Query No. 12

Subject:

Accounting treatment of replacement cost of a part of a fixed asset. [1]

A. Facts of the Case

1. A public sector enterprise is engaged in mining of bauxite, manufacturing of alumina and aluminium, and selling of these products. While mining, the overburden, i.e., the top layer of soil, is removed and bauxite is transported to the primary crushers through dumpers. After such primary crushing, bauxite is transported through a 14.6 km. long conveyor belt to the alumina refinery.

2. The conveyor system was capitalised on 1.1.1987 with a value of Rs. 41.37 crore. The break-up of the capital cost was as follows:

3. The company’s accounting policy on treatment of replacement of major machinery components as listed under paragraph 6.1 of ‘Statement on Significant Accounting Policies’ is reproduced below:

“Replacements of major machinery components of high value like gear boxes, transformers, conveyor belts, wire ropes etc. are charged to profit and loss account in the year of replacement.”

4. During the financial year 1996-97, due to wear and tear, the rope used in the conveyor system was replaced by a new one at a cost of about Rs. 8 crore. According to the querist, as the new rope did not increase the capacity and was a component of the total asset, i.e., conveyor system, the company charged the full cost of the new rope to repairs and maintenance in accordance with its accounting policy, with the old rope continuing to appear in the books of account.

5. As per the querist, the net book value of the rope as on 31.3.1998 was Rs. 1.19 crore. The company started the process for its disposal as scrap. The highest tendered rate obtained was Rs. 30.06 lakh.

6. According to the querist, during the audit of accounts for the year 1997-98, the government auditors pointed out that as per Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, assets retired should be shown separately at net book value or realisable value whichever is less. According to them, as the worn out rope had been withdrawn from use and action had been initiated for its disposal, it should be shown separately at realisable value and necessary provision should be created in the books of account.

7. As per the querist, the contention of the company is that the wire rope is a component of total conveyor system and is not considered as an independent item of plant and machinery. Replacement of wire rope during 1996-97 was charged to profit and loss account as was being done in all other similar cases of replacements of individual components of various machineries like motors, gear boxes, transformers, etc. Moreover, the new rope in no way increased the capacity of the conveyor system. Therefore, the company considered it proper to charge the cost of the new rope to revenue and retain the value of the old rope in asset account and continue to charge the depreciation on the whole conveyor system in the normal course.

8. According to the querist, the government auditors were not satisfied with the reply of the company and requested the company to get an expert opinion from the Institute of Chartered Accountants of India.

B. Queries

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

(a)     Whether charging the cost of replacement of individual components of plant and machinery to revenue and retaining the value of old component in the asset account is in order when the replacement does not add to the efficiency or life of such plant and machinery.

(b)     Whether the accounting policy disclosed by the company needs any review.

C.  Points Considered by the Committee

10. The Committee notes paragraph 23 of Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, which states as under:

“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.”

11. Expenditure on fixed assets subsequent to their installation may be categorised into:

(i)  repairs and replacements, and

(ii)  improvements or betterments.

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” [Kohler’s Dictionary for Accountants (6th Edition)]. 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 future benefits” [Kohler’s Dictionary for Accountants (6th Edition)]. It is obvious that only the latter types of expenditure increase the future benefits from an existing asset beyond its previously assessed standard of performance.

12. Based on the facts of the query, the Committee is of the view that the expenditure on replacement of the worn out rope only resulted in maintaining the previously assessed standard of performance; it did not result in an improvement beyond the previously assessed standard of performance. Therefore, the expenditure is in the nature of repairs and replacements and it is appropriate to expense it in the year of incurrence.

13. The Committee notes paragraphs 24 and 26 of AS 10 which provide as below:

“24. Material items retired from active use and held for disposal should be stated at the lower of their net book value and net realisable value and shown separately in the financial statements.”

“26. Losses arising from the retirement or gains or losses arising from disposal of fixed asset which is carried at cost should be recognised in the profit and loss statement.”

The Committee is of the view that AS 10 lays down the above requirements in respect of a complete unit of fixed asset and not in respect of its component parts. In the present case, the rope is not being accounted for as a separate unit of fixed asset. Therefore, the Committee is of the view that the above requirements of AS 10 are not per se applicable in the present case.

14. As regards the estimated scrap value of the worn out rope, the Committee is of the view that this should be shown as a deduction from the cost of the new rope and only the net expenditure charged to the profit and loss account. As the worn out rope is held for disposal, it should be included as a part of current assets in the balance sheet and shown separately, if the amount is material.

D. Opinion

15. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 9:

(a)  Yes. The cost of replacement of the rope should be charged to revenue. However, in doing so, the estimated scrap value of the worn out rope should be deducted from the cost of the new rope.

(b)    The accounting policy disclosed by the company is in order provided the replacements referred to therein do not increase the future benefits from the assets concerned beyond their previously assessed standard of performance.

[1] Opinion finalised by the Committee on 15.1.1999.