Accounting treatment of insurance spares

A. Facts of the Case

1. A government undertaking registered as a company under the Companies
Act, 1956, operates under the Department of Defence Production, Ministry
of Defence, Government of India. The company manufactures a wide range
of products like super alloys, titanium alloys, maraging steel, molybdenum,
etc., for strategic sectors like space, aeronautical, nuclear power and
commercial sectors like lamp, furnace, instrumentation, electronics,
communications, petroleum, petrochemicals, fertilisers, etc. The turnover of
the company for the financial year 2000-2001 was Rs. 112 crore.
2. While procuring plant and machinery, spares for two years normal
operations are also procured by the company from the original equipment
manufacturers and are capitalised in line with the accounting policy of the
company which reads as below:
Initial pack of spares procured along with plant, machinery and equipment
are capitalised and depreciated in the same manner as plant and
machinery.
3. The company, as on 31st March, 2001, has in stock and categorized as
inventory, spares procured subsequently in various years amounting to Rs.
441.58 lakh of which Rs. 327.29 lakh are identified as insurance spares, to
be used in repair and replacement of spares of the machinery and
equipment as and when the breakdown occurs. They are stocked and stored
as insurance spares in order to ensure that there is no interruption in
production process for want of such spares. The company also provides for
redundancy @ 50% of the book value of such spares which have not moved
for more than three years. The company is maintaining these spares for
plant, machinery and equipment which have been in use for more than 20
years and have already served their useful life and due to paucity of funds,
have not been replaced but are still being used.
4. The querist has referred to an earlier opinion of the Expert Advisory
Committee on the accounting treatment of inventory of capital/insurance
spares published in Compendium of Opinions, Volume XVII (No.1.30) which
states in paragraph 3 that .capital spares/insurance spares of the nature
of stand-by equipment should be capitalised. Depreciation on such spares
should be charged from the date they are ready for use even though kept in
stores since as stand-by spares, their use is to await their turn in the
production process in the event of breakdown. On the other hand,
machinery spares should be charged to profit and loss account as and when
consumed. However, where such spares could be used only in connection
with an item of fixed asset and their use is expected to be irregular, then it
would be appropriate to allocate the total cost of the spares on a systematic
basis over a period not exceeding the useful life of the asset from the date
of acquisition.
5. The querist has also referred to another opinion of the Expert Advisory
Committee published in Compendium of Opinions, Volume XVIII (No.12) on
the accounting treatment of replacement cost of a part of a fixed asset

which states that keeping in view paragraph 23 of Accounting Standard

(AS) 10, Accounting for Fixed Assets, repair and replacement cost which
does not increase the previously estimated service life or productive
capacity, should be charged to revenue.
6. As per the querist, the insurance spares, usually, are in the nature of
spares for repair and replacement and they do not either increase the
previously estimated service life or increase the productive capacity of the
asset, but are stored for use to ensure that the operations of the company
do not come to a grinding halt for want of the required spares. The querist
has stated that if the opinion referred to in paragraph 4 above, is to be
followed, it would be in violation of the opinion referred to in paragraph 5
above.
7. As per the querist, the government auditors while auditing the accounts
of the company for the year 2000-01, have commented that the spares
valuing Rs. 327.29 lakh, which are stand-by insurance spares and relatable
to specific items of fixed assets, should be capitalised in terms of paragraph
8.2 of AS 10.
B. Queries
8. The querist has sought the opinion of the Expert Advisory Committee on
the following issues :
(a) Whether it would be in order to carry the insurance spares as a part of
inventory till they are charged off to revenue as and when the same are
used, keeping in view paragraph 23 of AS 10 which states that 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.
(b) If the answer to (a) above is in the affirmative, whether it would be
correct to write off the whole amount of such insurance spares that could be
used in connection with that fixed asset, as and when such fixed asset is
either discarded or sold?
(c) If the answer to (a) above is not in the affirmative, what would be the
basis of charging the cost of spares on the machine when the useful life of
the machine has already expired.
(d) Whether an item of capital/insurance spares, that can be identified with
a particular asset, can be charged to revenue, if the year of purchase and
consumption (use) is the same, since there is no necessity to stock the
spares or retain it as a part of inventory.
D. Opinion
On the basis of the above, the Committee is of the following opinion on the
issues raised in paragraph 8:
(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 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.
(b) The answer to (a) above is not in the affirmative. However, it would be
correct to write off the whole amount less its disposable value, if any, of
such insurance spares that could be used in connection with a fixed asset as
and when such fixed asset is either discarded or sold.
(c) When the useful life of the related fixed asset expires and the asset is
retired from active use, the insurance spares which are specific to the fixed
asset should also be retired from active use and should be valued at their
net book value or net realisable value whichever is lower, as in the case of a
retired fixed asset. However, where the useful life of the fixed asset has
expired and it is not being replaced because of paucity of funds as in the
case of the company, the written down value of the insurance spare should
be written off.
(d) An item of capital/insurance spares should be charged to revenue, if the
year of purchase and consumption is the same.
Opinion finalised by the Committee on 18.12.2001.