Query No. 17

Subject:

Accounting for spares.¹

A. Facts of the Case

1. A public sector company which owns an integrated steel plant is engaged in the manufacture and sale of iron and steel products. With a total capital outlay of about Rs. 8,500 crore and an installed capacity of 3 million tonnes of liquid steel per annum, the plant has all the production and other related facilities required to convert the iron ore into iron and steel products. It has its own thermal power plant (TPP), set up with an investment of over Rs. 740 crore, to cater to the energy needs of the plant.

2. During the financial year 2003-04, the company has achieved a turnover of Rs. 6,169 crore and earned a net profit of Rs. 1,547 crore. At the end of the financial year 2003-04, the total inventories and the inventory of stores and spares stood at Rs. 706 crore and Rs. 293 crore, respectively. The aforesaid inventories do not include the value of insurance spares of Rs. 46 crore, capitalised and disclosed as part of ‘Fixed Assets’. Each item of stores and spares is identified with a unique catalogue number. There are about one lakh catalogues. Out of these, insurance spares account for 900 catalogues.

3. According to the querist, the company capitalises machinery spares, which are in the nature of insurance spares, at the time of their purchase. These spares are capitalised whether they are procured at the time of purchase of the fixed asset concerned or subsequently. The total cost of such machinery spares is allocated over the useful life or the remaining useful life, as the case may be, of the related fixed asset. When insurance spare is used as a replacement of an existing part in the fixed asset, the written down value of the insurance spare is charged to the statement of profit and loss.

4. The accounting policy no. 2(f) on machinery spares, followed by the company, reads as follows:

 

“Machinery spares identified with production/service units, whose use is expected to be irregular, but non-availability of which affects the production/service units are categorised as ‘Risk Insurance Spares’. The cost of such items is depreciated over the useful life of the principal plant unit.”

5. During the financial year 2003-04, the company procured, inter alia, the following spares for using them in the generators of its Captive Thermal Power Plant and these were issued for consumption in the financial year as mentioned below:
 

As these spares were issued for consumption in the same financial year within a span of one to three days from the date of their procurement, their total cost was charged to the statement of profit and loss for the financial year 2003-04. However, during the audit of accounts for the financial year 2003-04, the government auditors observed that the company had charged-off the cost of two insurance spares to consumption instead of depreciating the same over the useful life of the principal plant unit in accordance with the accounting policy of the company. The government auditors’ observation on the accounting treatment of insurance spares is as follows:

“2. Fixed assets are understated by Rs. 3341.65 lakh:

(a) due to charging-off the cost of two risk insurance spares (Rotor and Stator in TPP) as stores and spares consumed instead of depreciating the same over the useful life of the principal plant unit as per the accounting policy no. 2(f). As a result, ‘stores and spares consumed’ stands overstated by Rs. 938.43
lakh and depreciation and net profit for the year stand understated by Rs. 140 lakh and Rs. 798.43 lakh respectively.

(b) due to decapitalisation (Rs.2403.22 lakh) of risk insurance spares and charging off to stores and spares consumed, which is contrary to the accounting policy no. 2(f) as well as Accounting Standards 2 and 10, ‘stores and spares consumed’ stands overstated by Rs.1064.02 lakh and depreciation and net profit for the year stand understated by Rs.1339.20 lakh and Rs.1064.02 lakh respectively.”

6. The querist has stated that the accounting treatment of insurance spares is in accordance with the applicable accounting standards, the Opinion of the Expert Advisory Committee of the Institute of Chartered Accountants of India (ICAI) and the accounting policy followed by the company. In reply to the observations of the government auditors, the company has reproduced the following paragraphs of accounting standards:

Accounting Standard (AS) 2, ‘ Valuation of Inventories’

“4. …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.”

Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’

“8.2 … 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.”

7. The querist has also referred to an earlier opinion of the Expert Advisory Committee (published in Compendium of Opinions Volume XXI, page 201), which states in paragraph 18(a) that “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.”

8. According to the querist, the accounting policy followed by the company is in line with AS 10 which states “the cost of insurance spares is depreciated over the useful life of the principal plant unit”.

9. The querist has further stated that in compliance with AS 2, AS 10, the Opinion of the Expert Advisory Committee and the accounting policy of the company, insurance spares are capitalised on their purchase; are depreciated over the useful life of the principal plant unit; and their written down value is charged to revenue as and when they are used. However, the spares referred to in the provisional comment 2(a) of the government auditors, as reproduced in paragraph 5 above, were charged to consumption since these spares were consumed, within a few days of their procurement, in the same financial year. Further, according to the querist, the company decapitalised and accorded proper treatment for the insurance spares referred to in comment 2(b) of the auditors in accordance with the aforementioned Opinion of the Expert Advisory Committee. Therefore, the accounting treatment followed by the company is in order and is not contrary to AS 2, AS 10 as well as accounting policy no. 2(f) of the company.

10. As per the querist, since the accounting treatment is in line with AS 2, AS 10 and Opinion of the Expert Advisory Committee, no elaboration in accounting policy is required. Further, the effect of change in the accounting policy has been disclosed in Note no. 19 of the notes to accounts (Schedule 27 B). Hence, the government auditors were requested to drop the provisional comments.

11. The government auditors, considering the above reply and the further explanations given during the discussions on the observations, dropped part (b) of their observation pertaining to charging-off the written down value of insurance spares consumed. However, the government auditors were not convinced with the company’s reply and its explanations on part (a) of the observation. Besides, the following further contentions were made by the auditors during the discussions in support of part (a) of their observation:

(a) The stator assembly and rotor assembly cost Rs. 5.41 crore and Rs. 3.98 crore respectively and, thus, are high value spares. Therefore, their written down value cannot be charged-off to revenue as and when they are issued for consumption like any other spare. Being in the nature of high value spares, they need a different accounting treatment unlike normal insurance spares and their cost is to be allocated over the useful life or the remaining useful life of the principal plant unit, as the case may be.

(b) The stator assembly was used as a replacement of an existing assembly in the generator. However, the replaced stator assembly failed and, therefore, the company again started using the old stator assembly. Since the stator assembly, which has failed, is under warranty, it can be repaired without any additional cost and can be used like a new spare. Therefore, charging-off its total cost to revenue is not in order.

(c) The stator assembly and rotor assembly are in the nature of stand-by equipment and AS 10 requires capitalisation of such equipment. Therefore, charging-off the cost of these items to revenue as and when they are issued for consumption is contrary to AS 10.

12. The querist has mentioned that during discussions, the company replied to the above contentions of the government auditors as below:

(a) Characteristics of a spare do not depend on its value. In other words, irrespective of the cost, the spare is a consumable item and it does not have an independent function/utility in order to treat it as a separate fixed asset. Further, the accounting standards do not permit any special accounting treatment for high value spares. The Expert Advisory Committee of the ICAI opined [Volume XXI, Page 202, paragraph 18(d)] that “An item of capital/insurance spares should be charged to revenue, if the year of purchase and consumption is the same”. In line with this expert opinion, the company has charged-off the cost of stator assembly and rotor assembly to revenue, since these insurance spares were purchased and consumed in the financial year 2003-04.

(b) As the old stator assembly had developed technical snag, it was replaced by the stator assembly in question. Since the stator assembly also developed a technical problem after working for a few days, the old stator assembly, after carrying out some repairs, was put to re-use as a temporary measure. The new stator assembly has been sent to the supplier for repair and would be reused. Therefore, it cannot be termed as a new spare.

(c) Stator assembly and rotor assembly are insurance spares and can be used only as parts in a generator. They cannot be separately operated/used to produce any output. Therefore, they are only spares and not stand-by equipment.

13. As the government auditors were not satisfied with the above reply and explanations on the accounting treatment of rotor assembly and stator assembly, the company assured them that the matter would be referred to the Expert Advisory Committee of the ICAI for an opinion.

14. The querist has furnished the following additional information on the stator assembly and rotor assembly for perusal of the Committee:

(i) The thermal power plant of the company consists of, inter alia, boilers, turbo generators and turbo blowers.

(ii) Turbo generators consist of turbine, generator and other connected equipments.

(iii) The rotor assembly and stator assembly are used in the generator mentioned at (ii) above. Besides these two assemblies, a generator consists of bearings, cooling equipment, bus ducts, excitation supply equipment, etc.

(iv) Rotor assembly is driven by turbine and excitation energy is supplied to it to create a rotating magnetic field in a generator.

(v) The rotating magnetic field when it cuts into the stator winding of stator assembly, a voltage (Electro Motive Force) is generated.

(vi) As such, a rotor assembly and stator assembly are not independent equipments but are parts of a generator.

B. Query

15. On the basis of the above facts, the querist has sought the opinion of the Expert Advisory Committee on the following issues:

(a) Whether the accounting treatment of insurance spares, viz., stator assembly and rotor assembly, followed by the company in its accounts for the financial year 2003-04 is in line with the accounting standards and accounting policy of the company.

(b) Whether the high value insurance spares require an accounting treatment which is different from the accounting treatment prescribed in AS 2 and AS 10 for insurance spares.

(c) In case a separate accounting treatment is to be followed for high value insurance spares, what are the criteria for determining the high value spares?

C. Points considered by the Committee

16. The Committee presumes that the spares, namely, rotor assemblies and stator assemblies, have been capitalised in accordance with the requirements of paragraph 8.2 of AS 10 (reproduced in paragraph 6 above). Accordingly, the Committee has addressed the issue of whether the said spares can be charged to the profit and loss account in the year of its consumption as done by the company.

17. In this context, the Committee also notes paragraphs 4 and 10 of Accounting Standards Interpretation (ASI) 2, ‘Accounting for Machinery Spares’, issued by the ICAI, for interpreting, inter alia, paragraph 8.2 of AS 10, which state as below:

“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.”

“10. A stand-by equipment is not of the nature of a 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. Therefore, the stand-by equipment is a separate fixed asset in its own right and is depreciated like any other fixed asset.”

18. On the basis of the above, the Committee is of the view that insurance spares of the nature described by the querist cannot be considered as stand-by equipments since these cannot be independently operated as fixed assets. The Committee is, further, of the view that treatment of a spare depends on its nature rather than its value. Thus, the value of a spare is not a consideration for deciding its accounting treatment.

19. The Committee notes from paragraphs 11(b) and 12(b) above that the original stator assembly was removed from the fixed assets and was put back again when the new stator assembly developed snag. The Committee thus observes that the stator assembly which was removed from the fixed asset can be used again and is not discarded. Therefore, the old stator assembly still has an economic value. Accordingly, the Committee is of the view that when the new stator assembly replaces the old stator assembly in the fixed asset, the written down value of the new stator assembly should not be charged off to profit and loss account instead depreciation should continue to be charged on the stator assembly as a separate capital spare. However, in a case where a capital spare replaces an existing part of a fixed asset permanently, i.e., the old part is not retained as a spare, the written down value of the capital spare should be charged off to the profit and loss account.

D. Opinion

20. On the basis of the above, the opinion of the Expert Advisory Committee on the issues raised by the querist in paragraph 15 above is as below:

(a) Please refer to paragraph 19 above.

(b) No, high value insurance spares do not require different accounting treatment than that prescribed in AS 2 and AS 10.

(c) The answer to this question does not arise in view of (b) above.

¹ Opinion finalised by the Committee on 27.6.2005