Query No. 20

Subject:           Accounting treatment of subsequent expenditure on technological upgradation/ improvements on capital assets.[1]

A.        Facts of the Case

1.         A company is a wholly owned Government of India enterprise incorporated in the year 1965 with the main objective of setting up cement plants in deficit areas to cater to the needs of that area and other neighbouring States. Indian cement industry being the second largest producer of cement in the world after China, is comparable with any advanced country in terms of technology involved in cement manufacture. With the best energy efficient practices and environment friendly equipments, Indian cement industry is the most competitive globally. International  trends in technology, like latest grinding systems, advanced  material handling systems, automation in process control, high efficiency particle separation, clinker cooling, quality monitoring and control, etc. have been adopted by Indian cement industry.

2.         The querist has stated that though the company is the only Government of India enterprise in the country in cement sector, its market share is less than 1% of the total market share in the country thereby leading to severe competition from private entrepreneurs in the market. The company has one of its cement factories in one of the districts of Andhra Pradesh.  It was commissioned in the year 1987.  The plant has been in operation for more than 25 years after its commissioning and most of its major equipments have outlived their lives. 

3.         The querist has further stated that cement industry is a process industry and functions of various departments are inter-dependent.  The process starts from extracting and crushing of limestone, making it raw meal and then feeding into the kiln where burning takes place at a temperature of 1300 degrees C with the help of coal and its output is clinker.  Grinding of clinker takes place in the cement mill by adding certain additives to make it cement, the final product, before the same is packed and despatched by rail/road.

4.         Due to company having been declared sick by Hon’ble Board for Industrial and Financial Reconstruction (BIFR) in the year 1996 due to erosion of its net worth, no technological upgradation/modernisation could take place, as was called for in the cement industry due to fast technological changes.  However, normal maintenance was carried out to keep the plant running.   As many new cement plants with higher capacity and latest technology have been set up by private entrepreneurs in the vicinity of the plant of the company in Andhra Pradesh and Karnataka, the company had been facing severe competition from private entrepreneurs in the industry and the company is finding difficulty to operate the plant economically without modernisation/ technology upgradation.  Therefore, in place of changing the vital equipments with latest technology which entails substantial investment, the company made an endeavour to upgrade/ improve its certain equipments with certain amount of expenditure with a view to increase the standard efficiency of the vital equipments, increase  its  useful life and to reduce the operating cost to the extent possible. The modernisation programme was planned for a period of around 3 months by engaging best consultants in the industry  and all the activities involved were meticulously worked out and taken up for implementation. The company has, therefore, undertaken modernisation/upgradation of vital equipments, keeping energy efficiency and environment friendly technology in mind, to increase their standard performance with increase in overall productivity and standard operating efficiency of the plant. Major jobs involved and gist of results envisaged are as follows:

Jobs involved:

1.         Modernisation of kiln with grate cooler.
2.         Upgradation of Vertical Roller Mill (VRM) and VRM fan assembly.
3.         Upgradation of Electrostatic Precipitator (ESP) for VRM/Kiln.
4.         Renovation of blending system of raw mill silo.
5.         Upgradation of cement mill.
6.         Upgradation of coal mill.
7.         Upgradation of limestone crusher.

Results:

1.         Increased kiln output rate.
2.         Considerable effect on output rate of cement mill, raw mill, coal mill, etc.
3.         Better utilisation of false waste heat.
4.         Better process control.
5.         Reduction in electricity power consumption.
6.         Control on dust emission.
7.         Enhance the life of equipments.

5.         The equipment-wise details are as follows:

(i)           Kiln

Kiln is considered to be heart and soul of the plant.  The kiln has been upgraded with girth gear reversal and changing of approx. 43 meters length of kiln out of 68 meters shell to increase the standard output rate and to reduce the standard operating cost.  With the above improvements, the standard revolutions per minute  (rpm) of the kiln has increased from 2.2 rpm to 3 rpm resulting into increase in overall rated output from 3000 tonnes per day (tpd) to 3500 tpd resulting into increase in production of clinker by approximately 2 lakh MT.  The above modifications along with other modifications in retrofitting of the clinker cooler and controlled feed of coal to calciner through installation of modified and accurate weigh feeder of 30 tph has resulted in better heat recovery and thus helped in reducing the rated coal consumption from 24% to 19%.  The girth gear reversal had also helped in increasing the life of kiln by atleast another 10 to 15 years and also improving the brick lining life and reduction of refractory consumption.  The increased output has further reduced the standard power consumption of clinkerisation section from 100 units to 85 units.  The technical experts in the field were involved in the works associated with kiln section. The cost of new kiln would be around Rs. 100 crore.

(ii)        ESP connected to kiln and VRM

The ESP connected to kiln and VRM are vital for plant operations and to maintain the requisite statutory emission norms as fixed by the Pollution Control Board.  Since the plant was commissioned more than 25 years ago, the Pollution Control Board has been changing the emission norms periodically considering various parameters and also due to technological improvements/ developments in the cement industry over the years.  The existing ESP has been modified/ upgraded in order to achieve the revised norms by changing the internals and gas distribution (GD), rapping mechanism and other related changes in the existing ESP System.  With the above modifications, the reduction in emission has been achieved to 100 mg/Nm3 from earlier 150 mg/Nm3.  The life of the modified ESP is also increased by more than 10 to 15 years, besides increased efficiency and savings in ground/calcined materials due to collection of recycling into system, which also brings productivity improvement. The approximate cost to upgrade the existing ESP with latest new ESP would be around Rs. 15 crore.

(iii)       Vertical Roller Mill (VRM)

Major changes in the Vertical Roller Mill under the technical guidance of experts, such as, changing of roller assembly, table liner with improved ones and by doing  other allied jobs have helped in improving the rated output of VRM from 260 tph to 280 tph.  The increased rated output has further resulted in lower consumption of power to the extent of 2 to 2.5 kwh/tonne.  The mill performance has increased which has been able to meet out the grinding requirement of additional raw material due to increase in clinker output. The works related to VRM main drive gear box was supervised by engineers from Germany.  The life of VRM has increased by at least another 15 years.  The cost of new VRM would be around Rs. 80 crore.

(iv)       Coal mill section  

Coal mill is a vital equipment for coal grinding in kiln operations.  Retrofitting of coal mills with modified rings and balls have been done in order to increase the efficiency of the coal mill and to reduce the operating cost.  The gear box and grinding table along with polyclone have been modified and replaced to improve the standard output of the coal mill from 15 tph to 20 tph.  The power consumption of the coal mill has also reduced from standard consumption of 30 units per tonne to 25 units per tonne.  With the above modification, the useful life of the coal mill has increased further at least by 15 years.  The cost of latest new coal mill would be around Rs.70 crore.

(v)        Cement mill section

Grinding of cement takes place in cement mill before it is sent for packing and despatch.  To modernise/upgrade the standard output rate of the cement mill, the gear box with latest technology/model was changed and girth gears of the cement mill were reversed.  The cement mill operations had been upgraded with new Distributed Control System (DCS) which has computerised controlled operations instead of manual control.  With the above modifications, the mill rated output has gone upto 100 tph in place of 80 tph besides overall improvement in productivity, better operational controls and fault annunciation through computer aided operations. 

(vi)       Crusher section

The function of crusher is to crush the limestone and supply to the raw mill which was upgraded by changing the rotor assembly and other allied internals with a view to obtain uniform grade of output and to increase the productivity. The crusher operations together with stacker/reclaimer operations have been upgraded with new DCS system instead of manual control. Installation of efficient crusher exhaust fans, apron feeder gear box assembly, reinforcement of concreting in hopper and above modifications have increased the overall productivity of the crusher and also resulted in saving the operating cost, besides increase in the life of the crusher by another 10 to 12 years.  The installation cost of new crusher would be around Rs. 12 to 15 crore.

6.         The company, being sick, does not have sufficient funds to modernise/change the entire old equipments with latest technology available in the world for manufacture of cement and therefore, efforts were made to upgrade/modernise the above equipments with certain modifications involving good amount of expenditure so as to obtain increased efficiency by way of increase in rated output with reduction in the standard operating cost and to lower the breakdown rates, wherever possible. The following amounts have been spent on the above upgradations/improvements:

                      :         

B.        Query

7.         In view of the above, the opinion of the Expert Advisory Committee of the Institute of Chartered Accountants of India is sought on the following issues: 

(a) Whether the cost of above modifications/upgradation/improvements can be  capitalised along with the cost of concerned equipments and depreciation charged accordingly; or

(b) Whether the cost of above modifications/upgradations/improvements should be amortised/ depreciated over a period of 10-15 years as the benefit of the above works would result in further increase in useful life of the equipments by not less than 10 years.

                     
C.        Points considered by the Committee
8.         The Committee notes from the Facts of the Case that the querist has stated that certain amount of expenditure has been incurred to upgrade/modernise certain vital equipments of the cement plant with a view to  obtain increased efficiency by way of increase in rated output alongwith reduction in operating cost and increasing their lives. Accordingly, the company has raised an issue as to whether the expenditure incurred on such upgradation/modernisation can be capitalised as part of concerned equipment and depreciated accordingly or whether expenditure, so incurred, could be amortised over the period by which the life of the equipments has increased. The Committee has, therefore, considered only these issues and has not examined any other issue that may arise from the Facts of the Case.

9.         As far as accounting for the expenditure incurred on upgradation/modernisation of equipments is concerned, the Committee notes that paragraph 23 of Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, notified under the Companies (Accounting Standards) Rules, 2006 (hereinafter referred to as the ‘Rules’) 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."

10.       The Committee is of the view that expenditure on fixed assets subsequent to their installation may be categorised into (i) repairs and (ii) improvements or betterments. Repairs, the Committee notes, implies "the restoration of a capital asset to its full productive capacity after damage, accident, or prolonged use, without increase in the previously estimated service life or capacity." It frequently involves replacement of parts. On the other hand, betterment is defined as "…an expenditure having the effect of extending the useful life of an existing fixed asset, increasing its normal rate of output, lowering its operating cost, or otherwise adding to the worth of benefits it can yield. The cost of adopting a fixed asset to a new use is not ordinarily capitalised unless at least one of these tests is met. A betterment is distinguished from an item of repair or maintenance in that the latter has the effect of keeping the asset in its customary state of operating efficiency without the expectation of added future benefits." (These definitions are reproduced from the Dictionary for Accountants by Eric C. Kohler, Sixth Edition.)

11.       From the above, the Committee is of the view that normally, expenditure on repairs, including replacement cost necessary to maintain the previously estimated standard of performance, is expensed in the same period. Similarly, the cost of adopting a fixed asset to a new use or modernisation of such asset without actually improving the previously estimated standard of performance is also expensed. Accordingly, in the view of the Committee, only such expenditures that add new fixed asset units, or that have the effect of improving the previously assessed standard of performance, e.g., an extension in the asset’s useful life, an increase in its capacity, or a substantial improvement in the quality of output or a reduction in previously assessed operating costs are capitalised. The Committee is of the view that ‘previously assessed standard of performance’ is not the actual performance of the asset at the time of repair/improvement etc., but the standard performance of the same asset in its original state.

12.       The Committee notes from the Facts of the Case that it has been stated that the expenditure has resulted in increased productivity, reduced operating costs and also enhancing the life of the equipments. However, the querist has not informed whether the increase in productivity or enhancing the life is beyond the previously assessed standard of performance of the concerned equipments as stated in paragraph 11 above. It is only the increase beyond the standard of performance of the concerned equipments in their original state, which is treated as betterment and related expenditure is capitalised. In this regard, the Committee also notes paragraph 12.2 of AS 10, notified under the Rules, which is reproduced below:

"12.2    The cost of an addition or extension to an existing asset which is of a capital nature and which becomes an integral part of the existing asset is usually added to its gross book value. Any addition or extension, which has a separate identity and is capable of being used after the existing asset is disposed of, is accounted for separately."

From the above, the Committee is of the view that if the expenditure incurred by the company has a separate identity and is capable of being used after the existing asset is disposed of, it should be accounted for separately and accordingly, depreciation should be provided considering the provisions of Accounting Standard (AS) 6, ‘Depreciation Accounting’, notified under the Rules and the Companies Act, 1956.  However, if the expenditure incurred results into betterment of an existing asset, which cannot be used independently of the existing asset then the same should be added to the gross book value of the concerned asset and depreciated at the rates applicable to the asset considering the requirements of paragraph 24 of AS 6, notified under the Rules, which is reproduced as below:

“24.     Any addition or extension which becomes an integral part of the existing asset should be depreciated over the remaining useful life of that asset. The depreciation on such addition or extension may also be provided at the rate applied to the existing asset. Where an addition or extension retains a separate identity and is capable of being used after the existing asset is disposed of, depreciation should be provided independently on the basis of an estimate of its own useful life.” 

13.       As regards the period over which the asset can be depreciated, the Committee notes the requirements of paragraph 23 of AS 6, notified under the Rules, which provides as follows:

“23.    The useful lives of major depreciable assets or classes of depreciable assets may be reviewed periodically. Where there is a revision of the estimated useful life of an asset, the unamortised depreciable amount should be charged over the revised remaining useful life.”

On the basis of the above, the Committee is of the view that if the above  upgradation/modernisation  results into an increase in the useful life of the concerned asset, the unamortised depreciable amount of the concerned asset alongwith the expenditure incurred on upgradation/modernisation (provided it is to be capitalised as discussed in paragraph 12 above) should be charged over the revised remaining useful life subject to the useful life implicit from the specified rates as per Schedule XIV to the Companies Act, 1956. The Committee wishes to point out that such depreciation should be charged with reference to the ‘useful life’ and not with reference to ‘physical life’ of the asset.
D.        Opinion            

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

(i)         If the expenditure incurred on upgradation/modernisation of equipments increases the future benefits of the existing equipments beyond their previously assessed standard of performance, the cost of such upgradation/modernisation can be capitalised along with the cost of concerned equipments, as discussed in paragraphs 11 and 12 above and depreciation should be charged accordingly, as discussed in paragraphs 12 and 13 above. However, if such expenditure does not result into such increase in future benefits, it should be expensed as and when incurred.

(ii)        If the above upgradation/modernisation results in increase of the useful life of the equipments, the unamortised depreciable amount of the concerned assets alongwith the expenditure incurred on its upgradation/modernisation (provided it is capitalised) should be charged over the revised remaining useful life, subject to the useful life implicit from the rates specified in Schedule XIV to the Companies Act, 1956, as discussed in paragraph 13 above.

---------------------