Expert Advisory Committee
ICAI-Expert Advisory Committee
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 Query No. 15

Subject:

Accounting for spares.1

A. Facts of the Case


1. A government company, established under the Companies Act, 1956, is under the administrative control of the Ministry of Civil Aviation. The company is presently engaged in operation and maintenance of its fleet of helicopters, which provides necessary logistic support to an oil producing company to transport their men and material at both off-shore and on-shore locations. Besides this, the company is catering to the transport needs of some other public sector undertakings (PSUs) and state governments. The company’s annual turnover for the financial year 2003-04 was approximately Rs. 224 crore.

 


2. The company holds a large inventory of ‘rotables’ along with the fleet of helicopters and spare engines. Such rotables which, according to the querist, are in the nature of capitalised machinery spares, form an integral part of a helicopter. The nature of a rotable is such that it has a fixed life based on the number of flying hours/cycles. Its scheduled maintenance is carried out once it has completed the prescribed number of hours/cycles. On completion of this scheduled maintenance, its operational life is again brought back equivalent to that of a new item and it can be used for specified flying hours. Except for a small percentage, which could be damaged during the course of its use as a part of helicopter, each of these major items are expected to have a useful life equivalent to the useful life of the related type of helicopters. It is, therefore, a common practice in the aviation industry, according to the querist, to charge-off the original cost of rotables over the useful life of the related type of helicopters.

 


3. The company has decided to reclassify rotables as fixed assets and charge depreciation thereon from financial year 2003-04. These were hitherto classified as inventory items under the head ‘current assets’ till 31/03/2003 and obsolescence reserve was created in respect thereof. The change in accounting policy was made to comply with Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’ and Accounting Standards Interpretation (ASI) 2, ‘Accounting for Machinery Spares’, issued by the Institute of Chartered Accountants of India, and also in view of audit observations made by the statutory auditors regarding classification of rotables as inventory in the earlier periods. The querist has separately informed that other companies in the aviation industry are following the same accounting policy with regard to rotables. The querist has also submitted, for the perusal of the Committee, Record Note of the meeting of the representatives of the civil aviation industry whereat the decision to follow the same accounting policy was taken.


4. Depreciation policy of the company with regard to helicopters and air frame/aero engine equipment – rotables, is as below:

(a) Depreciation is provided on straight-line basis at the rates prescribed under Schedule XIV to the Companies Act, 1956, unless the useful life of the asset warrants higher rate of depreciation. In case of acquisition of second hand helicopters and aero-engines, depreciation is provided at a rate so as to write off 95% of the cost of such assets over the balance specified life. In the case of MI-172 helicopters, taking into consideration the life of 7,000 hours or 15 years, whichever occurs earlier, depreciation is provided at the minimum rate of 6.33% per annum, for upto 466 flying hours each year and for additional hours flown, depreciation is charged on the basis of actual hours flown in excess of 466 hours multiplied by the hourly rate computed by dividing 95% of the original cost by
7,000 hours for each helicopter.

(b) From the financial year 2003-04, the company has reclassified air frame and aero engine equipment – rotables, as fixed assets which were hitherto treated as inventory and depreciation is charged on straight-line basis in a manner so as to write-off 95% of the amount thereof over the remaining useful life of the principal asset (type of helicopters) to which they pertain, subject to a minimum charge as per the statutory rate. For this purpose, the remaining useful life of the last batch of helicopters (in case of Dauphin N since these constitute significant strength of the fleet) or latest helicopter (in the case of other fleet) is considered. Effective from financial year 2003-04, the useful life of helicopters has been considered as 20 years (hitherto 17 years) or 16,000 hours, whichever is later (for other than MI-
172 helicopters, in respect of which there is a life limitation as explained above) based on technical estimates and the disposal policy of helicopters evolved by the company.

5. According to the querist, as per the approved accounting policy, while depreciation on helicopters is provided on straight-line basis at the prescribed rate of 5.60% p.a, as required under Schedule XIV to the Companies Act, 1956, depreciation on rotables is computed in a manner so as to write-off 95% of the amount thereof over the remaining useful life of the principal asset (type of helicopters) to which they pertain, subject to a minimum charge as per the statutory rate of 5.60% applicable to helicopters.


6. The querist has stated that the government auditors are not in agreement with the above change in accounting policy with regard to the rate of depreciation charged in respect of rotables over the residual useful life of the helicopters beyond the specified period and are of the view that it is in contravention of AS 10 (paragraph 8.2). In their opinion, the company’s accounting policy of considering extension of the useful life of helicopters to 20 years beyond its specified period of 17 years is in contravention to the Companies Act, 1956, as the specified period for the helicopters derived from the depreciation rate of 5.60 % under Schedule XIV to the Act is fixed and the same should also be considered as its useful life (emphasis supplied by the querist). Accordingly, the government auditors are of the view that rotables purchased after the date of acquisition of the helicopter should be written off upto 95% of cost over the remaining period of 17 years and in case the helicopter fleet is fully depreciated, rotables purchased after that date should be written off @ 95% of cost in the year of purchase itself, notwithstanding the useful life of 20 years as determined by the company and that the fleet is still in operation.


7. The company is of the view that there is a need to distinguish between the ‘specified period’ as derived under Schedule XIV for helicopters and its useful life, which is the period over which such depreciable asset is expected to be used by the company, depending upon technical and economic factors. According to the querist, as per Accounting Standard (AS) 6, ‘Depreciation Accounting’, issued by the Institute of Chartered Accountants of India, the useful life is a matter of estimation by the management based on various factors and the Standard recognises the need for its periodic review. The quantum of depreciation to be provided on a depreciable asset will depend upon the balance useful life subject to the minimum depreciation rate as per the statute. In case of revision of the original estimate of useful life of an asset, the unamortised depreciable amount of the asset is charged over the revised remaining useful life. In the present context, while the extension of useful life of helicopters will have no impact on the depreciation to be charged on helicopters in view of the minimum depreciation rate of 5.6% to be applied, there will be a direct impact relating to depreciation in respect of rotables, specially those items which are purchased from the fifth year onwards from the year of purchase of helicopter as per the accounting policy stated at paragraph 4(b) above. The depreciation rate in respect of rotables purchased during the fifth year and onwards will be derived based on the 95% cost divided by the remaining useful life (in years) of the related helicopter, subject to a minimum charge of depreciation rate of 5.60% p.a. Accordingly, depreciation rate will be 5.94% for items purchased in fifth year, 6.33% in sixth year, 6.79% in seventh year and so on. Since the base year for the ‘Dauphin’ helicopter fleet is taken as 1987-88 and the fleet is fully depreciated in books, the rate of depreciation in respect of rotables related to such fleet and acquired during the financial year 2003-04 is 23.75%, which is derived by dividing 95% cost with the remaining 4 years of useful life of the fleet, which is considered as 20 years.


8. As per the querist, the statutory auditors, branch and internal auditors were consulted and according to them, the change in policy is in compliance with AS 6 and AS 10. The querist has stated that this policy is also in line with the accounting policy followed by another company in the industry in respect of rotables which has been accepted by their auditors.


9. In accordance with the change in accounting policy, the remaining useful life for respective types of helicopters has been determined. The impact of the extension of useful life on depreciation of air frame and aero engine equipment – rotables has been given effect in the accounts for the financial year 2003-04. The effect of the change in the accounting policy has been shown in the notes to accounts as under:

 


“ In respect of air frame and aero engine equipment – rotables, the charge to the profit and loss account under the head depreciation for the year is lower by Rs.5.54 crore as compared to the obsolescence reserve of air frame and aero engine equipment – rotables which could have been charged as per the earlier policy.”

10. The government auditors have further observed that the company should separately disclose the financial effect on savings in income tax, resulting due to change in accounting policy in respect of rotables in addition to the direct financial implications arising due to such change as already disclosed as per the requirements of Accounting Standard (AS) 5, ‘Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies’, issued by the Institute of Chartered Accountants of India. In the view of the querist, AS 5 does not require separate disclosure of the consequential financial effect on tax saving, if any, owing to changes in an accounting policy. Net impact of such accounting changes are, however, considered while computing provision for taxation for the year.


B. Query

 


11. In view of the above facts and the government audit observations, the querist has sought the opinion of the Expert Advisory Committee on the following issues

 

:

(a) Whether the term ‘useful life’ as referred to in AS 6, AS 10 and ASI 2 is the same as the term ‘specified period’ defined under section 205 of the Companies Act, 1956, which is linked to the rate of depreciation mentioned in Schedule XIV to the Companies Act, 1956;

(b) Whether revision of the original estimate of ‘useful life’ of an asset by the management based on technical and economic considerations contravenes the provisions of the Companies Act, 1956, and the relevant Accounting Standards;

(c) In case the ‘useful life’ of a principal asset is extended beyond its ‘specified period’ as per the Companies Act, 1956, whether the capital spares which form an integral part of such asset can be depreciated upto 95% of cost over the extended residual useful life of the principal asset, subject to charge of minimum rate of depreciation as prescribed in Schedule XIV to the Companies Act, 1956;

(d) In a situation, where the principal asset (viz. helicopter fleet) is fully depreciated in the books, whether the major components (viz. airframe and aero engine equipment – rotables) which form an integral part of such principal asset, purchased subsequently from year to year should be charged off as depreciation @ 95% of its cost in the year of purchase, inspite of the availability of the residual extended useful life of the principal asset, i.e., related helicopter fleet;

(e) Whether there is any requirement as per AS 5 to disclose separately in notes to accounts, apart from the financial effect arising due to change in the accounting policy, the consequential impact on tax saving, if any, owing to such change.

C. Points considered by the Committee

 


12. The Committee notes that the basic issue raised in the query relates to the accounting policy followed by the company in respect of the
‘rotables’ and the disclosures required as a consequence of change in accounting policy. Therefore, the Committee has answered only this issue and has not examined any other issue arising from the Facts of the Case, such as, the method of depreciation adopted by the company in respect of helicopters, etc.

 



13. The Committee notes from the Facts of the Case that ‘rotables’ are part of helicopters which can be used by any helicopter of the same type. In other words, if there are 10 helicopters of one type, a rotable can be used in any of the helicopters of that type, if the need arises. The Committee further notes from the Facts of the Case that although the querist has stated that the said rotables are now being treated as ‘fixed assets’, these are, in fact, being considered as spares covered by paragraph 8.2 of AS 10, since the company is contemplating to charge depreciation on such spares over the useful life of the principal item, i.e., the helicopter. In other words, the company is still treating these as spares and not as independent fixed assets having their own useful lives.

 


14. The Committee notes that paragraph 8.2 of AS 10 provides 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.”

 


15. The Committee further notes the following extracts from the Accounting Standards Interpretation (ASI) 2, ‘Accounting for Machinery Spares’, issued by the Institute of Chartered Accountants of India:


“2. 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. Such machinery spares should be charged to the statement of profit and loss as and when issued for consumption in the ordinary course of operations.”

“3. Whether to capitalise a machinery spare under AS 10 or not will depend on the facts and circumstances of each case. However, the machinery spares of the following types 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.”

“9. Machinery spares of the nature of capital spares/insurance spares are capitalised. Capital spares/insurance 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.”

16. The Committee notes that the rotables can be used in any helicopter of the same type of helicopters. Further, if one helicopter is disposed of, the rotables can still be used in another helicopter of the same type. Thus, the rotables are not meant for use only in relation to a specific item of fixed asset. Accordingly, in the view of the Committee, the rotables cannot be considered as capital spares. In the view of the Committee, rotables are general spares to be treated as inventories within the meaning of Accounting Standard (AS) 2, ‘Valuation of Inventories’, issued by the Institute of Chartered Accountants of India.


17. The Committee further notes that the minutes of the meeting of the representatives of the civil aviation industry referred to in paragraph 3 of the ‘Facts of the Case’, inter alia, state as below:

 

“An extract from AICPA/IATA Airlines Guidelines relating to fixed assets was also circulated wherein the General Accounting Policy followed by IATA Airlines has been incorporated. The component of fleet cost includes, inter alia, rotables assets including parts and assemblies, which are normally maintained and reused. They also include repairable parts which are capable of being repaired and reused but which could be only repaired a limited number of times. For this purpose, rotables are classified as those which are normally repaired and reused as opposed to those parts that are consumed in the operation. The guidelines also state that rotable parts and assemblies of significant value are classified along with Flight Equipment as fixed assets. Because they are classified in the nature of fixed assets, asset valuation of rotables parts and assemblies is similar to that of other property and equipment. Rotable parts and assemblies are normally depreciated over their useful lives or service life according to a group method of depreciation. Generally, the cost of repairing the rotables is charged to Expense Account as it is incurred.”



18. The Committee notes from the above that apparently the AICPA/ IATA Airlines Guidelines treat the rotables as independent fixed assets since these are normally depreciated over ‘their useful lives’ rather than linking the same with the life of the helicopter. In this context, the Committee notes paragraph 8.3 of AS 10 which states as below:


“8.3 In certain circumstances, the accounting for an item of fixed asset may be improved if the total expenditure thereon is allocated to its component parts, provided they are in practice separable, and estimates are made of the useful lives of these components. For example, rather than treat an aircraft and its engines as one unit, it may be better to treat the engines as a separate unit if it is likely that their useful life is shorter than that of the aircraft as a whole.”


19. On the basis of the above, the Committee is of the view that if the company so desires, it may follow the approach of recognising the fixed asset (here, helicopter) by breaking-up the value of helicopter into rotables and other major component parts as per the provisions of AS 10 reproduced in paragraph 18 above, and treat rotables as well as other component parts as independent fixed assets and charge depreciation thereon on the basis of their respective useful lives which, in any case, can not be more than the ‘specified life’ as defined under section 205 of the Companies Act, 1956, since the depreciation rates prescribed under Schedule XIV to the Companies Act are the minimum rates and the companies cannot charge a lower depreciation than that prescribed under Schedule XIV. It may be noted that if this accounting policy is followed, the rotable and other component parts should be segregated as separate fixed assets at the time of the purchase of helicopters so that these may be treated as separate items of fixed assets. If this approach is followed, the rotables purchased as spares would also be treated as separate fixed assets and depreciated over their own useful lives.


D. Opinion

 


20. On the basis of the above, the Committee is of the opinion that the accounting policy of the company in respect of accounting for rotables is not correct. It is incorrect to consider rotables as capital spares within the meaning of paragraph 8.2 of AS 10. The said rotables should be considered as general spares and treated as inventory within the meaning of AS 2. However, in case the company decides to adopt the components approach as envisaged in paragraph 8.3 of AS 10, and considers that the nature of rotables is such that it would be appropriate to treat them as separate items of fixed assets and charge depreciation thereon on the basis of their own useful lives within the meaning of paragraph 8.3 of AS 10, the company may do so as explained in paragraph 19 above. With regard to the specific issues raised by the querist in paragraph 11 above, the Committee is of the following opinion:

(a) The term ‘useful life’ as referred to in AS 6, AS 10 and ASI 2 is the same as the term ‘specified period’ defined under section 205 of the Companies Act, 1956, which is linked to the rate of depreciation mentioned in Schedule XIV to the Companies Act, 1956, subject to the condition that if, on a technical evaluation, the useful life comes to be shorter than that determined on the basis of the depreciation rate as per Schedule XIV, the shorter life would be the basis for charging depreciation.

(b) The useful life of an asset cannot be more than the useful life determined by applying the depreciation rate prescribed under Schedule XIV to the Companies Act, 1956. However, based on technical evaluation, if the useful life of an asset comes to be shorter than the useful life determined on the basis of Schedule XIV rates, the shorter life should be adopted for the purpose of charging depreciation.

(c) This question does not arise in view of (a) and (b) above.

(d) Since the rotables are of the nature of general spares (and not capital spares), this question does not arise.

(e) The change in accounting treatment of spares would amount to change in accounting policy within the meaning of provisions of AS 5. Consequently, the impact of, and the adjustments resulting from such change, if material, should be shown in the financial statements as per paragraph 32 of AS 5. AS 5 does not envisage disclosure of saving in tax as a result of a change in accounting policy.


1 Opinion finalised by the Committee on 27.6.2005