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Query No. 27
Subject:
Accounting for mandatory refurbishment cost.1
A. Facts of the Case
1. A company owns and operates a combined cycle power plant in India. The
plant was installed and commissioned under a turnkey engineering, procurement
and construction contract by a foreign company. The commercial operation of the
company was achieved in the year 2001-02.
2. The company has entered into a Power Purchase Agreement (PPA) with a State
Electricity Board (SEB) for the sale of the entire power generated. The pricing
is consistent with the standard norms as per the policy of the Government of
India in respect of independent power producers based on capacity of operation,
i.e., Plant Load Factor (PLF), including fuel cost on Axiomatic Standard
Efficiency including post-tax return. The PPA is backed by a sovereign guarantee
of the State Government.
3. According to the querist, the company is preparing accounts in accordance
with the requirements of Schedule VI to the Companies Act, 1956, and depreciation is charged based upon the rates prescribed in Schedule XIV to the Act.
4. The querist has supplied the following information in respect of
accounting for mandatory refurbishment cost:
(a) The power plant that has been installed is an imported one.
(b) The maintenance cycle of the power plant is periodical as per the
recommendation of the original equipment manufacturer (OEM) beginning with ‘combustor inspection’ followed by ‘turbine inspection’ and so on for every pre-determined equivalent operating
hours (EOH). Certain machinery spares, also referred to as ‘hot gas path spares’
(HGPS), individually have different pre-determined life in terms of EOH, which
could extend beyond one or more financial years depending on the usage. Those
HGPS of the power plant need to be maintained regularly at a specific EOH of
usage. For example, the requirements of maintenance as stipulated by the OEM and
committed by the company after completion of every 8,000 and 16,000 EOH for
combustor parts and turbine parts respectively.
(c) At the time of each and every maintenance cycle inspection, HGPS are
taken out and sent to the manufacturer for refurbishment. The new HGPS kept in
stock is put into the gas turbine, whilst refurbishment of the set of HGPS that
is rolled out takes place. One more set is retained as spares to take care of
exigencies.
(d) After completion of refurbishment, the refurbished set of HGPS is held for using it in the gas turbine in future maintenance cycles. The
HGPS is thus used until it runs out its predetermined life in EOH.
(e) The company has been following the practice of provisioning for mandatory
refurbishment cost in the period in which such HGPS are put to use in the gas
turbine to generate electricity. According to the querist, the statutory
auditors have accepted this method of accounting in prior years.
5. As per the querist, the issue that now arises is that whether
refurbishment cost ought to be charged in the books for that particular year
only when the refurbishment is completed by the OEM as provisioning for
refurbishment costs in the books of accounts during the use of HGPS is not consistent with the Accounting Standards and Generally Accepted Accounting Principles (GAAP) in India.
6. The querist has expressed his views as below:
(a) Refurbishment in respect of the HGPS of the power plant is proprietary to
the OEM.
(b) Accounting followed by the company is based on going concern, which is
one of the fundamental accounting assumptions.
(c) Refurbishment is, therefore, a committed obligation on the company (a
constructive obligation as per the provisions of International Accounting
Standard (IAS) 37, ‘Provisions, Contingent Liabilities and Contingent Assets’,
issued by the International Accounting Standards Board).
(d) ‘Constructive obligation’ is defined by paragraph 3 of IAS 37 as under:
"3. The Standard defines a constructive obligation as an obligation that derives from an entity’s actions where:
(a) by an established pattern of past practice, published policies or a
sufficiently specific current statement, the entity has indicated to other
parties that it will accept certain responsibilities; and
(b) as a result, the entity has created a valid expectation on the part of
those other parties that it will discharge those responsibilities."
(e) The ingredients flowing from the above definition of constructive
obligation and the facts of the issue are as under:
Sl. Ingredient/requirements Satisfaction in the instant case
No. of the definition
1 past practice establishment Exists since the company has completed three cycles of refurbishment over the past three
years.
2 published policies or sufficie- Exists as evidenced above. ntly specific
current state-ment
3 the enterprise has indicated The company has a subsisting PPA
to other parties that it will with the SEB. There is commit- accept certain
responsibilities ment to generate and supply power consistently. Failure to adhere would disable recoupment of costs and hence sustenance of business.
The company has also indicated to the SEB and the OEM that it would do mandatory refurbishment as recommended by carrying
out three cycles of such refurbishment.
4 as a result, the enterprise The company has created valid has created a
valid expecta- expectations on both SEB and tion on the part of those OEM by
past practice as above. other parties that it will dis-charge those responsibilities
(f) Prudence is fundamental for not merely accounting but also for conduct of
business. Hence, it is not appropriate to presume that mandatory maintenance
requirements would be ignored, especially, when it results in breach of
committed obligations of supply of power.
(g) Propensity of abuse through non-provisioning:
A company which has such predetermined maintenance cycles would be able to
postpone or bunch up refurbishment of the spares in a manner that the desired
and incorrect profits are posted. This is illustrated in the Annexure.
(h) Refurbishing of aircraft, as referred in Example 9B of Appendix
‘C’ to Accounting Standard (AS) 29, ‘Provisions, Contingent Liabilities and
Contingent Assets’, issued by the Institute of Chartered Accountants of India,
adds to the value/marketability of the aircraft, and the aircraft could be sold
as a unit. The refurbishment of HGPS cannot be compared to such cases. In
this case, it is mandatory for the repairs to be done for the purposes of
continuance of the business (emphasis supplied by the querist). Hence,
according to the querist, the company’s contention that the cost has to be
provided on the basis of EOH seems to be acceptable even from the view point of
conservatism and prudence as it is a provision for a known liability.
B . Query
7. The querist has sought the opinion of the Expert Advisory Committee as to whether the creation of provision for refurbishment cost is in
accordance with the requirements of the relevant accounting standard in
India.
C. Points considered by the Committee
8. The Committee notes that Accounting Standard (AS) 29, ‘Provisions,
Contingent Liabilities and Contingent Assets’, issued by the Institute of
Chartered Accountants of India, defines the terms ‘provision’, ‘liability’ and
‘obligating event’ as follows:
"A provision is a liability which can be measured only by using a substantial degree of estimation."
"A liability is a present obligation of the enterprise arising from past
events, the settlement of which is expected to result in an outflow from the
enterprise of resources embodying economic benefits."
"An obligating event is an event that creates an obligation that results in
an enterprise having no realistic alternative to settling that
obligation."
9. The Committee further notes that paragraph 18 of AS 29 explains ‘past event’ as follows:
"18. It is only those obligations arising from past events existing
independently of an enterprise’s future actions (i.e., the future conduct of its
business) that are recognised as provisions. Examples of such obligations are
penalties or clean-up costs for unlawful environmental damage, both of which would lead to an outflow of resources embodying
economic benefits in settlement regardless of the future actions of the
enterprise. Similarly, an enterprise recognises a provision for the
decommissioning costs of an oil installation to the extent that the enterprise
is obliged to rectify damage already caused. In contrast, because of commercial
pressures or legal requirements, an enterprise may intend or need to carry out
expenditure to operate in a particular way in the future (for example, by fitting smoke filters in a certain type of factory). Because the enterprise can avoid the future
expenditure by its future actions, for example by changing its method of
operation, it has no present obligation for that future expenditure and no
provision is recognised."
10. The Committee also notes that Appendix ‘C’ to AS 29, illustrates the
application of the principles laid down in the Standard. The Committee notes
that Example 9A and Example 9B illustrate the application of the principles laid
down in paragraph 18 as below:
" Example 9A: Refurbishment Costs – No Legislative Requirement
A furnace has a lining that needs to be replaced every five years for
technical reasons. At the balance sheet date, the lining has been in use for
three years.
Present obligation as a result of a past obligating event –
There is no present obligation.
Conclusion – No provision is recognised (see paragraphs 14 and
16-18).
The cost of replacing the lining is not recognised because, at the
balance sheet date, no obligation to replace the lining exists independently
of the company’s future actions – even the intention to incur the
expenditure depends on the company deciding to continue operating the
furnace or to replace the lining."
"Example 9B: Refurbishment Costs – Legislative Requirement
An airline is required by law to overhaul its aircraft once every three
years.
Present obligation as a result of a past obligating event –
There is no present obligation.
Conclusion – No provision is recognised (see paragraphs 14 and
16-18).
The costs of overhauling aircraft are not recognised as a provision for
the same reasons as the cost of replacing the lining is not recognised as a
provision in example 9A. Even a legal requirement to overhaul does not make
the costs of overhaul a liability, because no obligation exists to overhaul
the aircraft independently of the enterprise’s future actions – the
enterprise could avoid the future expenditure by its future actions, for
example by selling the aircraft."
11. The Committee notes that the querist has argued that there is a ‘constructive obligation’ within the meaning of corresponding International
Accounting Standard, namely, IAS 37 to refurbish the HGPS spares. The Committee
notes that AS 29 does not recognise ‘constructive obligation’ and the reasons
therefor have been, inter alia, explained in paragraph 3 of Appendix ‘E’ to AS
29, ‘Comparison with IAS 37, Provisions, Contingent Liabilities and Contingent
Assets (1998)’, as follows:
"IAS 37 deals with ‘constructive obligation’ in the context of creation of a
provision. The effect of recognising provision on the basis of constructive
obligation is that, in some cases, provision will be required to be recognised at an early stage. For example, in case of a restructuring,
a constructive obligation arises when an enterprise has a detailed formal plan for the restructuring and the enterprise has raised a
valid expectation in those affected that it will carry out the restructuring by
starting to implement that plan or announcing its main features to those
affected by it. It is felt that merely on the basis of a detailed formal plan
and announcement thereof, it would not be appropriate to recognise a provision
since a liability can not be considered to be crystalised at this stage.
Further, the judgment whether the management has raised valid expectations in
those affected may be a matter of considerable argument.In view of the above, the Accounting Standard does not deal with ‘constructive obligation’. Thus, in situations such as restructuring, general
recognition criteria are required to be applied."
12. The Committee further notes that paragraph 19 of AS 29, inter alia,
states that "An obligation always involves another party to whom the obligation
is owed".
13. From the above, the Committee is of the view that in accordance with the
requirements of AS 29, the company does not have any obligation to a third party to refurbish HGPS spares and even though it may be essential
to refurbish the spares periodically to continue to run the plant as in the case of the examples given in Appendix ‘C’ to AS 29, no obligating
event has occurred as on the balance sheet date requiring creation of a
provision in this regard. The Committee does not agree with the contention of the querist that overhaul of aircraft, which is mandatory, is different
from the refurbishment of the spares in question.
D. Opinion
14. On the basis of the above, the Committee is of the opinion that a
provision for refurbishment cost should not be created in view of the
requirements of AS 29.
Annexure
(Refer paragraph 6(g) of the Facts of the Case)
Facts taken for the purposes of this working:
Hot Gas Path Spares (HGPS) require periodical refurbishment; once at the end of 8,000 hours and 16,000 hours. At the end of 24,000 hours, the spares will have to be retired permanently.Cost of servicing after 8,000/16,000 hours: Rs 1,400 lakh for each
refurbishment
Accounting based on accruing in the year of effective usage without waiting for actual Refurbishment:
Company A
The company follows a practice of provisioning for refurbishment cost in the period in which such HGPS are put to use based on their usage in terms
of Equivalent Operating Hours.
Accounting only in the year of refurbishment
Company B
The company follows a practice of accounting for refurbishment costs in the particular year in which the refurbishment is completed by the
original equipment manufacturer and received back by the company. The company is
regular in having their parts refurbished promptly. The company had received the
refurbished parts only in the third year of operation and hence the first
instance of charge of refurbishment costs has happened only in the third year of
operation. Similarly, the next incidence of charge of refurbishment could happen
either in the fifth year or in the sixth year which again skews the
profitability of the company.
Company C
The company follows a practice of accounting for refurbishment costs in the particular year in which the refurbishment is completed by the
original equipment manufacturer and refurbishes the parts in the year of its
choice in order to suit its revenue.
(Rs. lakh)
Statement of Refurbishment expenses
The company follows provisioning based on anticipated refurbishment cost
based anterior to actual refurbishment
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Company A I set
(part of OE) spare 1,400 1,400
II set spare 1,400 1,400
III set spares 1,400 1,400
Total 1,400 1,400 1,400 1,400 1,400 1,400
Company B and C follow the method of charging of refurbishment on
completion of refurbishment. It should be noted that Company C is able to do
profit manipulation by postponement of refurbishment and deferring debits to
the profit and loss account. In so far as Company B is concerned, the charge
to the profit and loss account is not commensurate with the use of spares in
the initial years.
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Company B I set
(part of OE) spare 1,400 1,400
II set spare 1,400 1,400
III set spare 1,400
Total - - 1,400 1,400 2,800 1,400
Company C Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Decides to postpone servicing of I set spare(part of OE) 1,400 1,400
Decides to have II set spares serviced on schedule 1,400
Decides to have III set spares serviced on schedule 1,400
Total - - - 2,800 1,400 1,400
1 Opinion finalised by the Committee on 27.12.2004
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