Concepts, Rules, and Examples
Property, Plant, and Equipment
Property, plant, and equipment (also variously referred to as plant assets, or fixed assets, or as PP&E) is the term most often used to denote tangible property to be used in a productive capacity that will benefit the enterprise for a period of greater than one year. This term is meant to distinguish these assets from intangibles, which are long-term, generally identifiable assets that do not have physical substance, or whose value is not fully indicated by their physical existence.
There are four concerns to be addressed in accounting for fixed assets.
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The amount at which the assets should be recorded initially on acquisition;
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How value changes subsequent to acquisition should be reflected in the accounts, including questions of both value increases and possible decreases due to impairments;
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The rate at which the amount the assets are recorded should be allocated to future periods; and
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The recording of the subsequent disposal of the assets.
Initial measurement.
All costs required to bring an asset into working condition should be recorded as part of the cost of the asset. Examples of such costs include sales or other nonrefundable taxes or duties, finders' fees, freight costs, site preparation and other installation costs, and setup costs. Thus, any reasonable cost incurred prior to using the asset in actual production involved in bringing the asset to the buyer is capitalized. These costs are not to be expensed in the period in which they are incurred, as they are deemed to add value to the asset and indeed were necessary expenditures to obtain the asset, provided that this does not lead to recording the asset at an amount greater than fair value.
Estimated costs to dismantle or remove spent equipment or to restore property, when subject to accurate determination and if constituting a legal or constructive commitment by the reporting entity, are to be recognized over the life of the related asset. Before IAS 16 was amended in 1998, this was accomplished by one of two acceptable means. First, these costs could have been estimated and used to reduce the estimated residual value of the asset, thereby increasing periodic depreciation charges (potentially even to the extent that a negative net book value would result, representing the net obligation for costs associated with asset retirement, less salvage value). Alternatively, the estimated costs could have been accrued periodically, by a charge to current operations and a credit to a provision for an estimated liability. The overall impact on the financial statements would have been equivalent under either approach.
In order to conform to the requirements set forth in IAS 37, Provisions, Contingent Liabilities, and Contingent Assets, IAS 16 was amended with regard to the accounting for estimated costs of asset retirement obligations. Under the current standard, the elements of cost to be incorporated in the initial recognition of an asset are to include the estimated costs of its eventual dismantlement. That is, the cost of the asset is "grossed up" for these estimated terminal costs, with the offsetting credit being posted to a liability account. It is important to stress that this only applies when all the criteria set forth in IAS 37 for the recognition of provisions are met. These criteria are that a provision will be recognized when (1) the reporting entity has a present obligation, whether legal or only constructive, as a result of a past event; (2) it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and (3) a reliable estimate can be made of the amount of the obligation.
For example, assume that it were necessary to secure a government license in order to construct a particular asset, such as a power generating plant, and a condition of said license would be that at the end of the expected life of the property the owner would dismantle it, remove any debris, and then restore the land to its previous condition. These conditions would qualify as a present obligation resulting from a past event (the plant construction), which will probably result in a future outflow of resources. The cost of doing this, while perhaps challenging due to the long time horizon and the possible intervening evolution of technology, can normally be estimated. Per IAS 37, a best estimate is to be made of the future costs, which is then to be discounted to present value. This present value is to be recognized as an additional cost of acquiring the asset.
The cost of dismantlement and similar legal or constructive obligations do not extend to operating costs to be incurred in the future, since those would not qualify as "present obligations." The precise mechanism for making these computations is addressed in Chapter 12.
If estimated costs of dismantlement, removal, and restoration are included in the cost of the asset, the effect will be to allocate this cost over the life of the asset through the depreciation process. While not explicitly addressed by either IAS 37 or the revisions to IAS 16, logic suggests that, if originally recorded at discounted present value, each period the provision (i.e., the estimate liability) should be accreted, so that at the expected date on which the expenditure is to be incurred it will be appropriately stated. The offset to this accretion should be reported as interest expense or a similar financing cost. It should not be added to the cost of the asset to which the estimated dismantlement costs related.
In certain cases, other costs will be incurred during the initial break-in period. These costs may, alternatively, be referred to as start-up or preproduction costs. Under the provisions of IAS 16, these costs are not to be added to the amount recorded for the asset unless they are absolutely necessary to bring the asset to a workable condition. Notwithstanding this rule, this remains an area of subjective judgment; under many circumstances there will be justification for adding certain costs, such as those associated with materials used in testing or adjusting the machinery or equipment in order to place it into actual production. If these amounts are significant and incurrence of the costs is a necessary precedent to using the asset, they should be added to the carrying amount of the asset. On the other hand, losses incurred in the early stages of actually employing the asset in its intended use clearly cannot be capitalized, but instead must be charged to expense as incurred, as these are not assets (i.e., these do not represent economic benefits that will later be received by the entity).
While interest costs incurred during the construction of certain assets may be added to the cost of the asset (as described below), if an asset is purchased on deferred payment terms, the interest cost, whether made explicit or imputed, is not part of the cost of the asset. Accordingly, such costs should be expensed currently as interest charges. If the purchase price for the asset incorporates a deferred payment scheme, only the cash equivalent price should be capitalized as the initial carrying amount of the asset. If the cash equivalent price is not explicitly stated, the deferred payment amount should be reduced to present value by the application of an appropriate discount rate. This would normally be best approximated by use of the enterprise's incremental borrowing cost for debt having a maturity similar to the deferred payment term.
Administrative costs, as well as other categories of overhead, are not normally allocated to fixed asset acquisitions, despite the fact that some such costs, such as the salaries of the personnel who evaluate assets for proposed acquisitions, are in fact incurred as part of the acquisition process. As a general principle, administrative costs are expensed in the period incurred. On the other hand, truly incremental costs, such as a consulting fee or commission paid to an agent hired specifically to assist in the acquisition, may be treated as part of the initial amount to be recognized.
Initial recognition of self-constructed assets.
Essentially the same principles that have been established for recognition of the cost of purchased assets also apply to self-constructed assets. All costs that must be incurred to complete the construction of the asset can be added to the amount to be recognized initially, subject only to the constraint that if these costs exceed the recoverable amount (as discussed fully later in this chapter), the excess must be expensed currently. This rule is necessary to avoid the "gold-plated hammer syndrome," whereby a misguided or unfortunate asset construction project incurs excessive costs that then find their way onto the balance sheet, consequently overstating the entity's current net worth and distorting future periods' earnings. Of course, internal (intracompany) profits cannot be allocated to construction costs.
Self-constructed assets may include, in addition to the range of costs discussed earlier, the cost of borrowed funds used during the period of construction. Capitalization of borrowing costs, as set forth by IAS 23, is discussed in a later section of this chapter.
The other issue that arises most commonly in connection with self-constructed fixed assets relates to overhead allocations. While capitalization of all direct costs (labor, materials, and variable overhead) is a well-settled matter in accounting thought, a controversy exists regarding the proper treatment of fixed overhead. Two alternative views of how to treat fixed overhead are to
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Charge the asset with its fair share of fixed overhead (i.e., use the same basis of allocation used for inventory); or
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Charge the fixed asset account with only the identifiable incremental amount of fixed overhead.
While international standards do not address this concern, it may be instructive to consider nonbinding guidance included in US GAAP. AICPA Accounting Research Monograph 1 has suggested that
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... in the absence of compelling evidence to the contrary, overhead costs considered to have "discernible future benefits" for the purposes of determining the cost of inventory should be presumed to have "discernible future benefits" for the purpose of determining the cost of a self-constructed depreciable asset.
The implication of this statement is that a logic similar to what was applied to determining which acquisition costs may be included in inventory might reasonably also be applied to the costing of fixed assets. Also, consistent with the standards applicable to inventories, if the costs of fixed assets exceed realizable values, any excess costs should be written off to expense and not deferred to future periods.
Costs incurred subsequent to purchase or self-construction.
Costs that are incurred subsequent to the purchase, such as those for repairs, maintenance, or betterments, are treated in one of the following ways:
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Expensed;
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Capitalized; or
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Recognized by a reduction of accumulated depreciation.
Costs can be added to the carrying value of the related asset only when it is probable that future economic benefits beyond those originally anticipated for the asset will be received by the entity. For example, modifications to the asset made to extend its useful life (measured either in years or in units of potential production) or to increase its capacity (e.g., as measured by units per hour) would be capitalized. Similarly, if the expenditure results in an improved quality of output, or permits a reduction in other cost inputs (e.g., would result in labor savings), it is a candidate for capitalization. As with self-constructed assets, if the costs incurred exceed the defined threshold, they must be expensed currently.
It can usually be assumed that ordinary maintenance and repair expenditures will occur on a ratable basis over the life of the asset and should be charged to expense as incurred. Thus, if the purpose of the expenditure is either to maintain the productive capacity anticipated when the asset was acquired or constructed, or to restore it to that level, the costs are not subject to capitalization.
A partial exception is encountered if an asset is acquired in a condition that necessitates that certain expenditures be incurred in order to put it into the appropriate state for its intended use. For example, a deteriorated building may be purchased with the intention that it be restored and then utilized as a factory or office facility. In such cases, costs that otherwise would be categorized as ordinary maintenance items might be subject to capitalization, subject to the constraint that the asset not be presented at a value that exceeds its recoverable amount. Once the restoration is completed, further expenditures of similar type would be viewed as being ordinary repairs or maintenance, and thus expensed as incurred.
Extraordinary repairs.
In contrast to normal maintenance costs, extraordinary repairs or maintenance increase the value (utility) of the asset or increase the estimated useful life of the asset. Extraordinary repairs may also be referred to variously as overhauls, betterments or renewals; ultimately, it is not the term used, but the substance of what has been performed that is of most concern. There has long been widespread recognition that such expenditures can validly be used to increase the net carrying value of the asset, and that these costs are not to be immediately expensed. However, IAS 16 did not directly address this subject (it does set forth an economic benefit criterion for subsequent expenditures on plant assets already deployed), nor did it stipulate how these were to be accounted for.
Two methods of accounting for extraordinary repairs have been advocated. The more direct approach is to simply add these costs to the gross carrying value of the asset. The alternative is to reduce the previously accumulated depreciation, thereby also increasing the net book value. There is a logical basis for increasing the asset account for those repairs that increase the value of the asset, while decreasing the accumulated depreciation account for those repairs that extend the useful life of the asset. In effect, those that extend the life of the asset have "recovered" some of the depreciation previously recorded, and the asset will be depreciated again over its new, lengthier, lifetime.
While the appropriateness of these methods has yet to be addressed by the IASC, the issuance of SIC 23, Property, Plant, and Equipment—Major Inspection or Overhaul Costs, has for the first time offered official support for the concept of capitalizing extraordinary repair costs. SIC 23 states that while the costs of a major inspection or overhaul of property, plant, and equipment occurring subsequent to the acquisition of that property, plant, and equipment are generally expensed, such costs are capitalized under certain circumstances. Specifically, if the entity has already depreciated a component to reflect the consumption of benefits which are replaced or restored by the major inspection or overhaul, and the capitalized overhaul costs are identified as a separate component of the asset, then such costs can be added to the carrying value of the asset. Thus, a qualified endorsement for capitalization of overhaul (or, also, presumably extraordinary repairs and similar) costs has now been granted.
The chart on the following page summarizes the treatment of expenditures subsequent to acquisition consistent with the foregoing discussion.
Depreciation of fixed assets.
In accordance with one of the more important basic accounting concepts, the matching principle, the costs of fixed assets are allocated to the periods benefited through depreciation. Whatever the method of depreciation chosen, it must result in the systematic and rational allocation of the cost of the asset (less its residual value) over the asset's expected useful life. The determination of the useful life must take a number of factors into consideration. These factors include technological change, normal deterioration, actual physical use, and legal or other limitations on the ability to use the property. The method of depreciation is based on whether the useful life is determined as a function of time (e.g., technological change or normal deterioration) or as a function of actual physical usage.
Since depreciation accounting is intended as a strategy for cost allocation, it does not necessarily reflect changes in the value of the asset being amortized. Thus, with the exception of land, which has infinite life, all tangible fixed assets must be depreciated, even if (as sometimes occurs, particularly in periods of general price inflation) their nominal or real values increase.
Furthermore, if the recorded amount of the asset is allocated over a period of time (as opposed to units of production), it should be the expected period of usefulness to the entity, not the physical life of the property itself, that governs. Thus, such concerns as technological obsolescence, as well as normal wear and tear, must be addressed in the initial determination of the period over which to allocate the asset cost. The reporting entity's strategy for repairs and maintenance will also affect this computation, since the same physical asset might have a longer or shorter economic useful life in the hands of differing owners, depending on the care with which it is intended to be maintained.
Similarly, the same asset may have a longer or shorter economic life, depending on its intended use. A particular building, for example, may have a fifty-year expected life as a facility for storing goods or for use in light manufacturing, but as a showroom would have a shorter period of usefulness, due to the anticipated disinclination of customers to shop at enterprises housed in older premises. Again, it is not physical life, but useful economic life, that should govern.
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| Charge to asset | Charge to accum. deprec. | ||||
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Compound assets, such as buildings containing such disparate components as heating plant, roofs, and other structural elements, are most commonly recorded in several separate accounts, to facilitate the process of amortizing the different elements over varying periods. Thus, a heating plant may have an expected useful life of twenty years, the roof a life of fifteen years, and the basic structure itself a life of forty years. Recordation in separate accounts eases the calculation of periodic depreciation in such situations, although for financial reporting purposes certain of these categories might be combined, based on materiality or other considerations.
Originally, a stand-alone IAS addressed depreciation accounting. However, the guidance formerly located in that standard was absorbed by or superseded by IAS 16 for tangible long-lived assets, and IAS 38 for intangible assets. The allocation of the costs of intangibles to the periods benefited is addressed in Chapter 9. Methods of allocating the costs of tangible assets are discussed in the following section of this chapter.
Depreciation methods based on time.
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Straight-line—Depreciation expense is incurred evenly over the life of the asset. The periodic charge for depreciation is given as
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Accelerated methods—Depreciation expense is higher in the early years of the asset's useful life and lower in the later years. IAS 16 only mentions one accelerated method, the diminishing balance method, but other methods have been employed in various countries under earlier or other contemporary accounting standards.
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Diminishing balance—A multiple of the straight-line rate times the net carrying value at the beginning of the year.
Example
Double-declining balance depreciation (if salvage value is to be recognized, stop when book value = estimated salvage value)
Depreciation = 2 x Straight-line rate x Book value at beginning of year
Another method to accomplish a diminishing charge for depreciation is the sum-of-the-years' digits method, that is commonly employed in the United States and certain other venues.
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Sum-of-the-years' digits (SYD) depreciation =
(Cost less salvage value) x Applicable fraction
and
and n = estimated useful life
Example
An asset having a useful economic life of 5 years and no salvage value would have 5/15 (= 1/3) of its cost allocated to year 1, 4/15 to year 2, and so on.
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Present value methods—A characteristic of this method of depreciation is that expense will be lower in the early years and higher in the later years. The effect of this pattern results in having the rate of return on the investment remain constant over the life of the asset. Time value of money formulas are used to effect this method of depreciation.
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Sinking fund method—Uses the future value of an annuity formula.
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Annuity fund method—Uses the present value of an annuity formula.
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The present value approach is rarely encountered in practice, due to computational complexity, despite what many consider to be its theoretical validity. IAS 16 is silent regarding these methods, and the fact that the standard refers only to straight-line, diminishing balance, and sum-of-the-units methods may suggest that increasing charge methods would not be acceptable. However, the statement in IAS 16 that a "variety of depreciation methods can be used to allocate the depreciable amount of an asset on a systematic and rational basis over its useful life" would at the same time seemingly support other unnamed methods, albeit that they are not explicitly discussed in that standard. Clearly, it would be incumbent upon those choosing to employ such methods to demonstrate why these better represented the actual economic depreciation of the assets in question.
Partial-year depreciation.
Although IAS 16 is silent on the matter, when an asset is either acquired or disposed of during the year, the full year depreciation calculation should be prorated between the accounting periods involved. This is necessary to achieve proper matching. However, if individual assets in a relatively homogeneous group are regularly acquired and disposed of, one of several conventions can be adopted, as follows:
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Record a full year's depreciation in the year of acquisition and none in the year of disposal.
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Record one-half year's depreciation in the year of acquisition and one-half year's depreciation in the year of disposal.
Example of partial-year depreciation
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Assume the following:
Taj Mahal Milling Co., a calendar-year entity, acquired a machine on June 1, 2002, that cost $40,000 with an estimated useful life of four years and a $2,500 salvage value. The depreciation expense for each full year of the asset's life is calculated as follows:
| Straight-line | Double -declining balance | Sum-of-years' digits | |||||||||
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| Year 1 | 37,500 [a] 4 = 9,375 | 50% | x | 40,000 | = | 20,000 | 4/10 | x | 37,500[a] | = | 15,000 |
| Year 2 | 9,375 | 50% | x | 20,000 | = | 10,000 | 3/10 | x | 37,500 | = | 11,250 |
| Year 3 | 9,375 | 50% | x | 10,000 | = | 5,000 | 2/10 | x | 37,500 | = | 7,500 |
| Year 4 | 9,375 | 50% | x | 5,000 | = | 2,500 | 1/10 | x | 37,500 | = | 3,750 |
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[a]$40,000 - $2,500. | |||||||||||
Because the first full year of the asset's life does not coincide with the company's year, the amounts shown above must be prorated as follows:
| Straight-line | Double -declining balance | Sum-of-years' digits | |||||||||
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| 2002 | 7/12 x 9,375 = 5,469 | 7/12 | x | 20,000 | = | 11,667 | 7/12 | x | 15,000 | = | 8,750 |
| 2003 | 9,375 | 5/12 | x | 20,000 | - | 8,333 | 5/12 | x | 15,000 | = | 6,250 |
| 7/12 | x | 10,000 | = | 5,833 | 7/12 | x | 11,250 | = | 6,563 | ||
| 14,166 | 12,813 | ||||||||||
| 2004 | 9,375 | 5/12 | x | 10,000 | = | 4,167 | 5/12 | x | 11,250 | = | 4,687 |
| 7/12 | x | 5,000 | = | 2,917 | 7/12 | x | 7,500 | = | 4,375 | ||
| 7,084 | 9,062 | ||||||||||
| 2005 | 9,375 | 5/12 | x | 5,000 | = | 2,083 | 5/12 | x | 7,500 | = | 3,125 |
| 7/12 | x | 2,500 | = | 1,458 | 7/12 | x | 3,750 | = | 2,188 | ||
| 3,541 | 5,313 | ||||||||||
| 2006 | 5/12 x 9,375= 3,906 | 5/12 | x | 2,500 | = | 1,042 | 5/12 | x | 3,750 | = | 1,562 |
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Depreciation method based on actual physical use—Sum-of-the-units (or units of production) method.
Depreciation may also be based on the number of units produced by the asset in a given year. IAS 16 identifies this as the sum-of-the-units method, but it is also commonly known as the units of production approach. It is best suited to those assets, such as machinery, that have an expected life that is most rationally defined in terms of productive output; in periods of reduced production (such as economic recession) the machinery is used less, thus extending its life when measured in units of time. It would not be rational to charge the same depreciation expense to such periods, as would be the case if straight-line or diminishing balance depreciation were used. Furthermore, if the depreciation finds its way into inventory, the unit cost in periods of reduced production would be exaggerated and could even exceed net realizable value unless a units of production approach to depreciation were taken.
Other depreciation methods.
Although IAS 16 does not discuss other methods of depreciation (nor even all the variations noted in the foregoing paragraphs), at different times and in various jurisdictions other methods have been used. Some of these are summarized as follows:
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Retirement method— Cost of asset is expensed in period in which it is retired.
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Replacement method— Original cost is carried in accounts and cost of replacement is expensed in the period of replacement.
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Group (or composite) method— Averages the service lives of a number of assets using a weighted-average of the units and depreciates the group or composite as if it were a single unit. A group consists of similar assets, while a composite is made up of dissimilar assets.
Depreciation expense = Depreciation rate x Total group (composite) cost
A peculiarity of the composite approach is that gains and losses are not recognized on the disposal of an asset, but rather, are netted into accumulated depreciation. This is because it is a presumption of this method that although dispositions of individual assets may yield proceeds greater than or less than their respective book values, the ultimate gross proceeds from a group of assets will not differ materially from the aggregate book value thereof, and accordingly, recognition of those individual gains or losses should be deferred and effectively netted out.
Residual value.
Most depreciation methods discussed above require that a factor be applied to the net depreciable cost of the asset, where net depreciable cost is the historical cost or amount substituted therefor (i.e., fair value) less the estimated residual value of the asset. Although residual value is often not material and in practice is frequently ignored, the concept should nonetheless be understood, particularly since it is defined differently in the context of the benchmark and allowed alternative methods described by IAS 16.
If the benchmark method (historical cost) is used, residual value is defined as the expected worth of the asset, in present dollars (i.e., without any consideration of the impact of future inflation), at the end of its useful life. Residual value should, however, be net of any expected costs of disposition. In some cases, assets will have a negative residual value, as for example when the entity must incur out-of-pocket costs to dispose of the asset, or to return the property to an earlier condition, as in the case of certain operations, such as strip mines, that are subject to environmental protection or other laws. In such instances, periodic depreciation should total more than the asset's original cost, such that at the expected disposal date, an estimated liability has been accrued equal to the negative residual value.
If the alternative (revaluation) method is elected, residual value takes on a rather different meaning. Under this scenario, residual value must be assessed anew at the date of each revaluation of the asset. This is accomplished by using data on realizable values for similar assets, ending their respective useful lives at the time of the revaluation, after having been used for purposes similar to the asset being valued. Again, no consideration can be paid to anticipated inflation, and expected future values are not to be discounted to present values to give recognition to the time value of money. As with historical cost based accounting for plant assets, if a negative residual value is anticipated, this should be effectively recognized over the useful life of the asset by charging extra depreciation, such that the estimated liability will have been accrued by the disposal date.
Choice of depreciation method.
While a number of different methods have been officially endorsed by international accounting standards, and others might be rationally supportable as well, in theory one method will be best in any given fact situation at reporting on the expiration of the service potential of the asset. Thus, straight-line presumes that the same economic value is obtained from use of the asset each period, while such accelerated approaches as the diminishing balance method are intended to combine decreasing periodic charges for depreciation with presumably increasing costs for repairs and maintenance as the asset ages, for an approximately level total cost of use across the years.
In practice, the amount of real support marshaled for the particular depreciation method employed will vary significantly, and it is very unusual for certifying (i.e., outside) accountants to dispute any entity's choice of method, as long as it is among those deemed to be GAAP. It is presumed that full disclosure of the methods used will permit the financial statement reader to interpret the financial statements meaningfully, in any event.
IAS 16 requires that the method of depreciation be critically reviewed periodically. If the expected pattern of utility of the asset has changed from when the method used was decided on, a different and more appropriate method should be selected. This change would be accounted for as a change in an accounting estimate and would affect financial reporting only on a prospective basis.
Useful lives.
Irrespective of the method of depreciation used, the estimate of useful life must be revisited periodically. Useful life is defined in terms of expected utility to the enterprise, and as such may differ from both the physical life and economic life of the asset. Useful life is affected by such things as the entity's practices regarding repairs and maintenance of its assets, as well as the pace of technological change and the market demand for goods produced and sold by the entity using the assets as productive inputs. If it is determined that the estimated life is greater or less than previously believed, the change is handled as a change in accounting estimate, not as a correction of fundamental error. Accordingly, no restatement is made to previously reported depreciation; rather, the change is accounted for strictly on a prospective basis, being reflected in the period of change and all subsequent periods.
Example of estimating the useful life
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To illustrate this concept, consider an asset costing $100,000 and originally estimated to have a productive life of 10 years. The straight-line method is used, and there was no residual value anticipated. After 2 years, management revises its estimate of useful life to a total of 6 years. Since the net carrying value of the asset is $80,000 after 2 years ($100,000 x 8/10), and the remaining expected life is 4 years (2 of the 6 revised total years having already elapsed), depreciation in years 3 through 6 will be $20,000 ($80,000/4) each.
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Tax methods.
The methods of computing depreciation discussed in the foregoing sections relate only to financial reporting under international accounting standards. Tax laws in different nations of the world vary widely in terms of the acceptability of depreciation methods, and it is not possible for a general treatise such as this to address those in any detail. However, to the extent that depreciation allowable for income tax reporting purposes differs from that required or permitted for financial statement purposes, deferred income taxes might have to be presented. Interperiod income tax allocation is discussed more fully in Chapter 15.
Revaluation of Fixed Assets
IAS 16 establishes two alternative approaches to accounting for fixed assets. The first of these is the benchmark treatment, under which acquisition or construction cost is used for initial recognition, subject to depreciation over the expected economic life and to possible write-down in the event of a permanent impairment in value. The allowed alternative treatment is to recognize upward revaluations.
The logic of recognizing revaluations relates to both the balance sheet and the measure of periodic performance provided by the income statement. Due to the effects of inflation (which even if quite moderate when measured on an annual basis can compound dramatically during the lengthy period over which fixed assets remain in use) the balance sheet can become a virtually meaningless agglomeration of dissimilar costs.
Furthermore, if income is determined by reference to historical costs of assets acquired in earlier periods, the replacement of those assets in the normal course of events may well require more resources than are provided by depreciation. Under these circumstances, even a nominally profitable enterprise might find that it has self-liquidated and is unable to continue in existence, at least not with the same level of productive capacity, without new debt or equity infusions. In fact, a number of enterprises in many capital-intensive industries have suffered just such a fate over the past generation.
At varying times the securities regulatory and other authorities and private sector standard setters in different nations have proposed or even required a range of alternative price level adjusted or current cost methods of accounting to address this problem. Notwithstanding these efforts, no uniform approach has ever gained the wide acceptance that would create a de facto standard. In certain jurisdictions, less complex and less useful methods have been tried to crudely compensate for the effects of inflation; accelerated depreciation methods (including 100% write-offs in the year of acquisition, in some cases) and LIFO inventory costing are the most prominent of these. Of course, these are not true substitutes for a comprehensive system of inflation-adjusted financial reporting.
Fair value.
As a practical yet reasonably effective alternative, IAS 16 promotes the concept of asset revaluation. The standard stipulates that fair value (defined as the amount for which the asset could be exchanged between knowledgeable, willing parties in an arm's-length transaction) be used in any such revaluations. Furthermore, the standard requires that, once an entity undertakes revaluations, they must continue to be made with sufficient regularity that the carrying amounts in any subsequent balance sheet are not materially at variance with then-current fair values. In other words, if the reporting entity adopts the allowed alternative treatment, it cannot report balance sheets that contain obsolete fair values, since that would not only obviate the purpose of the allowed treatment, but would actually make it impossible for the user to meaningfully interpret the financial statements.
Fair value is defined in IAS 16 as generally being the market value of assets such as land and buildings, as determined by appraisers employing normal commercial valuation techniques. Market values can also be used for machinery and equipment, but since such items often do not have readily determinable market values, particularly if intended for specialized applications, they may instead be valued at depreciated replacement cost.
Before its 1998 revision, IAS had specified that the estimated fair value of an asset was to be made in the context of the same type of service for which it has been deployed. Thus, the fair value of a factory building could only be ascertained by reference to the replacement cost or other measure of a factory building. This would be true even if, for example, the factory building being valued had alternative use as residential lofts, due to the ongoing evolution of the area in which it was sited.
Revised IAS 16 clarified the determination of fair value in such situations. Conforming to the guidance in revised IAS 22, it defines fair value as the amount at which the property would be exchanged between parties in an arm's-length transaction. Since this does not restrict the hypothetical buyer to utilize the asset in the same manner as the present owner of the property, accordingly, the operative definition of fair value is not restricted as it was previously. Fair value should be understood now to denote the amount at which the property could be exchanged, whether or not this usage would conform to that currently in effect. Fair values of land and buildings are still to be determined, in most instances, by reference to appraisals made by qualified personnel.
The logic of the change is clear. If a given property has a "higher and better" use, then current operations should bear the extra depreciation cost (if the revaluation method is used) necessitated by, in effect, underutilizing the property. This accounting could well inform owners and managers that potentially greater financial performance has been forgone due to explicit or implicit decisions which have created a suboptimal return on investment. This is precisely the sort of insight that proponents of various "current value" approaches have long held would be the benefit from dispensing with historical cost conventions.
Alternative concepts of current value.
A number of different concepts have been proposed over the years to achieve inflation accounting. Methods that address changes in specific prices, in contrast to those that attempt to adjust for general purchasing power changes, have measured reproduction cost, replacement cost, sound value, exit value, entry value, and net present value.
In brief, reproduction cost refers to the actual current cost of exactly reproducing the asset, essentially ignoring changes in technology in favor of a strict bricks-and-mortar concept. Since the same service potential could be obtained currently, in many cases, without a literal reproduction of the asset, this method fails to fully address the economic reality that accounting should ideally attempt to measure.
Replacement cost, in contrast, deals with the service potential of the asset, which is after all what truly represents value for its owner. An obvious example can be found in the realm of computers. While the cost to reproduce a particular mainframe machine exactly might be the same or somewhat lower today versus its original purchase price, the computing capacity of the machine might easily be replaced by one or a small group of microcomputers that could be obtained for a fraction of the cost of the larger machine. To gross up the balance sheet by reference to reproduction cost would be distorting, at the very least. Instead, the replacement cost of the service potential of the owned asset should be used to accomplish the revaluation contemplated by IAS 16.
Furthermore, even replacement cost, if reported on a gross basis, would be an exaggeration of the value implicit in the reporting entity's asset holdings, since the asset in question has already had some fraction of its service life expire. The concept of sound value addresses this concern. Sound value is the equivalent of the cost of replacement of the service potential of the asset, adjusted to reflect the relative loss in its utility due to the passage of time or the fraction of total productive capacity that has already been utilized.
Example of depreciated replacement cost (sound value)
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An asset acquired January 1, 2001, at a cost of $40,000 was expected to have a useful economic life of 10 years. On January 1, 2004, it is appraised as having a gross replacement cost of $50,000. The sound value, or depreciated replacement cost, would be 7/10 x $50,000, or $35,000. This compares with a book, or carrying, value of $28,000 at that same date. Mechanically, to accomplish a revaluation at January 1, 2004, the asset should be written up by $10,000 (i.e., from $40,000 to $50,000 gross cost) and the accumulated depreciation should be proportionally written up by $3,000 (from $12,000 to $15,000). Under IAS 16, the net amount of the revaluation adjustment, $7,000, would be credited to revaluation surplus, an additional equity account.
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An alternative accounting procedure is also permitted by the standard, under which the accumulated depreciation at the date of the revaluation is written off against the gross carrying value of the asset. In the foregoing example, this would mean that the $12,000 of accumulated depreciation at January 1, 2004, immediately prior to the revaluation, would be credited to the gross asset amount, $40,000, thereby reducing it to $28,000. Then the asset account would be adjusted to reflect the valuation of $35,000 by increasing the asset account by $7,000 ($35,000 - $28,000), with the offset again in stockholders' equity. In terms of total assets reported in the balance sheet, this has exactly the same effect as the first method.
However, many users of financial statements, including credit grantors and prospective investors, pay heed to the ratio of net property and equipment as a fraction of the related gross amounts. This is done to assess the relative age of the enterprise's productive assets and, indirectly, to estimate the timing and amounts of cash needs for asset replacements. There is a significant diminution of information under the second method. Accordingly, the first approach described above, preserving the relationship between gross and net asset amounts after the revaluation, is recommended as being the preferable alternative if the goal is meaningful financial reporting.
Application of revaluation to all assets in class.
IAS 16 prudently requires that if any assets are revalued, all other assets in those groupings or categories also be revalued. This is necessary to avert the presentation of a balance sheet that contains an unintelligible mixture of historical costs and current values. Coupled with the requirement that revaluations take place with sufficient frequency to approximate fair values as of each balance sheet date, this preserves the integrity of the financial reporting process. In fact, given that a balance sheet prepared under the benchmark method of historical cost will, in fact, contain different historical costs (due to assets being acquired at varying times using dollars having different general and specific purchasing powers) the allowable alternative approach has the promise of providing even more consistent financial reporting. Offsetting this potential improvement somewhat, of course, is the greater subjectivity applied in determining fair values, vs. actual historical costs.
Although the requirement of IAS 16 is to revalue all assets in a given class, the standard recognizes that it may be more practical to accomplish this on a rolling, or cycle, basis. This would be done by revaluing one-third of the assets in a given asset category, such as machinery, in each year, so that as of any balance sheet date one-third of the group is valued at current fair value, another one-third is valued at amounts that are one year obsolete, and another one-third are valued at amounts that are two years obsolete. Unless values are changing rapidly, it is likely that the balance sheet would not be materially distorted, and therefore, this approach would in all likelihood be a reasonable means to facilitate the revaluation process.
Revaluation adjustments taken into income.
While, in general, revaluation adjustments are to be shown directly in stockholders' equity as revaluation surplus, if a downward adjustment had previously been made to the asset and was recognized as an expense, the later upward revaluation would also be reported as income. Any revaluation receiving this treatment would be limited to the amount of expense recognized previously. As a practical matter this should be a rare occurrence, since if the asset was revalued downward, the reference for that measurement would have been the estimated recoverable amount, and given what was judged to be a permanent impairment at an earlier date, it is very unlikely that there could be a later upward revaluation that could recover more than a minor portion of that impairment. However, in these unusual situations, a gain would be taken through the income statement.
The converse of the foregoing is also true: If an asset's carrying amount is decreased by recognition of a permanent impairment, but the asset had previously been revalued upward by crediting revaluation surplus, the decline should be reported as a reduction of that surplus account rather than being reported as income. Any decline in value in excess of the amount previously recognized as an upward revaluation should be reported in earnings currently.
Under the provisions of IAS 16, the amount credited to revaluation surplus can either be amortized to retained earnings (but not through the income statement!) as the asset is being depreciated, or it can be held in the surplus account until such time as the asset is disposed of or retired from service. In the example below, periodic amortization is utilized.
Example of revaluation and later downward adjustment
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Consider the following example to illustrate the foregoing:
An asset was acquired January 1, 2001, for $10,000 and is expected to have a 5-year life. Straight-line depreciation will be used. At January 1, 2003, the asset is appraised as having a sound value (depreciated replacement cost) of $9,000. On January 1, 2005, the asset is appraised at a sound value of $1,500. The entries to reflect these events are as follows:
| 1/1/01 | Asset | 10,000 | |
| 10,000 | ||
| 12/31/01 | Depreciation expense | 2,000 | |
| 2,000 | ||
| 12/31/02 | Depreciation expense | 2,000 | |
| 2,000 | ||
| 1/1/03 | Asset | 5,000 | |
| 2,000 | ||
| 3,000 | ||
| 12/31/03 | Depreciation expense | 3,000 | |
| 3,000 | ||
| Revaluation surplus | 1,000 | ||
| 1,000 | ||
| 12/31/04 | Depreciation expense | 3,000 | |
| 3,000 | ||
| Revaluation surplus | 1,000 | ||
| 1,000 | ||
| 1/1/05 | Accumulated depreciation | 6,000 | |
| Revaluation surplus | 1,000 | ||
| Loss from asset impairment | 500 | ||
| 7,500 |
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Certain of the entries in the foregoing example may need elaboration. The entries at 2001 and 2002 year-ends are to record depreciation based on original cost, since there had been no revaluations through that point in time. On January 1, 2003, the revaluation is recorded; the appraisal of sound value ($9,000) suggests a 50% increase in value over depreciated historical cost ($6,000), which in turn means that the gross asset should be written up to $15,000 (a 50% increase over the historical cost, $10,000) and the accumulated depreciation should be written up proportionately (from $4,000 to $6,000). Had the appraisal revealed that the useful life of the equipment had also changed from its originally estimated amount, that would have been dealt with prospectively, as prescribed by IAS 8 (see Chapter 21 for a discussion of this matter).
In 2003 and 2004, depreciation must be provided on the new higher value recorded at the beginning of 2003 (assuming that no additional appraisal is obtained in 2004). Since the asset has been written up by 50%, the periodic charge for depreciation must reflect the higher cost of doing business. However, while the income statements in each year must absorb greater depreciation expense, within the equity section of the balance sheet there will be an offsetting adjustment to transfer revaluation surplus to retained earnings, in the amount of the extra depreciation recognized each year.
As of January 1, 2005, the book value of the equipment is $3,000, which reflects the fact that the asset, having a gross replacement cost when last appraised of $15,000, is now 80% used up. A new appraisal reveals that the fair value is only $1,500 at this time. However, rather than charging the $1,500 decline in value ($3,000 - $1,500) to income, the portion of the decline that represents a retracing of the value increase previously recognized should be accounted for as a reversal of the revaluation surplus, not as a realized loss.
To effect the foregoing, the gross asset and related accumulated depreciation should be written down from amounts based on the 2003 appraisal (updated, in the case of accumulated depreciation, to the current balance) to original cost. Thus, the asset should be written down from $15,000 to $10,000, and the accumulated depreciation adjusted downward from $12,000 to $8,000. The further reduction in book value (from $2,000 to $1,500, as indicated by the latest appraisal) will be taken into income as a realized loss. The offset will be to accumulated depreciation, since the decline in value effectively means that the amount recognized as depreciation in prior periods had been understated; assuming no change in useful life, the depreciation charge for the final year (2005) will be $1,500, reducing the book value to zero at year-end.
Exchanges of assets.
IAS 16 discusses the accounting to be applied to those situations in which assets are exchanged for other similar or dissimilar assets, with or without the additional consideration of monetary assets. This topic is addressed later in this chapter, under the heading "Nonmonetary (Exchange) Transactions."
Revisions to estimated residual value.
Under the benchmark treatment prescribed by IAS 16, the amount estimated for residual value is made at the date of acquisition (or date a self-constructed asset is placed in service) and is not revised subsequently. In this regard the international standard departs from what has been the common practice of treating changes in estimated residual or salvage value as a change in an accounting estimate, and accounting for it prospectively by altering the annual depreciation charge for later years.
If the allowable alternative treatment is elected, at the date of each revaluation of the asset the expected residual amount should also be reassessed. The standard suggests that reference be made to actual residual values of similar assets reaching the end of their useful economic lives about the time the reevaluation is being conducted.
Deferred tax effects of revaluations.
As described in great detail in Chapter 15, the tax effects of temporary differences must be provided for by the process commonly referred to as deferred tax accounting. Thus, if depreciable plant assets are depreciated over longer lives for financial reporting purposes than for tax reporting purposes, a deferred tax liability will be created in the early years and then drawn down in later years. Generally speaking, the deferred tax provided will be measured by the expected future tax rate applied to the temporary difference at the time it reverses; unless future tax rate changes have already been enacted, the current rate structure is used as an unbiased estimator of those future effects.
In the case of revaluation of plant assets, it will almost universally be true that taxing authorities will not permit the higher revalued amounts to be depreciated for purposes of computing tax liabilities. Instead, only the actual cost incurred can be used to offset tax obligations. On the other hand, since revaluations are intended to reflect actual current fair values or values in use, they do portend that taxes will be imposed at some future date, typically when the assets are disposed of at gains (when measured against historical costs). Accordingly, a deferred tax liability is still required to be recognized, even though it does not relate to temporary differences arising from periodic depreciation charges.
The IASC's Standing Interpretation Committee has confirmed, in SIC 21, that measurement of the deferred tax effects relating to the revaluation of nondepreciable assets must be made with reference to the tax consequences that would follow from recovery of the carrying amount of that asset through an eventual sale. This is necessary because the asset will not be depreciated, and hence, no part of its carrying amount is considered to be recovered through use. As a practical matter this means that if there are differential capital gain and ordinary income tax rates, deferred taxes will be computed with reference to the former.
Impairment of Tangible Long-Lived Assets
Until the promulgation of IAS 36, Impairment of Assets, there was very limited guidance available under international accounting standards to deal with the possible diminution in value that might be associated with long-lived assets. It had long been established under various national accounting standards that permanent impairments (sometimes called "other than temporary" impairments) in long-lived assets necessitated write-downs in carrying values, but in general the two critical questions—when to test for impairment and how to measure it—were left unaddressed. IAS 16 did state that property, plant, and equipment items should be periodically reviewed for possible impairment—defined as having occurred when an asset's recoverable amount fell below its carrying value. While some reporting enterprises undoubtedly did apply the spirit as well as the letter of IAS 16, particularly when a significant event had occurred which made economic viability of major assets an obvious issue, in general, the lack of specific guidance more likely was an impediment to application of the impairment requirements of that standard. Now, however, with a comprehensive standard, the process of considering impairments will be greatly facilitated.
Principal requirements of IAS 36.
The standard on impairment requires that the recoverable amount of tangible (and intangible—discussed in the following chapter) long-lived assets be estimated, for purpose of identifying and measuring impairments, whenever there are indications that such a circumstance might exist. There is no fixed requirement to make this determination on a regular schedule (as there is for certain intangible assets), but a fairly extensive set of criteria is included in IAS 36 to assist entities in making the determination of when such a review might be warranted. If an asset or a group of assets which comprise what is now called a "cash generating unit" is found to be impaired, which means that the carrying amount exceeds the net recoverable amount as determined by reference to net selling prices and value in use, a write-down is required. Thus, IAS 36 responds to the two key questions that, because they were heretofore left unanswered, made it difficult to formally address impairment concerns.
Impairment is defined as the excess of carrying value over recoverable amount; recoverable amount is the greater of net selling price or value in use. Net selling price is essentially fair value less costs of disposal (i.e., what would be netted by the entity in an arm's-length transaction, or what is sometimes referred to as "exit value") and value in use is most commonly defined as the net present value of future cash flows associated with the asset or group of assets. Under different circumstances, it may be more or less difficult to obtain these data, but IAS 36 offers sufficient guidance to deal with most situations likely to be encountered in practice.
When it is determined that an asset (or cash generating unit) has indeed been impaired, IAS 36 requires that its carrying value be reduced. Any decline in value is recognized currently in income, for assets accounted for by the benchmark (amortized historical cost) method as set forth in IAS 16. Declines affecting assets accounted for by the allowed alternative (revaluation) method are recognized in the revaluation (stockholders' equity) account. Recoveries in value, not to exceed pre-impairment carrying value, are also given recognition, consistent with the accounting applied to the decline in value.
Identifying impairments.
According to IAS 36, at each financial reporting date the reporting entity should determine whether there are conditions that would indicate that impairments may have occurred. Note that this is not a requirement that possible impairments be calculated for all assets at each balance sheet date, which would be a formidable undertaking for most enterprises. Rather, it is the existence of conditions that might be suggestive of a heightened risk of impairment that must be evaluated. However, if such indicators are present, then further analysis will be necessary.
The standard provides a set of indicators of potential impairment and suggests that these represent a minimum array of factors to be given consideration. Other more industry- or entity-specific gauges can and should be devised and employed by the reporting enterprise, particularly when the more general indicators are found over time to be less sensitive than is deemed desirable. As experience with IAS 36 is gained, it is likely that more tailored indicators will evolve for some industries.
At a minimum, the following external and internal signs of possible impairment are to be given consideration on an annual basis:
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Market value declines for specific assets or cash generating units, beyond the declines expected as a function of asset aging and use;
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Significant changes in the technological, market, economic, or legal environments in which the enterprise operates, or the specific market to which the asset is dedicated;
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Increases in the market interest rate or other market-oriented rate of return such that increases in the discount rate to be employed in determining value in use can be anticipated, with a resultant enhanced likelihood that impairments will emerge;
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Declines in the (publicly owned) entity's market capitalization suggest that the aggregate carrying value of assets exceeds the perceived value of the enterprise taken as a whole;
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There is specific evidence of obsolescence or of physical damage to an asset or group of assets;
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There have been significant internal changes to the organization or its operations, such as product discontinuation decisions or restructurings, so that the expected remaining useful life or utility of the asset has seemingly been reduced; and
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Internal reporting data suggest that the economic performance of the asset or group of assets is, or will become, worse than previously anticipated.
The indicators which are derived from information internally generated by the reporting entity are the more difficult to interpret, and also the ones which, should it be so inclined to do so, may be subject to greater obfuscation by the entity. Information such as the cash flows being generated by an asset or group of assets, or the future cash needs to operate or maintain the asset, for example, may be rather subjective and not immediately apparent. Some of the information is likely to only be accessible "off-line" (i.e., from budgets and forecasts, rather than from the entity's actual accounting system) and thus may lack the credibility of historical data. Finally, the financial performance of individual assets will almost never be ascertainable even from historical accounting records, and the minimum level of aggregation of bookkeeping information will almost always be higher than the level required by IAS 36 (discussed below). Thus, in practical terms, there will be many instances in which there are at best only vague intimations of impairment, and whether further corroborating or disconfirming data is sought out will be a matter of judgment.
The mere fact that one or more of the foregoing indicators suggests that there might be cause for concern about possible asset impairment does not necessarily imply that formal impairment testing must proceed. For example, as noted in IAS 36, an increase in the market rate of interest would not trigger a formal impairment evaluation if either (1) the relevant discount rate to be applied in the determination of the value in use of an asset (via the present value of future net cash flows) would not be expected to track the general changes in market rates of interest, or (2) the effects of changes in the discount rate, tracking changes in market rates of interest, would tend to be offset by other changes in future cash flow, as when an entity has a history of adjusting revenues (and thus cash inflows) to compensate for interest rate rises. However, in the absence of a plausible explanation of why the signals of possible impairment should not be further considered, the implication is that the presence of one or more of these would necessitate some follow-up investigation.
Computing recoverable amounts—General concepts.
IAS 36 defines impairment as the excess of carrying value over recoverable amount, and goes on to define recoverable amount as the greater of two alternative measures, net selling price and value in use. The objective is to recognize an impairment only when the economic value of an asset (or cash generating unit consisting of a group of assets) is truly below its book (carrying) value. In theory, and for the most part in practice also, an entity making rational choices would sell an asset if its net selling price (fair value less costs of disposal) were greater than the asset's value in use, and would continue to employ the asset if value in use exceeded salvage value. Thus, the economic value of an asset is most meaningfully measured with reference to the greater of these two amounts, since the entity will retain or dispose of the asset consistent with what appears to be its highest and best use. Once recoverable amount has been determined, this is to be compared to carrying value; if recoverable amount is lower, the asset has been impaired, and under the new rules this impairment must be given accounting recognition.
Determining net selling prices.
While the concept of recoverable amount has a clear meaning, the actual determination of both the net selling price and the value in use of the asset being evaluated will typically present some difficulties. For actively traded assets, net selling price can be ascertained by reference to publicly available information (e.g., from price lists or dealer quotations), and costs of disposal will either be implicitly factored into those amounts (such as when a dealer quote includes pick-up, shipping, etc.) or can be readily estimated. Most productive tangible assets, such as machinery and equipment, will not be easily priced in active markets, however. While IAS 36 offers only limited guidance for such situations, it is clear that it will often be necessary to reason by analogy (i.e., to draw inferences from recent transactions in similar assets), making adjustments for age, condition, productive capacity, and other variables. In many industries, trade publications and other data sources can provide a great deal of insight into the market value of key assets, and if there is a sincere effort to tap into these resources, much could be accomplished. On the other hand, some work will be required and it is not difficult to imagine that there may be reluctance to undertake this, although an entity's ability to claim compliance with IAS will encourage it to do so.
Despite the concerns noted above, the difficulties in identifying net selling prices should not be overstated. Experience with SFAS 144, the US GAAP requirement for determining, measuring, and reporting on asset impairments (which replaced the earlier, but very similar, SFAS 121), suggests that there is a wealth of information to be used. In this era of Internet access and vast amounts of published industry data, from both governmental and private sources, estimating net selling prices for a wide range of productive assets should be quite feasible. Furthermore, in many nations for which persistent inflation has been a problem for decades, some form of inflation-adjusted financial reporting may have been practiced, as indeed it was for a period in both the US and the UK, and that experience taught many corporate and public accountants how to develop similar information. Finally, in many (perhaps most) cases, there will either be no signs of possible impairment, in which case no effort to compute recoverable amounts will be needed, or despite one or more indicators of possible impairment the asset's value in use will clearly exceed carrying amount, thus dispensing with any need to measure impairment.
Computing value in use.
The second component of recoverable amount is value in use, and when there are indicators of impairment and no clear evidence that either net selling price or value in use exceed carrying value, then value in use will often need to be estimated. The computation of value in use involves a two-step process: first, future cash flows must be estimated; and second, the present value of these cash flows must be calculated by application of an appropriate discount rate. These will be discussed in turn in the following paragraphs.
Projection of future cash flows must be based on reasonable assumptions; exaggerated revenue growth rates, significant anticipated cost reductions, or unreasonable useful lives for plant assets must be avoided. In general, recent past experience is a fair guide to the near-term future, but a recent growth spurt should not be extrapolated to more than the near-term future. Industry patterns as well as the experiences of the entity itself usually must be considered, since no single company, no matter how well managed or fortunate, can long escape from the implications of industry or economy-wide trends. For example, consider an entity which produces goods that are becoming, or are reasonably forecast to become, obsolete, but which are currently quite profitable. Given these facts, a limited horizon of usefulness should be imposed upon the equipment used for the production of these goods, which might imply an impairment should be recognized.
Typically, extrapolation to future periods cannot exceed the amount of "base period" data upon which the projection is built. Thus, a five-year projection, to be mathematically sound, must be based on at least five years of actual historical performance data. Also, since no business can exponentially grow forever, even if, for example, a five-year historical analysis suggests a 20% annual (inflation adjusted) growth rate, beyond a horizon of two years, a moderation of that growth must be hypothesized. This is even more true for a single asset or small cash generating unit, since physical constraints and the ironclad law of diminishing marginal returns makes it virtually inevitable that a plateau will be reached, beyond which further growth will be tightly constrained. If exceptional returns are being reaped from the assets used to produce a product line, competitors will enter the market and ultimately this, too, will restrict future cash flows.
For purposes of determining value in use, cash flow projections must represent management's best estimate, not its most optimistic view of the future. Externally sourced data is considered to be more valid than purely internal information. To the extent that internal sources such as budgets and forecasts are employed, these will have greater probative value if they have been reviewed and approved by upper levels of management, and if similar budgets and forecasts used in prior periods have been shown to be accurate. More modest assumptions should be made when projecting beyond the periods covered in the formally prepared and reviewed budgets, since not only are estimates about the future inherently less reliable as the horizon is extended, but also the absence of a formal budgeting process regarding the "out years" reduces the credibility of any such projections.
IAS 36 stipulates that steady or declining growth rates must be utilized for periods beyond those covered by the most recent budgets and forecasts. It further states that, barring an ability to demonstrate why a higher rate is appropriate, the growth rate should not exceed the long-term growth rate of the industry in which the entity participates.
Finally, with regard to cash flow projections, it is clear that projections for a period longer than the asset's remaining depreciable life would not be credible. Since the cost of tangible long-lived assets should be rationally allocated over their useful lives, it is implicitly management's representation that no cash flows will occur after the estimated lives are completed. On the other hand, an insistence that there will be work produced by the asset after its nominal terminal date would imply that IAS governing depreciation accounting was not conformed with.
With reference to cash flow projections, the guidance offered by IAS 36 suggests that only normal, recurring cash inflows from the continuing use of the asset being evaluated should be considered, plus the estimated salvage value at the end of its useful life, if any. Cash outflows needed to generate the cash inflows must also be included in the analysis, including any cash outflows needed to prepare the asset for its intended productive use. Noncash costs, such as depreciation of the asset, obviously must be excluded, inasmuch as these do not affect cash flows, and in the case of depreciation, this would in effect "double count" the very thing being measured. Projections should always exclude cash flows related to financing the asset, for example, interest and principal repayments on any debt incurred in acquiring the asset, since operating decisions (e.g., keeping or disposing of an asset) are separate from financing decisions (borrowing, leasing, buying with equity capital funds). Also, cash flow projections must pertain to the asset that exists and is in use, not to hypothetical future assets or assets currently in use but to be value enhanced by later overhauls or redesigns. Income tax effects are also to be disregarded (i.e., the entire analysis should be on a pretax basis).
The need to identify specific cash flows is the reason why an asset-by-asset approach will most often be ineffective or impossible to perform, since few individual assets have identifiable cash flows. For example, a factory which employs dozens of drill presses, lathes, grinding machines, and other related types of equipment to produce precision components for the automobile industry cannot possibly identify the contribution to cash flow made by a given drill press. For this reason, IAS 36 has developed the concept of the "cash generating unit."
Cash generating units.
Under IAS 36, when cash flows cannot be identified with individual assets, these may need to be grouped in order to conduct an impairment test. The requirement is that this grouping be performed at the lowest level possible, which would be the smallest aggregation of assets for which discrete cash flows can be identified, and which are independent of other groups of assets. In practice, this may be a department, a product line, or a factory, for which the output of product and the input of raw materials, labor, and overhead can be identified. While the precise contribution to overall cash flow made by a given drill press may be impossible to surmise, the cash inflows and outflows of a department which produces and sells a discrete product line to an identified group of customers can be readily determined.
An obvious temptation would be to essentially aggregate the entire enterprise into a single cash generating unit, arguing perhaps that it represents an integrated operation. While in some instances this may be correct, in most cases it will not. The risk in too-generously aggregating long-lived assets into cash generating units is that many possible impairments will be concealed, as the subunits having recoverable amounts in excess of carrying amounts will offset those having the opposite circumstance. In this, the effect is identical to applying lower of cost or market to the aggregate inventory of an entity, rather than to component groups or to each inventory item taken by itself. Thus IAS 36 is clear that care must be exercised to be sure that all aggregation is conducted at the lowest feasible level.
Some expansion of the aggregation process will become necessary when an entity's operations are vertically integrated. IAS 36 provides one such example of a mining enterprise which has a private railway to haul its ore; since the railway has no external customers and thus no independent cash inflows, impairment can only be assessed by grouping the mine and the railway into a single cash generating unit. Another such example is a bus line that is a contract provider to a municipality; evaluation of subunits, such as individual bus routes, is not feasible since the contractual arrangement precludes taking individual decisions, such as discontinuing service, regarding any single route. IAS 36 requires that cash generating units be defined consistently from period to period.
Discount rate.
The other part of the challenge in computing value in use comes from identifying the appropriate discount rate to apply to projected future cash flows. There are actually two key issues to address. The first is to determine an appropriate rate, ignoring inflation effects. IAS 36 stipulates that a risk rate must be used which is pertinent to the type of asset being valued. Thus, arguably at least, the discount rate to be applied to projected cash flows relating to a steel mill might be somewhat lower than that used to compute the present value of cash flows arising from the use of a piece of high-technology equipment, since the latter may be subject to far greater risk of sudden, unanticipated obsolescence than the former. This concept is supported by market data, which prices debt offerings by entities in riskier industries at higher yields than those in more stable industries.
IAS 36 suggests that identifying the appropriate risk-adjusted cost of capital to employ as a discount rate can be accomplished by reference to the implicit rates in current market transactions (e.g., leasing transactions), or from the weighted-average cost of capital of publicly traded enterprises in the same industry grouping. There are such statistics available in many markets, and the entity's own recent transactions, typically in leasing or borrowing to buy other long-lived assets, will be highly salient information.
When risk-adjusted rates are not available, however, it will become necessary to develop a rate from surrogate data. The two aspects of this are to (1) identify the pure time value of money for the requisite time horizon over which the asset will be utilized—short term almost always carrying a lower rate than intermediate or long term; and (2) to add an appropriate risk premium to the pure interest factor, which is related to the variability of future cash flows, with greater variability (the technical definition of risk) being associated with higher risk premiums. Of these two tasks, the latter is likely to prove the more difficult in practice. IAS 36 provides a fairly extended discussion of the methodology to utilize, however, addressing such factors as country risk, currency risk, cash flow risk, and pricing risk. As with all aspects of the impairment analysis, this must be done on a pretax basis and is independent of any considerations regarding how the asset was financed.
The second aspect of determining an appropriate discount rate is somewhat more subtle than that discussed above. The rate used must either be inflation-adjusted or inflation-unadjusted, consistent with how the future cash flows were determined. If the future cash flows were developed in nominal currency units, and if (as has often been true, although for much of the developed world less so now than for any time over the past generation) there is an expectation that prices will inflate over time, future cash inflows and outflows will be projected to grow even if input and output factors will remain constant. If nominal currency units are used, thus inflating the gross amounts and net cash flows increasingly over the years due to the compounding effect of annual inflation assumptions, the discount rate must be similarly increased.
On the other hand, if future cash inflows and outflows are projected in real currency units, the appropriate discount rate will be a lower, inflation-unadjusted rate. If consistent assumptions are used for cash flows and the discount rate, the net result, that is, the present value of future cash flows, will be identical, and thus either approach, if properly applied, is acceptable. The practical risk is that in performing the analyses inconsistent assumptions will be made, thus making the results of little worth.
The interest rate to apply must reflect current market conditions as of the balance sheet date. This means that, during periods of changing rates (e.g., from the early 1990s to the present date, rates have been generally declining in many industrial nations) the computed value in use of assets will change, perhaps markedly, even if projected cash flows before discounting are stable. This reflects economic reality; however, as rates decline, holdings of productive assets become more valuable, holding all other considerations constant; and as rates rise, such holdings lose value as alternative market-priced investments (such as fixed-income securities) become more attractive. The accounting implication is that long-lived assets that were unimpaired one year earlier may fail an impairment test in the current period if rates have risen during the interim. Since accountants tend not to contemplate such economic matters, however, the risk is that impairments may be overlooked when they are due only to market rate changes, as contrasted to those which result from more attention-getting events such as technological obsolescence or macroeconomic trends such as recessions.
Corporate assets.
Another issue that is prone to being ignored has to do with corporate assets, such as headquarters buildings and other long-lived tangible assets such as data processing equipment, which do not generate identifiable cash flows. It should be clear that all such assets need to be tested for impairment, and it should be equally clear that these cannot be tested in the abstract, since there are no cash inflows to weigh against the cash outflows and the net result of any stand-alone test would be to indicate severe impairment.
To cope with the foregoing matter, IAS 36 requires that corporate assets be allocated among or assigned to cash generating units with which they are most closely associated. For a large and diversified enterprise, this probably implies that corporate assets will be allocated among all the cash generating units, perhaps in proportion to annual turnover (revenue). Failure to do this will not only ignore the possible impairment of the corporate assets, per se, but also will distort the impairment testing for the operating assets, since in effect they will be held accountable for shouldering too light a burden, as in reality the cash generating units in the aggregate must cover not only their own costs, but the corporate overhead as well. (The issue of impairment of corporate assets is similar to the matter of impairment of goodwill, which is discussed later in this chapter.)
Accounting for impairments.
After computing net selling price and value in use, and then comparing the greater of these to carrying value of an asset or cash generating unit, and assuming an impairment is indicated, this must be reflected in the financial statements. The mechanism for recording an impairment depends upon whether the entity adheres to the benchmark or the allowed alternative treatment prescribed by IAS 16. The benchmark treatment is amortized historical cost, and any impairments computed under this scenario will be reported as a charge against current period earnings, either included with depreciation or set forth separately in the income statement.
For assets for which impairment was determined on a stand-alone basis, the write-down in carrying value is accomplished directly. However, for assets grouped into cash generating units, it will not be determinable which specific assets have suffered the impairment loss, and thus a formulaic approach is prescribed by IAS 36. If goodwill (discussed later in this chapter) was allocated to the cash generating unit, any impairment should be allocated fully to that intangible asset until its carrying value has been reduced to zero. Any further impairment would be allocated proportionately to all the other assets in the cash generating unit. While IAS 36 is silent on this point, presumably the pro rata allocation would also include any corporate assets that had been assigned to that cash generating unit. The standard also does not provide guidance regarding whether the impairment should be credited to the asset account or to the accumulated depreciation (contra asset) account; in either event, the net result would be the same, although for certain analytical purposes (such as computing return on gross investment in the operations of the business) some prefer to leave the gross asset balances intact.
The charge arising from a recognition of an impairment will be reflected either in earnings or directly in stockholders' equity, depending on whether the reporting entity applies the benchmark or the allowable alternative method of accounting for its long-lived assets. If the benchmark method (amortized historical cost) is used, then impairments must be recognized as current period expenses and charged against earnings. Logically, it would seem that the charge could be merged with depreciation expense, since the impairment does represent part of the process of cost allocation to operations over the period of the asset's use. Presumably a separate caption could also be presented, if it is desired that the charge for impairments be made distinct from that for depreciation. It would not be appropriate, however, to imply that impairment losses are not part of recurring operations costs (i.e., to suggest that these expenses are somehow extraordinary or unusual in nature). Whether part of depreciation or a separate charge, therefore, impairment costs should be included in income from operations.
If the entity has applied the allowed alternative method of revaluation of long-lived assets, the impairment adjustment will be accounted for as the partial reversal of a previous upward revaluation. Thus, the charge will be made against the revaluation account in stockholders' equity and not shown in the current period's income statement. However, if the entire revaluation account is eliminated due to recognition of an impairment, any excess impairment should be charged to expense. In other words, the revaluation account cannot contain a net debit balance.
Example of accounting for impairment
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Xebob Corp. has one (of its many) departments that performs machining operations on parts that are sold to contractors. A group of machines have an aggregate book value at the latest balance sheet date (December 31, 2002) totaling $123,000. It has been determined that this group of machinery constitutes a cash generating unit for purposes of applying IAS 36.
Upon analysis, the following facts about future expected cash inflows and outflows become apparent, based on the diminishing productivity expected of the machinery as it ages, and the increasing costs that will be incurred to generate output from the machines:
| Year | Revenues | Costs, excluding depreciation |
|---|---|---|
| 2003 | $ 75,000 | $ 28,000 |
| 2004 | 80,000 | 42,000 |
| 2005 | 65,000 | 55,000 |
| 2006 | 20,000 | 15,000 |
| Totals | $240.000 | $140,000 |
The net selling price of the machinery in this cash generating unit is determined by reference to used machinery quotation sheets obtained from a prominent dealer. After deducting estimated disposition costs, the net selling price is calculated as $84,500.
Value in use is determined with reference to the above-noted expected cash inflows and outflows, discounted at a risk rate of 5%. This yields a present value of about $91,981, as shown below.
| Year | Cash flows | PV factors | Net PV of cash flows |
|---|---|---|---|
| 2003 | 47,000 | .95238 | $44,761.91 |
| 2004 | 38,000 | .90703 | 34,467.12 |
| 2005 | 10,000 | .86384 | 8,638.38 |
| 2006 | 5,000 | .82270 | 4,113,51 |
| Total | $91,980,91 |
Since value in use exceeds net selling price, value in use is selected to represent the recoverable amount of this cash generating unit. This is lower than the carrying value of the group of assets, however, and thus an impairment must be recognized as of the end of 2002, in the amount of $123,000 - $91,981 = $31,019. This will be included in operating expenses (either depreciation or a separate caption in the income statement) for 2002.
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Reversals of previously recognized impairments—Benchmark method used for long-lived assets.
Recoveries in value of previously impaired assets are also to be given recognition, provided that criteria established by IAS 36 are met. In order to recognize what is ostensibly a recovery of a previously recognized impairment, a process similar to that which led to the original loss recognition must be followed. This begins with a consideration, as of each balance sheet date, of whether there are indicators of possible impairment recoveries, utilizing external and internal sources of information including that pertaining to material market value increases; changes in the technological, market, economic or legal environment or the market in which the asset is employed; and the occurrence of a favorable change in interest rates or required rates of return on assets which would imply changes in the discount rate used to compute value in use. Also to be given consideration are data about any changes in the manner in which the asset is employed, as well as evidence that the economic performance of the asset has exceeded expectations and/or is expected to do so in the future. If one or more of these indicators is present, it will be necessary to compute the recoverable amount of the asset in question or, if appropriate, the cash generating unit containing that asset, to determine if the current recoverable amount exceeds the carrying amount of the asset, which had been reduced for the impairment.
If the current recoverable amount exceeds the carrying amount of the asset or cash generating unit, a recovery can be recognized. The amount of recovery to be given accounting recognition is limited to the difference between the carrying value and the amount which would have been the current carrying value had the earlier impairment not been given recognition. Note that this means that restoration of the full amount at which the asset was carried at the time of the earlier impairment cannot be made, since time has elapsed between these two events and further depreciation of the asset would have been recognized in the interim.
Example of impairment recovery—Benchmark method
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To illustrate, assume an asset had a carrying value of $40,000 at December 31, 2002, based on its original cost of $50,000, less accumulated depreciation representing the one-fifth, or 2 years, of its projected useful life of 10 years which already has elapsed. The carrying value of $40,000 is after depreciation for 2002 has been computed, but before impairment has been addressed. At that date, a determination was made that the asset's recoverable amount was only $32,000 (assume this was properly computed and that recognition of the impairment was warranted), so that an $8,000 adjustment must be made. For simplicity, assume this was added to accumulated depreciation, so that at December 31, 2002, the asset cost remains $50,000 and accumulated depreciation is stated as $18,000.
At December 31, 2003, before any adjustments are posted, the carrying value of this asset is $32,000. Depreciation for 2003 would be $4,000 ($32,000 book value 8 years remaining life), which would leave a net book value, after current period depreciation, of $28,000. However, a determination is made that the asset's recoverable amount at this date is $37,000. Before making an adjustment to reverse some or all of the impairment loss previously recognized, the carrying value at December 31, 2003, as it would have existed had the impairment not been recognized in 2002 must be computed.
| December 31, 2002 preimpairment carrying value | $40,000 |
| 2003 depreciation based on above | 5,000 |
| Indicated December 31, 2003 carrying value | $35,000 |
The December 31, 2003 carrying value would have been $40,000 - $5,000 = $35,000; this is the maximum carrying value which can be reflected on the December 31, 2003 balance sheet. Thus, the full recovery cannot be recognized; instead, the 2003 income statement will reflect (net) a negative depreciation charge of $35,000 - $32,000 = $3,000, which can be thought of (or recorded) as follows:
| Actual December 31, 2002 carrying value | $32,000 | |
| 2003 depreciation based on above | 4,000 | (a) |
| Indicated December 31, 2003 carrying value | $28,000 | |
| Indicated December 31, 2003 carrying value | $28,000 | |
| Actual December 31, 2003 carrying value | 35,000 | |
| Recovery of previously recognized impairment | $ 7,000 | (b) |
Thus, the net effect on the 2003 income statement is (a) - (b) = $(3,000). The asset cannot be restored to its indicated recoverable amount at December 31, 2003, amounting to $37,000, as this exceeds the carrying amount that would have existed at this date had the impairment in 2002 never been recognized.
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Reversals of previously recognized impairments—Allowed alternative method used for long-lived assets.
Reversals of impairments are accounted for differently if the reporting entity used the allowed alternative method of accounting for long-lived assets. Under this approach, assets are periodically adjusted to reflect current fair values, with the write-up being recorded in the asset accounts and the corresponding credit reported directly in stockholders' equity and not included in earnings. Impairments are viewed as being downward adjustments of fair value in this scenario, and accordingly are reported as reversals of previous revaluations, not reported in income unless the entire remaining, undepreciated portion of the revaluation is eliminated as a consequence of the impairment; any further impairment is reported in earnings in such case.
When an asset (or cash generating group of assets) was first revalued upward, then written down to reflect an impairment, and then later adjusted to convey a recovery of the impairment, the procedure is to report the recovery as a reversal of the impairment, as with the historical cost (benchmark) method. Since in most instances impairments were accounted for as reversals of upward revaluations, a still-later reversal of the impairment will be seen as yet another upward revaluation and accounted for as an addition to an equity account, not reported through earnings. In the event that the impairment had eliminated the entire revaluation capital account, and the excess loss was reported in earnings, the later recovery will be reported in earnings to the extent the earlier write-down had been so reported, with the balance taken to stockholders' equity.
Example of impairment recovery—Allowed alternative method
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To illustrate, assume an asset was acquired January 1, 2001, and it had a net carrying value of $45,000 at December 31, 2002, based on its original cost of $50,000, less accumulated depreciation representing the one-fifth, or 2 years, of its projected useful life of 10 years, which has already elapsed, plus a revaluation write-up of $5,000, net. The increase in carrying value was recorded a year earlier, based on an appraisal showing the asset's then fair value was $56,250.
At December 31, 2003, an impairment is detected, and the recoverable amount at that date is determined to be $34,000. Had this not occurred, depreciation for 2003 would have been $45,000 8 years remaining life = $5,625; book value after recording 2003 depreciation would have been $45,000 - $5,625 = $39,375. Thus the impairment loss recognized in 2003 is $39,375 - $34,000 = $5,375. Of this loss amount, $4,375 represents a reversal of the net amount of the previously recognized valuation increase remaining (i.e., undepreciated) at the end of 2003, as shown below.
| Gross amount of revaluation at December 31, 2001 | $6,250 |
| Portion of the above allocable to accumulated depreciation | 625 |
| Net revaluation increase at December 31, 2001 | 5,625 |
| Depreciation taken on appreciation for 2002 | 625 |
| Net revaluation increase at December 31, 2002 | 5,000 |
| Depreciation taken on appreciation for 2003 | 625 |
| Net revaluation increase at December 31, 2003, before recognition of impairment | 4,375 |
| Impairment recognized as reversal of earlier revaluation | 4,375 |
| Net revaluation increase at December 31, 2003 | $ 0 |
The remaining $1,000 impairment recognized at December 31, 2003, is reported as a current period expense, since it exceeds the available amount of revaluation surplus.
In 2004 there is a recovery of value that pertains to this asset; at December 31, 2004, it is valued at $36,500. This represents a $2,500 increase in carrying amount from the earlier year's balance, net of accumulated depreciation. The first $1,000 of this recovery in value is credited to income, since this is the amount of previously recognized impairment that was charged against earnings; the remaining $1,500 of recovery is accounted for as revaluation, and thus is to be credited to a stockholders' equity (revaluation surplus) account.
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Deferred tax effects.
Recognition of an impairment for financial reporting purposes is most likely to not be accompanied by a deduction for current tax purposes. As a consequence of the nondeductibility of most impairments, the book value and tax basis of the impaired assets will diverge, with the difference thus created to gradually be eliminated over the remaining life of the asset, as depreciation for tax purposes varies from that which is recognized for financial reporting. Following the dictates of IAS 12, deferred taxes must be recognized for this new discrepancy. The accounting for deferred taxes is discussed at great length in Chapter 14 and will not be addressed here.
Impairments which will be mitigated by recoveries or compensation from third parties.
Impairments of tangible long-lived assets may result from natural or other damages, such as from floods or windstorms; in some such instances, there will be the possibility that payments from third parties (typically commercial insurers) will mitigate the gross loss incurred. A reasonable question in such circumstances is whether the gross impairment must be recognized, or whether it may be offset by the actual or estimated amount of the recovery to be received by the reporting entity.
An interpretation from the Standing Interpretations Committee of the IASC (SIC 14) holds that when property is damaged or lost, impairments and claims for reimbursements should be accounted for separately. Impairments are to be accounted for per IAS 36 as discussed above; disposals (of damaged or otherwise impaired assets) should be accounted for consistent with guidance in IAS 16. Compensation from third parties should be recognized as income when the funds become receivable. The cost of replacement items or of restored items is determined in accordance with IAS 16.
Disclosure requirements.
IAS 36 has set forth an array of new disclosure requirements pertaining to impairments. For each class of long-lived asset, the amount of impairment losses recognized in earnings for each period being reported upon must be stated, with indication of where in the income statement it is included (i.e., depreciation or other charges). For each class of asset, the amount of any reversals of previously recognized impairment must also be stipulated, again with an identification of where in the income statement this is included. If any impairment losses were recognized in stockholders' equity directly (i.e., as a reversal of previously recognized upward revaluation), this must be disclosed. Finally, any reversals of impairment losses that were recognized in equity must be stated.
If the reporting entity applies IAS 14, the amounts of impairments, and the amounts of reversals of impairments, recognized in income and in stockholders' equity during the year must be stipulated also. Note that the segment disclosures pertaining to impairments need not be categorized by asset class, and the income statement location of the charge or credit need not be stated (but will be understood from the disclosures relating to the primary financial statements themselves).
IAS 36 further provides that if an impairment loss for an individual asset or group of assets categorized as a cash generating unit is either recognized or reversed during the period, in an amount which is material to the financial statements taken as a whole, disclosures should be made of the following:
-
The events or circumstances that caused the loss or recovery of loss;
-
The amount of the impairment loss recognized or reversed;
-
If for an individual asset, the nature of the asset and the reportable segment to which it belongs, using the primary format as defined under IAS 14;
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If for a cash generating unit, a description of that unit (e.g., defined as a product line, a plant, geographical area, etc.), the amount of impairment recognized or reversed by class of asset and by reportable segment based on the primary format, and, if the unit's composition has changed since the previous estimate of the unit's recoverable amount, a description of the reasons for such changes;
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Whether net selling price or value in use was employed to compute the recoverable amount;
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If recoverable amount is net selling price, the basis used to determine it (e.g., whether by reference to active market prices or otherwise); and
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If recoverable amount is value in use, the discount rate(s) used in the current and prior period's estimate.
Furthermore, when impairments recognized or reversed in the current period are material in the aggregate, the reporting entity should provide a description of the main classes of assets affected by impairment losses or reversals of losses, as well as the main events and circumstances that caused recognition of losses or reversals. This information is not required to the extent that the disclosures above are given for individual assets or cash generating units.
Retirements and Other Dispositions
In general, when an asset is no longer employed by an entity it is removed from the balance sheet. In the case of fixed assets, both the asset and the related contra asset, accumulated depreciation, should be eliminated. The difference between the net carrying amount and any proceeds received will be given immediate recognition as a gain or loss on the disposition.
If the allowed alternative treatment has been employed, the asset and the related accumulated depreciation account have been adjusted upward, and the asset is subsequently disposed of before the asset is fully depreciated, note that the gain or loss computed will be identical to what would have been determined had the benchmark treatment been used. That is because at any point in time the net amount of the revaluation (the step-up in gross asset amount less the present balance in the step-up in accumulated depreciation) will be offset exactly by the remaining balance in the revaluation surplus account. Elimination of the asset, contra asset, and equity accounts will balance precisely and there will be no gain or loss on this part of the disposition transaction. The gain or loss will be determined by the discrepancy between the net book value, based on historical cost, and the proceeds from the disposition.
Examples of accounting for asset disposition
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On January 1, 2001, Zara Corp. acquired a machine at a cost of $12,000; it had an estimated life of 6 years, no residual value, and was expected to provide a level pattern of utility to the enterprise. Thus, straight-line depreciation in the amount of $2,000 was charged to operations. At the end of 4 years, the asset was sold for $5,000. Accounting in conformity with the IAS 16 benchmark approach was elected. The entries to record depreciation and to report the ultimate disposition on January 1, 2005, are as follows:
| 1/1/01 | Machinery | 12,000 | |
| 12,000 | ||
| 12/31/01 | Depreciation expense | 2,000 | |
| 2,000 | ||
| 12/31/02 | Depreciation expense | 2,000 | |
| 2,000 | ||
| 12/31/03 | Depreciation expense | 2,000 | |
| 2,000 | ||
| 12/31/04 | Depreciation expense | 2,000 | |
| 2,000 | ||
| 1/1/05 | Cash | 5,000 | |
| Accumulated depreciation | 8,000 | ||
| 12,000 | ||
| 1,000 |
Now assume the same facts as above, but that the allowed alternative method is used. At the beginning of year 4 (2004) the asset is revalued at a gross replacement cost of $15,000. A year later it is sold for $5,000. The entries are as follows (note in particular that the gain on the sale is identical to that reported under the benchmark approach):
| 1/1/01 | Machinery | 12,000 | |
| 12,000 | ||
| 12/31/01 | Depreciation expense | 2,000 | |
| 2,000 | ||
| 12/31/02 | Depreciation expense | 2,000 | |
| 2,000 | ||
| 12/31/03 | Depreciation expense | 2,000 | |
| 2,000 | ||
| 1/1/04 | Machinery | 3,000 | |
| 1,500 | ||
| 1,500 | ||
| 12/31/04 | Depreciation expense | 2,500 | |
| 2,500 | ||
| Revaluation surplus | 500 | ||
| 500 | ||
| 1/1/05 | Cash | 5,000 | |
| Accumulated depreciation | 10,000 | ||
| Revaluation surplus | 1,000 | ||
| 15,000 | ||
| 1,000 |
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Depletion
IAS 16 specifically excludes forests and other regenerative natural resources, as well as mineral rights and other nonregenerative resources, from applicability. No other international accounting standard addresses these matters, either. However, given the long-lived nature of those assets, the allocation of cost to periods benefited by a process similar to depreciation is an obvious necessity.
For example, under US GAAP, depletion is the annual charge for the use of natural resources. The depletion base includes all development costs, such as exploring, drilling, excavating, and other preparatory costs. The amount of the depletion base charged to income is determined by the following formula:
The unit depletion rate is revised frequently due to the uncertainties surrounding the recovery of natural resources. The revision is made prospectively; the remaining undepleted cost is allocated over the remaining recoverable units.
Given the absence of an international standard on the matter of depletion, and given the need for rational allocation of the cost of long-lived mineral and other natural resource assets to the periods to be benefited, it is reasonable to follow the guidelines set forth above, which are based on US GAAP. For natural resource assets, which are typically harvested, mined, or otherwise placed into production or sold in patterns that are not stable over time (demand for commodities typically being far more volatile than demand for manufactured goods), the units of production method of depletion is almost always superior to straight-line methods.
Example of computing depletion costs
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Assume that the rights to extract oil from a field are obtained for an initial payment of $2 million at the start of 2001, plus a commitment to restore the topography of the land, for an estimated cost of $1 million, after the extraction process has run its course. Geological surveys have suggested that the field contains 1,000,000 recoverable barrels of crude oil. Actual recoveries are 300,000 barrels in 2001 and 400,000 barrels in 2002. At the end of 2002, the estimated remaining recoverable crude oil was thought to be 400,000 barrels, and the cost to restore the condition of the land was now believed to be $900,000. Recovery in 2003 is 140,000 barrels, after which the field is abandoned and agreed-upon restoration is performed at a cost of $850,000 in early 2004. The entries to record these events are as follows:
| 1/1/01 | Drilling rights | 2,000,000 | |
| 2,000,000 | ||
| 12/31/01 | Depletion expense | 900,000 | |
| 900,000 | ||
| 12/31/02 | Depletion expense | 1,200,000 | |
| 1,100,000 | ||
| 100,000 | ||
| 12/31/03 | Depletion expense | 280,000 | |
| 280,000 | ||
| 2/15/04 | Land restoration liability | 380,000 | |
| Depletion expense | 470,000 | ||
| 850,000 |
The annual depletion costs in 2001 and 2002 are based on estimates of recoverable oil of 1,000,000 barrels and total costs of $3 million, including estimated land restoration (which is effectively negative salvage value). Depletion in 2003 is based on remaining accruable cost of $800,000 (the newly estimated land recovery cost of $900,000, less the already accrued $100,000) and revised recoverable oil of 400,000 barrels. When the facts ultimately become known in 2004 (that the recoverable oil was less than forecast and the restoration costs differ somewhat from the estimate made in 2003), the adjustment is really a change in an accounting estimate and thus must be reflected as an operating cost in 2004.
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Disclosure Requirements: Tangible Long-Lived Assets
The disclosures required under IAS 16 for property, plant, and equipment, and under IAS 38 for intangibles, are similar. Furthermore, IAS 36 requires extensive disclosures when assets are impaired or when formerly recognized impairments are being reversed. The requirements that pertain to property, plant, and equipment are as follows:
For each class of tangible asset, disclosure is required of
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The measurement basis used (benchmark or alternative approaches)
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The depreciation method(s) used
-
Useful lives or depreciation rates used
-
The gross carrying amount and accumulated depreciation at both the beginning and end of the period
-
A reconciliation of the carrying amount at the beginning and end of the period, showing additions, dispositions, acquisitions by means of business combinations, increases or decreases resulting from revaluations, reductions to recognize impairments, amounts written back to recognize recoveries of prior impairments, depreciation, the net effect of translation of foreign entities' financial statements, and any other material items. (An example of such a reconciliation is presented below.) This reconciliation is to be provided for only the current period if comparative financial statements are being presented.
In addition, the statements should also disclose the following facts:
-
Any restrictions on titles and any assets pledged as security for debt
-
The accounting policy regarding restoration costs for items of property, plant, and equipment
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The expenditures made for property, plant, and equipment, including any construction in progress
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The amount of outstanding commitments for property, plant, and equipment acquisitions
In addition, the statements should also disclose the following facts:
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Whether, in determining recoverable amounts, future projected cash flows have been discounted to present values
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Any restrictions on titles and any assets pledged as security for debt
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The amount of outstanding commitments for property, plant, and equipment acquisitions
Example of reconciliation of asset carrying amounts
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| Date | Gross cost | Accumulated depreciation | Net book value |
|---|---|---|---|
| 1/1/03 | $4,500,000 | $2,000,000 | $2,500,000 |
| Acquisitions | 3,000,000 | 3,000,000 | |
| Disposals | (400,000) | (340,000) | (60,000) |
| Impairment | 600,000 | (600,000) | |
| Depreciation | 200,000 | (200,000) | |
| 12/31/03 | $7,100,000 | $2,460,000 | $4,640,000 |
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Nonmonetary (Exchange) Transactions
Currently, international accounting standards do not address the accounting which would be appropriate to apply when nonmonetary exchanges are engaged in, such as occurs when an item of machinery and equipment is exchanged for another similar item. Because of the absence of guidance, that provided under US GAAP is discussed in this section, not as authoritative literature, but rather to inform decision making which might have to occur until IAS has been established for such economic events.
Recently, the IASB has exposed a series of amendments to a number of extant standards under the banner of its Improvements Project. Some of these will, for the first time, if adopted (as seems likely to occur by 2003), establish accounting standards for the non-monetary exchanges of similar long-lived assets. This amendment would provide that the cost of the asset obtained in the exchange is to be measured by the fair value of the asset given up, adjusted by the amount of any cash or cash equivalents transferred. In those situations (expected to be very uncommon) where the fair value of neither of the assets exchanged can be determined reliably, then the carrying amount of the asset given up would be used as the cost of the asset acquired. The proposed language of the revised standard suggests that this would occur when, for example, comparable market transactions are infrequent and alternative estimates of fair value (for example, based on discounted cash flow projections) cannot be calculated.
Under US GAAP there exist very detailed rules (APB Opinion 29) governing accounting for nonmonetary transactions. By contrast, under international standards, this topic is dealt with only superficially. Both IAS 16 and the new standard for intangibles, IAS 38, note the accounting implications of exchanges of one item of property, plant, or equipment, or one intangible, for another of similar nature. The rules are simply that
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The value is to be ascertained by reference to the asset received in the exchange, adjusted for any cash or equivalents paid or received.
-
If the exchange involves similar assets to be used by the enterprise in essentially the same manner and for the same purpose as the item given up in the exchange, the exchange is not deemed to be the culmination of an earnings process, and accordingly, no gain or loss is recognized; the new asset will be recorded as the carrying amount of the asset given up, adjusted for any cash or equivalent given or received.
-
If dissimilar assets are exchanged, the cost of the item received is measured by reference to its fair value, which is generally the fair value of the asset given up, adjusted for any cash or cash equivalent received or given.
Dissimilar assets.
An exchange is deemed to be the culmination of the earnings process when dissimilar assets are exchanged. The general rule is to value the transaction at the fair market value of the asset given received (unless the fair value of the asset given up is more clearly evident) and to recognize the gain or loss. If there is a settle-up paid or received in cash or cash equivalent, this is often referred to as boot.
Example of an exchange involving dissimilar assets and no boot
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Assume the following:
-
Jamok, Inc. exchanges an automobile with a carrying value of $2,500 with Springsteen & Co. for a tooling machine with a fair market value of $3,200.
-
No boot is exchanged in the transaction.
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The fair value of the automobile is not readily determinable.
In this case, Jamok, Inc. has recognized a gain of $700 ($3,200 - $2,500) on the exchange. Because the exchange involves dissimilar assets, the earnings process has culminated and the gain should be included in the determination of net income. The entry to record the transaction would be as follows:
| Machine | 3,200 | |
| 2,500 | |
| 700 |
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Similar assets.
Similar assets are those that are used for the same general purpose, are of the same general type, and are employed in the same line of business. Thus, it is not necessary to exchange identical assets. The treatment described applies to those assets that are exchanged as a result of technological advancement as well as to those that are exchanged as a result of wearing out. The general rule involving the exchange of similar assets involving a gain is to value the transaction at the book value of the asset given up. In this situation, the gain is effectively deferred over the life of the new asset by causing a lesser amount of annual depreciation to be charged to operations.
If cash or an equivalent is also included in the transaction, this suggests that the non-monetary assets exchanged did not have equivalent values. If there is evidence that the asset given up was impaired as to value, as might be suggested if cash was needed to even up the trade, the impairment must be recognized. To fail to do this would result in an overstatement of the carrying amount of the new asset and excessive periodic depreciation charges over the term of its use.
Example of an exchange involving similar assets and boot
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Assume the following:
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Metronome exchanged a casting machine for a technologically newer model. The cost of the old machine was $75,000, and the accumulated depreciation was $5,000.
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The fair value of the machine received was $90,000.
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Boot was paid in the amount of $40,000.
A loss in the amount of $20,000 is recognized in connection with this transaction. This amount is the difference between the fair value of the asset received less the boot paid ($90,000 - $40,000 = $50,000) and the carrying value of the asset surrendered ($70,000). The entry required to record the transaction is as described below.
| Loss on trade of machine | 20,000 | |
| New machine | 90,000 | |
| Accumulated depreciation | 5,000 | |
| 75,000 | |
| 40,000 |
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International accounting standards do not presently address the accounting for other types of nonmonetary exchanges that are nonreciprocal in nature. Under US GAAP, nonreciprocal transfers with owners and with nonowners are dealt with as described below.
Nonreciprocal transfers.
Examples of nonreciprocal transfers with owners include dividends-in-kind, nonmonetary assets exchanged for common stock, split-ups, and spin-offs. An example of a nonreciprocal transaction with other than the owners is a donation of property either by or to the enterprise.
The valuation of most nonreciprocal transfers should be based on the fair market value of the asset given (or received, if the fair value of the nonmonetary asset is both objectively measurable and would be clearly recognizable). However, nonmonetary assets distributed to owners of an enterprise in a spin-off or other form of reorganization or liquidation should be based on the recorded amount. Where there is no asset given, the valuation of the transaction should be based on the fair value of the asset received.
Example of accounting for a nonreciprocal transfer
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Assume the following:
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XYZ donated property with a book value of $10,000 to a charity during the current year.
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The property had a fair market value of $17,000 at the date of the transfer.
According to the US GAAP requirements, the transaction is to be valued at the fair market value of the property transferred, and any gain or loss on the transaction is to be recognized. Thus, XYZ should recognize a gain of $7,000 ($17,000 - $10,000) in the determination of the current period's net income. The entry to record the transaction would be as follows:
| Charitable donations | 17,000 | |
| 10,000 | |
| 7,000 |
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Capitalization of Borrowing Costs
Logic suggests that the cost of an asset should include all the costs necessary to get the asset set up and functioning properly for its intended use. For some years there has been a question of whether such costs should be included in the definition of all costs necessary or whether such costs should continue to be treated as purely a period expense. A corollary issue is whether an imputed cost of capital for equity financing should similarly be treated as a cost to be capitalized: The implicit argument is that the cost of a self-constructed asset, for example, should not differ between two entities simply because one finances it internally while another finances the asset with externally supplied (debt) capital.
This question was resolved in the United States with the promulgation of SFAS 34, which established US GAAP concerning the capitalization of interest. Borrowing costs, under defined conditions, are added to the cost of fixed assets (and inventory, in very limited circumstances), but the cost of equity capital may not be imputed.
The principal purposes to be accomplished by the capitalization of interest costs are as follows:
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To obtain a more accurate original asset investment cost
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To achieve a better matching of costs deferred to future periods with revenues of those future periods
International accounting standards differ from US GAAP in that both benchmark and allowed alternative treatments have been prescribed; the alternative treatment is very similar to that which is mandatory in the United States.
Benchmark treatment.
The IAS 23 benchmark remains the method formerly universally followed in the United States and elsewhere. All borrowing costs are treated as period costs and expensed as incurred.
Alternative treatment.
Interest actually incurred on borrowed funds used to finance the acquisition, construction, or production of a qualifying asset (defined below) is added to the carrying value of the asset. The amount of interest so accounted for depends on whether funds were borrowed specifically for the project in question or whether a pool of borrowed funds was deployed for a variety of projects, some of which may be subject to the interest capitalization rules.
Qualifying assets are those that normally take an extended period of time to prepare for their intended uses. While IAS 23 does not give further insight into the limitations of this definition, over fifteen years of experience with SFAS 34 yields certain insights that may be germane to this matter. In general, interest capitalization has been applied to those asset acquisition and construction situations in which
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Assets are being constructed for an entity's own use or for which deposit or progress payments are made
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Assets are produced as discrete projects that are intended for lease or sale
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Investments are being made that are accounted for by the equity method, where the investee is using funds to acquire qualifying assets for its principal operations which have not yet begun
Generally, inventories and land that are not undergoing preparation for intended use are not qualifying assets. When land is in the process of being developed, it is a qualifying asset. If land is being developed for lots, the capitalized interest cost is added to the cost of the land. The related borrowing costs are then matched against revenues when the lots are sold. If, on the other hand, the land is being developed for a building, the capitalized interest cost should instead be added to the cost of the building. The interest is then matched against revenues as the building is depreciated.
The capitalization of interest costs would probably not apply to the following situations:
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The routine production of inventories in large quantities on a repetitive basis
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For any asset acquisition or self-construction, when the effects of capitalization would not be material, compared to the effect of expensing interest
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When qualifying assets are already in use or ready for use
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When qualifying assets are not being used and are not awaiting activities to get them ready for use
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When qualifying assets are not included in a consolidated balance sheet
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When principal operations of an investee accounted for under the equity method have already begun
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When regulated investees capitalize both the cost of debt and equity capital
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When assets are acquired with grants and gifts restricted by the donor to the extent that funds are available from those grants and gifts
If funds are borrowed specifically for the purpose of obtaining a qualified asset, the interest costs incurred thereon should be deemed eligible for capitalization, net of any interest earned from the temporary investment of idle funds. It is likely that there will not be a perfect match between funds borrowed and funds actually applied to the asset production process, at any given time, although in some construction projects funds are drawn from the lender's credit facility only as vendors' invoices, and other costs, are actually paid. Only the interest incurred on the project should be included as a cost of the project, however.
In other situations, a variety of credit facilities may be used to generate a pool of funds, a portion of which is applied to the asset construction or acquisition program. In those instances, the amount of interest to be capitalized will be determined by applying an average borrowing cost to the amount of funds committed to the project. Interest cost could include the following:
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Interest on debt having explicit interest rates
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Interest related to finance leases
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Amortization of any related discount or premium on borrowings, or of other ancillary borrowing costs such as commitment fees
The amount of interest to be capitalized is that portion that could have been avoided if the qualifying asset had not been acquired. Thus, the capitalized amount is the incremental amount of interest cost incurred by the entity to finance the acquired asset. A weighted-average of the rates of the borrowings of the entity should be used. The selection of borrowings to be used in the calculation of the weighted-average of rates requires judgment. In resolving this problem, particularly in the case of consolidated statements, the best criterion to use is the identification and determination of that portion of interest that could have been avoided if the qualifying assets had not been acquired.
The base (which should be used to multiply the rate by) is the average amount of accumulated net capital expenditures incurred for qualifying assets during the relevant time frame. Capitalized costs and expenditures are not the same terms. Theoretically, a capitalized cost financed by a trade payable for which no interest is recognized is not a capital expenditure to which the capitalization rate should be applied. Reasonable approximations of net capital expenditures are acceptable, however, and capitalized costs are generally used in place of capital expenditures unless there is a material difference.
If the average capitalized expenditures exceed the specific new borrowings for the time frame involved, the excess expenditures amount should be multiplied by the weighted-average of rates and not by the rate associated with the specific debt. This requirement more accurately reflects the interest cost incurred by the entity to bring the fixed asset to a properly functioning position.
The interest being paid on the debt may be simple or compound. Simple interest is computed on the principal alone, whereas compound interest is computed on principal and on any interest that has not been paid. Compounding may be yearly, monthly, or daily. Most fixed assets will be acquired with debt having interest compounded, and that feature should be considered when computing the amount of interest to be capitalized.
The total amount of interest actually incurred by the entity during the relevant time frame is the ceiling for the amount of interest cost capitalized. Thus, the amount capitalized cannot exceed the amount actually incurred during the period involved. On a consolidated basis, the ceiling is defined as the total of the parent's interest cost plus that of the consolidated subsidiaries. If financial statements are issued separately, the interest cost capitalized should be limited to the amount that the separate entity has incurred, and that amount should include interest on intercompany borrowings. The interest incurred is a gross amount and is not netted against interest earned except in rare cases, such as when there are externally restricted tax-exempt borrowings in certain jurisdictions.
IAS 23, while offering a choice between immediate expensing and capitalization of qualifying borrowing costs, did not indicate whether a given enterprise could use both procedures, for different qualifying properties. In SIC 2, the Standing Interpretations Committee has responded to this previously unanswered question. The consensus stipulates that if capitalization (the allowed alternative treatment under the standard) is elected, it should be used for all qualifying assets and for all periods. It also states that if interest is capitalized, the asset must not be reflected at an amount in excess of recoverable amount—any excess is an impairment to be recognized immediately.
Example of accounting for capitalized interest costs
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Assume the following:
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On January 1, 2003, Gemini Corp. contracted with Leo Company to construct a building for $2,000,000 on land that Gemini had purchased years earlier.
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Gemini Corp. was to make five payments in 2003, with the last payment scheduled for the date of completion.
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The building was completed December 31, 2003.
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Gemini Corp. made the following payments during 2003:
January 1, 2003
$ 2,000,000
March 31, 2003
4,000,000
June 30, 2003
6,100,000
September 30, 2003
4,400,000
December 31, 2003
3,500,000
$20.000,000
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Gemini Corp. had the following debt outstanding at December 31, 2003:
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A 12%, 4-year note dated 1/1/03 with interest compounded quarterly. Both principal and interest due 12/31/06 (relates specifically to building project)
$8,500,000
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A 10%, 10-year note dated 12/31/99 with simple interest and interest payable annually on December 31
$6,000,000
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A 12%, 5-year note dated 12/31/01 with simple interest and interest payable annually on December 31
$7,000,000
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The amount of interest to be capitalized during 2003 is computed as follows:
| Average Accumulated Expenditures | |||
|---|---|---|---|
| Date | Expenditure | Capitalization period[a] | Average accumulated expenditures |
| 1/1/03 | $ 2,000,000 | 12/12 | $2,000,000 |
| 3/31/03 | 4,000,000 | 9/12 | 3,000,000 |
| 6/30/03 | 6,100,000 | 6/12 | 3,050,000 |
| 9/30/03 | 4,400,000 | 3/12 | 1,100,000 |
| 12/31/03 | 3,500,000 | 0/12 | -- |
| $20,000,000 | $9,150,000 | ||
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[a]The number of months between the date when expenditures were made and the date on which interest capitalization stops (December 31, 2003). | |||
| Potential Interest Cost to Be Capitalized | ||||||
|---|---|---|---|---|---|---|
| ($8,500,000 | x | 1.12551) [a] | - | $850,000 | = | $1,066,840 |
| 650,000 | x | 0.1108[b] | = | 72,020 | ||
| $9,150,000 | $1,138,860 | |||||
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[a]The principal, $8,500,000, is multiplied by the factor for the future amount of $1 for 4 periods at 3% to determine the amount of principal and interest due in 2003.
[b]Weighted-average interest rate | ||||||
| Principal | Interest | |
|---|---|---|
| 10%, 10-year note | $ 6,000,000 | $ 600,000 |
| 12%, 5-year note | 7,000,000 | 840,000 |
| $13,000,000 | $1,440,000 |
The actual interest is
| 12%, 4-year note [($8,500,000 1.12551) - $8,500,000] | = | $1,066,840 |
| 10%, 10-year note ($6,000,000 x 10%) | = | 600,000 |
| 12%, 5-year note ($7,000,000 x 12%) | = | 840,000 |
| $2,506,840 |
The interest cost to be capitalized is the lesser of $1,138,860 (avoidable interest) or $2,506,840 (actual interest). The remaining $1,367,980 ($2,506,840 - $1,138,860) would be expensed.
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Determining the time period for interest capitalization.
Three conditions must be met before the capitalization period should begin.
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Expenditures for the asset are being incurred
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Borrowing costs are being incurred
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Activities that are necessary to prepare the asset for its intended use are in progress
As long as these conditions continue, interest costs can be capitalized.
Necessary activities are interpreted in a very broad manner. They start with the planning process and continue until the qualifying asset is substantially complete and ready to function as intended. These may include technical and administrative work prior to actual commencement of physical work, such as obtaining permits and approvals, and may continue after physical work has ceased. Brief, normal interruptions do not stop the capitalization of interest costs. However, if the entity intentionally suspends or delays the activities for some reason, interest costs should not be capitalized from the point of suspension or delay until substantial activities in regard to the asset resume.
If the asset is completed in a piecemeal fashion, the capitalization of interest costs stops for each part as it becomes ready to function as intended. An asset that must be entirely complete before the parts can be used as intended can continue to capitalize interest costs until the total asset becomes ready to function.
Suspension and cessation of capitalization.
If there is an extended period during which there is no activity to prepare the asset for its intended use, capitalization of borrowing costs should be suspended. As a practical matter, unless the break in activity is significant, it is usually ignored. Also, if delays are normal and expected given the nature of the construction project (such as a suspension of building construction during the winter months), this would have been anticipated as a cost and would not warrant even a temporary cessation of borrowing cost capitalization.
Capitalization would cease when the project has been substantially completed. This would occur when the asset is ready for its intended use or for sale to a customer. The fact that routine minor administrative matters still need to be attended to would not mean that the project had not been completed, however. The measure should be substantially complete, in other words, not absolutely finished.
Costs in excess of recoverable amounts.
If the capitalization of borrowing costs causes the carrying value of the asset to exceed its recoverable value (if property, plant, or equipment) or its net realizable value (if an item held for resale), it will be necessary to record an adjustment to write the asset carrying value down. In the case of plant, property, and equipment, a later write-up may occur due to use of the allowed alternative (i.e., revaluation) treatment, recognizing fair value increases, in which case, as described earlier, recovery of a previously recognized loss will be reported in earnings.
Consistency of application.
IAS 23 did not address the question of whether an entity would be justified in capitalizing interest costs (i.e., using the allowed alternative treatment) for some qualifying assets, while expensing currently (i.e., applying the benchmark treatment) interest incurred in the acquisition, construction, or production of other qualifying assets. While the issue was not raised at the time, logic suggested that if both methods were employed for qualifying assets by a single entity, it would make meaningful interpretation of the resulting financial statements more difficult for users. Subsequently, the IASC's Standing Interpretations Committee (SIC) addressed this matter. It concluded that if the allowed alternative method (i.e., capitalizing borrowing costs) is used for some qualifying assets, the method should be used for all such assets.
In reaching this conclusion, the committee weighed the guidance already contained in IAS 27 (on consolidated financial reporting) and the Framework for the Preparation and Presentation of Financial Statements. The existing standard on consolidations provides that uniform accounting policies are to be used for like transactions and other events in similar circumstances. The logic is to avoid having consolidated financial statements that are the summation of dissimilar measurements of like transactions or other economic phenomena. The IASC's Framework for the Preparation and Presentation of Financial Statements similarly expresses the notion that measurement of like transactions and other events should be carried out in a consistent manner throughout an entity and over the time of its ongoing existence, for purposes of both separate and consolidated financial reporting. Finally, as IAS 23 stipulates only one alternative methodology, capitalization of interest costs, the SIC was led to conclude that the intention was to not leave financial statement preparers with any further discretion. Accordingly, the Committee's finding was that it would not be appropriate to apply capitalization to some but not all qualifying assets.
Disclosure requirements.
With respect to an entity's accounting for borrowing costs, the financial statements must disclose which policy (benchmark or allowed alternative) is being utilized, as well as the actual borrowing costs capitalized during the period and the rate used to determine the amount of such costs eligible for capitalization. As noted above, this rate will be the weighted-average of rates on all borrowings included in an allocation pool or the actual rate on specific debt identified with a given asset acquisition or construction project.
Proposed Changes to IAS 16
As part of its current Improvements Project, the IASB has proposed a number of changes to the requirements under IAS 16. Since these are anticipated to be approved and enacted, probably by 2003, they are summarized in the following paragraphs.
The revised standard will amend the definition of residual value to clarify that the reporting entity is to use current (i.e., asset acquisition date) prices for assets of an age and condition similar to the estimated age and condition of the asset when it reaches the end of its useful life. It is not expected to project future salvage values, which would inevitably take into account factors such as price level changes that would not be relevant to the cost allocation process.
Importantly, the revised IAS 16 will stress that a component approach to depreciation is required, and also to the treatment of expenditures to replace or renew a component of an item or property, plant, and equipment. Under the component approach, each material component of an asset with a different useful life or different pattern of depreciation must be depreciated separately, and expenditures for replacing or renewing the component are to be capitalized. While this principle is already established under existing IAS, the revised language would provide greater consistency of application, it is believed.
The cost of long-lived assets includes all costs necessary to bring them to the place where they are to be used, and includes such ancillary costs as testing and calibrating, where relevant. The revised standard will state that to be netted against such costs are any revenues received during the installation process. As an example, it cites the sales of prototypes or samples produced during this procedure. Absent this rule, the cost of the equipment could have been "grossed up" for all the installation and testing costs, while the revenues produced as a by-product of the efforts would be taken into current earnings, thereby creating a mismatching of costs and revenues.
The revised standard will distinguish the situation in the preceding paragraph from other situations where incidental operations may occur before or during the construction or development activities. For example, it notes that income may be earned through using a building site as a car parking lot until construction begins. Because incidental operations such as this are not necessary to bring the asset to the location and working condition necessary for it to be capable of operating in the manner intended by management, the income and related expenses of incidental operations are to be recognized in current earnings, and included in their respective classifications of income and expense in the income statement.
There will be further guidance provided on the matter of including the estimated cost of dismantlement, disposition, or rehabilitation to the cost of the assets to which these pertain, as is already required under IAS 16 (discussed earlier in this chapter). Specifically, it would establish that if the costs relate to land, the costs must be amortized over the expected period of use of the land, even though land is, itself, a nondepreciating asset. It further states that when the expected term of use of the land is limited, it may also be necessary to depreciate the cost of the land. This probably applies most obviously to situations where the land will be damaged through use, as in strip mining for coal or other minerals, and thus suffer from both a limited period of use and diminished value at the termination of that period.
As discussed earlier in this chapter, the revised IAS 16 will specify that exchanges of similar items of property, plant, and equipment are to be measured at fair value, except that when the fair value of neither of the assets exchanged can be determined reliably, the cost of the asset acquired in the exchange is measured at the carrying amount of the asset given up. Exchanges of dissimilar property items is already addressed by the existing standard, with fair value being the required mode of measurement.
IAS 16 addresses the criteria for adding subsequent expenditures to the capitalized cost of long-lived assets. An amendment would replace the "originally assessed standards of performance" as a criterion with the "standard of performance assessed immediately before the expenditure was made."
The amendment will also make it clear that the residual value of an asset is to be reviewed at each balance sheet date whether the asset is being carried at amortized historical cost (the benchmark treatment) or at a revalued amount (the allowed alternative). A change in the asset's residual value, other than a change reflected in an impairment loss recognized under IAS 36, would be accounted for prospectively as an adjustment to future depreciation. Furthermore, it will be mandated that reviews of useful life and depreciation method must occur at least at each financial year-end.
A new requirement will be added to the effect that compensation received from third parties (e.g., insurers) for items of property, plant, and equipment that were impaired, lost, or given up is to be reported in earnings in the period received, with separate disclosure made in the financial statements. In other words, these payments cannot be used to reduce the capitalized cost of the replacement asset. This principal was already established by SIC 14.
Under the expected revision to IAS 16, depreciation of an item of property, plant, and equipment will not cease when it becomes temporarily idle or is retired from active use and held for disposal. This will conflict with the requirement under US GAAP, which holds that it would be mismatching to depreciate equipment not being used to produce goods which are currently available for sale.
The amendment to IAS 16 would delete certain currently required disclosures, add new disclosures, and eliminate several currently outstanding interpretations.
EAN: 2147483647
Pages: 147