A.  Facts of the Case

1. A government company produces fertilisers at three manufacturing units located at two places. The company’s various plants use different processes/technologies for the manufacture of intermediate/finished products.  The company has an inventory of machinery spares of Rs. 85.76 crore as on 31^st March, 2000.  The company categorises the machinery spares as “insurance spares” since some of them are of proprietary nature with a long lead time for procurement (mainly in respect of imported spares).

2. The querist has referred to paragraph 4 of the revised Accounting Standard (AS) 2, ‘Valuation of Inventories’ which is mandatory for accounting periods beginning on or after 1.4.1999 which states, inter alia, 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’.  The querist has also referred to paragraph 8.2 of AS 10 which states as below:

“8.2  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.”

3.  As per the querist, according to AS 2, inventories should not include machinery spares which can be sparingly used.  Such categories of spares are generally called insurance/capital spares.  It will include spares which are proprietary in nature.  The querist has referred to an opinion issued by the Expert Advisory Committee earlier which is contained in Compendium of Opinions, Volume XVII, page 95, relating to accounting treatment of inventory of capital/insurance spares.

4.  The company has adopted the following procedure for accounting for machinery spares:

“If the machinery spare is used as an installed stand-by equipment, the company capitalises the same along with the original equipment.  If it is not installed but kept as a reserve in stores, it is charged to the revenue only as and when it is put to use.  If the value of the item is very high, and the benefit arising from such spare is estimated for a longer period, the new spare is capitalised as an additional item and written down value of the original spare is removed from the books.”

5.  As per the querist, fertiliser industry is a highly capital intensive industry and requires certain spares which can be used only at critical times.  The lead time required for procurement of such spares is very high as these are, generally, imported items.  Since the technology has been obtained from abroad the spares are also available only from abroad.

6. The statutory auditors of the company, in their comments on the annual accounts of the company for the year ended 31^st March, 2000, observed as below:

“Machinery spares which can be used only in connection with fixed assets, have been included in inventories instead of treating it as part of machinery”.

“Machinery spares, which can be used only in connection with an item of fixed asset and their use is expected to be irregular have to be written off on a systematic basis over a period not exceeding the useful life of the principal item.  Presently, machinery spares have been included in inventories without being written off over the life period of principal item.  The closing stock of spares at the end of the year is valued at Rs. 85.76 crore.  In our opinion this aspect is to be verified and depreciation should be provided in accordance with the Accounting Standard.”

7.  The company replied as under to the statutory auditors:

“Machinery spares cannot be included under fixed assets and its disclosure in inventory under current assets is in order.  We also have a system of making provision for obsolescence.”

8.  The government auditors also made the following comments, in their report under section 619(4) of the Companies Act, 1956:

“Inventory includes machinery spares of Rs. 907.20 lakh which can be used only in connection with an item of fixed asset and whose use is irregular.  This has not been accounted for in accordance with the provisions of AS 2 read with AS 10.”

9.  In its reply to the comments of the government auditors, the company stated that the amount represents certain insurance/critical spares identified by the company so far.  The company also stated that AS 2 and AS 10 do not deal specifically with insurance/critical spares.  They refer to only machinery spares which can be used only in accordance with an item of fixed asset and whose use is expected to be irregular.  The company will review such items presently included under machinery spares in the year 2000-01 after obtaining clarification from the Institute of Chartered Accountants of India.  Pending such clarification, the inclusion of these items under machinery spares was in accordance with the past practice.

10.   The querist has stated that different companies adopt different methods for dealing with machinery spares.  The querist has provided separately extracts from the annual reports of certain companies in this regard. According to the querist, certain companies follow the accounting standard only for spares procured on or after 1.4.1999.  As per the querist, due to lack of uniformity in the accounting treatment for machinery spares, more audit comments could arise in future.

B.  Queries

11. Keeping the above in view, the querist has sought the opinion of the Expert Advisory Committee on the following issues:

(a) Whether an item of machinery spares can be capitalised before it is put to use.

 

(b) Whether it is obligatory to capitalise the machinery spares whose use is expected to be irregular.  If yes, whether all the machinery spares held in inventory as on 31.3.1999 should be capitalised or whether only those machinery spares should be capitalised that are procured on or after 1^st April, 1999, i.e., from the date AS 2 became mandatory.

 

(c) Whether the machinery spares whose use is expected to be irregular can be shown in the balance sheet under the head ‘current assets’ with the nomenclature ‘other current assets --- machinery spares’.

 

(d) When the machinery spare is capitalised, whether depreciation is to be calculated on the basis of estimated residual life of the original plant/equipment on which the machinery spare is proposed to be utilised or whether depreciation has to be calculated with reference to the estimated life of the relevant item of machinery spare.  According to the querist, this aspect assumes importance since the company has plants with older vintage where a substantial portion of the cost has already been depreciated in the accounts and in such cases the life of the new machinery spare will be more than the estimated residual life of the original plant.

C.  Points considered by the Committee

12. The Committee notes extracts from paragraph 4 of AS 2, and paragraph 8.2 of AS 10 as reproduced in paragraph 2 above.

13. The Committee is of the view that the machinery spares referred to in paragraph 8.2 of AS 10 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’).  Such spares will also include spares of the nature of stand-by equipment.  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 item of fixed asset are of the nature of maintenance spares and not of the nature of capital spares.  Such machinery spares should be treated as inventory items and expensed when put to use.  The Committee is of the view that determination of whether a machinery spare is a capital spare or not cannot be decided merely on the basis of lead time required for procurement of such spare.  Factors normally considered in classification of spares include the purpose for which the spares are kept, separate identification with an item of plant and machinery and their value.

14. The Committee notes that both the Accounting Standards, viz., AS 2 and AS 10, are mandatory in nature.  Therefore, it is obligatory to capitalise machinery spares which are of the nature of capital spares as explained in paragraph 13 above.  The date of purchase of such spares would have no relevance on the accounting treatment.  In other words, the machinery spares of the nature of capital spares held in inventories as on 31^st March, 1999, should also be capitalised in accordance with the principles enumerated above.  Since AS 10 is mandatory in respect of accounts for periods commencing on or after 1.4.1991, appropriate disclosures may be required in accordance with Accounting Standard (AS) 5, “Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies” consequent upon change in the accounting treatment of spares to bring it in line with AS 10.

D.  Opinion

15.  On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 11:

(a) Machinery spares of the nature of capital spares as explained in paragraph 13 above should be capitalised when they are ready for use even though kept in stores.

 

(b) All machinery spares whose use is only expected to be irregular are not required to be capitalised.  However, machinery spares that can be used only in connection with a particular item of fixed asset and whose use is expected to be irregular should be capitalised.  This principle is applicable to all machinery spares irrespective of the date of their purchase (refer to paragraph 14 above).

(c)  Machinery spares that are not of the nature of capital spares should be disclosed in the balance sheet under the head ‘current assets’ as ‘machinery spares’.  However, capital spares should not be shown in this manner.  These should be disclosed under the head ‘fixed assets’.

 

(d)  Please refer to paragraph 13 above.

1Opinion finalised by the Committee on 17.1.2001.

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