Statutory Audit of Capital Work-in-Progress (CWIP) in Indian Companies [Company law]

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Introduction

Capital Work-in-Progress (CWIP) refers to assets that are under construction or development and are not yet ready for use. These are typically large projects like buildings, machinery, or infrastructure which are recorded on the balance sheet until they are completed and capitalized as fixed assets. Auditing CWIP is critical because it involves ensuring proper accounting, classification, valuation, and compliance with relevant laws and accounting standards.

Legal Framework

1. Companies Act, 2013:
   • Section 128: Requires companies to maintain proper books of accounts, including detailed records for CWIP.
   • Section 129: Mandates that financial statements must be prepared in accordance with the prescribed accounting standards, ensuring CWIP is accounted for accurately.
   • Schedule III: Prescribes the format of the balance sheet, which includes CWIP under non-current assets. This schedule provides the detailed classification of CWIP.
   • Section 134: Requires the Board of Directors to approve financial statements, ensuring they include proper disclosures related to CWIP.
2. Indian Accounting Standards (Ind AS):
   • Ind AS 16 – Property, Plant, and Equipment (PPE): Governs the accounting treatment of CWIP since it relates to future PPE. Key aspects include:
     • Recognition: CWIP should be recognized when expenditure is incurred that will bring the asset to the condition necessary for it to be capable of operating.
     • Measurement: CWIP should be measured at cost, which includes all directly attributable costs such as labor, materials, and overheads.
     • Capitalization: Upon completion, CWIP should be transferred to the appropriate asset category (e.g., buildings, machinery).
     • Impairment: Ind AS 36 – Impairment of Assets mandates that CWIP should be tested for impairment if there are indicators of a reduction in value.
3. Accounting Standards (AS):
   • AS 10 – Accounting for Fixed Assets: For companies not covered under Ind AS, this standard governs the treatment of CWIP.
   • AS 16 – Borrowing Costs: Provides guidelines for capitalizing borrowing costs directly attributable to the construction or development of CWIP.
4. Income Tax Act, 1961:
   • Section 32: Deals with depreciation on assets once CWIP is capitalized. While CWIP is not depreciated, it must be capitalized before depreciation can be claimed.
5. ICAI Guidance Notes:
   • The Institute of Chartered Accountants of India (ICAI) provides guidelines for auditors on how to audit CWIP, emphasizing the need for proper classification, allocation of costs, and disclosure.

Detailed Audit Procedures

1. Understanding the Nature of CWIP
   • Review the nature and purpose of the projects classified as CWIP. Assess the type of assets under construction and their expected completion timeline.
   • Understand how the company identifies and tracks CWIP costs, ensuring that only capitalizable expenses are included.
2. Verification of Recognition and Measurement
   • Ensure that only those expenditures which are directly attributable to the construction or development of the asset are classified as CWIP.
   • Review the supporting documents (e.g., invoices, contracts, and payment vouchers) to verify the nature and legitimacy of expenses.
   • Check whether costs like labor, materials, and allocated overheads have been accurately recorded and capitalized.
3. Review of Borrowing Costs
   • For projects that involve significant borrowing, ensure that borrowing costs are capitalized in accordance with AS 16 or Ind AS 23 (as applicable).
   • Review loan agreements and interest computations to ensure proper allocation of borrowing costs to CWIP.
4. Physical Verification of Assets
   • Conduct physical verification of the assets under construction to ensure that the CWIP is genuine and not inflated.
   • Compare the progress of construction with project plans and timelines to ensure the accuracy of recorded costs.
5. Review of Contracts and Project Timelines
   • Examine contracts with suppliers and contractors to verify the scope of work and completion milestones.
   • Cross-check project timelines with the completion status to ensure that costs are not prematurely capitalized.
6. Review of Capitalization
   • Ensure that completed CWIP is transferred to the appropriate fixed asset category when the asset is ready for use.
   • Check for proper documentation to support the completion of the asset (e.g., completion certificates, invoices for final payments).
   • Verify that depreciation is only charged after capitalization and not during the CWIP phase.
7. Impairment Testing
   • Assess whether there are any indicators of impairment for CWIP, such as delays in project completion, cost overruns, or changes in market conditions.
   • If there are indicators, review impairment tests performed by management in line with Ind AS 36 and ensure proper disclosure of impairment losses.
8. Disclosure and Compliance
   • Ensure that disclosures related to CWIP in the financial statements are in compliance with Schedule III of the Companies Act, 2013, and the relevant accounting standards.
   • Verify that CWIP is classified under non-current assets and that adequate details are provided in the notes to the financial statements, including information on capital commitments, advances to contractors, and borrowing costs capitalized.
9. Reconciliation with General Ledger
   • Reconcile the CWIP ledger with the general ledger to ensure accuracy in reporting.
   • Verify that no operating expenses are incorrectly charged to CWIP, and only appropriate capital expenditures are included.
10. Review of Work Stoppages and Abandoned Projects
    • Review projects that have been stopped or delayed to ensure that costs are not capitalized beyond the point of abandonment.
    • If a project is abandoned, ensure that the related CWIP is written off in the books.

Practical Examples

1. Scenario 1: Overstatement of CWIP Costs
   • Scenario: A company has recorded substantial costs under CWIP for a factory under construction, but some of the costs appear to be related to repairs of existing equipment.
   • Audit Approach: Review the nature of the expenses charged to CWIP, cross-check with invoices, and ensure that only construction-related costs are capitalized.
   • Practical Insight: Reclassify any non-capitalizable costs (such as repairs) as operating expenses to avoid overstatement of CWIP.
2. Scenario 2: Borrowing Costs Not Capitalized
   • Scenario: The company financed the construction of a plant through loans, but failed to capitalize the borrowing costs.
   • Audit Approach: Review loan agreements, calculate the borrowing costs attributable to CWIP, and ensure that they are capitalized in compliance with AS 16 or Ind AS 23.
   • Practical Insight: Ensure proper capitalization of interest costs related to the project to reflect the correct value of CWIP.
3. Scenario 3: Delayed Project Completion
   • Scenario: A company’s construction project has been delayed by several months due to regulatory issues, but the CWIP continues to accumulate costs.
   • Audit Approach: Assess the reasons for the delay, ensure that impairment testing is conducted, and verify whether costs beyond the delay period should be capitalized.
   • Practical Insight: Impairment may need to be recognized if the project’s expected benefits are diminished due to delays, avoiding overstatement of CWIP.
4. Scenario 4: CWIP Transferred Without Completion
   • Scenario: The company transferred a significant portion of CWIP to fixed assets even though the asset was not ready for use.
   • Audit Approach: Verify the completion certificates and project milestones, ensuring that capitalization only occurs once the asset is fully operational.
   • Practical Insight: Ensure the asset is only capitalized upon completion to prevent premature depreciation.
5. Scenario 5: Incorrect Classification of Operating Costs
   • Scenario: The company capitalized routine operating expenses, such as utilities and rent, into CWIP.
   • Audit Approach: Review the nature of the costs, ensuring that only those directly attributable to the construction of the asset are capitalized.
   • Practical Insight: Reclassify operating expenses to the profit and loss account and ensure proper allocation of capitalizable costs to CWIP.
6. Scenario 6: Work Stoppage Due to Legal Issues
   • Scenario: Construction on a project was halted due to a legal dispute, but costs continued to be capitalized in CWIP.
   • Audit Approach: Assess the impact of the legal dispute on the project and ensure that no further costs are capitalized unless construction resumes.
   • Practical Insight: Impairment testing may be necessary, and any ongoing costs during the stoppage should be expensed, not capitalized.
7. Scenario 7: Impairment of CWIP Due to Technological Obsolescence
   • Scenario: The company’s CWIP for a manufacturing plant is impacted by new technological advancements, rendering parts of the project obsolete.
   • Audit Approach: Evaluate whether the technological advancements impact the future benefits of the asset under construction, and perform impairment testing.
   • Practical Insight: Record an impairment loss if the project is no longer expected to deliver the originally anticipated benefits.
8. Scenario 8: Incorrect Treatment of Advances to Contractors
   • Scenario: The company treated advances to contractors as part of CWIP.
   • Audit Approach: Review contract terms, ensure that advances are recorded as advances and not capitalized into CWIP until actual work is completed.
   • Practical Insight: Reclassify advances to contractors and recognize costs as part of CWIP only when work is performed.

Conclusion

Auditing Capital Work-in-Progress requires careful attention to detail, a thorough understanding of applicable laws, and familiarity with the company’s projects and accounting policies. Auditors need to ensure that costs are appropriately capitalized, borrowing costs are handled properly, and impairment issues are addressed. By following detailed audit procedures and considering practical scenarios, auditors can enhance the accuracy and reliability of financial reporting related to CWIP.

Author

CA Sourabh Kothari (C.A., B.Com)
He is currently working as Partner – Risk and Transaction advisory with a renowned firm in Jaipur having experience in Internal Audit, IFC Audit, Business consultancy, Due Diligence and Management consultancy.
E-mail: Sourabh.kothari@jainshrimal.in | LinkedIn: Sourabh Kothari

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