Query No. 22

Subject:

Treatment of spares. ¹

A. Facts of the Case

1. A public sector company is in the business of refining and marketing of petroleum products. The company’s books of account are subjected to audit by both the statutory auditors and the Comptroller and Auditor General of India (C&AG). According to the querist, accounting policy of the company as disclosed in the Notes to Accounts is in conformity with the Accounting Standards/ Guidance Notes issued by the Institute of Chartered Accountants of India.

2. The querist has referred to an earlier opinion sought by him from the Expert Advisory Committee on a similar subject (published in Volume XXV of the Compendium of Opinions, Query No. 16). The querist has stated that although he agrees with the views of the Committee, it is observed that there are certain practical difficulties in implementing the same retrospectively. In order to explain the issues to the Committee, the querist has elaborated the case in the following paragraphs.

3. The querist has mentioned that as per Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, issued by the Institute of Chartered Accountants of India (paragraph 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”. Further, as per paragraph 4 of Accounting Standards Interpretation (ASI) 2, ‘Accounting for Machinery Spares’, “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”.

4. The querist has stated that the earlier opinion of the Committee mentioned above, states that “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” (paragraph 18 of the Opinion). According to the querist, in order to implement the views of the Committee, it is essential that the original spares are capitalised separately, independent of the main equipment and depreciated over the life of the parent asset. However, the practice followed consistently over the years by the company is that the main equipment, in combination with several machinery spares together is treated as a single unit. Accordingly, it is capitalised and depreciated as one unit. When some spares of this main equipment need to be replaced, taking out the worn out parts and replacing the same with a new spare is while possible physically, dropping the spare from the fixed asset register is not possible in view of the absence of separate identity for the individual spares. In these circumstances, charging-off the carrying value of these replaced spares (hitherto, held in warehouse) to the profit and loss account is not feasible and consequently, replacement spares (new spares) are being charged to revenue in the year of purchase. Original spares not being dropped from the gross block, continue to be depreciated even after replacement.

5. Accordingly, the querist has stated that the significant accounting policy published by the company includes the following clause:

 “Machinery spares which could be used only in connection with an item of fixed asset and their 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”.

6. The querist has further stated that the Accounting Standards Board of the Institute of Chartered Accountants of India has recently issued an Exposure Draft of Revised AS 10, ‘Tangible Fixed Assets’, which upon coming into effect would supercede, among others, the existing Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’ and Accounting Standards Interpretation (ASI) 2, ‘Accounting for Machinery Spares’. The said exposure draft, according to the querist, has considered the practical aspects of some of the issues faced by the industry and, in the context of what is discussed above, provides companies an option either to capitalise the cost of replacement spares with the consequent derecognition of the replaced parts or to recognise such costs in the statement of profit and loss (refer paragraph v, Appendix B to the draft). As per the querist, the policy of the company is in line with the relevant paragraph of the exposure draft. In refineries, most of the assets are such that the main equipment, in combination with several machinery spares, together form a single unit. Being so, the cost of replacement is charged to revenue in view of the difficulties of derecognising the carrying value of original spares. As per the querist, the draft visualises these situations where major parts of a tangible fixed asset are not capitalised separately and for replacement of such spare parts, suggests as one of the treatment that the enterprise should recognise the cost of replacing a major part of an asset in the statement of profit and loss as incurred (paragraph 14 and 14(b) of the exposure draft) (emphasis supplied by the querist).

B. Query

7. In the light of the problems/difficulties faced by the company as described in the above paragraphs and the treatment suggested in the exposure draft as discussed by the querist above, the querist has sought the opinion of the Expert Advisory Committee on the following issues:

(i) It is expected that the exposure draft would be finalised soon and its implementation date would be notified. It is the standard practice that on notification of the Standard, earlier adoption by the companies would be encouraged though the Standard could come into effect at a later date. In view of the accounting policy of the company being in consonance with the treatment permitted in the exposure draft, the company desires to continue its accounting policy, viz., “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”. The quantum of the machinery spares so charged to the profit and loss account in the year of purchase will be disclosed suitably by way of a note. The querist has sought the opinion of the Expert Advisory Committee as to whether this will be in order.

(ii) Otherwise, if the company has to implement the earlier opinion of the Expert Advisory Committee, whether it will be correct to implement the opinion prospectively for the assets (main equipment) that are to be commissioned from the current financial year onwards.

C. Points considered by the Committee

8. The Committee notes that the querist has relied upon the treatment prescribed in the exposure draft of Revised AS 10, while insisting upon the charging-off of replacement of capital spares to revenue. The Committee notes that the said exposure draft distinguishes between the accounting for major spare parts and accounting for major components forming part of the fixed asset. As per paragraph 8 of the exposure draft, the major spare parts which are expected to be used during more than one period as also the spare parts that can be used only in connection with a tangible fixed asset, have to be capitalised separately as a tangible fixed asset. The exposure draft does not provide any alternative treatment for such spare parts. The paragraphs referred to by the querist, viz., paragraphs 14 and 14(b) of the exposure draft, and paragraph (v) of Appendix B to the exposure draft deal with the accounting treatment of components forming part of the fixed asset. Paragraph 14(b) of the exposure draft provides that where an enterprise is not following the components approach of capitalising fixed assets, the cost of replacement of any major part should be charged to revenue. Similarly, if the component part in such a situation is replaced by an existing spare part (which is separately capitalised by virtue of paragraph 8 of the exposure draft), the carrying amount of such spare part should be charged to revenue. Paragraph 14(b) does not deal with the spare parts that are purchased to replace an existing spare part (which replaces a component part of the tangible fixed asset). In any case, the Committee is of the view that the exposure drafts are the proposed guidelines which are subject to amendments/changes based on the comments received thereon and hence, cannot form the basis for determination of accounting treatment before the final accounting standard comes into force.

9. As far as the accounting treatment in respect of replacement of a major part of a fixed asset with a spare is concerned, the Committee notes from the Facts of the Case that the company is treating the main asset and its several machinery spares as a single unit. However, as per paragraph 4 of ASI 2 (reproduced in paragraph 3 above), capital spares have to be capitalised separately from the principal fixed asset. Hence, in the present case, the company should apportion the carrying amount of the fixed asset to various machinery spares, which hitherto were being treated as a part of the value of fixed asset. At the time of replacement of the component part of the fixed asset by a spare part, the carrying amount of the spare should be charged to the profit and loss account and the new spare which is purchased to be kept in the store for replacement of the capital spare so used should be capitalised separately and be depreciated over the remaining useful life of the principal asset. With regard to the practical difficulties in determining the carrying amount of the replaced part, the Committee is of the view that the Accounting Standard does not envisage any relaxation on this ground. The company should estimate the carrying amount of the replaced spare part on a reasonable basis, e.g., the cost of replacement may be used as an indicator of what the cost of the replaced part was at the time it was acquired.

10. The Committee is also of the view that the principles of accounting for spare parts are contained in Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’ which has been in existence since 1985. If the company has not followed the principles contained therein, it should rectify the error for the existing assets and account for accordingly. In the view of the Committee, it would be incorrect to apply the said principles prospectively, only for the assets that are to be commissioned from the current financial year onwards, as stated by the querist.

D. Opinion

11. On the basis of the above, the Committee is of the following opinion on the issues raised by the querist in paragraph 7 above:

(i) No, the charging-off of the capital spares to the profit and loss account in the year of purchase is not in order in the light of accounting treatment prescribed in the applicable Accounting Standard. Please refer to paragraphs 8 and 9 above.

(ii) No, the company should implement the above-said opinion for all the existing assets.

¹ Opinion finalised by the Committee on 18.9.2006