to accounting issues that may need to be dealt with in a different way. Such accounting issues, inter alia, are accounting for discount or premium relating to bor­rowings and ancillary costs incurred in connection with the arrangement of borrowings, share issue expenses and discount allowed on the issue of shares.
    
     
21. The auditor should examine whether the payment of brokerage, commission, etc., is authorised by articles of association or other rules/regulations and is in accordance with the provisions of the relevant statute.
    
     
22. The auditor should also examine whether the rates of commission paid or payable to brokers and under­writers are in accordance with the disclosures made in the prospectus. The auditor should verify the commission with reference to the agreements with brokers and underwriters.
    
     
23. The auditor should examine the certificate issued by the merchant bankers with regard to commission payable to underwriters, and ensure that the payment made to underwriters is in accordance with such certificate.
    
     
24. Other expenses on issue of shares or debentures, such as fees of the managers to the issue, fees of the registrars to the issue including mailing and handling charges, fees of the advisors to the issue, advertisement expenses, expenses on printing and supply of prospectus and application forms, expenses on printing of share/debenture certificates, etc., should be verified with reference to supporting documents such as invoices, agreements, etc. The auditor should also exam­ine whether the Emits on such expenses as laid down in the applicable statute have been complied with.

Research and Development Expenditure

25. Entities generally incur expenditure on research and development activities. Paragraph 41 of AS 26, Intangible Assets provides that no intangible asset arising from research or from the research phase of an internal project should he recognised and should therefore, be charged as an expenses, as and when incurred. According to AS 26, expenditure incurred, in the development or during the development phase of an enterprise is required to be recognised as an intangible asset if, and only if, the requirements of paragraph 44 of AS 26 are met. It may be noted that the expenditure incurred on research or incurred during the research phase of an enterprise are required to be recognised as an expense when such expenses are incurred.

26. The expenditure, therefore, incurred in the develop­ment or during the development phase of an enterprise on or after the date on which the Standard becomes mandatory for an enterprise or the preliminary expenses incurred on or after the date on which the enterprise opts to apply the Standard in the preparation and presentation of financial statements would be recognised as an asset if the requirements of paragraph 44 of AS 26 are met. Where the expenditure qualifies to be recognised as an intangible asset then the require­ments, related to carrying amount of the intangible asset, its amortisation and disclosures, laid down by AS 26 shall apply to the development expenditure.

27. The development expenditure shown in the balance sheet on the date on which the Standard is first applied shall be accounted for in accordance with the requirements of paragraph 99 of AS 26 from that date. If any expenditure incurred on the research or during the research phase of an enterprise already appears in the balance sheet, the same shall also be required to be accounted for in accordance with paragraph 99 of AS 26 from the date the Standard is first applied by the enterprise.

28. The auditor should perform the following audit pro­cedures with regard to research and development expenditure:

(a)     The auditor should verify the research expendi­ture and development expenditure with reference to supporting documents such as purchase invoices, agreements with third parties etc. A variety of expenses may be incurred by an enter­prise during the research phase or development phase of an enterprise. The auditor should apply the procedures mentioned in the Guidance Note on Audit of Expenses with regard to the items of expenditure covered therein.

(b)     The auditor should verify that the expenses incurred on research incurred on research or incurred during the research phase of an internal project on or after the date the Standard is first applied by the enterprise are entirely charged to the profit and loss account in the year in which they are incurred;

(c)     In the case of research and development expenses already appearing in the balance sheet on the date the Standard is first applied, the auditor should satisfy himself that the estimate made by the management of the enterprise of the useful life of such expenses is appropriate;

(d)     The auditor should verify whether the carrying amount of the research and development expenses already appearing in the balance sheet is eliminated with a corresponding adjustment to the opening balance of the revenue reserve in case the amortisation period determined under paragraph 63 of AS 26 has already expired.

(e)     The auditor should satisfy himself that the research and development expenses already appearing in the balance sheet are being amortised in accordance with the requirements of As 26 in case the amortisation period determined under paragraph 63 of AS 26 has not expired.

(f)       The auditor should also examine that the intangible asset recognised is accounted for in accordance with the requirements of AS 26.

(g)     Where an intangible asset has been recognised, the auditor should verify whether the asset so recognised is tested for impairment in accordance with Accounting Standard (AS) 28, Impairment of Assets. The auditor should examine whether the test of impairment is appropriate and where impairment has occurred, an impairment loss has be provided for in the financial statements.

OTHER ITEMS

29. Expenditure during construction period includes a variety of expenditure. Some of the expenditure dur­ing construction period may also constitute rniscella­neous expenditure. Where an enterprise applies AS 26 to account for intangible assets, either voluntarily or is required to do so by operation of the accounting stan­dard itself, the accounting treatment of some of the items of expenditure during construction period might be governed by the principles enunciated in AS 26. The auditor, in such cases, should verify the expense incurred during the construction period with reference to the supporting documents, such as, invoices, contracts, etc., relating to those expenses. The auditor should also verify that the requirements of AS 26 have been complied with in accounting for such items.

30. In case where an enterprise does not apply AS 26 to account for intangible assets because it is not required to do so, the auditor apart from verifying the expense incurred during the construction' period with reference to the supporting documents, such as, invoices, contracts, etc., relating to those expenses should also examine whether the deferral and the amortisation of expenditure incurred dur­ing the construction period are in accordance with recognised accounting policies and practices (see, for example, Guidance Note on Treatment of Expenditure During Construction Period, issued by the Institute of Chartered Accountants of India). Where the entity incurs heavy expenditure of a revenue nature during the year, the benefits of which are likely to extend beyond that year, the expenditure may sometimes be deferred and written‑off over the number of years for which the benefits are expected to be derived by the entity. Some instances of such expenditure are removal of business from one location to another and massive advertisement in one year to introduce a product or develop a market. In such cases, the auditor should examine whether the deferred of the expenditure meets the relevant criteria and whether the amount of periodic write‑off of the expenditure is appropriate.

DISCLOSURES

30. The auditor should examine whether the financial statements contain adequate disclosures as required by AS 26. The auditor should also examine that the financial statements disclose the accounting policy with regard to miscellaneous expenditure. On the first occasion when AS 26 is applied by an enterprise for accounting for items of miscellaneous expendi­ture, the financial statements should also disclose the change in accounting policy with regard to miscella­neous expenditure. in accordance with the require­ments of paragraph 32 of Accounting Standard (AS) 5, Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies.

*Issued in September, 2003. The Guidance Note on Audit of Miscellaneous Expenditure shown in the Balance Sheet shall stand withdrawn in respect of audit of financial statements of enterprises for which AS 26, "Intangible Assets" has become mandatory, and in respect of entity that has chosen to apply AS 26 to account for intangible assets.

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