Expert Advisory Committee

1.19 Query:

Capitalisation of expenditure incurred on

replacement/improvements in machines.

1. A state government corporation is engaged in the activity of manufacturing of cotton and man-made fibre yarn at its different mills scattered all over the State of Uttar Pardesh. These mills were established between the year 1976-77 to 1986-87. Due to wear and tear and technological obsolescence, the corporation had to incur heavy expenditure on replacement of some of the parts of the machines. In addition, the corporation is also working on a scheme of modernisation and diversification.

2.The querist has stated that the capacity in the spinning industry is decided on the basis of the number of spindles on the ring frames installed and worked. In order to improve the efficiency and productivity and take advantage of improved ring spinning technology, some important part of rings frames such as drafting systems, rings, spindles etc., require replacement and were accordingly replaced. Similarly, other back process machines like cards, draw-frames and speed-frames were also suitably modernised by replacing some of the crucial parts from time to time.

3. The querist has further stated that normal life of spindle and rings and drafting conversion ranges from 6 to 10 years and the conventional replacement was being done according to schedule, subject to availability of funds. However, by replacing parts like latest developed spindles and rings although the capacity (installed) does not increase but the productivity is increased. For example, in the given case, as per the querist, the earlier assessed speed of spindles was 13000 – 14000 R.P.M. and due to the change of the latest technology of spindles and rings the speed has increased to 16000 – 17000 R.P.M., which resulted in the increased efficiency and production per machine. Similarly, the earlier drafting system which was suitable to produce cotton yarn and to a limited extent man – made fibre also. However, due to change of drafting system the corporation is now in a position to process the man-made fibres, although, in the machines having changed drafting system, processing of cotton fibre is now not possible. The querist has further mentioned that in this case the technology is the same, only there is a change in design of the system which could have been opted at the time of purchase of machines itself.

4. The querist has sought the opinion of the Expert Advisory Committee on the following issues:

(a) Whether the expenditure on replacement of spindles, rings and drafting system and also replacement of some other parts under modernisation and diversification scheme should be treated as capital expenditure or revenue expenditure?

(b) Whether the said expenditure can be treated as ‘deferred revenue expenditure’ (if it can not be treated as capital or revenue) to be written-off preferably in 5 years, because the cost is ranging from 10% to 15% of the cost of individual machine.

(i) Whether individual machines should be revalued, or revaluation should be done in respect of all the machines of one category at a time?

(ii) Whether the revaluation should be done in respect of all the machines of the mill at one time?

(iii) Whether alongwith the machines, other assets like buildings, investments (unquoted) and other fixed assets should also be revalued at the same time, or the same is not necessary?

Opinion November 25, 1994

1. The Committee notes para 23 of Accounting Standard (AS) 10 on ‘Accounting for Fixed Assets’, issued by the Institute of Chartered Accountants of India, which reads as follows:

“23. Subsequent expenditures related to an item of fixed asset should be added to its book value only if they increase the future benefits from the existing asset beyond its previously assessed standard of performance.”

2. The Committee is of the view that expenditure on fixed assets subsequent to their installation may be categorised into (i) repairs, and (ii) improvements or betterment. Repairs, the Committee notes, implies “the restoration of a capital asset to its full productive capacity after damage, accident, or prolonged use, without increase in the previously estimated service life or capacity.”[1] It frequently involves replacement of parts. On the other hand, betterment is defined as “..an expenditure having the effect of extending the useful life of an existing fixed asset, increasing its normal rate of output, lowering its operating cost, or otherwise adding to the worth of benefits it can yield. The cost of adopting a fixed asset to a new use is not ordinarily capitalised unless at least one of these tests is met. A betterment is distinguished from an item of repair or maintenance in that the latter has the effect of keeping the asset in its customary state of operating efficiency without the expectation of added future benefits.”[2]

3. The Committee is of the view, on the basis of the above, that normally expenditure on repairs, including replacement cost necessary to maintain the previously estimated standard of performance, is expensed in the same period. Similarly, the cost of adopting a fixed asset to a new use or modernisation of such asset without actually improving the previously estimated standard of performance, is also expensed. Accordingly, in the view of the Committee, only such expenditures that add new fixed asset units, or that have the effect of improving the previously assessed standard of performance, e.g., an extension in the asset’s useful life, an increase in its capacity, or a substantial improvement in the quality of output or a reduction in previously assessed operating costs are capitalised. The Committee is of the view that ‘previously assessed standard of performance’ is not the actual performance of the asset at the time of repair/improvement etc., but the standard performance of the same or similar machine in its original state.

4. The Committee is of the view that although the expenditure incurred on replacement on spindles, drafting systems, rings etc., in various mills of the said corporation has stated to be resulted into change in physical performance of the corporation, it is not necessary that it would also result into improvements in previously assessed standard of performance as per para 3 above.

5. The Committee further notes that “The revaluation of fixed assets is normally done in order to bring into books the replacement cost of such assets.” [3] The Committee is of the view that the question of revaluation of assets is independent of expenditure incurred on repair/improvement of assets, notwithstanding that such expenditure may influence the replacement cost of the concerned assets. Also, in the view of the Committee, revaluation is not a substitute for capitalisation of cost incurred on improvement of the assets. Hence, the question of revaluation is not related to the main issue raised by the querist.

6. On the basis of the above. The Committee is of the following opinion in respect of the issues raised at para 4 of the query:

(a) The corporation should expense the normal expenditure on repairs of the machines, including the cost of replacement necessary to maintain the previously assessed standard of performance of the machines, in the year when such expenditure is incurred. The incremental expenditure, over and above the normal repairs, incurred on improvement of textile mills to adopt it to new use should be capitalised provided such improvements will result into improvement in the previously assessed standard of performance of such machines, as per para 3 above. In other cases, however, the whole expenditure on improvements should be expensed in the relevant year.

(b) No.

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[1] A Dictionary for Accountants by Eric C. Kohler, Fourth Edition.

[2] Ibid

[3] Para 12 of ‘Guidance Note on Treatment of Reserve Created on Revaluation of Fixed Assets’, issued by the Institute of Chartered Accountant of India.