Accounting for Tangible Assets - Current Issues - Essay Example

Accounting for tangible assets (current issues) Introduction Two standards are usually used to account for tangible assets. These are international accounting standard 16 (IAS 16) used internationally and Financial Reporting Standard 15 (FRS 15) used commonly in UK (International Accounting Standards Board, 2008.). Tangible fixed assets are defined under FRS 15 as those assets which have physical substance and are held by an entity for use in either production or supply of goods or services, for rental or for administrative functions on continuous basis in the reporting of activities of an entity (Catty, 2010). The aspect of having a physical substance differentiates tangible assets from intangible ones while the aspect of being used on continuous basis differentiates fixed assets from current assets held by an entity. On the other hand IAS 16 considers any property, plant and equipment to be an asset only if the item has a probability of having future economic benefit associated with it which will flow to the entity and that its cost can be measured reliably. Thus, property, plant and equipment under IAS 16 are equivalent to tangible fixed assets under FRS 15. This paper describes how these tangible assets are accounted for in both IAS 16 and FRS 15 standards. International Accounting Standards 16 (IAS 16) Initial recognition IAS is recognized internationally and covers tangible fixed assets such as property, plant and equipment. It covers the initial measurement, valuation and subsequent depreciation of these assets. Initially IAS 16 stated that the land and buildings fair value was normally the market value and that the equipment and plant fair value was the market value or if specialized depreciated replacement cost (DRC). The latest standard does not provide bases definition but instead provides description of the process. Fair value is no longer synonymous to market value in the new standard (Catty, 2010). The standard allows the use of either a depreciated replacement cost or a profit’s test approach for both plant and property where there is no market evidence. The change was not accompanied by reason and debate has been ongoing since 1998 concerning the appropriate basis of determining owner occupied property fair value after references to market value for existing use was removed from IAS 16. This debate is still going on as fundamental reviews are being undertaken by IASB on the measurement of assets and liabilities in financial statements. In the new IAS, disclosure of the method used for deriving the fair value and the extent of deriving this based on market evidence is required. The use of profit test or depreciated replacement cost is only used in cases where there is no market based evidence that is reliable. Preparation of valuation under new IAS requires valuers to provide much justification for adopting a certain approach than in previous IAS. Members carrying out valuation using IAS are required by the RICS Red Book to follow IV A1 in which valuation is covered in IAS 16. Depreciation Under IAS 16, is based on componentization in which each part of the plant, property and equipment with a cost which is significant in relation to the cost of the item is separately depreciated. For instance, buildings which are significantly different on a site may be depreciated separately as may significant parts of a building that can be identified readily. The standard requires that the frequency of depreciation on items be done at least once annually. The allocation of depreciable amount of an asset is done on systematic baiss over the useful life of property, plant and equipment. The method used to depreciate the item is required to reflect the pattern in which the future economic benefits of the asset are expected to be consumed by the business. Land is not depreciated since it has an indefinite economic life. Thus, buildings and land are depreciated separately (International Accounting Standards Board 2008). This implies that an increase in the value of land on which the building stands does not have an effect on how th depreciable amount of the building is determined. When valuing for depreciation, the market based evidence is not reflected (Catty, 2010). The residual value is assessed based on the useful life of the asset to the business entity which is usually determined by the enterprise and is specific to that particular entity. Valuers are required to discuss the componentization of the major assets when providing valuation for depreciation. The intentions of the entity are reflected in the residual value under IAS 16 and hence components which cannot be sold or bought separately in their current state are required to be assessed. Disposal Acquisition of an asset in exchange for another under IAS 16 requires that the asset be valued at fair price (IASB, 2009). This implies thjat the gain or loss is reported when an asset is being disposed. There are exceptions to this in instances where the exchange transaction does not have commercial substance in which case the measurement of the cost is at the carrying amount of the asset disposed (Mirza, Holt, and Orrell, 2010). A transaction that has financial substance is one which could give rise to future cash flow that is significant. Revaluation Any firm which currently carries property assets at the revalued amount under FRS 15 are allowed to treat a revaluation on transition date as the initial cost when adopting IAS for the first time (International Accounting Standards Board, 2008). This subject to provision that revaluation figure is comparable to the fair value. It is considered under RICS that revaluation bases specified in FRS 15 meet this criterion. Revaluation frequency in IAS depends on changes in the fair value. Volatile items may require annual revaluation while in other instances P, P&E may require revaluation after every 3 to 5 years (Epstein and Jermakowicz, 2010). Increases in revaluation go to equity. However, if revaluation reverses a previous loss, then the amount required to reverse the loss goes to P&L. On the other hand; reductions in revaluations go to P&L. However, if there is an existing revaluation surplus in equity then reduction is allowed to be offset against this surplus revaluation in equity to the extent of the available credit balance. Impairment IAS 16 requires that an entity applies IAS 36 while determining whether an item of plant, equipment and property is impaired (IASB, 2009). An impaired asset is one which has no future economic benefits for its use or disposal. The standard states that an asset is derecognized once it is disposed or when no future economic benefits are foreseen on its use or disposal. Financial Reporting Standard 15 (FRS 15) FRS 15 deals mainly with three separate issues. These include determination of cost (initial recognition), revaluations and depreciation. Initial recognition FRS 15 provides procedures to be followed when revaluing tangible fixed assets. The standard gives firms a choice to either hold their tangible fixed assets at historic cost or to revalue their properties. Under FRS 15 tangible fixed assets are initially valued on the basis of existing use. The methodology used to determine the existing use is depreciated replacement cost (DRC) with properties having a surplus being valued at an exit basis. Under FRS 15 tangible assets are initially measured at its cost. The standard has provisions for both purchased and constructed assets (International Accounting Standards Board, 2008). The cost of an asset is considered to be cost of purchase net of any trade discounts plus any costs incurred to bring the asset to its working conditions (directly attributable costs) for the intended use of the asset. Directly attributable costs; are the labor costs arising directly from the acquisition or construction of the tangible asset and incremental costs that would have been avoided in case the asset was not constructed or acquired (IASB, 2009). Thus administrative and overhead costs are not included in the cost of a tangible fixed asset. Any additional expenditure on a tangible fixed asset is usually written off to the profit and loss account (Catty, 2010). However, there are exceptions to this. First is any expenditure which enhances the economic benefit of the asset. Second is expenditure which restores or replaces a component of an asset which has been treated separately for depreciation purposes. The third exception is expenditure relating to a major overhaul or inspection which restores economic benefit of an asset previously reflected in depreciation (Roehl-Anderson, 2010). Depreciation FRS 15 defines depreciation as the measure of the cost or revalued amount of the economic benefits of the tangible fixed asset that has been consumed during the period. Under FRS 15, depreciation is recognized as an expense in profit and loss account. FRS 15 requires that assets which still have an increase in value be depreciated also (IASB, 2009). This impacts on depreciation of fixed assets which have been revalued since revaluation increases the depreciable amount of a fixed asset. Thus accountants need to understand that depreciation is framed in terms of the consumption of economic benefits through use and not in terms of loss in value of the asset. Under FRS 15, two methods are commonly used to allocate depreciation to specific accounting periods. These are the straight line method and the reducing balance method (IASB, 2009). The straight line method is recommended where the pattern of economic benefits is uncertain. Components of an asset which have substantially different economic lives are accounted for separately for the purposes of depreciation and depreciated over its useful economic life. Like IAS 16, FRS 15 stipulates that land and buildings are separate components and ought to be dealt with separately for the purposes of depreciation. In addition, FRS states that freehold land does not require depreciation. However, land acquired for extractive purpose can be depreciated. On the other hand buildings are depreciated since they have a limited life. FRS 15 states that appreciation of the land on which the building stands does not have an effect on the determination of the useful economic life or residual value of the building. FRS 15 allows the use of renewals accounting in case where an entity holds fixed assets of low value in large numbers. Revaluation Even though it is not an FRS requirement, FRS allows fixed assets to be carried at revalued amounts by entities. In case a firm chooses a valuation route, the application of the route ought to be consistent across all fixed assets of the same class. In addition, revaluation needs to be updated regularly (IASB, 2009). Thus valuation is done at least once every five years accompanied by less detailed valuation in the third year and in other years where there is evidence of a significant change in the value of the asset. The valuation in FRS 15 can also be carried out on rolling basis over five year where there a change in material value. The basic valuation principle under FRS 15 is value for the existing use which does not reflect any potential for development. Directly attributable acquisition costs; are also included in case there are changes in the material value. In addition, specialized properties may be valued based on DRC to provide data for valuing existing use. In case the properties are surplus to the requirement of the entity, then such properties are valued at an open market value net of expected directly attributable selling costs (IASB, 2009). FRS requires that revaluation losses which are due to a clear consumption of benefits to be accounted for in profit and loss account unlike IAS 16 which does not apply this rule to the extent that there is a related revaluation surplus. Increases in revaluation go to the statement of total recognized gains and loses. However, if revaluation reverses a previous loss, then the amount required to reverse the loss goes to profit and loss account. On the other hand; reductions in revaluations go to profit and loss account. However, if there is an existing revaluation surplus in the statement of total recognized gains and loses then reduction is allowed to be offset against this surplus revaluation in the statement of total recognized gains and loses to the extent of the available credit balance. Conclusion Under FRS 15 tangible fixed assets are initially valued on the basis of existing use. However, IAS values property, plants and equipment based on the fair value. Thus, IAS 16 reports the gain or loss on disposal of an asset unlike FRS 15 which does not. FRS requires that revaluation losses which are due to a clear consumption of benefits to be accounted for in profit and loss account unlike IAS 16 which does not apply this rule to the extent that there is a related revaluation surplus. Under IAS 16 increases in revaluation are recorded in the equity. However, if revaluation reverses a previous loss, then the amount required to reverse the loss goes to P&L. On the other hand; reductions in revaluations go to P&L. Like IAS 16, FRS 15 stipulates that land and buildings are separate components and ought to be dealt with separately for the purposes of depreciation. Reference Catty, J. 2010. Wiley Guide to Fair Value Under IFRS. New York: John Wiley and Sons Epstein, B., and Jermakowicz, E. 2010. WILEY Interpretation and Application of International Financial Reporting Standards 2010, 7th Ed. New York: John Wiley and Sons IASB. 2009. International financial reporting standards. London: Kluwer Publishers International Accounting Standards Board. 2008. International Financial Reporting Standards IFRS 2008. London: Kluwer Publishers. Mirza, A., Holt, G., and Orrell, M. 2010. International Financial Reporting Standards (IFRS) Workbook and Guide: Practical Insights, Case Studies, Multiple-choice Questions, Illustrations. California: John Wiley and Sons. Roehl-Anderson, J. 2010. IT Best Practices for Financial Managers. New York: John Wiley and Sons. Read More