Query No. 16

Subject:

Accounting treatment of machinery spares of capital nature

purchased subsequently as replacement of worn-out spares.¹

A. Facts of the Case

1. A public sector company is in the business of refining and marketing of petroleum products. As per the querist, the accounting policies of the company as disclosed in the notes to accounts are in conformity with the Accounting Standards/Guidance Notes issued by the Institute of Chartered Accountants of India (ICAI).

2. Accounting Standard (AS) 2, ‘Valuation of Inventories’ (revised 1999), issued by the ICAI, has come into force with effect from 1st April 1999, and is mandatory from that date. As per the querist, in line with the said AS 2, the company has an established system of identifying spares which are not specific to a particular item of fixed asset but can be used generally for different items of fixed assets and charging the same to revenue in the year of consumption. Such spares purchased but not consumed, are taken into inventory.

3. The querist has further stated that Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, issued by the ICAI, which became mandatory with effect from 1st April, 1991, requires that machinery spares  should be usually charged to the statement of profit and loss, 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 their total cost on a systematic basis over a period not exceeding the useful life of the principal item.

4. The querist has stated that as per AS 10, machinery spares of the nature of capital spares/insurance spares should be capitalised separately at the time of their purchase whether procured at the time of purchase of the fixed asset concerned or subsequently and their cost should be allocated on a systematic basis over a period not exceeding the useful life of the principal item, i.e., the fixed asset to which they relate.

5. As per the querist, normal spares are those items that have been identified by the supplier/company as required to be replaced on a regular basis due to normal wear and tear of the spares. Spares that are critical for running of the machinery for uninterrupted refinery operations, but not in the nature of the normal spares as defined above and are required to be kept for use in case of breakdown, are considered as spares with irregular use. For example, spares like “Shaft/Impeller with hub” is identified for use in a particular machinery “ID-Fan” and its usage is irregular. Shaft/Impellers do not wear out in the normal course, but it is critical for the machinery as any breakdown of this item would bring down the refinery operation. This is required to be replaced only if the item breaks down due to any abnormal conditions. According to the querist, the first purchase of these spares are identified as machinery spares referred to in AS 10 and depreciated over a period not exceeding the useful life of the principal item. On consumption of these spares, replacement spares are procured and charged off to revenue in the year of purchase by the company. Thus, as per the querist, in line with AS 10, the company has been identifying spares which are exclusively used with specific items of fixed assets and whose consumption pattern is irregular.

6. Most of the assets of the refinery are such that the main equipment, in combination with several machinery spares, forms a single unit. Accordingly, they are depreciated as one unit. When some spares of this asset need to be replaced, taking out the worn-out spare and replacing the same with a new spare, while possible physically, removing the spare from the fixed asset register and capitalising the replaced spare in the books is not possible in view of the absence of separate identity of the individual spares.

7. According to the querist, while AS 10 has prescribed the accounting treatment for the purchase of spares, it has not dealt with the treatment to be followed for the worn-out spares that are replaced. In these circumstances, for replacement of such spares, the company has adopted a policy of not removing the original spares from their gross block. Instead, replacement spares are charged to revenue in the year of purchase. Original spares not being removed from the gross block, continue to be depreciated even after replacement. Accordingly, the relevant accounting policy includes the following clause:

“Machinery spares which could be used only in connection with an item of fixed asset and whose use is expected to be irregular are depreciated over a period not exceeding the useful life of the principal item of fixed asset. Replacement of such spares is charged to revenue.”

8. The querist has stated that on AS 10 becoming mandatory, members of the Oil industry, which is a specialised continuous process industry, deliberated at length and came to a consensus that subsequent procurement of machinery spares covered under AS 10 would be charged to revenue in the year of procurement. As per the querist, this needs to be done in view of the absence of separate identification of spares at the time of capitalising the parent asset as explained above.

9. Replacement spares may also sometimes be installed when the principal item of fixed asset is substantially depreciated. According to the querist, AS 10 does not deal with such assets whose useful life has expired as per the books of account but the assets are still in use. In these cases, charging-off of replacements to revenue would be the most appropriate method of accounting. While AS 10 requires that the cost of spares be depreciated over the life of the principal asset, the company has taken a conservative approach of absorbing the total cost of such replaced spares to revenue in the year of procurement instead of amortising the cost over the life of the parent asset.

10. The C&AG, while carrying out the audit of accounts, has observed as follows:

“As per the new accounting policy 1(i), while the machinery spares are depreciated over a period not exceeding the useful life of the principal item of fixed assets, replacement of such spares is charged off to revenue. Accordingly, during the year, replacement of such machinery spares costing Rs. 47.59 lakh was charged off to revenue. Since AS 10 does not differentiate between machinery spares and their replacements, charging-off the replacement of such spares to revenue as per the new accounting policy is contrary to AS 10. Further, the effect of this change in accounting policy has not been disclosed in the accounts, though required as per Accounting Standard (AS) 1, ‘Disclosure of Accounting Policies’.”

11. According to the querist, AS 10 requires that spares which are identifiable to a fixed asset and whose usage is irregular should be capitalised whether purchased along with the principal asset or purchased subsequently. The Standard does not make a specific mention of replacement spares. The Standard has also not dealt with the treatment to be given to the worn-out spares that have been replaced. Accordingly, the company is of the opinion that since the original spares not being removed from the gross block, continue to be depreciated even after replacement, charging-off of replacement spares to revenue would be appropriate.

12. According to the querist, the company in question as well as the other oil refining and marketing companies in India have been following this practice of charging the replacement spares to revenue consistently.

B. Query

13. The querist has sought the opinion of the Expert Advisory Committee as to whether the accounting policy followed by the company in respect of replacement of worn-out spares is correct or not.

C. Points considered by the Committee

14. The Committee restricts itself to the particular issue raised in the query, i.e., the accounting treatment of machinery spares purchased for replacement of worn-out spares and has not examined other related matters such as appropriateness of the identification of the spares as capital spares.

15. The Committee notes from the Facts of the Case that it is not clear as to whether the company purchases the components to be kept in stores until the need arises for replacement thereof or it purchases the components when the breakdown in a machine occurs. In the latter case, the components purchased to replace the worn-out components immediately after its purchase cannot be termed as ‘spares’. The Committee is of the view that in such a case, since the component purchased is immediately issued to be used as a part of the machine, it would be appropriate to charge all the cost of such a component in the year in which it is purchased and replaced in the asset. However, in case the spare is kept in the stores whether acquired with the machine or, subsequently, pending its use in the machine on replacement of worn-out part, it should be capitalised separately provided it is of the nature of capital spares within the meaning of paragraph 8.2 of AS 10 read with Accounting Standards Interpretation (ASI) 2, ‘Accounting for Machinery Spares’. In this context, the Committee wishes to draw the attention of the querist to paragraph 8.2 of AS 10 and paragraphs 3 and 4 of ASI 2 as reproduced below:

AS 10

“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.”

ASI 2

“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.

4. Machinery spares of the nature of capital spares/insurance spares should be capitalised separately at the time of their purchase whether procured at the time of purchase of the fixed asset concerned or subsequently. The total cost of such capital spares/insurance spares should be allocated on a systematic basis over a period not exceeding the useful life of the principal item, i.e., the fixed asset to which they relate.”

16. The Committee is of the view that when a capital spare is used in a machine for replacement of a worn-out part, the carrying amount of that capital spare should be charged to revenue in the year in which it is so used. The new spare purchased as a replacement of the capital spare so used should be captialised separately and should be depreciated over the remaining useful life of the principal asset. However, where a component is purchased for immediate replacement of the worn-out component, the cost thereof should be charged to the statement of profit and loss. For example, a company purchases a fixed asset costing Rs. 1000, containing a component forming an integral part of the asset. The useful life of the fixed asset is 10 years and the depreciation rate on such asset is 10% per annum on straight-line basis. The company also purchases a capital spare for Rs. 100 at the time of purchase of the fixed asset, for replacement of that component in case of need. The capital spare should be depreciated separately at the rate of 10% per annum over the useful life of 10 years of the fixed asset. If the component is worn-out after 3 years and is replaced by the capital spare, then the carrying amount of the spare in the books of account, i.e., Rs. 70 would be charged to the profit and loss account, and the cost of new replacement spare, say, Rs. 150, which is purchased to replace the spare so used in the fixed asset, should be capitalised separately and depreciated over the remaining useful life of the related fixed asset, i.e., 7 years.

17. Regarding the accounting treatment of spares purchased subsequently in relation to fixed assets whose useful life has expired, the Committee notes that AS 10 requires that the cost of machinery spares of capital nature should be amortised on a systematic basis over a period not exceeding the useful life of the principal item. Since the concerned principal items of fixed assets have been fully depreciated in the books of account, i.e., their useful life has already expired, the Committee is of the view that the machinery spares of capital nature that can be used only in connection with the specific fixed assets, should be charged to the statement of profit and loss in the year of purchase itself.

D. Opinion

18. On the basis of the above, the Committee is of the opinion that the policy of the company is correct to the extent that the machinery spares which can be used only in connection with an item of fixed asset and whose use is expected to be irregular are depreciated over a period not exceeding the useful life of the principal item of fixed asset. However, the rest of the accounting policy stated in paragraph 7 above is not correct. The correct accounting treatment would be to charge-off the carrying amount of the capital spare to revenue when that spare is used to replace the worn-out part of the principal item of fixed asset. The new spare purchased to replace the capital spare so used should be capitalised separately and depreciated over the remaining useful life of the principal asset.

¹ Opinion finalised by the Committee on 27.6.2005