1.16 Query: Treatment of replacement cost of components of a fixed asset.
1. A Government of India Undertaking, registered under the Companies Act, 1956, engaged in refining and marketing of petroleum products, is having its refineries in Bombay and Visakhapatnam. The company’s refinery has a captive power plant operational since May 1989, with four Gas Turbine Generating Sets (GTGs) alongwith corresponding Heat Recovery Steam Generators (HRSGs). Various components of GTGs need regular overhauling in line with scheduled cycle of number of hours of operations prescribed as per Manufacturers’ Manual. In hot zone of the GTGs, critical parts are exposed all the time to very high temperatures leading to fracture of these parts as a result of which the parts in hot zone portion of GTG are required to be replaced strictly as per their life expectancy.
2. In line with the above referred overhauling schedule, replacement of major items (items comprising Combustors, Rotor Blades, Stator Blades, Disk Stopper, Trubine Inlet Casing etc.,) was carried out in two GTGs during the year 1993-94. The total cost of these parts was Rs.15.13 crores as against the original cost of the two GTGs of Rs. 43.52 crores. The entire cost of these parts was capitalised during the year 1993-94. Depreciation of these capitalised spares was provided over the useful life of these items, namely, four years, i.e., @ 25% per annum on Straight Line Method on the basis of the life expectancy advised by the manufacturers. Similarly, during the year 1994-95, major items needed for scheduled overhauling of three GTGs costing Rs.10.00 crores were capitalised with depreciation @ 25% per annum on Straight Line Method.
3. It may be mentioned in this context that at the time of capitalisation of the major parts as mentioned above, residual book value of the old parts was deleted from the books of account simultaneously. On the basis of the ‘matching concept’ of revenues with relevant costs, which is one of the fundamental principles of accounting, the capitalisation of the critical GTG spares is fully justified. This concept has been followed by the company consistently over a number of years and such capitalisation results in correct treatment in the accounts on ‘matching concept’ basis. In other words, the cost of the said critical parts is charged over the life of these parts so that costs are evenly spread over the life of these parts rather than loading the large value of these parts as costs of the year in which they ae used in overhauling.
4.The above accounting treatment is in line with Para 8.2 of AS-10 on “Accounting for Fixed Assets”, issued by the Institute of Chartered Accountants of India, which reads as under:
5. The querist has also relied upon an earlier opinion of the Expert Advisory Committee of the Institute of Chartered Accountants of India, in the case of Westland Helicopters which has been published in the Compendium of Opinions, Volume XI, Query 1.30, Para 4 of the Opinion, quoted as under: -
6. The Comptroller and Auditor General of India, while giving his comments under Section 619(4) of the Companies Act, 1956, has opined that replacement of certain parts of an existing asset as mentioned above should not be capitalised, but should be charged to revenue, in view of Para 23 of AS-10, as quoted hereunder:
7. The querist has sought the opinion of the Expert Advisory Committee on the appropriate method of treatment of the expenditure incurred on replacement of major parts of GTGs in the refineries of the querist company.
Opinion November 1, 1995
1. The Committee notes that para 8.2 of Accounting Standard (AS) 10, on ‘Accounting for Fixed Assets’, issued by the Institute of Chartered Accountants of India, states, inter alia, as quoted by the querist in para 4 of the query.
2. The Committee also notes from the facts of the query, that various components of (GTG) need regular overhauling which is in line with the scheduled cycle of number of hours of operations. Thus, the said spares are required to be replaced at regular intervals of time. The Committee further notes that the company has been originally treating a GTG as a single unit of fixed asset and charging depreciation accordingly on the composite GTG.
3. The Committee further notes para 23 of Accounting Standard (AS) 10 on ‘Accounting for Fixed Assets’ issued by the Institute of Chartered Accountants of India, as quoted by the querist in para 6 of the query.
4. The Committee is of the view that expenditure on fixed assets subsequent to their installation may becategorised into (i) repairs and replacements, and (ii) improvements or betterments. The Committee notes that repairs lead to “the restoration of a capital asset to its full productive capacity or a contribution thereto, after damage, accident, or prolonged use, without increase in its previously estimated service life or productive capacity.”* The Committee is of the view that the nature of replacements is similar to that of repairs. On the other hand, betterment is defined “... as expenditure having the effect of extending the useful life of an existing fixed asset, increasing its normal rate of output, lowering its operating cost, increasing rather than merely maintaining efficiency or otherwise adding to the worth of benefits it can yield. The cost of adapting 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 furure benefits.”** The Committee is of the view that only the latter types of expenditures increase the future benefits from the existing asset beyond its previously assessed standard of performance.
5. Based on the above, the Committee is of the view, that various components of Gas Turbine Generating Sets (GTG), could be used only in connection with an item of fixed assets but their use is not irregular. Moreover, the expenditure on regular overhauling only results in maintaining the previously estimated standard of performance and it does not have the effect of improving the previously assessed standard of performance.
6. The Committee is, therefore, of the opinion that the replacement of component parts in question should be expensed in the period of incurrence thereof and not capitalised.
__________________________ * A Dictionary for Accountants by Eric C. Kohler (5th Edition) ** Ibid. |