Query No. 40

Subject:           

Accounting treatment of insurance spares.1

A. Facts of the Case

1. A  government  undertaking  registered  as  a  company  under  the Companies  Act,  1956,  operates  under  the  Department  of  Defence Production,  Ministry  of  Defence,  Government  of  India.  The  company manufactures a wide range of products like super alloys, titanium alloys, maraging  steel,  molybdenum,  etc.,  for  strategic  sectors  like  space, aeronautical, nuclear power and commercial sectors like lamp, furnace, instrumentation, electronics, communications, petroleum, petrochemicals, fertilisers, etc. The turnover of the company for the financial year 2000-2001 was Rs. 112 crore.

2. While procuring plant and machinery, spares for two years’ normal operations are also procured by the company from the original equipment manufacturers and are capitalised in line with the accounting policy of the company which reads as below:

“Initial  pack  of  spares  procured  along  with  plant,  machinery  and equipment  are  capitalised  and  depreciated  in  the  same  manner  as plant and machinery.”

3. The company, as on 31st  March, 2001, has in stock and categorized as inventory, spares procured subsequently in various years amounting to Rs.  441.58  lakh  of  which  Rs.  327.29  lakh  are  identified  as  insurance spares, to be used in repair and replacement of spares of the machinery and equipment as and when the breakdown occurs. They are stocked and stored as insurance spares in order to ensure that there is no interruption in production process for want of such spares. The company also provides for redundancy @ 50% of the book value of such spares which have not moved  for  more  than  three  years.  The  company  is  maintaining  these spares for plant, machinery and equipment which have been in use for more than 20 years and have already served their useful life and due to paucity of funds, have not been replaced but are still being used.

4. The querist has referred to an earlier opinion of the Expert Advisory Committee on the accounting treatment of inventory of capital/insurance spares published in Compendium of Opinions, Volume XVII (No.1.30) which  states  in  paragraph  3  that  “….capital  spares/insurance  spares  of the nature of stand-by equipment should be capitalised. Depreciation on such spares should be charged from the date they are ready for use even though kept in stores since as stand-by spares, their ‘use’ is to await their turn in the production process in the event of breakdown. On the other hand, machinery spares should be charged to profit and loss account as and when consumed. However, where such spares could be used only in connection  with  an  item of  fixed  asset  and  their  use  is  expected  to  be irregular,  then  it  would  be  appropriate  to  allocate  the  total  cost  of  the spares on a systematic basis over a period not exceeding the useful life of the asset from the date of acquisition”.

5. The  querist  has  also  referred  to  another  opinion  of  the  Expert Advisory  Committee  published  in  Compendium  of  Opinions,  Volume XVIII (No.12) on the accounting treatment of replacement cost of a part of  a  fixed  asset  which  states  that  keeping  in  view  paragraph  23  of Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, repair and replacement cost which does not increase the previously estimated service life or productive capacity, should be charged to revenue.

6. As per the querist, the insurance spares, usually, are in the nature of spares  for  repair  and  replacement  and  they  do  not  either  increase  the previously estimated service life or increase the productive capacity of the  asset,  but  are  stored  for  use  to  ensure  that  the  operations  of  the company do not come to a grinding halt for want of the required spares. The  querist  has  stated  that  if  the  opinion  referred  to  in  paragraph  4 above, is to be followed, it would be in violation of the opinion referred to in paragraph 5 above.

7. As  per  the  querist,  the  government  auditors  while  auditing  the accounts of the company for the year 2000-01, have commented that the spares valuing Rs. 327.29 lakh, which are stand-by insurance spares and relatable to specific items of fixed assets, should be capitalised in terms of paragraph 8.2 of AS 10.

B. Queries

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

        (a)        Whether it would be in order to carry the insurance spares as a part  of  inventory till  they are  charged  off  to  revenue                      as  and when the same are used, keeping in view paragraph 23 of AS 10  which  states  that  “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”.

         (b)        If  the  answer  to  (a)  above  is  in  the  affirmative,  whether  it would  be  correct  to  write  off  the  whole  amount  of                      such insurance  spares  that  could  be  used  in  connection  with  that fixed asset, as and when such fixed asset is either                     discarded or sold?

         (c)        If the answer to (a) above is not in the affirmative, what would be  the  basis  of  charging  the  cost  of  spares  on  the                       machine when the useful life of the machine has already expired.

        (d)        Whether  an  item  of  capital/insurance  spares,  that  can  be identified with a particular asset, can be charged to revenue, if                      the year of purchase and consumption (use) is the same, since there is no necessity to stock the spares or retain it as a part                      of inventory.

C. Points considered by the Committee

9. The  Committee  has  examined  only  the  particular  issues  raised  by the querist in paragraph 8 above, and has not examined any other issue that may be contained in the facts of the case, such as, appropriateness or otherwise of the provision for redundancy, as those issues have not been specifically raised by the querist.

10. The  Committee  notes  paragraphs  8.2,  12  and  23  of  AS  10, ‘Accounting for Fixed Assets’, which state 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.”  

 

“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.”  

“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. The Committee also notes paragraph 4 of Accounting Standard (AS) 2,  ‘Valuation  of  Inventories’,  issued  by  the  Institute  of  Chartered Accountants of India, which states as below:  

“4. Inventories  encompass  goods  purchased  and  held  for  resale, for example, merchandise purchased by a retailer and held for resale, computer software held for resale, or land and other property held for resale. 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.”

12. On  the  basis  of  the  paragraphs  of  AS  2  and  AS  10  reproduced above,  the  Committee  is  of  the  view  that  the  accounting  treatment  of machinery spares should be as below:

         (a)        Machinery spares which are not specific to a particular item of fixed asset but can be used generally for various items of                       fixed assets should be treated as inventories for the purpose of AS 2.

         (b)        The following types of machinery spares should be capitalised being of the nature of capital spares/insurance spares –

                      (i)   Machinery spares which are specific to a particular item of fixed asset, i.e., they can be used only in connection with a                            particular item of the fixed asset, and

                      (ii)        their use is expected to be irregular.

Capital spares are meant for occasional use. Since they can be used only in relation to a specific item of fixed asset, they are to be discarded in case that specific fixed asset is disposed of. In other words, such spares are integral parts of the fixed asset.

13. Machinery spares of the nature described in paragraph 12(a) above, are charged to profit and loss account as and when issued for consumption.

14. Machinery  spares  of  the  nature  of  capital  spares/insurance  spares are capitalised separately at the time of their purchase whether procured at the time of the purchase of the fixed asset concerned or subsequently.Depreciation on capital spares purchased along with the fixed assets is charged on a systematic basis over a period not exceeding the useful life of the fixed asset to which they relate. When the capital spare/insurance spare  is  actually  used,  i.e.,  it  replaces  the  worn  out  spare  in  the  fixed asset, the written down value of the capital spare, on the date it is put to use, should be immediately expensed. This is because the replacement of the  spare  does  not  increase  the  future  benefits  from  the  existing  asset beyond its previously assessed standard of performance. The capital spare/ machinery spare purchased subsequent to the purchase of the machine is capitalised  and  depreciated  on  a  systematic  basis  over  a  period  not exceeding the remaining useful life of the related fixed asset and when replaced should be treated in the manner explained above.

15. A stand-by equipment is not of the nature of the spare but is of the nature  of  another  piece  of  equipment  which  is  being  used  in  the manufacturing process. For  example,  a  generator set  kept  in  store as  a stand-by to the generator set which is being used in the manufacturing process. The stand-by equipment is a separate fixed asset in its own right and is depreciated like any other fixed asset.

16. On the basis of the above, the Committee is of the view that there is no  contradiction  between  the  opinions  mentioned  in  paragraph  4  and paragraph 5 above.

17. The Committee is also of the view that the accounting policy followed by the company that the initial pack of spares procured along with plant, machinery and equipment are capitalised, should be reviewed in the light of the above, particularly, the company should distinguish between the spares of the nature of capital spares and other spares.

D. Opinion

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

                (a)        Insurance spares should be capitalised on purchase as explained above and should be depreciated on a systematic basis                            over the useful life of the related fixed asset. When an insurance spare is used as a replacement of the existing part in                            the fixed asset, the  written  down  value  of  the  spare  should  be  charged  to revenue. This meets the requirement of                            paragraph 23 of AS 10, i.e., it is not added to the book value of the fixed asset because it does not increase the future                            benefits from the existing asset beyond its previously assessed standard of performance.

                (b)    The answer to (a) above is not in the affirmative. However, it would  be  correct  to  write  off  the  whole  amount  less                          its disposable value, if any, of such insurance spares that could be used in connection with a fixed asset as and when                          such fixed asset is either discarded or sold.

                (c)        When the useful life of the related fixed asset expires and the asset is retired from active use, the insurance spares                            which are specific  to  the  fixed  asset  should  also  be  retired  from active use and should be valued at their net book                            value or net realisable value whichever is lower, as in the case of a retired fixed asset. However, where the useful life of                            the fixed asset has expired and it is not being replaced because of paucity of funds as in the case of the company, the                            written down value of the insurance spare should be written off.

                 (d)    An  item  of  capital/insurance  spares  should  be  charged  to revenue, if the year of purchase and consumption is the                            same

1Opinion finalised by the Committee on 18.12.2001.