THE CONCEPTUAL AND REGULATORY FRAMEWORK FOR FINANCIAL REPORTING
The IFRS Framework describes the basic concepts that underlie the preparation and presentation of financial statements for external users. A conceptual framework can be seen as a statement of generally accepted accounting principles (GAAP) that form a frame of reference for the evaluation of existing practices and the development of new ones.
Purpose of framework
It is true to say that the Framework:
- Seeks to ensure that accounting standards have a consistent approach to problem solving and do not represent a series of ad hoc responses that address accounting problems on a piece meal basis
- Assists the IASB in the development of coherent and consistent accounting standards
- Is not a standard, but rather acts as a guide to the preparers of financial statements to enable them to resolve accounting issues that are not addressed directly in a standard
- Is an incredibly important and influential document that helps users understand the purpose of, and limitations of, financial reporting
- Used to be called the Framework for the Preparation and Presentation of Financial Statements
- Is a current issue as it is being revised as a joint project with the IASB’s American counterparts the Financial Accounting Standards Board.
Advantages of a conceptual framework
- Financial statements are more consistent with each other
- Avoids firefighting approach and a has a proactive approach in determining best policy
- Less open to criticism of political/external pressure
- Has a principles based approach
- Some standards may concentrate on effect on statement of financial position; others on statement of profit or loss
Disadvantages of a conceptual framework
- A single conceptual framework cannot be devised which will suit all users
- Need for a variety of standards for different purposes
- Preparing and implementing standards may still be difficult with a framework
The purpose of financial reporting is to provide useful information as a basis for economic decision making.
OVERVIEW OF THE CONTENTS OF THE FRAMEWORK
The starting point of the Framework is to address the fundamental question of why financial statements are actually prepared. The basic answer to that is they are prepared to provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity.
In turn this means the Framework has to consider what is meant by useful information. In essence for information to be useful it must be considered both relevant, i.e. capable of making a difference in the decisions made by users and be faithful in its presentation, i.e. be complete, neutral and free from error. The usefulness of information is enhanced if it is also comparable, verifiable, timely, and understandable.
The Framework also considers the nature of the reporting entity and the basic elements from which financial statements are constructed. The Framework identifies three elements relating to the statement of financial position, being assets, liabilities and equity, and two relating to the statement of profit or loss, being income and expenses. The definitions and recognition criteria of these elements are very important and these are considered in detail below.
THE FIVE ELEMENTS
An asset is defined as a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.
Assets are presented on the statement of financial position as being non-current or current. They can be intangible, that is, without physical presence – for example, goodwill. Examples of tangible assets include property plant and equipment and inventory.
While most assets will be both controlled and legally owned by the entity it should be noted that legal ownership is not a prerequisite for recognition, rather it is control that is the key issue. For example IFRS 16, Leases, with regard to a lessee, is consistent with the Framework’s definition of an asset. IFRS 16 requires that the lessee should recognise a leased asset on the statement of financial position in respect of the benefits that it controls, even though the asset subject to the lease is not the legally owned by the lessee. So this reflects that from lessee‘s perspective the economic reality of a lease is a loan to buy an asset, and so the accounting is a faithful presentation.
A liability is defined as a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.
Liabilities are also presented on the statement of financial position as being non-current or current. Examples of liabilities include trade payables, tax payable and loans.
It should be noted that in order to recognise a liability there does not have to be an obligation that is due on demand but rather there has to be a present obligation. Thus for example IAS 37, Provisions, Contingent Liabilities and Contingent Assets is consistent with the Framework’s approach when considering whether there is a liability for the future costs to decommission oil rigs. As soon as a company has erected an oil rig that it is required to dismantle at the end of the oil rig’s life, it will have a present obligation in respect of the decommissioning costs. This liability will be recognised in full, as a noncurrent liability and measured at present value to reflect the time value of money. The past event that creates the present obligation is the original erection of the oil rig as once it is erected the company is responsible to incur the costs of decommissioning.
Equity is defined as the residual interest in the assets of the entity after deducting all its liabilities.
The effect of this definition is to acknowledge the supreme conceptual importance of identifying, recognising and measuring assets and liabilities, as equity is conceptually regarded as a function of assets and liabilities, i.e. a balancing figure.
Equity includes the original capital introduced by the owners, i.e. share capital and share premium, the accumulated retained profits of the entity, i.e. retained earnings, unrealised asset gains in the form of revaluation reserves and, in group accounts, the equity interest in the subsidiaries not enjoyed by the parent company, i.e. the non-controlling interest (NCI). Slightly more exotically, equity can also include the equity element of convertible loan stock, equity settled share based payments, differences arising when there are increases or decreases in the NCI, group foreign exchange differences and contingently issuable shares. These would probably all be included in equity under the umbrella term of Other Components of Equity.
Income is defined as the increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.
Most income is revenue generated from the normal activities of the business in selling goods and services, and as such is recognised in the Income section of the statement of profit or loss and other comprehensive income, however certain types of income are required by specific standards to be recognised directly to equity, i.e. reserves, for example certain revaluation gains on assets. In these circumstances the income (gain) is then also reported in the Other Comprehensive Income section of the statement of profit or loss and other comprehensive income.
The reference to ‗other than those relating to contributions from equity participants‘ means that when the entity issues shares to equity shareholders, while this clearly increases the asset of cash, it is a transaction with equity participants and so does not represent income for the entity.
Again note how the definition of income is linked into assets and liabilities. This is often referred to as ‗the balance sheet approach‘ (the former name for the statement of financial position).
Expenses are defined as decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.
The reference to ‗other than those relating to distributions to equity participants‘ refers to the payment of dividends to equity shareholders. Such dividends are not an expense and so are not recognised anywhere in the statement of profit or loss and other comprehensive income. Rather they represent an appropriation of profit that is as reported as a deduction from Retained Earnings in the Statement of Changes in Equity.
Examples of expenses include depreciation, impairment of assets and purchases. As with income most expenses are recognised in the profit or loss section of the statement of profit or loss and other comprehensive income, but in certain circumstances expenses (losses) are required by specific standards to be recognised directly in equity and reported in the Other Comprehensive Income section of the statement of profit or loss and other comprehensive income. An example of this is an impairment loss, on a previously revalued asset, that does not exceed the balance of its revaluation reserve.
The recognition criteria of elements of financial statements
The Framework also lays out the formal recognition criteria that have to be met to enable elements to be recognised in the financial statements. Recognition is the process of incorporating in the statement of financial position or statement of profit or loss an item that satisfies the following criteria for recognition:
- An item that meets the definition of an element
- It is probable that any future economic benefit associated with the item will flow to or from the entity and
- The item‘s cost or value can be measured with reliability.
Recap: Application of recognition criteria
- An asset is recognised in the statement of financial position when it is probable that the future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably.
- A liability is recognised in the statement of financial position when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably.
- Income is recognised in the statement of profit or loss when an increase in future economic benefits related to an increase in an asset or a decrease of a liability has arisen that can be measured reliably.
- Expenses are recognised when a decrease in future economic benefits related to a decrease in an asset or an increase of a liability has arisen that can be measured reliably.
Measurement issues for elements
Finally the issue of whether assets and liabilities should be measured at cost or value is considered by the Framework. To use cost should be reliable as the cost is generally known, though cost is not necessary very relevant for the users as it is past orientated. To use a valuation method is generally regarded as relevant to the users as it up to date, but value does have the drawback of not always being reliable. This conflict creates a dilemma that is not satisfactorily resolved as the Framework is indecisive and acknowledges that there are various measurement methods that can be used. The failure to be prescriptive at this basic level results in many accounting standards sitting on the fence how they wish to measure assets. For example, IAS 40, Investment Properties and IAS 16, Property, Plant and Equipment both allow the preparer the choice to formulate their own accounting policy on measurement.
Measurements of elements in financial statements
The IFRS Framework acknowledges that a variety of measurement bases can be used. Examples are as follows:
- Historical cost
- Current cost (Assets are carried at the amount of cash or cash equivalents that would have to be paid if the same or an equivalent asset was acquired currently)
- Net realisable value (The amount of cash or cash equivalents that could currently be obtained by selling an asset in an orderly disposal)
- Present value (A current estimate of the present discounted value of the future net cash flows in the normal course of business)
- Fair value (As per IFRS 13)
HISTORICAL COST ACCOUNTING
The application of historical cost accounting means that assets are recorded at the amount they originally cost, and liabilities are recorded at the proceeds received in exchange for the obligation.
- Simple to understand
- Figures are objective, reliable and verifiable
- Results in comparable financial statements
- There is less possibility for manipulation by using ‘creative accounting’ in asset valuation.
- The carrying value of assets is often substantially different to market value
- No account is taken of inflation meaning that profits are overstated and assets understated
- Financial capital is maintained but not physical capital
- Ratios like Return on capital employed are distorted
- It does not measure any gain/loss of inflation on monetary items arising from the impact Comparability of figures is not accurate as past figures are not restated for the effects of inflation
FINACIAL AND PHYSICAL CAPITAL MAINTENANCE
The IASB Conceptual Framework identifies two concepts of capital:
- A financial concept of capital
- A physical concept of capital
Financial capital maintenance
A financial concept of capital is whereby the capital of the entity is linked to the net assets, which is the equity of the entity.
When a financial concept of capital is used, a profit is earned only if the financial amount of the net assets at the end of the period is greater than the net assets at the beginning of the period, adjusted of course for any distributions paid to the owners during the period, or any equity capital raised.
The main concern of the users of the financial statements is with the maintenance of the financial capital of the entity.
Assets – Liabilities = Equity
Opening equity (net assets) + Profit – Distributions = Closing equity (net assets)
Physical capital maintenance
A physical concept of capital is one where the capital of an entity is regarded as its production capacity, which could be based on its units of output.
When a physical concept of capital is used, a profit is earned only if the physical production capacity (or operating capability) of the entity at the end of the period is greater than the production capacity at the beginning of the period, adjusted for any distributions paid to the owners during the period, or any equity capital raised.
QUALITATIVE CHARACTERISTICS OF USEFUL FINANCIAL INFORMATION
They identify the types of information likely to be most useful to users in making decisions about the reporting entity on the basis of information in its financial report.
Fundamental qualitative characteristics
Relevant financial information is capable of making a difference in the decisions made by users if it has predictive value, confirmatory value, or both.
Materiality is an entity-specific aspect of relevance based on the nature or magnitude (or both) of the items to which the information relates in the context of an individual entity’s financial report.
- Faithful representation
Information must be complete, neutral and free from material error
Enhancing qualitative characteristics
Comparison with similar information about other entities and with similar information about the same entity for another period or another date.
It helps to assure users that information represents faithfully the economic phenomena it purports to represent. Verifiability means that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement
It means that information is available to decision-makers in time to be capable of influencing their decisions.
Classifying, characterising and presenting information clearly and concisely. Information should not be excluded on the grounds that it may be too complex/difficult for some users to understand
The IFRS framework states that going concern assumption is the basic underlying assumption.
RESTRUCTURING OF CONCEPTUAL FRAMEWORK BY IASB
The International Accounting Standards Board (IASB) is coming towards the end of its own renovation process on the Conceptual Framework for Financial Reporting 2010.
Chapter 1, The objective of general purpose financial reporting
The only major change to ‗Chapter 1, The objective of general purpose financial reporting‘ is that the IASB proposes the reintroduction of the term ‗stewardship‘ into the objective of general purpose financial reporting. This is a relatively minor change and a nice gentle ease-in to the process.
As many respondents to the consultation highlighted, stewardship is not a new concept. The importance of stewardship by management is inherent within the existing framework and within financial reporting, so this statement may largely be reinforcing what already exists.
Chapter 2, The reporting entity
The 2010 framework has had ‗Chapter 2, The reporting entity‘ classified as ‗to be added‘ since inception.
The major additions here relate to the description and boundary of a reporting entity. The IASB has proposed the description of a reporting entity as an entity that chooses or is required to prepare general purpose financial statements.
The proposed boundaries outline that the financial statements of a reporting entity whose boundary is based on direct control only are called unconsolidated financial statements, whereas one with direct and indirect control are called consolidated financial statements.
Whilst these have been tentatively confirmed by the IASB, the terms ‗direct‘ and ‗indirect‘ control are likely to be changed and clarified, meaning that there may still be some time before the extension is ready to be inhabited.
Chapter 3, Qualitative characteristics of useful financial information
Originally, the IASB had not planned on making any changes to ‗Chapter 3, Qualitative characteristics of useful financial information‘, but following many responses to the discussion paper, there have been some changes that have tentatively been accepted by the IASB.
Primarily, the qualitative characteristics are unchanged. Relevance and faithful representation will remain as the two fundamentals. The four enhancing qualitative characteristics will continue to be timeliness, understandability, verifiability and comparability.
However, while the qualitative characteristics remain unchanged, the IASB has tentatively decided to reinstate explicit references to prudence and substance over form.
In the Conceptual Framework for Financial Reporting 2010, these were removed. The conclusion reached was that substance over form was not considered to be a separate component of faithful representation, because it would be redundant. It was decided that representing a legal form that differed from the economic substance could not result in a faithful representation.
Whilst that statement is true, the IASB felt that the importance of the concept needed to be reinforced and so a statement has now been included outlining that faithful representation provides information about the substance of an economic phenomenon rather than its legal form.
In the 2010 framework, faithful representation was defined as information that was complete, neutral and free from error. The basis for conclusions in the 2010 framework stated that prudence was not included, as including it would be inconsistent with neutrality. However, the removal of the term led to confusion and many respondents to the IASB‘s discussion paper urged the Board to reinstate prudence.
Therefore, an explicit reference to prudence has now been included, stating that ‗prudence is the exercise of caution when making judgments under conditions of uncertainty‘.
As is often the case with a building project, making one minor change may lead to others, and everyone wants a building that is on the level. The problem with adjusting the building blocks here, even slightly, was that by adding in the reference to prudence, the IASB encountered the further issue of asymmetry.
Many standards, such as IAS 37, Provisions, Contingent Liabilities and Contingent Assets, apply a system of asymmetric prudence. In IAS 37, a probable outflow of economic benefits would be recognised as a provision, whereas a probable inflow would only be shown as a contingent asset, disclosed in the financial statements. Therefore, two sides in the same court case could have differing accounting treatments despite the likelihood of the payout being identical for either party. Many respondents highlighted this asymmetric prudence as necessary under some accounting standards and felt that a discussion of the term was required. Whilst this is true, the IASB believes that the framework should not identify asymmetric prudence as a necessary characteristic of useful financial reporting.
The IASB has tentatively decided to state that the concept of prudence does not imply a need for asymmetry, such as the need for more persuasive evidence to support the recognition of assets than liabilities. It has included a statement that such asymmetry may sometimes arise in financial reporting standards as a consequence of requiring the most useful information.
Chapter 5, Recognition and derecognition
In terms of recognition, the current framework specifies three recognition criteria that apply to all assets and liabilities:
- The item meets the definition of an asset or liability;
- It is probable that any future economic benefit associated with the asset or liability will flow to or from the entity; and
- The asset or liability has a cost or value that can be measured reliably.
The IASB has confirmed the new approach to recognition, which requires decisions to be made by reference to the qualitative characteristics of financial information. The IASB has tentatively confirmed that an entity recognises an asset or a liability (and any related income, expense or changes in equity) if such recognition provides users of financial statements with:
- Relevant information about the asset or the liability and about any income, expenses or changes in equity;
- A faithful representation of the asset or liability and of any income, expenses or changes in equity; and
- Information that results in benefits exceeding the cost of providing that information.
A key change to this is the removal of a ‗probability criterion‘. This has been removed, as different financial reporting standards apply a different criterion, with some applying ‗probable‘, some ‗virtually certain‘, some ‗reasonably possible‘. This also means that it will not prohibit the recognition of assets or liabilities with a low probability of an inflow or outflow of economic resources.
The final major change in Chapter 5 relates to derecognition. This is an area not previously covered by the framework. The IASB tentatively accepted the principles in the exposure draft relating to derecognition, namely that accounting requirements for derecognition should aim to represent faithfully both:
- The assets and liabilities retained after the transaction or other event that led to the derecognition (including any asset or liability acquired, incurred or created as part of the transaction or other event); and
- The change in the entity‘s assets and liabilities as a result of that transaction or other event.
These are some of the changes with significant work being done to many aspects of the framework.
NOTE: The revised Conceptual Framework for Financial Reporting (Conceptual Framework) issued in March 2018 is effective immediately for the International Accounting Standards Board (Board) and the IFRS Interpretations Committee. The details are included in exposure drafts at the end of these notes.
STANDARD SETTING PROCESS
The due process for developing an IFRS comprises of six stages:
- Setting the agenda
- Planning the project
- Development and publication of Discussion Paper
- Development and publication of Exposure Draft
- Development and publication of an IFRS Standard
- Procedures after a Standard is issued
International Financial Reporting Standards Foundation (IFRS Foundation)
Responsible for governance of standard setting process. It oversees, funds, appoints and monitors the operational effectiveness of:
PRINCIPLES VS RULES BASED APPROACH
Rules-based accounting system
- Likely to be very descriptive
- Relies on a series of detailed rules or accounting requirements that prescribe how financial statements should be prepared
- Considered less flexible, but often more comparable and consistent, than a principles-based system
- Can lead to looking for ‗loopholes‘
Principles-based accounting system
- It relies on generally accepted accounting principles that are conceptually based and are normally underpinned by a set of key objectives
- More flexible than a rules-based system
- Require judgment and interpretation which could lead to inconsistencies between reporting entities and can sometimes lead to the manipulation of financial statements
Because IFRSs are based on The Conceptual Framework for Financial Reporting, they are often regarded as being a principles-based system.
PREPARATION OF FINANCIAL STATEMENTS FOR COMPANIES
IAS 1 Presentation of financial statements
A complete set of financial statements comprises:
- A statement of financial position
- A statement of profit or loss and other comprehensive income
- A statement of changes in equity
- A statement of cash flows
- Accounting policies and explanatory notes
Recommended basic formats (no complex treatments included) for financial statements are as follows:
THE STATEMENT OF FINANCIAL POSITION
Statement of Financial Position as at 31 December 20X8
|Property, plant and equipment||X|
|Cash and cash equivalents||X|
|Equity and liabilities|
|Capital and reserves:|
|Other components of equity||X|
|Trade and other payables||X|
|Current tax payable||X|
|Total equity and liabilities||X|
Current assets include all items which:
- Will be settled within 12 months of the reporting date, or Are part of the entity’s normal operating cycle.
Within the capital and reserves section of the statement of financial position, other components of equity include:
- Revaluation reserve
- General reserve
STATEMENT OF CHANGES IN EQUITY
The statement of changes in equity provides a summary of all changes in equity arising from transactions with owners in their capacity as owners.
This includes the effect of share issues and dividends.
Statement of changes in equity for the year ended 31 December 20X8
|Share||Share||Revaluation Other Retained||Total|
|Balance at 31 December 20X7||X||X||X||X||X||X|
|Change in accounting policy||(X)||(X)|
|Issue of share capital||X||X||X|
|Total comprehensive income||X||X||X|
|for the year|
|Adjustment to other component of equity||X/(X)||X/(X)|
|Transfer to retained earnings||(X)||X||–|
|Balance at 31 December 20X8||X||X||X||X||X||X|
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
A recommended format for the statement of profit or loss and other comprehensive income is as follows:
Statement of profit or loss and other comprehensive income for the year ended 31 December 20X8
|Cost of sales||(X)|
|Profit from operations||X|
|Profit before tax||X|
|Income tax expense||(X)|
|Net Profit for the period||X|
|Profit for the year||X|
|Other comprehensive income|
|Gain on property revaluation||X|
|Gain/Loss on financial asset fair value through OCI||X/(X)|
|Income tax relating to components of other comprehensive income||(X)|
|Other comprehensive income for the year, net of tax||X|
|Total comprehensive income for the year||X|
IAS 16 – PROPERTY, PLANT AND EQUIPMENT
The objective of IAS 16 is to prescribe the accounting treatment for property, plant, and equipment.
Property plant and equipment are tangible assets that:
- Are held for use in the production or supply of goods or services ,for rental to others, or for administrative purposes; and
- Are expected to be used during more than one period.
Carrying amount is the amount at which an asset is recognized after deducting any accumulated depreciation and accumulated impairment losses
Depreciation is systematic allocation of the depreciable amount of assets over its useful life.
Depreciable amount is the cost of an asset less its residual value.
Residual Value is the estimated amount that an entity can obtain when disposing of an asset after its useful life has ended. When doing this the estimated costs of disposing of the asset should be deducted.
There are essentially four key areas when accounting for property, plant and equipment:
- Initial recognition and measurement
- Derecognition (disposals).
PPE are recognized if
It is probable that future economic benefits associated with the item will flow to the entity; and The cost of the item can be measured reliably.
Note: This criteria is applicable for both initial and subsequent recognition.
Aggregation and segmenting This IAS does not provide what constitute an item of property, plant and equipment and judgment is required in applying the recognition criteria to specific circumstances or types of enterprise. That is: –
- It may be appropriate to aggregate individually insignificant items, such as moulds, tools dies, etc.
- It may be appropriate to allocate total expenditure on an asset to its component parts and
- Account for each component separately e.g. an aircraft and its engines, parts of a furnace.
PPE are initially recognized at the cost.
Elements of costs comprise:
- Its purchase price
- Any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating,
- The initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located. The present value of dismantling cost will be added to the cost of asset and provision will be created and the company will have to unwind this provision at every year end. The amount will be recognized in statement of profit or loss as finance cost and provision will be increased in statement of financial position. This treatment is as the accounting for provision as per IAS 37, Provisions, Contingent Assets and Liabilities
- Directly attributable cost of bringing the assets to the location and condition necessary for the intended performance, e.g.
- Costs of employees benefits arising directly from the construction or acquisition of property, plant and equipment
- The cost of site preparation
- Initial delivery and handling costs
- Installation costs
- Cost of testing whether the asset is functioning properly after the net proceeds from the sale of any trial production (samples produced while testing equipment)
- Professional fees (architects, engineers)
- Borrowing costs in accordance with IAS 23, Borrowing Costs.
Where these costs are incurred over a period of time (such as employee benefits), the period for which the costs can be included in the cost of PPE ends when the asset is ready for use, even if the asset is not brought into use until a later date. As soon as an asset is capable of operating it is ready for use. The fact that it may not operate at normal levels immediately, because demand has not yet built up, does not justify further capitalisation of costs in this period. Any abnormal costs (for example, wasted material) cannot be included in the cost of PPE.
IAS 16 does not specifically address the issue of whether borrowing costs associated with the financing of a constructed asset can be regarded as a directly attributable cost of construction. This issue is addressed in IAS 23, Borrowing Costs. IAS 23 requires the inclusion of borrowing costs as part of the cost of constructing the asset. In order to be consistent with the treatment of ‗other costs‘, only those finance costs that would have been avoided if the asset had not been constructed are eligible for inclusion. If the entity has borrowed funds specifically to finance the construction of an asset, then the amount to be capitalised is the actual finance costs incurred. Where the borrowings form part of the general borrowing of the entity, then a capitalisation rate that represents the weighted average borrowing rate of the entity should be used. (IAS 23 discussed in detail later)
The cost of the asset will include the best available estimate of the costs of dismantling and removing the item and restoring the site on which it is located, where the entity has incurred an obligation to incur such costs by the date on which the cost is initially established. This is a component of cost to the extent that it is recognised as a provision under IAS 37, Provisions, Contingent Liabilities and Contingent Assets. In accordance with the principles of IAS 37, the amount to be capitalised in such circumstances would be the amount of foreseeable expenditure appropriately discounted where the effect is material.
Measurement of self constructed and exchanged assets
- Cost of self-constructed assets will be the cost of its production
- If an asset is exchanged, the cost will be measured at the fair value unless
- The exchange transaction lacks commercial substance or
- The fair value of neither the asset received nor the asset given up is reliably measurable. If the acquired item is not measured at fair value, its cost is measured at the carrying amount of the asset given up.
SUBSEQUENT COSTS (SUBSEQUENT RECOGNITION)
Once an item of PPE has been recognised and capitalised in the financial statements, a company may incur further costs on that asset in the future. IAS 16 requires that subsequent costs should be capitalised if:
- It is probable that future economic benefits associated with the extra costs will flow to the entity
- The cost of the item can be reliably measured.
All other subsequent costs should be recognised as an expense in the statement of profit or loss in the period that they are incurred.
MEASUREMENT SUBSEQUENT TO INITIAL RECOGNITION:
IAS 16 permits two accounting models:
- Cost Model
- Revaluation Model
Under both models, the assets are reflected in statement of financial position at carrying value.
Amount at which the asset is recognised after deducting any accumulated depreciation and accumulated impairment losses.
DEPRECIATION OF PPE
IAS 16 defines depreciation as ‗the systematic allocation of the depreciable amount of an asset over its useful life‘.
‗Depreciable amount‘ is the cost of an asset, cost less residual value, or other amount.
Depreciation is not providing for loss of value of an asset, but is an accrual technique that allocates the depreciable amount to the periods expected to benefit from the asset. Therefore assets that are increasing in value still need to be depreciated.
The depreciation method used should reflect the pattern in which the asset’s economic benefits are consumed by the entity; a depreciation method that is based on revenue that is generated by an activity that includes the use of an asset is not appropriate.
IAS 16 requires that depreciation should be recognised as an expense in the statement of profit or loss, unless it is permitted to be included in the carrying amount of another asset.
Depreciation begins when the asset is available for use and continues until the asset is derecognised, even if it is idle.
A number of methods can be used to allocate depreciation to specific accounting periods. Two of the more common methods, specifically mentioned in IAS 16, are the straight line method, and the reducing (or diminishing) balance method.
- Straight line
- % on cost, or
- Cost – residual value
Useful economic life
- Reducing balance
- % on carrying value
Useful economic lives and residual value
The assessments of the useful life (UL) and residual value (RV) of an asset are extremely subjective. They will only be known for certain after the asset is sold or scrapped, and this is too late for the purpose of computing annual depreciation. Therefore, IAS 16 requires that the estimates should be reviewed at the end of each reporting period. If either changes significantly, then that change should be accounted for over the remaining estimated useful economic life.
If an asset comprises two or more major components with different economic lives, then each component should be accounted for separately for depreciation purposes and depreciated over its own useful economic life.
An item of PPE shall not be carried at more than recoverable amount. Recoverable amount is the higher of an asset’s fair value less costs to sell and its value in use (Discussed in detail later).
MODELS FOR SUBSEQUENT MEASUREMENT
The asset is carried at cost less accumulated depreciation and impairment.
The asset is carried at a revalued amount, being its fair value at the date of revaluation less subsequent depreciation and impairment, provided that fair value can be measured reliably.
The change from cost model to revaluation model is a change in accounting policy but is dealt with prospectively.
If the revaluation policy is adopted this should be applied to all assets in the entire category, i.e. if you revalue a building, you must revalue all land and buildings in that class of asset. Revaluations must also be carried out with sufficient regularity so that the carrying amount does not differ materially from that which would be determined using fair value.
Revalued assets are depreciated in the same way as under the cost model.
Accounting for a revaluation
There are a series of accounting adjustments that must be undertaken when revaluing a non-current asset. These adjustments are indicated below.
The initial revaluation
You may find it useful in the exam to first determine if there is a gain or loss on the revaluation with a simple calculation to compare:
Carrying value of non-current asset at revaluation date X
Valuation of non-current asset X
Difference = gain or loss revaluation X
Gain on revaluation should be credited to other comprehensive income and accumulated in equity under the heading “revaluation surplus” unless it represents the reversal of a revaluation decrease of the same asset previously recognized as an expense, in which case it should be recognized as income.
- Dr Non-current asset cost (difference between valuation and original cost/valuation)
- Dr Accumulated depreciation (with any historical cost accumulated depreciation)
- Cr Revaluation reserve (gain on revaluation)
A loss on revaluation should be recognized as an expense to the extent that it exceeds any amount previously credited to the revaluation surplus relating to the same asset.
A revaluation loss should be charged against any related revaluation surplus to the extent that the decrease does not exceed the amount held in the revaluation reserve in respect of the same asset. Any additional loss must be charged as an expense in the income statement.
- Dr Revaluation reserve (to maximum of original gain)
- Dr Statement of profit or loss (any residual loss)
- Cr Non-current asset (loss on revaluation)
The asset must continue to be depreciated following the revaluation. However, now that the asset has been revalued the depreciable amount has changed. In simple terms the revalued amount should be depreciated over the assets remaining useful economic life.
The depreciation charge on the revalued asset will be different to the depreciation that would have been charged based on the historical cost of the asset. As a result of this, IAS 16 permits a transfer to be made of an amount equal to the excess depreciation from the revaluation reserve to retained earnings.
Double entry: Dr Revaluation reserve Cr Retained earnings
This movement in reserves should also be disclosed in the statement of changes in equity.
In the exam make sure you pay attention to the date that the revaluation takes place. If the revaluation takes place at the start of the year then the revaluation should be accounted for immediately and depreciation should be charged in accordance with the rule above.
If however the revaluation takes place at the year-end then the asset would be depreciated for a full 12 months first based on the original depreciation of that asset. This will enable the carrying amount of the asset to be known at the revaluation date, at which point the revaluation can be accounted for.
A further situation may arise if the examiner states that the revaluation takes place mid-way through the year. If this were to happen the carrying amount would need to be found at the date of revaluation, and therefore the asset would be depreciated based on the original depreciation for the period up until revaluation, then the revaluation will take place and be accounted for. Once the asset has been revalued you will need to consider the last period of depreciation. This will be found based upon the revaluation rules (depreciate the revalued amount over remaining useful economic life). This will be the most complicated situation and you must ensure that your working is clearly structured for this; i.e. depreciate for first period based on old depreciation, revalue, then depreciate last period based on new depreciation rule for revalued assets.
Property, plant and equipment should be derecognised when it is no longer expected to generate future economic benefit or when it is disposed of.
When property, plant and equipment is to be derecognised, a gain or loss on disposal is to be calculated. This can be found by comparing the difference between:
Carrying value X
Disposal proceeds X
Profit or loss on disposal X
When the disposal proceeds are greater than the carrying value there is a profit on disposal and when the disposal proceeds are less than the carrying value there is a loss on disposal.
Remove the asset from statement of financial position when disposed of or abandoned. Recognize any resulting gain or loss in the statement of profit or loss.
Disposal of previously revalued assets
When an asset is disposed of that has previously been revalued, a profit or loss on disposal is to be calculated (as above). Any remaining surplus on the revaluation reserve is now considered to be a ‗realised‘ gain and therefore should be transferred to retained earnings as:
- Dr Revaluation reserve
- Cr Retained earnings