Expert Advisory Committee
ICAI-Expert Advisory Committee
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Query No. 22

Subject:

Accounting treatment of subsequent expenditure on capital assets.1

A. Facts of the Case

 

1. A limited company, established in 1873, is engaged in the manufacture of diversified value added jute goods mainly to cater to the sophisticated needs of the international market. For producing such items, the company has been carrying out continuous modernisation and renovation of its plant and machinery by replacing major components on regular basis. The querist has stated that these major components have generally different useful lives as compared to the machinery to which they relate. It is possible to consider such components as different fixed assets. This routine replacement of components increases the standard performance of the machine in a way that the recoverable amount of the machine is enhanced. As per the querist, the recoverable amount is not decided on the basis of net selling prices but it depends on the economic value of the assets also. In most cases, the company has identified such costs as separate components of the machine representing major overhaul and has already depreciated those components to reflect the consumption of benefits, which are replaced or restored by the subsequent major overhaul. As these original machines were installed long ago, the said overhaul/renovation has helped the machines to increase their economic lives and maintain efficiency in production.

 

B . Query

 

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

 

(a) Whether the expenditure on renovation/overhauling, which enhances the life and productivity of the machines, should be treated as an addition to the block of plant and machinery, or should be charged to revenue as normal repair expenses.

(b) If the expenditure is treated as addition to the block of assets, what should be the rate of depreciation to be provided on such asset? Whether the depreciation rate to be charged should be the rate as provided in Schedule XIV to the Companies Act, 1956, or some higher rate of depreciation.

 

C. Points considered by the Committee

 

3. The Committee notes that paragraph 23 of AS 10 states as below:

 

"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."

4. The Committee is of the view that expenditure on fixed assets subsequent to their installation may be categorised into (i) repairs, and (ii) improvements or betterments. Repairs, the Committee notes, implies "the restoration of a capital asset to its full productive capacity after damage, accident, or prolonged use, without increase in the previously estimated service life or capacity." It frequently involves replacement of parts. On the other hand, betterment is defined as "…an expenditure having the effect of extending the useful life of an existing fixed asset, increasing its normal rate of output, lowering its operating cost, or otherwise adding to the worth of benefits it can yield. The cost of adopting 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." (These definitions are reproduced from the Dictionary for Accountants by Eric C. Kohler, Sixth Edition.)

 

5. From the above, the Committee is of the view that, normally, expenditure on repairs, including replacement cost necessary to maintain the previously estimated standard of performance, is expensed in the same period. Similarly, the cost of adopting a fixed asset to a new use or modernisation of such asset without actually improving the previously estimated standard of performance is also expensed. Accordingly, in the view of the Committee, only such expenditures that add new fixed asset units, or that have the effect of improving the previously assessed standard of performance, e.g., an extension in the asset’s useful life, an increase in its capacity, or a substantial improvement in the quality of output or a reduction in previously assessed operating costs are capitalised. The Committee is of the view that ‘previously assessed standard of performance’ is not the actual performance of the asset at the time of repair/improvement etc., but the standard performance of the same machine in its original state.

6. The Committee notes from the facts of the case that it is not clear as to whether the ‘modernisation and renovation’ expenses incurred by the company increase the future benefits beyond its previously assessed standard of performance, as the facts supplied by the querist appear to be contradictory. In paragraph 1` above, the querist has stated that overhaul/renovation has helped to ‘maintain efficiency in production’, whereas, in paragraph 2(a) above, it has been stated that renovation/overhauling ‘enhances the productivity’ of the machines. The querist has also stated that such expenditure increases the ‘recoverable amount’ in terms of ‘economic value’ and also increases ‘economic life’ of the machines. The querist has not informed whether the increase in ‘economic value’ and ‘economic life’ is beyond the previously assessed standard of performance of the machines.It is only the increase beyond the standard of performance of the same machine in its original state, which is treated as betterment and is capitalised.

 

7. The Committee notes that in case the subsequent expenditure is to be capitalised keeping in view the considerations stated in paragraphs 5 and 6 above, paragraph 12.2 of AS 10 would be relevant. The said paragraph is reproduced below:

 

"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."

From the above, the Committee is of the view that only if the expenditure incurred by the company has a separate identity and is capable of being used after the existing asset is disposed of, it should be accounted for separately. If not, the same should be added to the gross book value of the asset and depreciated at the rates applicable to the asset.

 

8. In case the expenditure is capitalised as a separate asset after applying the above paragraphs, paragraph 13 of Accounting Standard (AS) 6,‘Depreciation Accounting’, issued by the Institute of Chartered Accountants of India, would be relevant, which provides as below:

 

"13. The statute governing an enterprise may provide the basis for computation of the depreciation. For example, the Companies Act, 1956 lays down the rates of depreciation in respect of various assets. Where the management’s estimate of the useful life of an asset of the enterprise is shorter than that envisaged under the provisions of the relevant statute, the depreciation provision is appropriately computed by applying a higher rate. If the management’s estimate of the useful life of the asset is longer than that envisaged under the statute, depreciation rate lower than that envisaged by the statute can be applied only in accordance with requirements of the statute."

 

9. The Committee notes from the above that in case of companies, sections 205 and 350 of the Companies Act, 1956, which govern provisions regarding charge of depreciation for the purpose of payment of dividends and computation of managerial remuneration, respectively, provide the basis for computation of depreciation. However, the Committee is of the view that in arriving at the rates at which depreciation should be provided, the company must consider the true commercial depreciation, i.e., the rate which is adequate to write off the asset over its normal working life. If the rate so arrived at is higher than the rate prescribed under Schedule XIV, the company should provide depreciation at such higher rate but if the rate so arrived at is lower than the rate prescribed in Schedule XIV, then the company should provide depreciation at the rate prescribed in Schedule XIV, since it represents the minimum rate of depreciation to be provided. Since the determination of commercial life of an asset is a technical matter, the decision of the Board of Directors based on technological evaluation should be accepted by the auditor unless he has reason to believe that such decision results in a charge which does not represent true commercial depreciation. In case a company adopts the higher rates of depreciation as recommended above, the higher depreciation rates/lower lives of the assets must be disclosed as required in Note No. 5 of Schedule XIV to the Companies Act, 1956.

 

10. The above view of the Committee is supported by the Department of Company Affairs. The Department has clarified in its Circular No. 2/89, dated March 7, 1989 that "the rates as contained in Schedule XIV should be viewed as the minimum rates, and, therefore, a company will not be permitted to charge depreciation at rates lower than those specified in the Schedule in relation to assets purchased after the date of applicability of the Schedule. If, however, on the basis of bona fide technological evaluation, higher rates of depreciation are justified, they may be provided with proper disclosure by way of a note forming part of annual accounts".

D. Opinion

11. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 2 above:

(a) The company should expense the normal expenditure on repairs of the machines, including the cost of replacement necessary to maintain the previously assessed standard of performance of the machines, in the year when such expenditure is incurred. The incremental expenditure, over and above the normal repairs, incurred on improvement and renovation of its plant and machinery to increase their efficiency in production should be capitalised provided such improvements will result into increase in the future benefits beyond the previously assessed standard of performance of such machines, as per paragraph 5 above. Please also refer to paragraph 6 above.

(b) Please refer to paragraphs 7, 9 and 10 above.

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1Opinion finalised by the Committee on 28.10.2003.

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