Query No. 13

Subject:   

A.    Facts of the Case

1.   A company is engaged in transmission, processing and marketing of natural gas.  Besides sale to different customers, natural gas is also used internally by the company as a major raw material for the manufacture of LPG, polymers and other value added products and also as a fuel.  The queries raised by the querist are in the context of stores, spares and similar items held by the company.

2.  Paragraph 4 of Accounting Standard (AS) 2, ‘Valuation of Inventories’, states that “inventories do not include machinery spares which can be used only in connection with an item of fixed asset and whose use is expected to be irregular; such machinery spares are accounted for in accordance with Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’.”

3.  Paragraph 8.2 of AS 10 states as below:

“Stand-by equipment and servicing equipment are normally capitalised.  Machinery spares are usually charged to the profit and loss statement as and when consumed.  However, if such spares can be used only in connection with an item of fixed asset and their use is expected to be irregular, it may be appropriate to allocate the total cost on a systematic basis over a period not exceeding the useful life of the principal item.”

4.  Paragraph 12 of AS 10 states the following:

“12.   Improvements and Repairs

“12.1  Frequently, it is difficult to determine whether subsequent expenditure related to fixed asset represents improvements that ought to be added to the gross book value or repairs that ought to be charged to the profit and loss statement. Only expenditure that increases the future benefits from the existing asset beyond its previously assessed standard of performance is included in the gross book value, e.g., an increase in capacity.”

“12.2  The cost of an addition or extension to an existing asset which is of a capital nature and which becomes an integral part of the existing asset is usually added to its gross book value. Any addition or extension, which has a separate identity and is capable of being used after the existing asset is disposed of, is accounted for separately.”

5.  As per paragraph 8.2 of AS 10 (reproduced above), machinery spares which can be used only in connection with an item of fixed asset and whose use is expected to be irregular are to be capitalised. According to the querist, the cost of such spares as are necessary to run a machinery is already capitalised with the cost of the said machinery (at the time of installation).  The querist has contended that subsequent capitalisation of other similar machinery spares as suggested in AS 10 does not result in any increase in future benefits from the existing asset beyond its previously assessed standard of performance, i.e., in increase in capacity or efficiency of the said machinery. The expenditure on such spares only enables the enterprise to maintain the concerned machinery to perform as per the previously assessed standard of performance.  As per paragraph 12 of AS 10, such expenditure is to be charged to revenue.  According to the querist, it appears that paragraph 8.2 and paragraph 12 of AS 10 are contradictory in nature.

6.  The querist has also referred to an earlier opinion of the Expert Advisory Committee (Volume XVII, Query No. 1.30) wherein the Committee had opined that “whether the spares are purchased alongwith the concerned plant and machinery or subsequently, is irrelevant from the point of view of accounting treatment thereof.”  The Committee had further opined that “similar would be the treatment in case of spares acquired prior to or subsequent to commencement of commercial production”.

7.  According to the querist, as per the above opinion, every time any spares are procured, they have to be capitalised.  As per the querist, this position appears to be contradictory to paragraph 12 of AS 10.

B.  Queries

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

(a)  What is the definition of stand-by equipment and servicing equipment?

(b)  Which machinery spares are usually charged to the profit and loss statement as and when consumed?

(c)   According to the querist, as the majority of machinery spares are such that they can be used only in connection with an item of fixed asset for which they are procured and their use is irregular, on what basis spares that can be used only in connection with an item of fixed asset and whose use is expected to be irregular are to be identified?

(d)    Whether allocation of the total cost on a systematic basis over a period not exceeding the useful life of the principal item refers to capitalisation of the spares along with the cost of the principal asset and writing them off in the form of depreciation.

(e)   Whether there is any contradiction between paragraph 8.2 and paragraph 12 of AS 10.

(f)   Whether there is any contradiction between the opinion issued by the Expert Advisory Committee (Volume XVII, Query No. 1.30) and paragraph 12 of AS 10.

C.  Points Considered by the Committee

9.  The Committee notes that ‘A Dictionary for Accountants’ by Eric Kohler (Fifth Edition) defines the term ‘stand-by equipment’ as “one or more machines or other fixed assets considered necessary to production but remaining idle during periods of off-peak or otherwise limited operations”.  In common parlance, this term is also used to refer to those items of equipment which are put into use in place of the principal equipment occasionally, e.g., when the principal equipment is under maintenance. A servicing equipment, on the other hand, is an equipment used to service one or more assets so as to maintain them in a proper working condition.

10. The principal consideration governing the accounting treatment of machinery spares is laid down in paragraph 23 of Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’ which states 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.”

11. As a general rule, machinery spares do not increase the future benefits from an existing asset beyond its previously assessed standard of performance; they only enable the enterprise to maintain the asset at its previously assessed standard of performance.  Accordingly, machinery spares are usually charged to the profit and loss statement as and when consumed.  However, there may be situations where a machinery spare increases the future benefits from the existing asset beyond its previously assessed standard of performance.  In such a case, the cost of the spare is capitalised and allocated over the remaining useful life of the asset or over its own useful life, which is lower.

12. The Committee is of the view that paragraphs 8.2 and 12 of AS 10, to which a reference has been made by the querist, recognise the above principle.  The Committee is further of the view that the reference in paragraph 8.2 to spares that "can be used only in connection with an item of fixed asset" is to ‘capital spares’ (also called ‘insurance spares’). Capital spares, like other spares, are meant for occasional use.  However, they are so essential for the smooth operation of the machinery concerned that for all practical purposes, they are considered an integral part of the machinery.  A common example of capital spares is the spare tyre of an automobile.  The cost of such spares is written off over the useful life of the principal asset unless the useful life of such a spare is shorter than the useful life of the principal asset.

13.  The Committee is of the view that there is no contradiction between paragraphs 8.2 and 12 of AS 10.  Paragraph 8.2 deals with capital spares procured along with the principal asset.  Paragraph 12 deals with subsequent expenditure on spares.  The mere fact that certain capital spares have also been procured along with the principal asset and capitalised does not imply that there cannot be any subsequent procurement of spares which increase the benefits from the asset beyond its previously assessed standard of performance and which, therefore, need to be capitalised.  The Committee also does not find any contradiction between its opinion referred to in paragraph 4 above and paragraph 12 of AS 10.  As stated earlier, capital spares are, for all practical purposes, an integral part of the principal asset and thus contribute directly to the benefits to be derived from the asset.  They are therefore capitalised.  The opinion under reference implies that spares acquired subsequent to commencement of commercial production that increase the future benefits from the existing asset beyond its previously assessed standard of performance are in the nature of 'improvements' and should be capitalised.  On the other hand, spares which do not increase the future benefits from the existing asset beyond its previously assessed standard of performance are in the nature of repairs and should be expensed in the year of incurrence.

D. Opinion

14.  On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 8:

(a)   Please see paragraph 9 above.

(b)   Machinery spares that do not increase the future benefits from the existing asset beyond its previously assessed standard of performance are charged to the profit and loss statement as and when consumed.

(c)   The issue whether certain spares are in the nature of capital spares should be determined based on the considerations set forth in paragraph 12 above.

(d)   In case the useful life of a capital spare is co-terminous with the useful life of the principal item, its cost can be capitalised along with cost of the principal item.  If, however, the useful life of the spare is shorter than the useful life of the principal item, it may be appropriate to account for the spare as a separate item and write it off over its own useful life on a systematic basis.

(e)   There is no contradiction between paragraphs 8.2 and 12 of AS 10.

(f)   There is no contradiction between the opinion issued by the Expert Advisory Committee earlier (Volume XVII, Query 1.30) and paragraph 12 of AS 10.

1Opinion finalised by the Committee on 24.4.2000.