IFRS impact on fixed assets — More than just a change in name

    In practice there may be situations where the determination of what comprises ‘directly attributable cost’ would involve exercise of judgment.

Directly attributable costs :

    At a general level, the concept of directly attributable costs in AS 10 is broadly consistent with what is provided by IAS 16. IAS 16 has provided examples of directly attributable costs. Some of these include :

•      Installation and assembly cost

•      Site preparation

•      Fees paid to professionals e.g. towards legal assistance for title report on land

•      Cost of employee benefits incurred for acquisition/construction of an asset e.g. share based payments provided to employees who have worked on the construction/acquisition of an asset

•      Interest and other borrowing costs can be capitalised as part of the cost of a qualifying asset

    These costs need to be incremental or external to be considered as directly attributable. For example : if a company is installing a machine in its factory and one of its engineers has been assigned this task on a full time basis then the cost of the engineer including employee benefits during the period of installation should be included in the cost of the machine even though this cost may have been incurred in any event. In any case, the cost of an asset can include expenditure only if an asset is acquired e.g. if a broker is paid fees to identify property, such fees can be added to the cost of property which is acquired since it is directly attributable to the acquisition of property, fees paid for other properties not acquired needs to be expensed.

    Care should be taken to ensure that expenses which are in the nature of administrative costs are not capitalised since these cannot be considered as directly attributable to acquisition of an asset. Also, abnormal amounts of material/labour/other costs that maybe incurred while constructing an asset cannot be added to the cost of that asset. These will have to be expensed in the period in which these have been incurred. The determination of what comprises ‘abnormal’ is subjective. For example, if the normal commissioning time for an asset is two weeks but it takes four weeks because a trainee engineer had installed a machine incorrectly or because site management forgot to schedule machine operators for the testing phase, then additional costs incurred as a result of such events should be considered ‘abnormal’ and expensed as incurred. However, the assessment of what is abnormal can be made by considering the level of technical difficulty associated with a project, timelines/estimates made at the time of planning etc. Having said that, there may be circumstances where there might be a delay in the process of constructing an asset due to some unexpected technical difficulties. This delay may give rise to additional costs being incurred which should then be capitalised and not expensed.

    As is the case with AS 10, IAS 16 also permits subsequent expenditure to be capitalised only if it is probable that future economic benefits associated with them will flow to the entity and its cost can be reliably measured.

Areas of GAAP difference : AS 10 v. IAS 16 :

    The accounting for PPE as required by IAS 16 is similar to accounting for fixed assets as per AS 10 in certain areas, while there are certain important differences such as :

•     Foreign exchange differences and preoperative expenses capitalised under Indian GAAP

•      Accounting for decommissioning costs

•     Depreciation

•      Component accounting

•      Revaluation approach for subsequent measurement of PPE

Foreign exchange differences and preoperative expenses capitalised under Indian GAAP :

    Under Indian GAAP, (based on principles laid out in the Companies Act 1956), companies have traditionally capitalised foreign exchange differences on monetary items relating to fixed assets as part of the acquisition cost. This has been recently amended by the Accounting Standard Rules 2006. However, prior capitalisation of foreign exchange differences still forms a part of the cost of fixed asset. On adoption of IFRS, companies need to strip out these capitalised exchange differences on the transition date so as to bring the cost of assets in line with IAS 16 and also rework depreciation for future years accordingly.

    It is important to note here that as per the recent March 2009 notification issued by the Ministry of Company Affairs, Indian companies have an option to adjust exchange differences arising on reporting of long term foreign currency monetary items to the cost of the fixed asset where they relate to the acquisition of a depreciable capital asset and consequently depreciated over the asset’s balance life. Such an option would not be available under IFRS and hence such capitalisation would also need to be adjusted on transition to IFRS.

The same rule applies to general and administrative overheads relating to start up activities capitalised under Indian GAAP as per Guidance note on expenditure during construction period, until the year 2008. These would also have to be stripped out from the cost of the PPE with a corresponding impact on opening reserves on the transition date.

Decommissioning:

Under IFRS, the cost of an asset also includes  the estimated cost of dismantling an asset and restoring the site. For example, consider that the installation and testing of a company’s new chemical plant results in contamination of the ground at the plant. The company will be required to clean up the contamination caused by the installation when the plant is dismantled. Hence it will recognise a provision for restoration, which is capitalised as part of the cost of the asset. Subsequent changes to these estimates due to change in the amount or timing of the expenditure are required to be accounted as change in estimates. Although AS 10 does not provide guidance on accounting for decommissioning costs, Appendix C to AS 29 provides an example of cost of restoring an oil rig at the end of production. Such costs are required to be included as part of the cost of oil rig. The key GAAP differences here are:

• IFRS requires recognition of provisions based on constructive obligations also as opposed to only contractual obligations under Indian GAAP

• Under  IFRS, such  provisions  need  to be recorded based on their discounted  values

Depreciation:   

Under IFRS,entities will have to estimate depreciation based on the estimated useful life of an asset. This is different from the current practice of using rates prescribed by Schedule XIV to the Companies Act, 1956 as the minimum rates for providing depreciation. IFRS does not prescribe any particular method of calculating depreciation but permits use of the straight line method, diminishing balance method and sum of units method. IAS 16 also requires a review of the estimated useful life of an asset, estimated residual value of an asset and the method of depreciation at each balance sheet date. Although AS 6 also requires estimated useful life ot'” major classes of depreciable assets to be periodically reviewed, given the current practice of using Schedule XIV rates for providing depreciation, this may be an area of focus for preparers and auditors while signing off on financial statements prepared under IFRS. Based on our recent conversion experiences we have noted differences in depreciation because the useful life of major property, plant and machinery is longer than the maximum lives permitted under Schedule XIV. In other cases, companies may not necessarily have estimated useful lives, but may have adopted the Schedule XIV rates, which may not correctly reflect the useful lives (for example, furniture and vehicles being depreciated over inappropriately long lives). In such cases, application of IFRS would result in assessment of useful lives and higher depreciation rates and depreciation charge.

Irrespective of the method of depreciation followed, entities will have to ensure that the cost or revalued amount of an asset is allocated on a systematic basis over the useful life of an asset.

The residual value, the useful life and the depreciation method used must be reviewed at least at each financial year-end. Any changes are accounted for prospectively by adjusting the depreciation charge for current and future periods from the date of the change in estimate. It is noteworthy here that if a change of depreciation method has to be made, the change should be accounted for as a change in accounting estimate, and not as a change in accounting policy, and the depreciation charge for the current and future periods should be adjusted accordingly.

Component accounting:

IAS 16 requires component accounting to be fol-lowed for assets which have individual significant components and for which different rates or methods of depreciation are appropriate. The separate component may be a physical component or non physical component. An example of a physical component is an aircraft engine. An aircraft engine is a significant physical component with a distinctly different useful life. Whilst an aircraft is depreciated over its useful life, its engine is separately depreciated on the basis of estimated flying hours. An example of a non physical component is where major overhaul costs are required to be incurred on a periodic basis. If a ship costing Rs.I00 is acquired with a useful life of 15 years and if it has to be dry-docked after every three years for a major overhaul at a cost of Rs 30 then the cost of ship is split into two components i.e. non physical component of Rs 30 and other components aggregating to Rs 70. The non physical component in this case is depreciated over its useful life of 3 years and the other components will be depreciated over their useful life of 15 years.

Component accounting does not apply only to specific assets like ships or aircrafts. A single plant and machinery comprising of different parts such as melting furnace, grinders, rolling mills, etc. could have different useful lives for these parts and hence need to follow component accounting. Similarly, a building can be broken into different components
 
like the roof top, basic structure and interior improvements which could have different useful lives. The key here is to assess firstly whether there are different components in one asset and then whether these different components have significantly different useful lives.

In many cases an entity acquires an asset for a fixed sum without knowing the cost of the individual components. In such cases, the cost of individual components should be estimated either by reference to current market prices (if possible), in consultation with the seller or contractor, or using some other reasonable method of approximation.

Generally Indian companies have depreciated all assets within a class using a uniform depreciation rate (for example, a single rate for all plant and machinery). However, useful lives of different types of plant and machinery may be different – and hence the need to use different depreciation rates under IFRS.

Revaluation approach for subsequent measurement of PPE:

PPE can be measured at fair value if its fair value can be reliably measured. If the revaluation approach is chosen then:

• All assets in that class of assets (being revalued) will have to be revalued. Class of assets would include assets which are of a similar nature and use in an entity’s operations

• Carrying value of assets under the revaluation model should not be materially different from their fair values

Any surplus arising on the revaluation is recognised directly in the revaluation reserve within equity except to the extent that the surplus reverses a previous revaluation deficit on the same asset recognised in profit and loss, in which case the credit to that extent is recognised in profit and loss. Any deficit on revaluation is recognised in profit or loss except to the extent that it reverses a previous revaluation surplus on the same asset, in which case it is taken directly to the revaluation reserve. Therefore, revaluation increases and decreases cannot be offset, even within a class of assets.

Fair value of an asset is its market value and is the highest possible price that could be obtained for that asset without regard to its existing use.

The frequency of revaluations depends upon the volatility of the movements in the fair values of the items of PPE being revalued. Revaluations every year are unnecessary for items of PPE with only insignificant movements in fair value. For items that usually experience significant and volatile movements in fair value, annual revaluations are necessary. It is important that revalued amounts do not differ materially from fair values as at the balance sheet date.

Comparison of the cost model with revaluation model:

Illustration:

Intangible    assets:

IAS 38 deals with accounting for intangible assets. An intangible asset is an identifiable non monetary asset without physical substance. It is identifiable (only) if it is separable or arises from contractual or other legal rights. An intangible asset should be controlled by the entity and should expect to get future economic benefits.

Initial recognition:

Like PPE, an intangible asset is initially measured at cost plus directly attributable expenditure incurred in preparing the asset for its intended use. Expenses incurred in training, initial operating losses should  be expensed as incurred.

An entity may either acquire or internally generate an intangible asset. An intangible asset maybe internally generated through research and development. Research costs are required to be expensed as incurred. If an internally generated intangible asset arises from development phase of a project, directly attributable expenses should be capitalised from the date that the entity is able to demonstrate:

• The technical feasibility of completing the intangible asset so that it will be available for use or sale;

• Its intention to complete the intangible asset and use or sell it;

• Its ability to use or sell the intangible  asset;

• How the intangible asset will generate probable future economic benefits;

• The availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset; and

• Its ability to measure reliably the expenditure attributable to the intangible asset during its development.

Expenses on internally generated brands,”r’ mastheads, publishing titles, customer lists are ‘not capitalised since such expenditure cannot be distinguished from developing the business as a whole. However, such intangibles are recognised when acquired in a business combination (acquisition). Hence, such internally generated, technology related or customer-related intangibles could form a part of the consolidated books of the acquirer entity although they do not meet the recognition criterion in the separate financial statements of the acquired entity. These principles are set out in IFRS 3 — ‘Accounting for business combinations’ .

There are certain expenses which should be expensed as incurred regardless of whether the criteria for recognition appear to be met:

• Internally generated goodwill
•  Training activities
•  Start up costs
• Advertising and promotional costs
• Expenditure on relocating or reorganising part or all of an entity

Principally, there are no differences between IAS 38 and AS 26 relating  to the identification  and recognition of intangible  assets. However,  with IFRS 3 in the picture,  the recognition  of some intangibles  in the consolidated financial statements of a group due to fair  value accounting  for business  combinations lead to differences between the two GAAPs.

Subsequent measurement:

The key difference between Indian GAAP and IFRS here is that IFRS recognises that an intangible may have an indefinite useful life and hence need not be amortised. However, the term ‘indefinite’ does not mean ‘infinite’. An intangible asset has an indefinite useful life when, based on an analysis of all the relevant factors (e.g., legal, regulatory, contractual), there is no foreseeable limit to the period over which the asset is expected to generate net cash inflows ‘for the entity.

Under Indian GAAP, an intangible asset has to be amortised over a maximum period of ten years unless a longer period can be justified. However, it does not give the option of not amortising the intangible altogether or considering an indefinite useful life.

An intangible asset with a finite useful life is sub-sequently amortised on a systematic basis over its useful life. Goodwill and intangible assets with an indefinite useful life are measured at cost or revalued amount less accumulated impairment charge. If an intangible asset is not amortised, its useful life must be reviewed at each annual reporting date to determine if the useful life continues to be indefinite.

The method of amortisation used should reflect the pattern of consumption of economic benefits. The method of amortisation used should be reviewed at each annual reporting date and any change in method should be accounted for prospectively as a change in estimate.

Intangible assets may subsequently be measured at fair value only if there is an active market. An active market exists if the items traded are homo-geneous, there are willing buyers and sellers and information on price is available. Under Indian GAAP, revaluation of intangible assets is not permitted. However, in practice, since an active market for intangible assets does not exist for most intangible assets, revaluation would typically not be permitted in the Indian context.

Acquired goodwill and intangible assets with an indefinite useful life will have to be tested annually for impairment or whenever there is a trigger for impairment. In a subsequent article, we will discuss the various impairment monitoring and measurement requirements under IFRS (IAS 36).

Conclusion:

The basic principles of accounting for PPE and intangibles under IFRS are not new to Indian GAAP. Concepts like component accounting and revaluations have been existing in the current Indian accounting framework. However, IFRS gives out clear principles and guidance in these matters. It aims at consistency in application of policies and accounting for PPE based on their composition.

PPE is one area that would need significant efforts and time for computations in order to converge with IFRS.