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December 2011

GAPs in GAAP — Amortisation Method for Intangibles

By Dolphy D’Souza, Chartered Accountant
Reading Time 6 mins
In the case of BOT type contracts, which are covered by a service concession agreement (SCA), and which are accounted for as intangibles, a question arises as to what is the most appropriate method for amortisation. Though this article is set out in the context of a toll road, it would also be applicable in many other cases of intangible assets.

Paragraphs 72 & 73 of AS-26, Intangible Assets set out the requirements with respect to the amortisation method.

72. The amortisation method used should reflect the pattern in which the asset’s economic benefits are consumed by the enterprise. If that pattern cannot be determined reliably, the straight-line method should be used.

73. A variety of amortisation methods can be used to allocate the depreciable amount of an asset on a systematic basis over its useful life. These methods include the straight-line method, the diminishing balance method and the unit of production method. The method used for an asset is selected based on the expected pattern of consumption of economic benefits and is consistently applied from period to period, unless there is a change in the expected pattern of consumption of economic benefits to be derived from that asset. There will rarely, if ever, be persuasive evidence to support an amortisation method for intangible assets that results in a lower amount of accumulated amortisation than under the straight-line method.

View 1

A revenue-based amortisation method better reflects the economic reality of the underlying terms of the SCA. This is particularly welcome in the case of the SCA where the tariff is lower in initial years, but the future increases in tariff will effectively recover the capital invested.

View 2

A time-based amortisation method i.e., the SLM is most appropriate as it reflects the duration of the SCA.

View 3

An amortisation method that reflects the usage of the toll road, for example, let’s say, during the entire duration of the SCA, 10 million trucks and 20 million cars are likely to use the toll road. For simplicity’s sake, let’s also assume that one truck’s consumption of economic benefits (in terms of wear and tear of the toll road, etc.) is twice that of one car. In other words one truck is equal to two cars for the purposes of amortisation. The toll road cost Rs.40 million. In the first year 1 million trucks and 2 million cars use the toll road. If we equal one truck to two cars, the amortisation would be 1/10th (4 million units/40 million units) of Rs.40 million, which is equal to Rs.4 million. This is the unit of production method. Which view is acceptable would be based on how the phrase ‘the method used for an asset is selected based on the expected pattern of consumption of economic benefits’ is interpreted.

Proponents of View 1 interpret the concept of consumption of economic benefits inherent in the licence as the generation of economic benefits arising from the asset’s use. Consequently, the generation of future revenues, future profits are appropriate parameters that could be used to reflect the way the asset is consumed. The application of this method involves an amortisation formula which uses a ratio of actual revenue to estimated revenue as the amortisation basis. Revenue is derived from an interaction between quantity and price, consequently the application of this amortisation method is considered a ‘derived computation’ which involves the use of ‘units of production’ (e.g., traffic volumes in the case of toll-roads) and toll rates. This method also gives a more consistent profit margin.

Proponents of View 2 feel that the contractual agreement only gives the operator the right of use, therefore, the amortisation method for the SCA should be focussed on the use of the contractual right more than on the use of the underlying tangible asset (the toll-road). Consequently, the focus appears to be on the right itself to operate the infrastructure for a certain period and is ‘consumed’ through the passage of time and consequently, a straight-line method of amortisation is more appropriate.

Proponents of View 3 observe that the economic benefits of an asset in an SCA are its ability to be used to provide the public service. The operator does not control the underlying asset and recognises an intangible asset to the extent that it receives a right (licence) to charge users of the public service. In some cases, the operator must return the underlying asset to the grantor in a wearable/ useable condition. Consequently, the physical wearing out of the underlying asset is relevant to the operation of the SCA even if an intangible asset, rather than the physical asset, is recognised in the financial statement. A volume-based method reflects this wearing out better than a time-based method. Further, the wearing out of the underlying asset is not affected by the revenue generated by each unit produced/used. For example, each car on a toll road has the same impact on the wearing out of the road, though the toll fee would have increased over the years for the car. Consequently, proponents of this view would support a units of production method, because it better reflects the pattern of consumption of the economic benefits embodied in the intangible asset.

Overall the author feels that a unit of production method better reflects the use of the underlying asset of a concession arrangement than an approach based on the passage of time. The author believes that View 1 is not acceptable. Paragraph 72 & 73 of AS-26 are clear that the amortisation method should ‘reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity’ and the focus should not be on the generation of economic benefits such as revenue. Revenue is not necessarily a feature of the intangible asset being amortised, because revenue is not necessarily a measure of the results of using an intangible asset in isolation but might incorporate the use of other assets, people and processes; and (b) revenue from the use of an asset does not necessarily reflect the pattern of consumption of the benefits inherent in the intangible asset itself. A revenue-based approach is used only in limited cases for assets that generate revenues directly and independently from other assets.

 This is the case for example of film rights that are amortised in the proportion that revenue in the year bears to the estimated ultimate revenue, after provision for any anticipated shortfall. In light of the discussions above, the author feels that View 3 is the preferred method, View 2 is acceptable and View 1 is unacceptable.

I would urge the Institute to issue a clarification as BOT type contracts are becoming the norm in such transactions and the clarification would also bring uniformity in accounting policy/practice and will encourage ‘comparability’ the avowed objective of accounting standard.

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