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.”
 

Answer: No.

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:

1. There is a present obligation as a result of a past event – this is called the obligating event),
2. The payment (outflow of economic benefits) is probable (‘more likely than not’), and
3. 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:

1. The amount of 100 related to the overhauling over 4 years, so at straight-line depreciation method, it is 25 per year,
2. 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.

No problem.

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.

How?

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!