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A. Facts of the Case
1. A listed company is engaged in manufacturing of chemicals. It has five factories located in various States of India. All the factories have, more or less, equal production capacity. The main building at one of its factories which also has other buildings, contains the production facility. The production facility is divided into various sections, according to the type of chemical produced, like stiff chemicals section, liquid chemical section, etc.
2. All the assets of this factory, e.g., buildings, plant and machinery, furniture, fixtures and inventories are insured under a fire insurance policy on the basis of reinstatement value option. Accordingly, the estimated replacement values of the various classes of factory assets were mentioned in the policy and the insurance premium was paid by the company based on those replacement values. The querist has stated that the memorandum for reinstatement value, which is a part of the insurance policy, includes the following terms:
“…the basis upon which the amount payable under the policy is to be calculated, shall be the cost of replacing or reinstating on the same site property of the same kind or type but not superior to or more extensive than the insured property when new…”
“Until expenditure has been incurred by the insured in replacing or reinstating the property destroyed or damaged the company shall not be liable for any payment in excess of the amount which would have been payable under the Policy if this memorandum had not been incorporated therein.”
“This memorandum shall be without force or effect if … the insured is unable or unwilling to replace or reinstate the property destroyed or damaged on the same or another site.”
3. In April 2006, some portion of the main building mentioned in paragraph 1 above, caught fire and the assets located in the said portion were damaged or destroyed by the fire. The details of damaged or destroyed fixed assets are as follows:
*The WDV of furniture affected is Rs.0.03 lakh only.
Apart from damage to fixed assets, inventory of Rs.700 lakh was also destroyed by the fire.
4. The company immediately lodged an insurance claim with the insurance company for Rs. 20 crore comprising loss of inventory and estimated replacement value of the destroyed assets. The company received Rs. 100 lakh from disposal of damaged assets. The company also started the work of installing new plant and machinery and repairing the building. Since the plant and machinery destroyed by fire were very old, the exact replacements were not available in the market. The company had to install higher versions of the plant and machinery available in the market. The new assets are of more sophisticated technology and have higher production capacity. The building repair work and installation work of the plant and machinery was completed during the financial year 2007-08. While the approval of the final amount of claim was pending, the company received on account payment of Rs.1,000 lakh during the financial year 2006-07 from the insurance company.
5. During the financial year 2006-07, the company recognised Rs.305 lakh in its profit and loss account (as ‘other income’) on account of surplus from insurance claim. The surplus from insurance claim was computed after deducting WDV of Rs.95 lakh of damaged or destroyed fixed assets and destroyed inventory of Rs.700 lakh from the disposal proceeds of Rs. 100 lakh and from the on account receipt of insurance claim of Rs.1,000 lakh. Since the company was unable to make a reliable estimate of the amount at which the claim of the company shall be settled, only the on account amount received, i.e., Rs.1,000 lakh was considered for computation of the surplus. During the financial year 2008-09, the final claim was approved for a total amount of Rs.1,931 lakh and the company received the balance claim amount of Rs.931 lakh which has been recognised as ‘other income’ in the profit and loss account.
6. As per the querist, the accounting treatment consistently followed by the company as discussed above in both the years is based on the following:
(i) The loss of assets, the related insurance claim and subsequent purchase of replacement assets are separate economic events and should be accounted for separately. On loss of assets, the relevant asset accounts should be credited with debit to the profit and loss account. Insurance claim should be recognised in the profit and loss account when it is appropriately certain to be received. The purchase of assets is the third event which should be recognised independently of the first two. As per Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, assets are recorded at cost. In the instant case, the cost of the replaced asset is what has actually been paid to acquire it.
(ii) The accounting treatment followed by the company is in consonance with the opinion given by the Expert Advisory Committee in a similar case published in the Compendium of Opinions – Vol. XI, page no. 89, paragraph 2 of which states as below:
“2. In the facts and circumstances of the present case, the Committee is of the opinion that it will be appropriate to credit the profit and loss account with the profit arising on settlement of insurance claim (i.e., the excess of insurance claim over the written down value of the helicopter) with the disclosure as per para 5 below.”
(iii) Reference may also be made to the following extracts from the Exposure Draft of Accounting Standard (AS) 10 (revised), ‘Tangible Fixed Assets’, issued by the Institute of Chartered Accountants of India, which specifically discusses the principles of accounting for compensation received from third parties for tangible fixed assets that were impaired, lost or given up and derecognition of tangible fixed assets:
“65. Compensation from third parties for tangible fixed assets that were impaired, lost or given up should be included in the statement of profit and loss when the compensation becomes receivable.
66. Impairments or losses of tangible fixed assets, related claims for or payments of compensation from third parties and any subsequent purchase or construction of replacement assets are separate economic events and are accounted for separately as follows:
(a) impairments of tangible fixed assets are recognised in accordance with AS 28;
(b) derecognition of tangible fixed assets retired or disposed of is determined in accordance with this Statement;
(c) compensation from third parties for tangible fixed assets that were impaired, lost or given up is included in determining profit or loss when it becomes receivable; and
(d) the cost of tangible fixed assets restored, purchased or constructed as replacements is determined in accordance with this Statement.
Derecognition
67. The carrying amount of a tangible fixed asset should be derecognised:
(a) on disposal; or
(b) when no future economic benefits are expected from its use or disposal.
68. The gain or loss arising from the derecognition of tangible fixed asset should be included in the statement of profit and loss when the asset is derecognised (unless AS 19, Leases, requires otherwise on a sale and leaseback). Gains should not be classified as revenue, as defined in AS 9, Revenue Recognition.”
“71. The gain or loss arising from the derecognition of a tangible fixed asset should be determined as the difference between the net disposal proceeds, if any, and the carrying amount of the asset.”
“73. The financial statements should also disclose:
…
(d) if it is not disclosed separately on the face of the statement of profit and loss, the amount of compensation from third parties for tangible fixed assets that were impaired, lost or given up that is included in the statement of profit and loss.”
As per the querist, as per the above, the claim, being compensation from a third party, should be included in the statement of profit and loss when it becomes receivable and should not be reduced from the cost of replaced assets. According to the querist, the accounting policy of the company is consistent with these principles also and same principles have been enunciated in International Accounting Standard (IAS) 16, ‘Property, Plant and Equipment’, issued by the International Accounting Standards Board (IASB).
7. As per the querist, an alternative approach to the accounting treatment followed by the company can be to reduce the surplus arising out of the insurance claim from the cost of replaced assets. The alternative treatment has the effect of reducing the total block of the fixed assets not only to the extent of the WDV of the relevant fixed asset but also to the extent of the surplus arising out of the claim over such WDV.
B. Query
8. The querist has sought the opinion of the Expert Advisory Committee on the following issues:
(i) Whether the accounting treatment followed by the company is correct.
(ii) If the answer to (i) above is in the affirmative, then, whether only the net gain should be disclosed in the profit and loss account with an explanatory note or whether the loss can be shown as a deduction from the insurance claim.
C. Points considered by the Committee
9. The Committee notes that the issue raised by the querist basically relates to the accounting treatment of insurance claim. Therefore, the Committee has examined only this issue and has not touched upon any other issue that may be contained in the Facts of the Case, such as, timing of recognition of insurance claim, etc. The Committee notes that while there was replacement of destroyed/damaged plant and machinery by new plant and machinery with higher production capacity, in the case of buildings, repair work was involved. It is not clear as to whether new inventory was purchased/ produced to replace the destroyed inventory. Further, while the querist has stated in paragraph 4 above that the company received Rs. 100 lakh from disposal of ‘damaged assets’, it appears that the disposal proceeds were in respect of disposal of damaged plant and machinery and no portion of it is attributed to inventory or building. (Furniture and fixtures are stated by the querist to be not significant in paragraph 3 above and, hence, are not specifically considered by the Committee.)
10. The Committee notes that the disposal of damaged/destroyed fixed assets (i.e., plant and machinery) took place in the same year in which the damage was caused by fire, i.e., 2006-07. Consequently, the loss or gain arising from such disposal should be recognised pursuant to paragraph 26 of Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, which reads as below:
“26. Losses arising from the retirement or gains or losses arising from disposal of fixed asset which is carried at cost should be recognised in the profit and loss statement.”
The Committee is of the view that loss or gain arising from disposal of damaged/destroyed fixed assets should be computed by deducting their carrying amount from the net disposal proceeds. Further, the Committee is of the view that insurance proceeds are not disposal proceeds since they do not arise on disposal of the fixed assets. Rather, they arise on the happening of the event and meeting the conditions specified under the contract with insurers.
11. With respect to the accounting for insurance claim, the Committee notes the following paragraphs from the Framework for the Preparation and Presentation of Financial Statements, issued by the Institute of Chartered Accountants of India, which reads as below:
“69. ...
(a) Income is increase in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.
(b)…”
“91. Income is recognised in the statement of profit and loss when an increase in future economic benefits related to an increase in an asset or a decrease of a liability has arisen that can be measured reliably. ...”
From the above, the Committee notes that compensation receivable from third parties by an enterprise for the loss of assets or restoration or replacement thereof meets the definition of the term ‘income’. Thus, the entire compensation amount should be credited to the profit and loss account as income in the year in which it is eligible for recognition. This may be included under the head ‘other income’. (See paragraph 16 below for further discussion.)
12. As regards accounting for the new fixed assets acquired/constructed as a replacement of the damaged/destroyed fixed assets, the Committee notes the following paragraphs of AS 10:
“9.1. ...The cost of a fixed asset may undergo changes subsequent to its acquisition or construction on account of exchange fluctuations, price adjustments, changes in duties or similar factors.”
“20. The cost of a fixed asset should comprise its purchase price and any attributable cost of bringing the asset to its working condition for its intended use.
21. The cost of a self-constructed fixed asset should comprise those costs that relate directly to the specific asset and those that are attributable to the construction activity in general and can be allocated to the specific asset.”
From the above, the Committee is of the view that proceeds from insurance claim cannot be deducted from the cost of fixed assets purchased or constructed as a replacement of damaged/destroyed fixed assets. Thus, the Committee does not agree with the alternative approach mentioned by the querist in paragraph 7 above. The capitalisation of expenditure on purchase or construction of fixed assets as replacements should be determined in accordance with AS 10.
13. The Committee notes paragraph 6 of Accounting Standard (AS) 2, ‘Valuation of Inventories’, which reads as below:
“6. The cost of inventories should comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.”
From the above, the Committee is of the view that insurance proceeds in respect of damaged inventory cannot be deducted from the cost of inventories restored, repurchased or reproduced, if any. Determination of costs that can be included in the cost of inventories should be in accordance with AS 2. For the reasons stated in paragraph 11 above, the Committee is of the view that insurance compensation amount in respect of damaged/destroyed inventory should be credited to profit and loss account which may be included under the head ‘other income’. As stated in paragraph 9 above, it appears that there were no disposal proceeds in respect of the inventory destroyed. The loss should be appropriately accounted for.
14. As regards the building, the Committee notes that it was not destroyed, rather it was damaged and repair work was undertaken on the same which was completed in the year 2007-08. In this context, the Committee notes paragraph 23 of AS 10 which states as below:
“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.”
The Committee is of the view that subsequent expenditure on fixed assets amounting to repairs implies expenditure on restoration of the capital asset without increase in the previously estimated service life or capacity after damage, accident or prolonged use. In other words, repair is undertaken to bring back the asset (in this case, the building) to its normal working condition, in which case, there is no question of impairment loss on account of the damage/accident. Accordingly, in the view of the Committee, the cost of repair to the building should be expensed in the year in which the same is incurred (unless it results into betterment or improvement and is eligible for capitalisation as per paragraph 23 of AS 10 reproduced above). No loss on account of damage to the building by fire should be debited to the profit and loss account separately. The insurance claim received on this account should be recognised as income as discussed in paragraph 11 above when it becomes eligible for recognition.
15. In view of the above, the Committee does not agree with the company’s treatment of recognition of excess of insurance claim and disposal proceeds over net book value of the damaged/destroyed fixed assets and inventories in the profit and loss account for the year 2006-07 as ‘other income’. The company’s treatment mixes up several items resulting in recognition of a single amount as ‘other income’ in the profit and loss account, without any disclosure of the break-up of the elements constituting the net amount, which is not proper. Further, when there is no disposal of building, deducting the entire WDV of damaged/destroyed fixed assets of Rs.95 lakh, which includes WDV of damaged building, i.e., Rs.5 lakh, from the total of disposal proceeds and insurance compensation is not correct.
16. As regards presentation in the profit and loss account, the Committee is of the view that the expense and income related to various items discussed in the above paragraphs should be presented separately. Alternatively, it is permissible to present the expense corresponding to each of the items, viz., plant and machinery, and building separately as a deduction from the corresponding insurance compensation and then a sub-total representing the net gain (loss) can be presented and appropriately described. Such presentation may be made either on the face of the profit and loss account or in the notes. In respect of the loss of inventory, the same may be recognised by way of lower closing inventory. Therefore, no separate debit would appear in the profit and loss account for this purpose. However, loss of stock should be reflected in the notes to accounts. Alternatively, closing stock may be presented at the gross amount and loss of stock may be shown as deduction therefrom in the inner column. The corresponding insurance claim recognised as income in the profit and loss account should be appropriately described. Assuming that timing of recognition of insurance claim is proper, the recognition of balance insurance amount of Rs.931 lakh as ‘other income’ in the profit and loss account for the year 2008-09 is in order.
D. Opinion
17. On the basis of the above, the Committee is of the following opinion on the issues raised by the querist in paragraph 8 above:
(i) The accounting treatment followed by the company is partially correct. It is correct to the extent that the cost of newly acquired fixed assets is not reduced by insurance compensation. It is not correct to the extent that it is not in accordance with the accounting treatment, presentation and disclosure requirements mentioned in paragraphs 10, 11, 12, 13, 14 and 16 above. The accounting treatment of insurance claim in the year 2008-09 is correct, assuming that timing of recognition of the same is correct.
(ii) See paragraph 16 above.
1 Opinion finalised by the Committee on 24.08.2009
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