Should we create a provision for major overhauling?
“We are manufacturing company and we have lots of heavy machines. Some of these machines require major maintenance works and overhauling after some time – some of them after 3 years, or 5 years.
In some cases we need to replace some components of the machines after few years.
The question is whether we should make a provision for major overhauling and replacement of components when we buy the machines, because we know at the time of purchase that we will have to spend some money to continue operating the machine in the future.”
Very good and very common question.
My short answer is – no, you should not make any provision, because it’s the wrong pill.
Instead, you should do something else.
Let me break it down.
Why shouldn’t you make any provision?
First, let’s go back to the basic rules about recognizing a provision.
You should recognize a provision only if:
- There is a present obligation as a result of a past event – this is called the obligating event),
- The payment (outflow of economic benefits) is probable (‘more likely than not’), and
- The amount can be estimated reliably
I understand that you easily meet the condition n. 2 and n. 3, because the payment is probable and maybe you can estimate the amount quite reliably.
But, there is NO obligating past event, is there?
Just ask yourself a question: Can you avoid the obligation to pay with some future actions?
In this case, yes, you can.
How is that possible?
Well, the company can still decide to sell the machine without making the repairs first. Or abandon the production and scrap the machines.
I know I know – it’s not your intention, but the point is that – no, there is no past event, because you are not obliged to pay for the future repairs.
When I was an auditor, I audited a small airline that performed major overhauling of the aircraft every 3 or 4 years or so, and the airline booked one quarter of assumed cost for overhauling in the cost of an asset and as a provision.
It was completely wrong and we proposed major adjustment in the financial statements to remove this provision as there was no past event.
How to treat the cost for major overhauling?
So what to do instead?
Well, in the case of major overhauling, you should try to:
- Identify the cost of assumed overhauling, and
- Depreciate it separately as a component.
Example: Major overhauling
Let’s say that the asset’s total cost is 1 000 CU and its useful life is 20 years.
After 4 years, you will need to perform major overhauling with assumed cost of 100.
- Debit PPE: CU 1 000, and
- Credit suppliers 1 000 (if you purchased on credit from your suppliers).
This is it – you do NOT recognize a provision for major overhauling of 100.
Instead, you would depreciate the aircraft in 2 separate components:
- The amount of 100 related to the overhauling over 4 years, so at straight-line depreciation method, it is 25 per year,
- The remaining amount of 900 (1 000 less 100) is depreciated over aircraft’s useful life of 20 years, which is 45 per year.
So, the total depreciation charge is 25 plus 45 = 70.
After 4 years, you need to make major overhauling and you spend CU 100. You book it as:
- Debit PPE – aircraft: CU 100
- Credit suppliers: CU 100
Again, you will depreciate the cost of 100 over next 4 years until the next major overhauling.
Now, what should you do if the overhauling is performed earlier than assumed?
Let’s say that instead of 4 years, an airline decided to perform overhauling after 3 years.
In this case, you need to derecognize any remaining carrying amount of previous overhauling.
After 3 years, you would depreciate 3*25 = 75 and the remaining carrying amount of previous overhauling is 25.
You simply book it as:
- Debit Profit or loss: CU 25,
- Credit PPE – aircraft: CU 25
What about the parts that need replacement?
It’s the same principle as we apply with major overhauling.
You need to depreciate the components separately over shorter useful life.
The standard IAS 16 illustrates it on an aircraft and its seats – the seats might require replacement a few times over the life of the airplane, so you might need to depreciate them separately.
What does it all practically mean?
Some big assets, like aircraft, furnaces and big machinery might have lots of components that require separate depreciation.
The reason is that many components of the same asset have different useful lives.
Also, when you acquire such an asset with major components, I’d like to warn you about the directly attributable cost.
It is necessary to allocate a part of these costs to each or at least some of separate components, but it requires careful judgment.
For example, when you buy a machine for 10 000 CU and the transportation expenses are 1 000, then the total cost of an asset is 11 000.
Imagine that the separate component with shorter useful life costs 2 000. So, you should not just depreciate 2 000 separately.
You should allocate some of the transportation expenses to that component.
It is on your judgment, for example – allocate by the weight of component and the whole machine when allocating transport.
You can use different allocation method for different types of expenses.
Any questions or comments? Have your word below this article – thank you!
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What if overhauling is done each year? How is it depreciated then?
i have a question, if company business is to provide operation and maintenance of power plant of another company , in that case company would have to incurred future major overhauling cost, it is contractual obligation. what should be the treatment of this major overhauling cost which will be incurred in future.
company is fixed fee for providing operation and maintenance . ( whether company should booked contract liability and what will be the treatment for that.) your prompt respond will be very helpful.
My question is in relation to a scheduled machinery overhaul where the major components to be overhauled were not recognised and depreciated separately on aacquisition of the machinery.
Is it appropriate to recognise accelerated depreciation on the book value of the components to be overhauled where the cost of overhaul sits in Capital Work In Progress as it is not yet completed and the time of completion of the overhaul is indeterminable?
I would really appreciate your thoughts on this.
In your example, when the overhauling happens at the end of the third year and not at the end of the fourth year, don’t you think it is change in estimate of the useful life. Why should the organization suffer in terms of taking the cost directly to the P&L a/c instead of adding to the new overhaul cost and depreciating over the revised useful economic life. Please let me know. Thanks.
yes, it is a change in useful life and it is accounted for prospectively – that is, one-off depreciation of the remaining carrying amount is made. You can’t do so as you described, because IAS 16 directly and explicitly says that you have to derecognize the remaining carrying amount of previous inspection (overhaul) in line with par. 67 and following of IAS 16 – that is, recognize any gain or loss in profit or loss and not in the cost of the new asset in this case. S.
I do agree that provision should not be recorded, but I disagree with the way you treated overhaul in your example. in the example you mentioned
I think the asset should be depreciated over 20 years, and nothing to be done over the first four years regarding the verhaul, in the fifth year when overhaul should be made Dr. Capital expenditure ( asset ) cr cash or Accounts payable, and then to amortize the cost of overhaul ( capital expenditure / asset ) over the coming four years or until the next overhaul. That’s what is think is right and that’s what we do in the airline business and in the company where I work
thanks a lot for your comment. In fact, I expected similar disagreement because indeed, this is what most companies do.
However, that’s not 100% right.
I would like to point you to the par. 14 of IAS 16, mainly last 3 sentences. They say that you have to derecognize any remaining carrying amount of previous inspection and this occurs REGARDLESS of whether the cost of previous inspection was identified in the transaction in which the item was acquired/constructed.
And then it goes on saying that the cost of future inspection may be used as an indication of what the cost of the existing inspection component was when the asset was acquired.
So, to wrap it up – you should do it initially as described above, because at the next major overhauling, you would have to identify the carrying amount of previous inspection and derecognize it anyway. It’s much better to do it initially, rather then upon next major inspection, due to smoother impact on P/L. Best, S.
Great Silvia??,my Exam is on Friday,with the help of this site,I am more confident ?
what did you mean when you said that Mohammed view isn’t 100% right?
Is it wrong, although most companies do that? Does it depend on auditor interpretation of the standard? Thank you
Hi Vittorio, please read my full comment, I explained it fully and gave reference to the standard.
Interesting discussion. I think you are both right in a way:
When the inspection/repair reallly means a value increase of the asset (The extension of the economc life > 20 years) , the methodology of Mohammed can be justified. In case of regular exchange of wear parts that does not extend the economic life of the main machine, then Silvia is right in running a separate depreciation cycle for these parts.
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