The Government Grants may be in the form of the following two.
1) In the nature of Promoter's Contribution
2) In the form of an Income, where the income is taken to the P&L and included for computation of profit or loss.
GRANTS IN THE FORM OF PROMOTER'S CONTRIBUTION
A Government may invest its grant money in an undertaking when the undertaking is initially setting up its business or is expanding its business or it might be in the form of contribution towards its total capital outlay (Example: Central Investment Subsidy Scheme).
In this case, no repayment is expected normally.
These grants in the form of Promoters Contribution are given to those based on certain conditions which the undertaking is supposed to meet.
They are not earned and represent an incentive provided by the Government without any related costs.
ACCOUNTING TREATMENT OF GRANTS RECEIVED AS PROMOTER'S CONTRIBUTION:
The grants are to be treated as capital reserve which can be neither distributed as dividend nor considered as deferred income.
The grants are to be treated as a capital reserve because and are not available for dividends because, capital reserves are special purpose reserves which can be utilized only for specific purposes. They are not free reserves.
Upon non-fulfillment of conditions attached to the grant, the grant becomes refundable.
The Accounting Treatment if the grant becomes refundable is to deduct the relevant amount, whether it becomes partly or fully refundable, such amount will be deducted from the Capital Reserve.
A Government grant which is refundable is treated as an extra-ordinary item.
Here comes an Illustration for your understanding
Finger Foods Pvt Ltd has decided to set up its business in a backward area which is designated by the Government. For this purpose, it made an investment of Rs.100 Lakhs. The company is eligible for 25% subsidy and received Rs.25 Lakhs from the Government. Explain the accounting treatment of the subsidy given by the Government. Is it a capital subsidy?
Subsidy received by Finger Foods Pvt Ltd is in the nature of Promoter's contribution, hence it is a Capital Subsidy. The Government has given the grant to the Company by way of contributing to total capital outlay. Looking at the nature of the grant, it is also understood that no repayment is expected. Hence this grant should be taken to the Capital Reserve. Since it is taken to the Capital Reserve, it is not to be used for any other non-specific purpose or for distribution of dividends.