Non current assets – IFRS roadmap.
Athens, August 2016
Chris Ragkavas, BA, MA, FCCA, CGMA
IFRS technical expert, financial consultant.
There is hardly any practitioner or auditor immune to the realm of non current assets (henceforth NCAs). Accountancy candidates are sometimes overwhelmed by the fact that the same piece of property’s treatment may be governed by more than one financial reporting standards. Whereas the concerns are understandable, the reason why this happens is because each standard deals with its own “part of the deal” of a transaction.
The purpose of this article is to clarify a series of issues related to the recognition and treatment of NCAs based on the nature of the transaction and the party in whose financial statements this transaction is recognized. It is not an exhaustive article on NCAs, however I refer to all material aspects deemed necessary to gain an insight into the mechanics of the mainstream transactions of which NCAs are a part.
The element of cost
All NCAs are initially recognized at cost. If purchased and not self-constructed, cost is most probably their fair value. Notwithstanding that, this fair value for the buyer is its cost. There are some slight differences amongst standards dealing with NCAs as to what constitutes cost of a NCA, however the general guidelines are that it includes:
Purchase price including import duties and non-refundable purchase taxes, less trade discounts and rebates. Early settlement discounts are recognized as a periodic income and are not deducted from the cost of the asset.
Any other directly attributable costs of bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management as electrical installations, site preparation, initial delivery and handling.
Any subsequent costs that increase the expected economic benefits expected to flow into the entity, are capitalized. These would be material expenditure incurred to either prolong the expected useful life of an asset, or enhance the economic benefits during the original expected useful life.
The element of fair value
As we will see later on, in some cases, NCAs may be subsequently measured at fair value. Since 2013, IFRS 13 Fair value measurement provides the framework for defining fair value whenever fair value is referred to, in individual standards. Fair value is defined as “the price that would be received to sell an asset or paid to transfer a liability in an orderly (previously referred to as “arm’s length”) transaction between market participants at the measurement date.
In order to calculate fair value, entities must use a range of inputs:
Level 1 inputs
These are quoted (unadjusted) prices in active markets for identical assets, which the entity can access at the measurement date.
Level 2 inputs
Inputs other than quoted prices included in Level 1, which are observable for the asset, either directly or indirectly, e.g. quoted prices for similar assets in active markets.
Level 3 inputs
Unobservable inputs for the asset should be used to the extent that observable inputs are not available. For a cash generating unit, this would be a cash flow forecast developed using the entity’s own data, provided there is no reasonably available information that indicates that market participants would use different assumptions.
We will now refer to a range of standards referring to NCAs.
Owner occupied properties, plant and equipment
IAS 16, Property plant & equipment is applicable.
Once the asset meets the definition of an element and has a cost that can be measured reliably, the entity must recognize it. These would be owner occupied properties, or other forms of tangible non-current assets (NCAs) held by an entity for use in the production or supply of goods or services, or for administrative purposes.
Cost is defined as the amount of cash or cash equivalents paid or the fair value of other consideration given to acquire an asset at the time of its acquisition or construction, or, the amount attributed to that asset when initially recognized in accordance with the specific requirements of other IFRSs (e.g. IFRS 2 Share based payments).
Cost elements have been referred to, above. In addition, for owner occupied NCAs, the entity should include where applicable:
The initial estimate of dismantling and removing the item and restoring the site on which it is located. The present value of these costs is recognized as part of the non-current asset and a corresponding provision is recognized for the same amount. Any subsequent amendments in the estimated value of the future obligation are applied prospectively and any difference is also duly recognized in the value of the non-current asset and the provision. This is a typical example where more than one standards are combined in the same transaction: IAS 16 related to the non current asset side of the entry, IAS 37 Provisions contingent liabilities and contingent assets related to the provision side of the entry, and IAS 8 Accounting policies, changes in accounting estimates and errors, stating that changes in estimates be treated prospectively.
Allowable subsequent measurement of the NCA according to IAS 16 is either based on historic cost or on revaluation (fair value).
The entity should apply the same model for subsequent measurement to all assets of each class. So an airline owning both cargo (Class 1) and passenger (Class 2) aircrafts, should apply the cost or revaluation model to all aircrafts belonging to each class.
When an entity applies the revaluation model to a class of assets, the fair value of each asset is determined individually and the corresponding upward revaluations or impairments are recognized per asset. This means that losses in one asset may not be offset against gains in another asset, with the purpose of avoiding the recognition of the losses. In the financial statements, gains and losses of all NCAs are presented as a total in the Statement of Profit or Loss and/or under Other Comprehensive Income. You need to consult the IAS 16 specific guidelines, for further reference.
Irrespective of the model used, all NCAs under IAS 16 are subject to impairment testing, i.e. if the recoverable amount is lower than the carrying value at each reporting date, a corresponding impairment loss/reduction of revaluation gains is recognized. For NCAs carried at history cost, the recoverable amount is always the higher of fair value less costs to sell and value in use. For NCAs carried at fair value, the fair value at the measurement date is compared to the carrying value and any differences are duly recognized.
Value in use is the sum of discounted relevant cash flows expected to flow into the entity from the continuing use of the asset.
Entities must consider at the end of each reporting period if there are any indications of impairment. Indications of impairment may be internal or external.
Examples of internal indicators are obsolescence, physical damage, or the fact that the asset is idle for a long period.
Examples of external indicators are increased market rates affecting the present value of the cash flows to be derived from the use of the asset, comparison of the fair value of the asset with similar assets in the market.
IAS 16 states that an asset is depreciated over its expected useful life, i.e. a systematic allocation of expensing must occur to match the economic benefits of the asset with the part of its value being consumed to obtain these economic benefits. Any changes in the expected useful life of an asset or its depreciation method, are applied prospectively, based on IAS 8.
IAS 40 Investment property
Investment property is defined as being property (land, building, or both) held by the owner or by the lessee under a finance lease, to earn rentals, for capital appreciation or both, rather than for:
Use in the production or supply of goods or services or for administrative purposes, or;
Sale in the ordinary course of business.
Items within the scope of IAS 40, are therefore:
Land held for long-term capital appreciation rather for short-term sale in the ordinary course of business;
Land held for a currently undetermined future use; it is regarded as being held for capital appreciation;
A building owned or held under a finance lease by an entity and leased out under operating lease(s);
A vacant building that is being held to be leased out under an operating lease(s);
Property that is being constructed or developed for future use as an investment property;
Items outside the scope of IAS 40 are :
Owner occupied property, where IAS 16 Property plant and equipment, applies;
Property that is held for sale in the ordinary course of business or is under construction for that purpose, where IAS 2 Inventories, applies;
Property leased under a finance lease to another entity, where IAS 17 Leases applies.
Investment properties are initially recognized at cost. Investment property is recognized as a tangible non current asset, when:
Its is probable that the future economic benefits that are associated with the investment property will flow into the entity; and
The cost of the investment property can be measured reliably.
There is a rebuttable presumption that the fair value of an investment property can be measured reliably. Investment properties should therefore be measured at fair value. If the property is measured upon commencement of operation at fair value, the entity must continue to its measurement at fair value until de-recognition or reclassification. There is no justification to withdraw from this measurement principle, even when comparable market transactions or market prices that would both assist in arriving at the fair value of the property become less readily available during the life of the investment property.
Movements in fair value are recognized in the statement of profit or loss, and investment properties measured at fair value are not subject to depreciation.
When fair valuing an investment property, the entity should ensure that it reflects among other things, rental income from current leases, and other assumptions that market participants would use when pricing the investment property under current market conditions [IAS 40:40].
In exceptional cases, when an investment property is initially acquired, constructed or reclassified as such, there may be clear evidence that its fair value is not readily measurable on a continuing basis. In this case, that particular investment property, is measured using the cost model as described under IAS 16 Property, plant and equipment.
IAS 2 Inventories
Any non-current asset, which is purchased or constructed with the sole purpose of being sold in the ordinary course of business, is subject to IAS 2 Inventories.
It should be obvious that entities manufacturing cars, buildings, machineries, treat these elements as inventories. They are meant to be sold in the ordinary course of business, and are therefore current assets.
Self-constructed NCAs, which are inventories, are recognized at cost during the construction period. Naturally, purchased NCAs, which are inventories, are recognized at purchased cost, please look at the beginning of the article for more information regarding the element of cost.
Post manufacturing/construction or purchase, they are carried at the lower of cost and net realizable value.
No revaluation gains should be recognized on these assets, as it is never justified to recognize prematurely gains on assets, which are meant to be sold in the ordinary course of business.
Impairment losses however should be recognized immediately once they are determined. An entity recognizing an asset as inventory at cost, claims that the future economic benefits to flow into the entity by selling the asset as part of its ordinary business are at least its cost. If there are any indicators that this is not the case, the entity must recognize immediately impairment losses, which are the difference between the asset’s net realizable value and its cost. Net realizable value is defined as “the estimated selling price in the ordinary course of business less the estimated costs of completion and estimated costs necessary to make the sale”.
Assuming entity A is a developer constructing properties to be sold in its ordinary course of business. Properties are recognized at cost during the construction period, based on IAS 2 rules, as regular inventory. Generally speaking directly attributable costs must be included in the cost of the property, i.e. purchase, conversion and other relevant costs. In IAS 2, there are some deviations from the general cost rules as explained so far, related to overhead absorption. [Based on IAS 2, cost includes a systematic allocation of fixed and variable overheads, whereas under IAS 16 (self-constructed NCAs) such an allocation is not permissible. Any additional details on this matter are beyond the scope of this article].
Once B buy the property, they will recognize it as a NCA (IAS 16) or Investment property (IAS 40). The same goes for cars, machinery, etc. A recognize them at cost as inventories, B upon purchase, as NCAs.
IFRS 15 Revenue from contracts with customers
If however, a NCA, let’s say a property, is constructed by A based on an order placed by B, it is very likely that this transaction is subject to IFRS 15, Revenue from contracts with customers. This means that it is very likely that A will not recognize the property as inventory and de-recognize it only on disposal to B. Οn the contrary, A gradually recognize the revenue and related costs incurred in order to complete the building, during the construction period.
A will gradually recognize revenue and related expenses during the construction period if any of the below mentioned criteria are met:
A’s performance creates or enhances an asset that the B controls (see below) as the asset is created or enhanced.
A’s performance does not create an asset with an alternative use to A and A has an enforceable right to payment for performance completed to date.
As for 1, control is deemed to exist when B, can do any of the following with the property A construct:
Using it to produce goods or render services;
Using it to enhance the value of other assets;
Selling or exchanging it;
Pledging the asset to secure a loan.
As for 2, it should be straightforward that provided A can not use the property at stake for any other purpose, e.g. direct it to another customer should B decline the contract and A is contractually entitled to payment for work performed to date, as in 1 above, A gradually recognize revenue and expenses related to the construction of the property.
If neither 1 nor 2 apply, then A will recognize the property as inventory based on IAS 2 and recognize revenue and cost of sales on disposal of the property to B.
Queries, comments, are welcome at [email protected]