Schedule II to the Companies Act, 2013 is
applicable from 1 April 2014. Notes to Schedule II, among other matters,
state as below:
“Useful life specified in Part C of the
Schedule is for whole of the asset. Where cost of a part of the asset is
significant to total cost of the asset and useful life of that part is
different from the useful life of the remaining asset, useful life of
that significant part shall be determined separately.”
An illustrative example is given below.
Some key issues are discussed in this article.
How does a company go about conducting this exercise?
Schedule
II requires separate depreciation only for parts of an item of tangible
fixed asset having (i) significant cost, and (ii) different useful
lives from remaining parts of the asset. In many cases, such
determination may be straight forward. For example, an IT company, which
has only computers as fixed assets, may be able to determine with
little analysis that there are no significant components requiring
separate depreciation. Similarly, for an airline company, it may be
clear that engine has different useful life vis-à-vis remainder of the
aircraft. In many other cases, identification of components requiring
separate depreciation may involve complex analysis.
The company
first splits the fixed asset into various identifiable parts to the
extent possible. The identified parts are then grouped together if they
have the same or similar useful life. There is no need to identify and
depreciate insignificant parts as separate components; rather, they can
be combined together in the remainder of the asset or with the principal
asset.
Identification of significant parts is a matter of
judgment and decided on case-to-case basis. Identification of separate
parts of an asset and determination of their useful life is not merely
an accounting exercise; rather, it involves technical expertise. Hence,
it may be necessary to involve technical experts to determine the parts
of an asset.
How does one judge materiality in the context of identification of components?
A
company needs to identify only material/significant components
separately for depreciation. Materiality is a matter of management/audit
judgment and needs to be decided on the facts of each case. Normally, a
component having original cost equal to or less than 5% of the original
cost of complete asset may not be material. However, a component having
original cost equal to 25% of the original cost of complete asset may
be material. In addition, a company also needs to consider impact on
retained earnings, current year profit or loss and future profit or loss
(say, when part will be replaced) to decide materiality. If a component
may have material impact from either perspective, the said component
will be material and require separate identification.
In many
cases, identification of material components may involve complex
judgment, particularly, for assessing impact on future P&L. Also
what may not be material in a particular period could become material in
later years, and vice versa.
Auditors will have to modify
their audit opinion for a company that does not follow component
accounting, the impact of which is likely to be material in the context
of the overall results or financial position of that company.
In the case of a company that has a manufacturing facility and is asset
intensive, component accounting is likely to be material, not only
because of depreciation impact, but also the way replacement costs are
accounted for.
How is depreciation computed for components vis-avis the requirements of Schedule II?
Each
significant component of the asset having useful life, which is
different from the useful life of the remaining asset, is depreciated
separately. Though component accounting is mandatory, its application should be restricted only to material items.
If the useful life of the component is lower than the useful life of
the principal asset as per Schedule II, such lower useful should be
used. On the other hand, if the useful life of the component is higher
than the useful life of the principal asset as per Schedule II, the
company has a choice of using either the higher or lower useful life.
However, higher useful life for a component can be used only when
management intends to use the component even after expiry of useful life
for the principal asset.
To illustrate, assume that the useful
life of an asset as envisaged under the Schedule II is 10 years. The
management has also estimated that the useful life of the principal
asset is 10 years. If a component of the asset has useful life of 8
years, AS 6 requires the company to depreciate the component using eight
year life only. However, if the component has 12 year life, the company
has an option to either depreciate the component using either 10 year
life as prescribed in the Schedule II or over its estimated useful life
of 12 years, with appropriate justification. However, in this case 12
years life for the component can be used only when management intends to
use the component even after expiry of useful life for the principal
asset.
How are replacement costs accounted for?
The
application of component accounting will cause significant change in
measurement of depreciation and accounting for replacement costs.
Currently, companies need to expense replacement costs in the year of
incurrence. Under component accounting, companies will capitalize these
costs as a separate component of the asset, with consequent expensing of
net carrying value of the replaced component. If it is not practicable
for a company to determine carrying amount of the replaced component, it
may use the cost of the replacement as an indication of what the cost
of the replaced part was at the time it was acquired or constructed.
Even
under the component accounting, a company does not recognise in the
carrying amount of an item of fixed asset the costs of the day-to-day
servicing of the item. These costs are expensed in the statement of
profit and loss as incurred.
How are major inspection/overhaul expenses accounted for when component accounting is applied?
Under
Indian GAAP, no specific guidance is available on component accounting,
particularly, major inspection/ overhaul accounting. In the absence of
guidance, the following two options are likely. A company can select
either of two options for accounting of major inspection/ overhaul. The
option selected should be applied consistently.
Option 1
Though
AS 10 Accounting for Fixed Assets or any other pronouncement under
Indian GAAP does not comprehensively deal with component accounting,
Ind-AS 16 Property, Plant and Equipment contains comprehensive guidance
on the matter. Under component accounting as envisaged in Ind-AS 16,
major inspection/overhaul is treated as a separate part of the asset,
regardless of whether any physical parts of the asset are replaced.
Hence, one option is to apply Ind-AS 16 guidance by analogy. The
application of this approach is explained below.
When a company
purchases a new asset, it is received after major inspected/ overhaul by
the manufacturer. Hence, major inspection/ overhaul is identified
separately even at the time of purchase of new asset. The cost of such
major inspection/ overhaul is depreciated separately over the period
till next major inspection/overhaul.
Upon next major inspection/overhaul, the costs of new major inspection/ overhaul are added to the asset’s cost and any amount remaining from the previous inspection/ overhaul is derecognized. There is no issue in application of this principle, if the company has identified major inspection/ overhaul at the time of original purchase. However, sometimes, it may so happen that the cost of the previous inspection/overhaul was not identified (and considered a separate part) when the asset was originally acquired or constructed (this may not necessarily be an error but a change in an estimate). This process of recognition and derecognition should take place even in such cases.
If the element relating to the inspection/overhaul had previously been identified, it would have been depreciated between that time and the current overhaul. However, if it had not previously been identified, the recognition and derecognition principles still apply. In such a case, the company uses estimated cost of a future similar inspection/overhaul to be used as an indication of the cost of the existing inspection/overhaul component to be derecognized after considering the depreciation impact.
OPTION 2
It may be argued that under AS 10 approach, all repair expenditure (including major inspection/overhaul) need to be charged to P&L as incurred. Though schedule II mandates component accounting, it does not state that application of component accounting is based on Ind-AS 16 principles. Hence, AS 10 applies for repair expenditure (including major inspection/overhaul).
Under this option, the application of component accounting is restricted only to physical parts. Neither on initial recognition nor subsequently, the compa- ny identifies major inspection/overhaul as separate component. Rather, any expense on major inspection/ overhaul is charged to P&L as incurred.
What are the presentation/disclosure requirements when component accounting is followed?
Component accounting is relevant for purposes such as depreciation and accounting for replacement cost. Companies are not required to disclose components separate- ly in the financial statements or notes thereto. Rather, the company discloses the asset with all its components as one line item.
With regard to disclosure of useful life/depreciation rates, Schedule II has prescribed depreciation rates only for principal asset and no separate rates are prescribed for its components. Also, schedule II requires disclosure of justification if a company uses higher/lower life than what is prescribed in Schedule II. To comply with these require- ments, the following principles are used:
(i) A company discloses useful life/depreciation rate used for the principal asset separately. If this life/rate is higher/ lower than life prescribed in schedule II, justification for the difference is disclosed in the financial statements.
(ii) There is no need to disclose useful lives or depreciation rates used for each component (other than principal asset) separately. It will be sufficient compliance, if disclosure is given as a range by presenting the highest and lowest amount. It may not be sufficient to present the average of the useful lives or depreciation rates used in that class of components.
What are the transitional provisions with respect to componentisation?
Component accounting is applicable from 1st April, 2014. It is required to be applied to the entire block of assets existing as at that date. It cannot be restricted to only new assets acquired after 1st April, 2014. Since companies may not have previously identified components separately, they may use estimated cost of a future similar replacements/ inspection/ overhaul as an indication of to determine their current carrying amount.
AS 10 gives companies an option to follow component accounting; it does not mandate the same. In contrast, component accounting is mandatory under the Schedule
II. Considering this, transitional provisions of Schedule II can be used to adjust the impact of component accounting. If a component has zero remaining useful life on the date of Schedule II becoming effective, i.e., 1st April 2014, its carrying amount, after retaining any residual value, will be charged to the opening balance of retained earnings. The consequent impact with respect to deferred taxes should also be adjusted to retained earnings. The carrying amount of other components, i.e., components whose remaining useful life is not nil on 1st April 2014, is depreciated over their remaining useful life.
In the case of listed companies do companies have to comply with component accounting in the quarterly results provided under Clause 41?
Listed companies having 31st March year-end need to apply component accounting for quarter ended 30th June, 2014. It may be possible that certain companies have not completed the process of identifying components by due date for publishing its results for quarter ended 30th June, 2014. In such a case, the auditors should make materiality assessment particularly considering that there is no need to publish balance sheet on a quarterly basis. In many cases, it may be clear that application of component ac- counting may not have impacted results for the quarter materially. If so, the auditor should document its basis for materiality assessment in the work papers. As already indicated elsewhere in this article, for most asset intensive companies, the impact on current or future results or financial position will most likely be material because of depreciation and accounting for replacement costs.
