Fixed Tangible - Dissertation Example

Fixed Tangible assets forms an important line item in the Balance Sheet of any company especially in the case of a manufacturing concern. As perthe International Accounting Standard (IAS) 16 Property, Plant and Equipment, items pertaining to various classes of property, plant and equipment shall be classified as assts when the following two conditions are fulfilled It is probable that the future economic benefits, associated with the assets will flow to the entity and; The cost of the asset can be measured reliably [1] The important thing to consider at the time of recognition of fixed asset is the identification of the relevant cost based on which the asset should be capitalized in the balance sheet of the company. The cost include cost incurred at the time of purchase of asset such as cash payment for the acquisition of assets, duty paid on the import of assets at the time of import, transportation cost incurred for bringing the asset to the desired location and place. Although, there might be cost incurred related to the acquisition of the assets but it might not be relevant and thus not capitalized. Examples of such cost are cost of opening a new production facility, cost of advertising and promotional activities and other indirect and administrative costs. The capitalization of the cost is stopped when the asset is the location or place for the intended use. Cost such as initial operating losses, initial cost incurred by the company when it is operating below the capacity and cost or relocation or reorganization of some or all of the holdings of the company, is also not capitalized. The expenditure incurred can also be capitalized in the cost of the asset subsequent to the acquisition of the assets. These costs primarily include significant maintenance or overhauling expenditure. These costs are only recognized in those circumstances when the future economic benefits associated with that expenditure lasts for more than one year. Other than general maintenance expenditure, there are other costs which can also be capitalized in the cost of the asset. For example borrowing cost, incurred on acquiring to the acquisition of qualifying assets is also recognized in the cost of the assets acquired. This capitalization is accounted for in accordance with the IAS 23 ‘Borrowing Cost’. [2] At the initial recognition of any item of property, plant and equipment, if the payment for an item of property, plant and equipment is deferred, interest at market rate must also be recognized. In certain circumstances, the asset might be acquired in an exchange for another asset, which could be similar or dissimilar to the asset being disposed off. In these cases, the cost is measured at the fair value of the asset being acquired. But this measurement technique would not be applicable if the asset exchange transaction lacks commercial substance or the fair value of the assets involved in the transaction cannot be determined reliably. In case where the fair value of the asset acquired is not reliably measured, the cost of the asset, at which it is recognized in the balance sheet of the company, is the fair value of the assets given up. Subsequent to the initial measurement, the IAS 16 has allowed to record the asset at accounting models which are Cost Model Revaluation Model [1] In the cost model, the asset is carried at cost less accumulated depreciation and impairment losses, if any. Whereas, according to the revaluation model, the items are carried at revalued amount. The revalued amount of an item of property, plant and equipment is its fair value at its revaluation date. According to IAS 16, when an item of property, plant and equipment is revalued, the entire class of assets to which that item belongs, is also revalued. In case where a company conducts the revaluation of an item of property plant and equipment, and it results in an increase in the amount at which it was previously recorded in the balance sheet, the increase is credited to equity and is represented as ‘revaluation surplus’ . The following examples clearly highlight the accounting treatment under various circumstances. CASE 1 In million ? Historical Cost of the asset 100 Total useful life 10 years Remaining useful life 7 years Accumulated Depreciation 30 Written Down Value at revaluation date 70 Fair value At revaluation date 150 Gain (credited to equity) 80 CASE 2 In million ? Asset carried at revalued amount 150 Accumulated Depreciation 21 Previously recorded gain in equity 80 Written Down Value at revaluation date 129 Fair value At revaluation date 120 Loss (debited to equity) (9) CASE 3 In million ? Historical Cost of the asset 100 Total useful life 10 years Remaining useful life 7 years Accumulated Depreciation 30 Written Down Value at revaluation date 70 Fair value At revaluation date 50 Impairment Loss recognized in P&L (20) CASE 4 In million ? Historical Cost of the asset 100 Total useful life 10 years Remaining useful life 7 years Accumulated Depreciation 30 Accumulated Impairment Loss 20 Written Down Value at revaluation date 50 Fair value At revaluation date 80 Total gain 30 Accumulated impairment loss reversed 20 Gain recognized in equity 10 Depreciation of any non-current assets can be due to the normal wear and tear over the course of its life or due to the technical obsolesce. The straight line method of depreciation which is calculated according to the following formula Annual Depreciation Expense = Cost of the asset - Salvage Value of the Asset Useful life of the asset [3] The same annual depreciation expense is charged to the profit and loss account annually. Whereas according to the reducing balance, the annual depreciation expense is calculated according to the following formula Annual Depreciation Expense = Written Down Value of the asset x Depreciation rate [3] Written down value for the first year the asset is purchased is the cost of the asset and for every subsequent year, it is the Cost less accumulated depreciation expense. Depreciation rate is determined based on the best judgment depending upon the useful life of the asset The accounting for property, Plant and equipment under GAAP framework of accounting is quite similar to that under the IAS 16. However there are certain differences. Unlike IAS 16, estimates of useful life and residual value, and the method of depreciation are reviewed only when there are circumstances which make the current methods inappropriate to implement. In addition to that, under GAAP framework of accounting, the revaluation of property, plant and equipment is not allowed. [4] The accounting for property plant and equipment is based on the concept that long term assets are recorded on the amount which embodies the future economic benefits to the entity. In this respect, IAS 16 appears to be more entity friendly as it allows the company to record the asset at the revalued amount, being the fair value of the asset. Such accounting treatment can significantly increase the overall asset base and the financial outlook of the company. Although, it could also provide an opportunity for the company to indulge in creative accounting by conducting fake revaluation of the property plant and equipment and window dressing its financial outlook. (2) The International Accounting Standard (IAS) 37 ‘Provisions, Contingent Liabilities and Contingent Assets’ describes the accounting treatment of in respect of financial provisions, contingent assets and contingent liabilities. Provision can be defined as a liability of uncertain timing or amount. Whereas contingent liability, as per IAS 37, is the present obligation in respect of past event the settlement requiring outflows of resources. Similarly, contingent asset also arises due to past events which are expected as an inflow of economic resources to the entity. Both contingent assets and contingent liabilities are not recognized but disclosed in the financial statement of the company. The entity only recognizes a provision, if the following conditions prevails which are: A present obligation has arise due to certain past event The outflow of economic resources, in order to settle that obligation, is probable; and The settlement amount can be reliably measured [5] Further elaborating on the above mentioned points, an obligating event is the one according to which the company has a legal or constructive obligation to settle that obligation and the company does not have any other alternative to that. As further explained in the relevant provisions of IAS 37, a constructive obligation usually arises on account of past practices. In certain circumstances, it might not be certain whether the entity has a present obligation, and even if it does have a present obligation, the outflow of economic resources out of the entity is not certain. The discussed circumstances give rise to a contingent liability, which is required to be disclosed in the financial statement of the company and does not need to recognize. If the possibility of economic out flow is highly remote, then the company is not required to even disclose it in its financial statements. The amount recognized as provision should be the best estimate of the expenditure that is required to settle the present obligation at the balance sheet date. The entity, while recording the provisions, should take into account all the relevant circumstances and risk that prevails at the balance sheet date. In some situations, it would be possible that a third party agrees to agree the whole or certain part of the asset. In such situations the entity should recognize the amount receivable in the form of reimbursement as asset. The following example further clarifies Company Alpha has decided to set up a temporary working facility in the southern area of the city. At the reporting date, the company recognizes a provision on account of dismantling of the working facility which will going to take place after 2 years of the reporting date. The amount of provision is recorded at 40,000$. The local government, being impressed from the social and corporate profile of the company, has decided to reimburse to the company, 80% of the cost of dismantling. At reporting date Cost of the asset 40,000 (Debit) Provision on account of Dismantling 40,000 (Credit) Receivable from Government 32,000 (Debit) P&L Income 32,000 (Credit) The amount of provision recorded should be reviewed at each balance sheet date, and if the outflow of economic resources is not probable, then the entity should reverse the provision. IAS 37 specifically talks about the restructuring provisions, according to which the amount of provision should only include direct expenditures caused by the restricting and not pertaining to the ongoing activities. Following representation further clarifies. Event Accounting treatment Sale of operation Provision is accrued only after a binding sale agreement Closure or reorganization Accrue only after a detailed formal plan is finalized Future Operating losses No provision should be recorded Restructuring provision on acquisition Provision is only recorded in case of obligation at acquisition date [5] The following decision tree presents the guidelines based on which the amount are disclosed or recognized in the financial statements of the company [6] The guidelines for accounting of provisions, contingent assets and contingent liabilities are the same in the GAAP accounting framework, as under the International Financial Reporting Framework (IFRS). However there are few differences such as unlike as per the guidelines of IAS 37, the recognized contingencies are not disclosed except in limited circumstances. In addition, in the GAAP framework of accounting, there is no general requirement to recognize a loss for onerous contracts. References [1] “IAS 16 – Property, Plant and Equipment” http://www.iasplus.com. IAS Plus – summaries of International Financial Reporting Standards. Web. 20th July. 2011. [2] “IAS 23 – Borrowing Cost” http://www.iasplus.com. IAS Plus – summaries of International Financial Reporting Standards. Web. 21th July. 2011. [3] “Depreciation – Reducing Balance Method” http://www.bizhelp24.com. Biz help 24, n.d. Web. 29 July. 2011. [4] “IFRS compared to US GAAP 2010 ” http://www.kpmg.com/Globa. KPMG International. Web. 23rd July. 2011. [5] “IAS 37 – Provisions, Contingent Assets and Contingent Liabilities” http://www.iasplus.com. IAS Plus – summaries of International Financial Reporting Standards. Web. 29th July. 2011. [6] “IAS 37 – Provisions, Contingent Assets and Contingent Liabilities” IASB IFRS Handbook. Appendix B Read More