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Evaluating the impact of a uniform residual value approach for pipelines on IND AS 16 requirements

Question

Riya Limited (hereinafter referred to as "the company"), engaged in gas distribution, natural gas exploration, renewable energy, and telecom services, operates a nationwide network of natural gas and LPG pipelines. As per the company's accounting policy, depreciation on Property, Plant, and Equipment (PPE), including pipelines, is charged using the straight-line method (SLM) over 30 years with a 5% residual value, in alignment with Schedule II of the Companies Act, 2013, and industry standards.

During the audit for FY 20X1-X2, concerns were raised regarding the appropriateness of applying a uniform 5% residual value for pipelines, as disposal costs often exceed recoverable amounts. This practice has led to an overstatement of PPE and profits, as well as understated depreciation in prior years. Additionally, it was observed that the Company does not have a policy for the periodic review of the residual value and useful life of assets, as required under Ind AS 16.

In this context, examine the compliance of the Company's residual value policy with the requirements of Ind AS 16 and Schedule II of the Companies Act, 2013, and suggest the appropriate accounting treatment for determining residual value and depreciation of pipelines.

Relevant Provisions

Ind AS 16: Property Plant and Equipment

Para 6: Cost is the amount of cash or cash equivalents paid or the fair value of the other consideration given to acquire an asset at the time of its acquisition or construction or, where applicable, the amount attributed to that asset when initially recognised in accordance with the specific requirements of other Indian Accounting Standards, egInd AS 102, Share-based Payment.

The residual value of an asset is the estimated amount that an entity would currently obtain from the disposal of the asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life.

Para 51: The residual value and the useful life of an asset shall be reviewed at least at each financial year-end and, if expectations differ from previous estimates, the change(s) shall be accounted for as a change in an accounting estimate in accordance with Ind AS 8, Accounting Policies, Changes in Accounting Estimates and Errors.

Para A of Schedule II to the companies Act

Para 1: Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life. The depreciable amount of an asset is the cost of an asset or other amount substituted for cost, less its residual value. ...

Para 3: Without prejudice to the foregoing provisions of paragraph 1

The useful life of an asset shall not ordinarily be different from the useful life specified in Part C and the residual value of an asset shall not be more than five percent of the original cost of the asset:

Provided that where a company adopts a useful life different from what is specified in Part C or uses a residual value different from the limit specified above, the financial statements shall disclose such difference and provide justification in this behalf duly supported by technical advice.

Guidance Note on Accounting for Depreciation in Companies in the Context of Schedule II to the Companies Act, 2013: The residual value of an asset should not exceed five percent of its original cost. If it does, the company can use the higher estimate but must justify it with technical advice and disclose the difference. If the residual value is less than five percent, no disclosure is needed.

Expert Advisory Committee

In this case, the Expert Advisory Committee (EAC) examined whether the company's policy of fixing the residual value of pipelines at 5% complies with the requirements of Ind AS 16 and Schedule II of the Companies Act, 2013. It observed that determining residual value is an asset-specific estimation process based on the expected recoverable amount after deducting disposal costs, considering prevailing market conditions. Ind AS 16 mandates a periodic review of residual values, and any deviation from 5% of an asset's original cost must be justified through technical evaluation and disclosed in accordance with Schedule II.

The EAC highlighted that applying a uniform residual value to all pipelines is inappropriate, as factors like operational conditions and geographical locations influence residual value estimates. While identifying whether a pipeline will be extracted or abandoned can be complex, a reasonable estimate should be made at the start of the asset's useful life, incorporating factors such as lease terms, historical experience, and other relevant inputs, with periodic updates. For pipelines abandoned in place, the residual value should be considered nil, as no recoverable value exists. Conversely, if pipelines are extracted and sold, the estimated residual value must account for extraction costs.

The EAC concluded that the company's standardized approach of assigning a 5% residual value to all pipelines does not comply with Ind AS 16. Residual value estimation must reflect specific asset conditions, disposal costs, and potential changes over time, with proper disclosures and justifications.

Conclusion

Based on the provision and analysis of the case law it is concluded that the company's accounting policy to keep a standard residual value of 5% without considering all the facts and circumstances is not appropriate. The Company should determine the residual value of its various pipelines considering its facts and circumstances at the beginning of their useful life, which should be reviewed at each financial year-end, as discussed in paragraph 10 above. Further, the estimated costs of disposal should also be considered as per the definition of residual value given in Ind AS 16.

In case, the pipeline will not be extracted and will just be abandoned, the residual value should be considered 'nil' as nothing can be sold as scrap or otherwise. Further, in case, it is estimated that the pipeline will be extracted and sold, the cost attributable to extraction activity should also be considered/adjusted while determining the residual value.

Query No. 12

Opinion Finalised on: 20/04/2023

Volume: Recent Opinions

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