What Is Accounting For Spare Parts Inventory?
Most manufacturing companies use assets in their manufacturing process. The assets are usually machines that convert raw materials into finished goods which are then sold. Most companies buy machines by using their equity which is known as capital expenditure.
These machines are usually part of the business’s fixed assets and are depreciated over their expected working life. In some cases, the machines can be leased from vendors.
Almost every machine needs repair and maintenance at some point in its operational life. and so many businesses keep spare parts for essential repairs. Depending on the nature of the manufacturing, some companies also keep a sizable spare parts inventory for key repairs.
These spare parts need to be accounted and this can be a complex process and is known as accounting for spare parts inventory.
Understanding Inventory when Accounting for Spare Parts
Inventory is used to report the physical stores of a company and generally covers raw materials, work in process as well as goods ready to sell. In short, inventory is any tangible stock that is used for company operations.
However, the machinery spare parts we discussed above? They can also come under the head of inventory.
This is a challenge in manufacturing concerns as while accounting for plant and equipment, accountants need to determine how to account for the spare parts used to service machines/goods, emergency or backup equipment, and other parts.
Adding to the confusion is the fact that the IFRS standards are almost silent about this area. This leaves little guidance for companies and there is a lot of room open for interpretation. There are two broad ways to treat these account items:
There are 2 challenges for accounting for such spare parts:
- Spares and other items can be listed (and presented) under the accounting head of plants and equipment (“PPE”) or as inventory
- What will be the depreciation method for any major spare part that is listed under PPE?
Treating Spare parts as Plant & Equipment or as part of Inventory?
The main challenge with accounting for spares is assessing if it should be treated as inventory, which is a short-term asset, or as a part of plant and equipment.
In treating spare parts as part of PPE, they fall under fixed assets which is a long-term asset items.
The technical accounting treatment for both categories is different, governed by different accounting standards and different entries.
The simple differences are:
- Inventory consists of items that are expected to stay on the books for less than a year.
- This short-term presence means that spares listed under inventory are reported at the lower of cost or net realizable value
- Companies that keep large amounts of spare parts can end up inflating their inventory levels, which is a cause of concern for lenders, shareholders, and suppliers.
- High inventory levels can inflate current assets unnecessarily and distort liquidity ratios.
Spare parts are items for the machinery that are surplus or extra to the business’s requirements. Many businesses keep spare parts to ensure the smooth running and maintenance of their machines.
As such, spare parts are not important enough to report under inventory, although many are used up within a year and should fall under current assets.
In some cases, where spare parts may be extra parts of a larger machine and may not be needed for a couple of years, in which case, they do not fit the definition of an inventory item and should be reported under plant and equipment.
This variability is what makes accounting for spare parts a complicated process. As per accounting principles, spare parts are resources that can generate a future flow of economic benefits.
This makes it clear that spare parts are a part of the company’s assets. The journal entries are therefore simple.
The differentiation between current and non-current assets is where the process becomes complicated. To make it simpler, accountants must ascertain if the spare part is a short-term or long-term purchase.
Classifying Spare Parts Inventory
Businesses can classify spare parts as inventories or fixed assets. For an inventory, the accounting standard IAS 2 applies. companies need to book spare parts as inventory items and report them at the Lower of Cost or Net Realizable Value.
For fixed assets, the accounting standard IAS 16 for Property, Plant, and Equipment is applicable. The reporting requirements will also change. In case businesses buy spare parts for reselling, the categorization will not apply, and such spare parts will be reported as part of the inventory
As a rule of thumb, the intended use and time of availability with the business will determine the accounting treatment of spare parts inventory.
Why Spare Parts Inventory is Important
For accountants, the assessment of spare parts as inventory or plant and equipment is important because the accounting treatment for both items is different, and the wrong selection can impact the financial statements.
For instance, the value of spare parts can be distorted by not being depreciated if they are treated as inventory. Similarly, the inaccurate presentation of spare parts under plant and equipment can affect liquidity and depreciation values as well.As a rule, the following parameters can help to accurately assess where spare part inventory should be
- Purpose of the spare parts: will the spare parts be used during the production process or be available for resale. The answer determines the treatment as inventory or plant and equipment
- Timing: knowing the timeline for the spare parts is helpful in determining their treatment. Will they be used up in one year? or will they be available for use after one production year has passed?