A. Facts of the Case
1. A public sector company registered under the Companies
Act, 1956, is engaged in the construction and operation of Hydro
Electric Power Projects. While procuring plant and machinery for
power stations, capital spares/insurance spares are also procured
or sometimes procured afterwards separately. As per the querist,
all such spares are capitalised in line with the accounting policy of
the company, which had been framed keeping in view Accounting
Standard (AS) 2, ‘Valuation of Inventories’, Accounting Standard
(AS) 10, ‘Accounting for Fixed Assets’, Accounting Standards
Interpretation (ASI) 2, ‘Accounting for Machinery Spares’ read with
an earlier opinion on the subject, ‘Accounting treatment of insurance
spares’ given by the Expert Advisory Committee of the Institute of
Chartered Accountants of India (published in Compendium of
Opinions, Volume XXI, Query No. 40). The said accounting policy
of the company is given below:
(a) Machinery spares procured along with the plant and
machinery or subsequently and whose use is expected
to be irregular are capitalised separately, if cost of such
spares is known and depreciated fully over the residual
useful life of the related plant and machinery. If cost of
such spares is not known particularly when procured
along with the mother plant, these are capitalised and
depreciated along with the mother plant.
(b) The written down value (WDV) of the spares is charged
to revenue in the year in which such spares are
consumed. Similarly, the value of such spares, procured
and consumed in a particular year is charged to revenue
in that year itself.
(c) When the useful life of the related fixed asset expires
and the asset is retired from active use, such spares
are valued at net book value or net realisable value
whichever is lower. However, in case the retired asset
is not replaced, WDV of related spares less disposable
value is written off.
(d) Other spares are treated as ‘stores and spares’ forming
part of the inventory and expensed when issued.
2. The querist has informed that during the audit of accounts of
the company for the year 2006-07, the government auditor has
raised an observation regarding accounting policy mentioned in
paragraph 1(b) above whereby, the company is charging WDV of
machinery spares to revenue in the year of consumption of spares.
The contention of the auditor is that the said accounting policy is
not in conformity with ASI 2 as charging of WDV of such spares to
revenue on consumption of such spares has resulted in
overstatement of consumption of spares, and understatement of
depreciation and net block of machinery spares and profit before
tax. The querist has provided the observation of the auditor which
is reproduced below:
“…based on the above policy, unit charged machinery spares
costing Rs.__ crore to revenue accounts-‘Consumption of
spares’ instead of allocating the cost of such spares over the
remaining useful life of the assets as required under Accounting
Standards Interpretation (ASI) 2 on Accounting Standards 2
and 10. This has resulted in overstatement of Consumption of
Spares by Rs.___ crore, understatement of Depreciation by
Rs.___ crore and understatement of Net Block and Profit
before tax by Rs.___ crore.”
3. The querist has further referred to the company’s reply to the
aforesaid observation, which is reproduced below:
“The Accounting Policy of the company is based on AS 2,
Accounting Standards Interpretation (ASI) 2 on Accounting
Standards 2 and 10 and opinion of the Expert Advisory
Committee of the ICAI on query No. 40 as available at page
No.196 to 202 of Compendium of Opinions, Volume XXI. A
careful reading of ASI 2 and that of the opinion referred to
above would reveal that both are recommending the same
accounting treatment. Opinion is however exhaustive and goes
on to further explain as under:
‘When the capital spare/insurance spare is actually used,
i.e., it replaces the worn out spare in the fixed asset, the
written down value of the capital spare, on the date it is
put to use, should be immediately expensed. This is
because the replacement of the spare does not increase
the future benefits from the existing asset beyond its
previously assessed standard of performance…’
(emphasis supplied by the querist).
In this connection attention is also invited to the following
portions of the operating part of the opinion as contained in
paragraph 18:
‘(a) 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 assets, 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. (Emphasis supplied by the querist.)
(d) An item of capital/insurance spares should be charged
to revenue, if the year of purchase and consumption is
the same.’
It would be noted from the above that the opinion not only
recognises the principles laid down in ASI 2 but it goes to
recognise the underlying principles contained in paragraph 23
of AS 10 which are of paramount importance.
In view of the above, the accounting policy as well as the
accounting treatment is as per laid down accounting principles
and it is requested that the provisional comment may please
be dropped.”
4. The querist has informed that the provisional comment was
dropped by the auditor on the assurance that the matter shall be
referred to Expert Advisory Committee of the Institute of Chartered
Accountants of India for further opinion in the matter.
B. Query
5. The querist has sought the opinion of the Expert Advisory
Committee on the issue as to whether the aforesaid policy of the
company complies with the provisions of AS 2, AS 10 and ASI 2
read with the referred opinion of the Expert Advisory Committee.
C. Points considered by the Committee
6. The Committee notes that the basic issue raised by the querist
relates to the expensing of the written down value of the capital/
insurance spare when it replaces an existing part in the fixed
asset. Therefore, the Committee has examined only this issue and
has not examined any other issue that may be contained in the
Facts of the Case, such as the appropriateness of other accounting
policies.
7. The Committee having perused Accounting Standards
Interpretation (ASI) 2, ‘Accounting for Machinery Spares’, notes
paragraph 4 of ASI 2, which states 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.”
8. The Committee also notes paragraphs 8.2 and 23 of
Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, which
state 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.”
“23. Subsequent expenditures related to an item of fixed
asset should be added to its book value only if they
increase the future benefits from the existing asset beyond
its previously assessed standard of performance.”
9. From the above stated paragraphs and the Facts of the Case,
the Committee notes that AS 10 and ASI 2, do not specifically
deal with the situation where the capital/insurance spares are
actually issued/used pursuant to a breakdown or failure of the
fixed asset to which they relate. The Committee is of the view that
the intended purpose behind the procurement of capital/insurance
spares is to ensure uninterrupted flow of production/operations in
the event of breakdown of the related fixed asset on account of
defective parts, etc. Uptil the time of such breakdown which requires
replacement of an old defective or scrapped part, the capital/
insurance spares having been capitalised on their purchase will be
depreciated by systematically allocating their total cost over a period
equal or shorter to the useful life of the related fixed asset. This is
in accordance with the requirements of ASI 2 and AS 10.
10. The Committee also notes that once the breakdown, etc.,
occurs and the capital/insurance spares are used, i.e., replace the
defective part, they become an integral part of the related fixed
asset. In effect, the capital/insurance spares cease to have their
own identity when they replace the existing part in the fixed asset.
Further, the Committee notes that as the capital/insurance spares
replace the defective parts of the principal fixed asset, the fixed
asset continues to maintain its same level of performance. Thus,
the replacement of a part by the capital/insurance spare does not
amount to an increase of the future benefits from the asset beyond
its previously assessed standard of performance. Also, the written
down value of the part that is replaced continues to be a part of
the total written down value of the fixed asset. Hence, the
Committee is of the view that in accordance with paragraph 23 of
AS 10 which is reproduced above, the written down value of the
spares should be charged to the profit and loss account when it
replaces the existing part in the fixed asset.
D. Opinion
11. On the basis of the above, the Committee is of the opinion
that the accounting policy followed by the company with respect to
expensing the written down value of the insurance/capital spare
when it replaces an existing part of the fixed asset, is in accordance
with AS 2, AS 10 and ASI 2.
1Opinion finalised by the Committee on 13.11.2007. |