Accounting Methods for Property, Plant and Equipment under IFRS-A - Research Proposal Example

Accounting Methods for Property, Plant and Equipment under IFRS-A Comparison to Canadian GAAP ACCT 341 Financial Accounting Carole Middleton Zhiying Yvonne Chen Student ID: 200204942 Bachelor of Applied Business Administration – Accounting JR Shaw School of Business October 6, 2009 Table of Contents Introduction 3 Methodology 4 Major differences in IFRS and Canadian GAAP 5 Scope: 5 Recognition: 5 Initial and subsequent costs: 6 Depreciation 7 Case Study: Analysis of a depreciation example 8 Effects on the Income Statement and the Balance Sheet 11 Impact on shareholder wealth 12 Conclusions 13 Works Cited 14 “Will IFRS help?” Quality Check. VancouverSun, Web. 16 Oct. 2009. 15 “Will IFRS experience boost Canadians pay?” Financial Executive. Allbusiness, Web. 16 Oct. 2009. 15 15 Introduction In a globalize economy, multinational organization dominate the global economic scenario. Investors, research houses and organizations are also becoming global. It is a common practice for investors to hold stocks in different stock markets at the same time. For such investors it becomes difficult to understand various reporting mechanisms at the same time. Similarly International acquisitions increase the complexity for multinationals. Reasons such as these create an environment which requires a set of internationally accepted reporting principles. These international accounting standards can increase understanding, reliability and comparability, for shareholders and analyst worldwide. This is however a very complex process because certain measures have to be taken in developing international standards e.g. safeguarding the rights of local companies; especially when we talk about international movement of capital. Accounting rules is the major concern which has created the need for better more suited accounting standard. This area is becoming increasingly important to companies because international accounting standard are shifting to unsmoothed, so-called "fair-value" methods. They aim to provide valuation frameworks which not give a distorted picture about the value of a company today, but in fact provide knowledge of expected value in the future. This will eliminate the chances for manipulation of company performance. The proposed scenario will results in standards that will make Balance Sheet and Income statement more volatile (as these would be more risk averse measurements), thus creating a demand to hold less volatile assets. Partially due to the above mentioned argument and some bad experiences with GAAP (such as Enron) reporting standards were changed in Canada. The Canadian Accounting Standard Board (ACSB) has announced a change from the current Canadian GAAP to IFRS from January 1, 2011. As a result the publicly trading companies will have to report under IFRS from that year. This transition creates a need for education in the new IRFS from the point of view of an account. However for a researcher and shareholder, only information about the new IRFS would not be enough. An understanding should be developed about the differences in reporting among the two methods, and how these differences will affect the financial picture, the financial reports present of a company. The above mentioned argument leads to our current problem statement which is as follow ‘What are the major differences in IFRS and Canadian GAAP, concerning reporting of property, plant and equipment?’ Methodology The research provided in the paper is exploratory in nature. Secondary data has been used along with critical logical argument to answer the problem statement. A case study example has been presented to increase the practical understanding of the reader about the stated problem statement. Major differences in IFRS and Canadian GAAP There are four major differences in IFRS and GAAP when it comes to reporting PP&E. They are identified below under suitable headings: Scope: PP&E is treated different in IFRS when it comes to investment properties. If we give a generic definition, investment properties are ‘properties held by an entity for rental or capital appreciations’. In Canadian GAAP they are treated similar to PP&E but in IFRS there is a separate ISA for investment properties (IAS 40). -ISA 16 applies to property being constructed as investment property. ISA 16 does not apply to PP&E classified as Held for Sale, biological assets, recognition and measurement of exploration and evaluation assets, and mineral rights and mineral reserves such as oil, natural gas and similar non-regenerative resources. -CICA Sec 3061 applies to leased assets as well; no comparable section in Canada for investment properties. CICA section does not deal with goodwill or other intangible assets, with the impairment of PP&E or with the disposal of PP&E. Recognition: Following is a brief summary of changes: -ISA 16 recognizes as an asset if future benefits exist and will flow to the entity or cost measurable. Spare parts and servicing equipment usually carried as inventory. Major spare parts and stand-by equipment are PP&E when entity expects to use for more than one period. If spare parts and servicing equipment can only be used with PP&E. It does not prescribe what constitutes a unit of measure for recognition. - CICA does not deal with spare parts. Recognition criteria not articulated: implied that you would recognize if meets the definition of an asset. Initial and subsequent costs: In both Canadian GAAP and IFRS the requirements on how to measure the initial cost of an asses recognized as property plant and equipment are the same. But there are some differences in certain cases e.g. IFRS requires constructive obligations to be included where as GAAP doesn’t. IFRS excludes certain costs from the cost of the asset, including costs of opening a new facility; costs of introducing a new product or service (including costs of advertising and promotional activities); costs of conducting business in a new location or with a new class of customer (including costs of staff training); and administration and other general overhead costs (IAS 16.19). Highlights of other changes are as follows: -IAS 16 PP&E acquired for safety or environmental reasons are assets (involuntary expenditures). It does not necessarily meet definition of asset but need to incur in order to use. -CICA does not deal with costs incurred for safety or environmental reasons. The test would be whether the cost was incurred to get the asset ready for its intended use. -IAS 16 carrying amounts of replaced parts must be derecognized. CICA does not require that carrying costs of replaced items be derecognized. -ISA has regular inspections capitalized include replacement and remaining carrying amount of previous inspection. CICA does not deal with inspections. Depreciation The method of charging depreciation is almost similar in both IFRS and Canadian GAAP. However both methods do differ on how this depreciation charge is determined. Under Canadian GAAP depreciation is charged on the greater of cost less residual value over its estimated useful life, and cost less salvage value (estimated net realizable value at the end of its life) over its estimated life. Under IFRS, depreciation is charged on the difference between the carrying value and the residual value over its estimated useful life. Bellow is a summary of some other changes: -GAAP objective is to provide a rational and systematic basis for allocating the amortizable amount of an item of property, plant and equipment over its estimated life (Section 3061.31). -IAS is more explicit in relation to the depreciation. An entity is required to select the depreciation method that closely reflects the pattern in which the asset’s future economic benefits are expected to be consumed by the entity over its estimated useful life (IAS 16.60 to IAS 16.62). -GAAP cost less residual value (the estimated net realizable value at the end of its useful life) over its estimated useful life and cost less salvage value (estimated net realizable value at the end of its life) over its estimated life. -IFRS the assets cost (or revalued cost) less its residual value over its estimated useful life. Case Study: Analysis of a depreciation example The following case example has been taken from Paragraph 44 of IAS 16 which has been enhanced with additions and analysis to increase, the understanding of the impact, IFRS has on both the income statement and balance sheet. The depreciation under IFRS can be allocated to different parts of equipment separately. This provides a more accurate measurement of the remaining useful life of equipment and also matches costs to revenues more accurately. As the example explained is of an aircraft for the clarity of discussion lets analyze a similar situation. For example there are two aircrafts Ace and Base. Ace flies three times a week to America and back. Base on the other hand deals local flights, it make on average 10 flights a week to different Canadian cities. Ace travels approximately 20 thousand miles a week, where as base travels only 15 thousand miles a week. Both air crafts are the same make and model, cost a total of $12 million each. As they have been purchased on debt individual accounting under GAAP for each will be as follow: Dr Asset 12m Cr Bank/Liability 12m The airline JETX uses straight line deprecation method for financial reporting purposes on all its equipment. Under the recent GAAP Canadian the yearly depreciation for a useful life of twenty years will be recorded as follow: Canadian GAAP Dr Depreciation 0.60m Cr Accumulated Depreciation 0.60m This however does not provide us with a true comparison of the salvage value of the two planes. Base has been making more landing and take offs as compared to Ace where as ace has more flight time each week. This means that different parts are deteriorating at different rates, thus their depreciation should also be on different basis. The new depreciation methods allow a company to depreciate its equipment under different rates for each part. For example let’s review entries under IFRS: IFRS Dr Aircraft – Airframe 6m Dr Aircraft – Engine 4m Dr Aircraft – Other 2m Cr Bank/Liability 12m As you can see each part will appear separately in the Balance sheet and will be treated separately for depreciation as shown below. Journal entry to record depreciation: IFRS Dr Depreciation Aircraft – Airframe 0.30m Dr Depreciation Aircraft – Engine 0.25m Dr Depreciation Aircraft – Other 0.25m Cr Accumulated Depreciation – Airframe 0.30m Cr Accumulated Depreciation – Engine 0.25m Cr Accumulated Depreciation – other 0.25m This allows the depreciation of different components on different rates, thus allowing the true reflection of salvage value. ACE and BASE will both be depreciated on different rates because different parts are exhausted in landing intensive services and different in flying service. This will affect the balance sheet and income statement. The total depreciation would increase from $0.6 million to $0.8 million thus reflecting the true cost of sales, giving shareholders and researchers a better picture of operations. This also goes a long way of keeping a primary rule of reporting which is conservatism. Effects on the Income Statement and the Balance Sheet In general there will be no major impact on the companies income statement and balance sheet as they shift from GAAP to IFRS in Canada. But for sure it can be said that their will be an increase in assets and increase in owners equity. The concept of IFRS and that of Canadian GAAP are quite alike, thus it can be assumed the just minor changes will occur in the financial reporting style. Also one of the important assumption that remain same in between Canadian GAAP and IFRS is the that financial statements are prepared under taking accrual basis and it is believed that the entity will be a going concern and it will continue to operate in the future. The transition will be complex because along with many similarities between Canadian GAAP, there are also certain dissimilarities. The flexibility which these companies are enjoying will not be there and they will be bound to structure their financial statements as prescribed by IFRS (CICA, “Implications”). IFSR does not require statement of retained earning; rather it needs just the statement of change in equity. IFRS also requires the balance sheet for the earliest period related to the retrogressive effect related to any policy which is getting reclassified. IFSR requires additional disclosure of the accounting treatments and it does not allow exemption of recognized amount which may result to serious prejudicial condition. For acquisition, many further details have to present which were not mandatory as per the Canadian GAAP. IFRS does not require the fund flow statement for the current interim period, just the financial statement for the cumulative period will be enough. Impact on shareholder wealth In light of the recent economic meltdown need for more strict reporting mechanisms has become evident. When it comes to priorities, accounts always do not keep in mind that their job is always to provide services to the shareholder and not just the CEO or CFO. There have been numerous cases of internal accountants finding ways to manipulate data in such a way that the financial portrait does not present, true nature of the company performance. There are many ways of these manipulations; such as manipulating (not illegally but unethically) with the income statement, Balance sheet and even cash flow statements. For many companies which are equipment intensive, financial reporting of Property Plant and Equipment is cruel to safeguard shareholder value. If we carry on discussing the case mentioned above; imagine a travel service provider reporting depreciation under GAAP. GAAP reporting would never give the shareholder the true value of company assets (in this case primary assets the aircrafts). Thus implementing new improved reporting mechanisms such as IFRS is crucial to safeguard the rights of shareholders which are the primary aims of reporting. This will go a long way in improving customer trust in financial reports, which will not only increase investments in both primary and secondary capital markets but also reduce volatility in stock markets. Overall this will increase economic stability and reduce incidents like Enron. Conclusions The transition process will be a real challenge for the companies. They need to plan, prepare, execute with appropriate lead times to allow completion of transition activities. Proper training and education is required in preparation for the new standards. Two main incentives of IFRS are ‘harmonization of accounting standards will result in comparable and consistent financial statements and improved quality of financial statements’ according to Financial Post journalist Karim Jamal and Hun-Tong Tan. These aims according to them would be unachievable unless Canadian auditors also improve audit quality, thus as mentioned proper education would be a key success factor. The accountants should be involved in setting up accounting systems to capture information that is required for IFRS purposes, because of the emphasis on FMV and professional judgment in IFRS. Adoption of IFRS will make comparison between inter industrial companies possible. The investors will be the ones who will benefit the most because at present they are unable to make such inter-industrial comparison. The concept of IFRS has been already adopted by many companies and from January 1, 2011 onward it will be mandatory for all profit making publicly influencing enterprises. Pinpointing the difficulties ahead in the transition from GAAP to IFRS Dzinkowski Ramona emphasizes the need for experts in IRFS that would be required in the transition process. According to him, large scale implementation would drain the experts leaving small and medium enterprises in peril; this would also create an opportunity of high accountant salaries and thus bring quality to financial reporting. Works Cited CANADIAN INSTITUTE OF CHARTERED ACCOUNTANTS (CICA). Comparison of IFRSs and Canadian GAAP. AcSb CNC. July 31, 2008. September 12, 2009 . CICA. The CICAs Guide to IFRS in Canada. 2009. Charted Accountants of Canada. Thiru, Y. IAS/IFRS, US-GAAP and others: What is next? 2004. Financial Statement Analysis. MBA 618 Austria Fall 2004. September 12, 2009 . “Will IFRS help?” Quality Check. VancouverSun, Web. 16 Oct. 2009. (http://www.vancouversun.com/business/story.html?id=914659) “Will IFRS experience boost Canadians pay?” Financial Executive. Allbusiness, Web. 16 Oct. 2009. 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