Query No. 32 Subject: Accounting treatment of machinery spares.1 A. Facts of the Case
1. A public sector undertaking is engaged in the business of manufacture and sale of heavy earth moving equipment like dumpers, dozers, graders and surface transport systems like electrical multiple units, rail coaches, etc. Apart from this, the company also produces sophisticated defence aggregates.
2. The manufacture of heavy earth moving equipment like dumpers calls for an array of processes and technologies. For instance, the basic raw material, i.e., steel plate may first undergo the flame cutting process in computer controlled flame cutting machines. Depending upon the requirement, the flame cut components may be subjected to boring, drilling or milling operations. These processes are highly capital and technology intensive warranting use of hightech computer based machines. In fact, some of the structures are welded using arc-welding robots before assembling them into products. These machines and manufacturing systems being highly capital intensive, demand a high degree of maintenance to keep them in continuous productive use. This, in turn, results in maintenance of inventory of consumables, stores and spares.
3. Upto the financial year 1998-99, machinery spares were being treated by the company as part of inventory and shown accordingly in the balance sheet. The profit and loss account was being debited at the time when issued for consumption. A provision of 5% of the value was also being made towards obsolescence in case of non-movement of spares for a period of more than two years. This accounting treatment for machinery spares was accepted both by the statutory auditors and the government auditors.
4. During the audit for the year 1999-2000 the government auditors raised an objection in respect of the accounting treatment being followed regarding machinery spares. They were of the view that machinery spares should not be reflected in the balance sheet as an item of inventory on the following grounds:
(a) The revised Accounting Standard (AS) 2, ‘Valuation of Inventories’, which is effective for accounting periods commencing on or after 01.04.1999, specifically excludes machinery spares. In the case of the company, the spares (with irregular use) are used only in connection with an item of fixed assets.
(b) Since they are excluded from AS 2, such machinery spares have to be accounted for in accordance with Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’.
5. The company contended that machinery spares, whether in regular use or not, is basically a current asset and as such forms part of inventory. The querist has forwarded the following arguments in support of the company’s contention:
(a) According to the querist, AS 10 is silent on the treatment of machinery spares. Therefore, it is prudent to categorise machinery spares as inventory.
(b) Replacement of a machinery part in a fixed asset, on account of wear and tear due to utilisation of the asset, does not result in an increase in the capacity of the asset, nor such replacement results in extension to an existing asset or in enhancing its technical life. Therefore, as per the querist, such replacement is of revenue nature and should not be included in the cost of the fixed asset.
(c) As per the querist, writing off the value of machinery spares over the technical life as deferred revenue expenditure is also not feasible, for the reason that such write-off is effected without the consumption of spares. Further, on the complete write-off of the value, the company will be holding spares at zero value without any consumption. Monitoring the movement of spare parts whose existence is not in the books of account or in stores record will lead to undermining of internal control system.
(d) According to the querist, considering the practical difficulties involved in treating machinery spares under AS 10, machinery spares should be disclosed under current assets as a part of inventory.
B. Query
6. The querist has sought the opinion of the Expert Advisory Committee on the treatment of machinery spares in the light of revised AS 2 and AS 10.
C. Points Considered by the Committee
7. The Committee notes paragraph 4 of Accounting Standard (AS) 2, ‘Valuation of Inventories’, which states, inter alia, that “inventories also encompass finished goods produced, or work in progress being produced, by the enterprise and include materials, maintenance supplies, consumables and loose tools awaiting use in the production process. 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’”.
8. The Committee also notes paragraph 8.2 of AS 10 which states as below:
9. The Committee is of the view that the machinery spares referred to in paragraph 8.2 that can be used only in connection with a particular item of fixed asset and their use is expected to be irregular are often termed as capital spares (also called ‘insurance spares’). Accordingly, for all practical purposes, they are considered an integral part of the machinery. 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. However, the machinery spares that can be used in connection with more than one equipment/item of fixed asset are of the nature of maintenance spares and not of the nature of insurance spares or capital spares. Such machinery spares should be treated as inventory items and expensed when put to use.
D. Opinion
10. On the basis of the above, the Committee is of the opinion that the cost of machinery spares of the nature of capital spares should be 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. However, the machinery spares not of the nature of capital spares should be treated as inventory items and expensed when put to use. 1Opinion finalised by the Committee on 25.9.2000 |