ACCA financial reporting F7LSBF TEXT f7 section 2

• Where the revaluation model is applied, it must be applied consistently to all assets in the same class, andthe valuation must be kept sufficiently up to date so that it is not signifi

Tangible Non-Current

Assets

FINANCIAL REPORTING (INTERNATIONAL)

TANGIBLE NON-CURRENT ASSETS

• Borrowing costs relating to non-current assets

• Government grants (which may or may not relate to the purchase of non-current assets), and

• Investment properties – a particular type of non-current asset which has its own accounting rules

Exam Hints

This area of the syllabus is examined either as part of the published accounts question (Q2) or in its ownright within question 4 or 5 of the paper

Key Learning Points

IAS 16 Property, Plant and Equipment

• A tangible non-current asset is initially recorded at cost which may include: purchase price after any tradediscounts, transport and handling costs, non-refundable tax such as import duties, site preparation, installationcosts,professional fees,labour costs of the entity’s own employees (Where asset is self constructed),borrowingcosts, future dismantling and restoration costs

• Any abnormal costs such as wastage and costs arising from errors do not form part of the cost of the asset,and must be expensed as incurred

• Subsequent expenditure on a non-current asset may be capitalised where it enhances the economic benefits

of the asset in excess of its current standard of performance

• A complex asset is one which is made up of several constituent parts, each with a different useful life Eachpart of the complex asset is depreciated over its useful life and, after this time, the cost of the replacementpart is capitalised

• Where the useful life or residual value of an asset changes, the change is applied on a prospective basis

• A change in the method of depreciation is allowed only where the new method is more appropriate Thechange is applied prospectively

• IAS 16 allows non-current assets to be measured using either the cost model or the revaluation model

• Where the revaluation model is applied, it must be applied consistently to all assets in the same class, andthe valuation must be kept sufficiently up to date so that it is not significantly different from fair value

• An upwards revaluation is credited to other comprehensive income (other than where it reverses a previousdownwards revaluation recognised in the income statement)

• A downwards revaluation is charged to the income statement (other than where it reverses a previousupwards revaluation recognised in other comprehensive income)

• Depreciation is charged on a revalued asset as normal, based on a depreciable amount of valuation lessresidual value spread over the remaining useful life

• A reserves transfer may be made to transfer the difference between the actual depreciation charge and thehistorical cost depreciation charge from the revaluation reserve to retained earnings

• Where a previously revalued asset is disposed of, any balance remaining in the revaluation reserve relating

to this asset is transferred to retained earnings and disclosed in the statement of changes in equity

IAS 23 Borrowing Costs

• IAS 23 requires that borrowing costs associated with the acquisition, construction or production of aqualifying asset are be capitalised as part of the cost of that asset

• Interest related to specific borrowings is capitalised net of income generated by the investment of surplusfunds

• Interest related to general borrowings is capitalised based on the amount of borrowings used on thequalifying asset and the weighted average cost of general borrowings

• Capitalisation commences when expenditure is being incurred on the asset, borrowing costs are beingincurred and activities to prepare the asset for its intended purpose are in progress

• Capitalisation ceases when substantially all the activities necessary to prepare the qualifying asset for itsintended use or sale are complete

• Capitalisation is suspended when work on the asset is suspended

IAS 20 Accounting for Government Grants and Disclosure of Government Assistance

• A grant is recognised in the financial statements only when there is reasonable assurance that:

o The entity will comply with the conditions attached to the grant, and

o The grants will be received

• A revenue grant is held as deferred income and released to the income statement over the period in whichthe related expenditure is incurred

• A capital grant is either :

o netted off against the cost of the asset with the net amount spread over the asset’s useful life andcharged to the income statement as depreciation; or

o held as deferred income and released to the income statement over the useful life of the asset

• Grants which relate to costs already incurred should be recognised in the income statement in the period

in which they become receivable

IAS 40 Investment Property

• Investment properties are defined as property (land or a building – or part of a building – or both) held toearn rentals or for capital appreciation or for both rather than for use or sale in the ordinary course ofbusiness

• They are accounted for according to either the cost model of IAS 16 or the fair value model of IAS 40

• Where the cost model is applied, investment property is held at cost less depreciation It is not revalued

• Where the fair value model is applied, investment property is re-measured to fair value each year with anychanges in fair value recognised in the income statement It is not depreciated

Relevant Accounting Standards

IAS 16 Property, Plant and EquipmentIAS 23 Borrowing Costs

IAS 20 Accounting for Government Grants and Disclosure of Government AssistanceIAS 40 Investment Property

Technical Articles

The following article (in two parts) explains property, plant and equipment and is available on ACCA’s website.http://www.accaglobal.com/pubs/students/publications/student_accountant/archive/robins0607.pdf

http://www.accaglobal.com/pubs/students/publications/student_accountant/archive/sa_aug07_robins.pdfFINANCIAL REPORTING (INTERNATIONAL)

1 Introduction

Tangible non-current assets is one of the biggest balances in the statement of financial position Although IAS

16 Property, Plant and Equipment is the main accounting standard which provides guidance on this topic, othersare also relevant:

IAS 23 Borrowing Costs provides rules as to when borrowing costs should be capitalised as part of the

cost of a non-current asset

IAS 20 Accounting for Government Grants and Disclosure of Government Assistance

considers how support received from the government, and often related to the purchase of non-current assets,should be reflected in the financial statements

IAS 40 Investment Properties provides specific guidance on how to account for properties held only

for investment purposes rather than to use within a business

2 IAS 16 Property, Plant and Equipment

Property, plant and equipment (PPE) is defined as:

Tangible items that:

(a) are held for use in the production or supply of goods or services, for rental to others, or for administrative purposes; and

(b) are expected to be used during more than one period.

IAS 16 requires that PPE is shown in the statement of financial position at its carrying value, defined as:

The amount at which an asset is recognised after deducting any accumulated depreciation and any accumulated impairment losses.

IAS 16 provides guidance on the calculation of an asset’s carrying value, and in particular:

1 the initial measurement of PPE, and treatment of any subsequent expenditure

2 the depreciation of PPE

3 the revaluation of PPE

4 the disposal of PPE

Guidance on accounting for impairments is provided in IAS 36 This is covered in detail in chapter 7

2.1 TANGIBLE NON-CURRENT ASSETS: MEASUREMENT

2.1.1 INITIAL MEASUREMENT

A tangible non-current asset is initially recorded at cost This may include:

• purchase price after any trade discounts (but before settlement discounts)

• transport and handling costs

• non-refundable tax such as import duties

• site preparation

• installation costs

• professional fees such as legal costs

• If the asset is self-constructed, labour costs of the entity’s own employees

• Borrowing costs (see section 3 of this chapter)

• Future dismantling and restoration costs

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FINANCIAL REPORTING (INTERNATIONAL)

$100,000/1.0510 = $61,391

The debit entry is to the non-current asset cost account, such that the total cost of the research centre is:

$Building cost 250,000Restoration cost 61,391

311,391Each year, the discount is unwound, and recorded as interest:

Year 1 $61,391 x 5% = $3,070

Dr Interest expense $3,070

Cr Provision $3,070The measurement of the non-current asset is not affected by the unwinding of the discount

Any abnormal costs such as wastage and costs arising from errors do not form part of the cost of the asset,and must be expensed as incurred

Exam Hint

In December 08, 7 marks were available for discussion of the treatment of a non-current asset and futureclean up costs.The examiner reported that common problems were:

- failure to include the clean up costs as part of the cost of the asset

- failure to discount the clean up costs

Even more common was a failure by those candidates who had discounted the clean up costs to unwind thediscount and arrive at a finance cost

In a different question on the same exam paper, 10 marks were available for the production of extracts offinancial statements relating to a non-current asset over 3 years The examiner commented that a number ofcandidates calculated the initial cost of the asset wrongly because they deducted a settlement discount fromcost This amount should have been recorded as income

The initial measurement of non-current assets may also appear in the published company accounts question(Q2), as it did in December 07

2.1.2 SUBSEQUENT COSTS

Subsequent expenditure on a non-current asset may be capitalised where:

• The expenditure enhances the economic benefits of the asset in excess of its current standard of performance

TANGIBLE NON-CURRENT ASSETS

• A component of an asset is treated separately for depreciation purposes and is replaced or restored

• A major overhaul restores the asset and the cost of previous overhauls have been reflected in pastdepreciation charges

Any other subsequent expenditure, including repairs, must be expensed to the income statement in the period

in which it is incurred

Learning Example 5.1

Broadoak has recently purchased an item of plant from Plantco The details of this are:

$Basic list price of plant 240,000Trade discount applicable to Broadoak 12.5% on list priceAncillary costs:

Shipping and handling 2,750Estimated pre-production testing 12,500Maintenance contract for 3 years 24,000Site preparation costs:

Electrical cable installation 14,000Concrete reinforcement 4,500

Broadoak paid for the plant (excluding the ancillary costs) within four weeks of order, thereby obtaining anearly settlement discount of 3%

Broadoak had incorrectly specified the power loading of the original electrical cable to be installed by thecontractor The cost of correcting this error of $6,000 is included in the above figure of $14,000

The plant is expected to last for 10 years At the end of this period there will be compulsory costs of $15,000

to dismantle the plant and $3,000 to restore the site to its original use condition

Calculate the amount at which the initial cost of the plant should be measured, ignoring discounting

2.2 TANGIBLE NON-CURRENT ASSETS: DEPRECIATION

Depreciation is:

The systematic allocation of the depreciable amount of an asset over its useful life.

The depreciable amount is:

The cost of an asset, or other amount substituted for cost, less its residual value.

2.2.1 METHODS OF DEPRECIATION

There are two key methods of depreciation, both of which are examined frequently:

1 the straight line method

2 the reducing balance method

Straight Line Method

This method results in a constant annual charge over the asset’s useful life It is calculated asCost – residual value

Useful life

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Reducing Balance Method

This method results in a decreasing annual charge over the asset’s useful life It is appropriate for assets such asmotor vehicles and IT equipment which provide greater benefit in earlier years

In both cases, depreciation is charged from the time that the asset becomes available for use in the normalmanner (even if it is not yet being used)

Note: Telenorth has the following depreciation policy:

Leasehold building – straight line over lease termPlant and equipment – five years straight line with residual values estimated at $5mComputer system – 40% per annum reducing balance

Depreciation of the leasehold building and plant is treated as cost of sales; depreciation of the computersystem is an administration cost

Calculate the depreciation charge and amounts to be included in the statement of financial position for theyear ended 31 September 20X8

2.2.2 DEPRECIATION OF COMPLEX ASSETS

Complex assets are those which are made up of various component parts, each of which has a differentuseful life

In this case, each part of the complex asset is treated separately for depreciation purposes The part isdepreciated over its useful life and, after this time, the cost of the replacement part is capitalised

2.2.3 CHANGE IN DEPRECIATION ESTIMATES

IAS 16 requires that the residual value and useful life of an asset is reviewed at least at each financial year-end,together with the depreciation method applied to the asset

If the residual value or useful life has changed, or the depreciation method applied to the asset is no longerappropriate to the pattern of consumption of economic benefits associated with the asset, then these arechanged

The change in estimate is applied to the carrying value of the asset on the date of the change on a prospectivebasis No adjustment is required to previously reported amounts

TANGIBLE NON-CURRENT ASSETS

Learning Example 5.3

Addingham has owned a non-current asset for 5 years, depreciating the cost of $40,000 on a straight linebasis over 20 years The company has conducted a review of its assets and now believes the asset to have aremaining useful life of 12 years, and a scrap value at the end of that life of $800

What is the old and new depreciation charge?

2.3 TANGIBLE NON-CURRENT ASSETS: REVALUATION

IAS 16 allows non-current assets to be measured using either the cost model or the revaluation model Wherethe revaluation model is applied, the carrying value of a non-current asset is

$000

Accumulated depreciation (X)Impairment losses (X)

XThe standard requires that where the revaluation model is applied:

o It is applied consistently to all assets of a class of property, plant and equipment

o Assets are revalued sufficiently regularly that their carrying amount is not significantly different fromtheir fair value

2.3.1 ACCOUNTING FOR A REVALUATION

Upwards Revaluation

Where an asset is revalued upwards, this is accounted for by:

Dr Non-current asset the difference between cost and

of the asset prior to revaluation and its revalued amount

Downwards Revaluation

Where an asset is revalued downwards, the accounting entries depend on whether the asset has previouslybeen revalued upwards:

Not previously revalued upwards Previously revalued upwards

Dr Income statement Dr Other comprehensive income (to extent revaluation

Cr Non-current asset surplus exists in relation to the asset)

Dr Income statement

Cr Non-current assetWhere an asset has been revalued downwards and is subsequently revalued upwards, the revaluation surplus iscredited to the income statement to the extent that the downwards revaluation was previously chargedagainst profit or loss

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2.3.2 DEPRECIATION OF A REVALUED ASSET

Depreciation is charged on a revalued asset as normal, based on a depreciable amount of valuation less residualvalue spread over the remaining useful life

Depreciation is charged to the income statement, but a reserves transfer may be made to transfer the differencebetween the actual depreciation charge and the historical cost depreciation charge from the revaluation reserve

to retained earnings:

Dr Revaluation reserve excess depreciation

Cr Retained earnings excess depreciation

Learning example 5.4

Allisterco buys property on 1 January 20X1 at a cost of $400,000, and commences depreciation on the basis

of 5% straight line On 31 December 20X4, the property is revalued to $750,000 Depreciation continues to

be charged over the remaining useful life of 21 years

On 31 December 20X8, the property is sold for $780,000

Prepare extracts from the statements of changes in equity and statement of comprehensive income for theyear ended 31 December 20X8

Exam hint

The published accounts questions (Q2) in the December 07, June 08 and December 08 exam papers allincluded a revaluation which had not yet been accounted for After each of these sittings, the examinercommented that many candidates had accounted for the revaluation as though it had arisen at the start ofthe period, even though the question clearly stated that it had occurred at the end If the question statesthat a revaluation occurs at the end of an accounting period, ensure that you charge depreciation for theyear before revaluing the asset

2.4 TANGIBLE NON-CURRENT ASSETS: DISPOSAL

The gain or loss on disposal of a non-current asset is calculated as the difference between proceeds and theasset’s carrying value on the date of disposal

This applies to assets held under both the cost and revaluation model

Any resulting gain or loss on disposal is recognised in the income statement

Where a previously revalued asset is disposed of, any balance remaining in the revaluation reserve relating tothis asset is transferred to retained earnings and disclosed in the statement of changes in equity

Learning Example 5.5

Hunt buys a building on 1 March 20X4 costing $500,000 It is depreciated monthly on a straight line basisover 40 years On 31 December 20X8, Hunt carries out a revaluation exercise and assesses the fair value

of the building to be $640,000, and its remaining useful life to be 38 years

How is the building reflected in the financial statements of Hunt for the year ended 31 December 20X8?FINANCIAL REPORTING (INTERNATIONAL)

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2.5 TANGIBLE NON-CURRENT ASSETS: DISCLOSURE

The standard disclosure note required by IAS 16 is sometimes required within a question Even where this isnot the case, it often provides a useful layout for workings

Land and Fixtures and Plant and TotalBuildings Fittings Machinery $000

The land and buildings were revalued by a qualified surveyor on 31 December 20X8 They are being depreciated

on a straight line basis over 20 years

3 IAS 23 Borrowing Costs

IAS 23 requires that borrowing costs associated with the acquisition, construction or production of a qualifyingasset are be capitalised as part of the cost of that asset

Borrowing costs are defined as:

interest and other costs that an entity incurs in connection with the borrowing of funds.

A qualifying asset is defined as:

an asset that necessarily takes a substantial period of time to get ready for its intended use or sale.

3.0.1 ELIGIBLE BORROWING COSTS

Where an entity borrows money specifically to acquire or construct a qualifying asset, all of the actual borrowingcosts incurred, less any income from the temporary investment of the money borrowed, must be capitalised

Where money is borrowed centrally from a number of sources, and to fund a number of projects, the borrowingcosts to be capitalised as part of the cost of a non-current asset must be calculated based on the weightedaverage cost of general borrowings

3.0.2 PERIOD OF CAPITALISATION

The capitalisation of borrowing costs commences when:

o Expenditure on the asset has commenced, and

o Borrowing costs are being incurred, and

o Activities necessary to prepare the asset for its intended use are in progress

The capitalisation of borrowing costs ceases when substantially all the activities necessary to prepare thequalifying asset for its intended use or sale are complete

If construction of the asset is suspended due to industrial action, for example, then the capitalisation ofborrowing costs is also suspended

Learning Example 5.6

MurphyCo commences building a new head office on 1 May 20X7 The project is anticipated to cost

$400,000 which MurphyCo believes can be financed from reserves On 1 October 20X7 it becomes apparentthat a loan is required to finance the project and $350,000 is advanced from the Northern Bank at a rate of4% Half of this is invested in an interest bearing account at a rate of 2.5% until it is required on 1 May 20X8.Building commences throughout the year ended 31 December 20X8, although work is forced to stoptemporarily for the month of February due to inclement weather At 31 December 20X8, it is anticipatedthat there are a further two months of work before the building is complete

What borrowing costs must be capitalised in the years ended 31 December 20X7 and 20X8?

3.0.3 DISCLOSURE OF BORROWING COSTS

The following should be disclosed in relation to borrowing costs:

o The amount of borrowing costs capitalised during the period

o The capitalisation rate used to determine the amount of borrowing costs eligible for capitalisation

4 IAS 20 Accounting for Government Grants and Disclosure of Government Assistance

Government grants are monetary amounts paid to a business by the authorities in return for meeting certainconditions such as employing a certain number of people

They may be categorised as either:

o Capital grants i.e those grants which are made to contribute towards the acquisition of an asset

o Revenue grants i.e those grants which are made for other purposes such as the payment of wages4.0.1 RECOGNITION OF GOVERNMENT GRANTS

A grant is recognised in the financial statements only when there is reasonable assurance that:

o The entity will comply with the conditions attached to the grant, and

o The grants will be receivedThe grant should be recognised in the income statement in the period in which the expenditure towardswhich it was intended to contribute is recognised

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4.0.2 ACCOUNTING FOR REVENUE GRANTS

The receipt of a revenue grant is recorded by:

Dr Cash

Cr Deferred income (liability)The grant held as deferred income is then released to the income statement over the period in which therelated expenditure is incurred:

o Revenue grants which are made to subsidise specific expenditure are recognised in the income statement

in the period in which that expenditure is recognised

o Revenue grants which are made to held achieve a non-financial goal are recognised in the incomestatement in which the costs of meeting that goal are recognised

The credit to the income statement may be:

o presented as a separate item of income; or

o deducted from the related expense which is then shown net

4.0.3 ACCOUNTING FOR CAPITAL GRANTS

IAS 20 allows two treatments with regard to the recognition of a capital grant:

1 Deduct grant from cost of the non-current 2 Record grant separately as deferredasset to which it relates income

Cr Non-current asset Cr Deferred income

Depreciate the net cost of the non-current Release the deferred income to the incomeasset over its useful life statement over the useful life of theTherefore both the grant and the full cost of non-current asset.

the non-current asset are spread over theuseful life of the asset

Note that where the grant is recognised as deferred income in the statement of financial position, this amountwill be split between current and non-current liabilities

4.0.4 GRANTS TO REIMBURSE PREVIOUSLY INCURRED COSTS

Grants which relate to costs already incurred should be recognised in the income statement in the period inwhich they become receivable

4.0.5 DISCLOSURE OF GOVERNMENT GRANTS

IAS 20 requires disclosure of the following in relation to government grants:

o The accounting policy adopted for government grants including methods of presentation in the financialstatements

o The nature and extent of government grants recognised in the financial statements

Learning Example 5.7

BrownCo is entitled to receive a grant of $30,000 on the condition that it is used to cover part of the cost ofthe purchase of new safety equipment The equipment is purchased on 1 December 20X8 at a cost of $55,000

It is expected to have a useful life of 10 years after which it will require replacing

Prepare extracts from BrownCo’s financial statements for the year ended 30 June 20X9 using both of thepermitted treatments under IAS 20 and comment on which is most useful to the users of financial statements

5 IAS 40 Investment Property

Investment properties are defined as:

Property (land or a building – or part of a building – or both) held to earn rentals or for capital appreciation or for both rather than for use or sale in the ordinary course

of business.

The definition would therefore include:

o Land held for a currently undetermined future use

o A building leased out under an operating lease

o Land held long term in order to benefit from an increase in market value

It also includes property which is currently under construction but will be used in the future to earn rentals orfor capital appreciation

5.0.1 EXCLUDED PROPERTIES

The following are not within the scope of IAS 40 investment property:

o Property intended for sale in the ordinary course of business (IAS 2)

o Property being constructed or developed on behalf of third parties (IAS 11)

o Owner occupied property (IAS 16)

o Property leased to another entity under a finance lease (IAS 17)5.0.2 THE ACCOUNTING ISSUE

In effect, acquiring investment properties is an alternative way for a company to utilise surplus cash to earnreturns rather than putting it in a bank or using it to purchase stocks and shares These properties are notused by the business, but rather held to generate income and long term capital growth

It therefore follows that the accounting treatment for non-current assets is not necessarily applicable toinvestment properties In particular, there is little need to depreciate such assets when they are held specificallyfor long-term capital appreciation

The provisions of IAS 40 are therefore applied to such investment properties, rather than those of IAS 16 orany other standard

5.1 ACCOUNTING TREATMENT OF INVESTMENT PROPERTIES

IAS 40 requires that investment properties are initially measured at cost It then allows a choice of subsequenttreatment Companies can choose to apply either

o The cost model of IAS 16, or

o A fair value modelThe choice must be applied consistently to all investment properties held by a company, and a change from onemodel to the other is not allowed unless it results in more appropriate presentation

5.1.1 THE COST MODEL

Investment properties accounted for using the cost model are held in accordance with IAS 16, at cost lessdepreciation less impairment losses

These properties can not be revalued

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Any change in fair value since the last measurement date is recognised in the income statement

Properties held under the fair value model are not depreciated

Advise the financial controller

Solution 5.1

$

Trade discount of 12.5% (30,000)Shipping and handling 2,750Estimated pre-production testing 12,500Electrical cable installation (14,000 – 6,000) 8,000Concrete reinforcement 4,500

Dismantling and restoration costs 18,000

263,250

- the early settlement discount is treated as income rather than a reduction in the asset cost;

- the abnormal costs associated with the cable error are not allowed to form part of the capitalised;cost per IAS 16

- the maintenance contract is a revenue expense and may not be capitalised

TANGIBLE NON-CURRENT ASSETS

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Solution 5.3

$000Old depreciation charge ($40,000/20) 2,000

CV at date of change ($40,000 – ($2,000x5)) 30,000New depreciation charge ($30,000 – 800)/12years 3,125

CV at date of revaluation 439,583Revaluation surplus (β) 200,417

FV at 31 December 20X8 640,000

Solution 5.5

Statement of Changes in Equity for Allisterco for the Year Ended 31 December 20X8

Retained Earnings Revaluation Reserve

Workings Reserves transfer

$ $ Rev Res $ Ret E’gsCost of property 400,000

Depreciation X1 (20,000)Depreciation X2 (20,000)Depreciation X3 (20,000)Depreciation X4 (20,000)

CV on 31 December 20X4 320,000Revaluation surplus 430,000 430,000

FV on 31 December 20X4 750,000Depreciation X5 (750/21) (35,714) (15,714) 15,714Depreciation X6 (750/21) (35,714) (15,714) 15,714Depreciation X7 (750/21) (35,714) (15,714) 15,714Depreciation X8 (750/21) (35,714) (15,714) 15,714

CV on 31 December 20X6 607,144

Profit on disposal 172,856Balance on revaluation reserve at disposal 367,144

Solution 5.6

$000Year ended 31 December 20X7

Investment income $175,000 x 2.5% x 3/12 (1,094)Capitalised borrowing costs 2,406Year ended 31 December 20X8

$350,000 x 4% x 11/12 12,833Investment income $175,000 x 2.5% x 3/12* (1,094)Capitalised borrowing costs 11,739

* investment income relating to February is not relevant, as interest costs relating to this month are ineligiblefor capitalisation

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Solution 5.7

FINANCIAL REPORTING (INTERNATIONAL)

Solution 5.8

This land meets the IAS 40 definition of investment property As yet the future purpose is undetermined, andtherefore despite a possible use of the land by Abbott Inc itself, the land is currently treated as held for capitalappreciation

The land should initially be measured at the cost of $1million, and then either the cost or fair value model ofIAS 40 should be applied

If Abbott Inc currently has any other investment properties, the model applied to these should also be applied

to the land, as IAS 40 requires consistency

If the cost model is applied, the land should be held in accordance with the requirements of the cost model ofIAS 16 In other words it should be held at cost of $1million There is no requirement to depreciate land as itsbenefits are not consumed

If the fair value model is applied, the land should be held at its year end fair value of $950,000, with a $50,000loss recognised in the income statement

Where the model applied is not dictated by an existing policy, in the light of the current fair value, the costmodel seems more attractive in terms of showing a better position and performance in the financial statements

It should, however, be remembered that the policy adopted can not be changed other than to result in a fairerpresentation, and therefore adopting the cost model now may mean that future increases in market value cannot be reflected in the financial statements

Learning Summary

• Ensure that you are familiar with the following in relation to non-current assets:

o The elements of cost

o Methods of depreciation and changes in depreciation estimates

o Rules regarding revaluations

• Learn the rules regarding when borrowing costs must be capitalised, and how much can be capitalised

• Learn the different rules for accounting for a capital government grant and a revenue government grant

• Learn the definition of an investment property and relevant accounting treatment

• Complete the quick test for Chapter 5

• Watch the video clip called ‘x

• Attempt question x from the Question and Answer book

6Intangible Assets

FINANCIAL REPORTING (INTERNATIONAL)

INTANGIBLE ASSETS

Context

This chapter considers intangible non-current assets, and in particular:

• How to identify them

• When they should be recognised in the financial statements, and

• How they are measured in the financial statements

It also recaps the accounting rules on goodwill, as seen in chapter 1 of this book

Exam Hints

This topic is often examined as part of the published company accounts question (Q2) Alternatively, it mayfeature in its own right within question 4 or 5

Key Learning Points

• In order for an intangible asset to be recognised in the financial statements it must:

1 meet the IAS 38 definition of an intangible asset;

2 meet the IAS 38 recognition criteria

• An intangible asset is defined as an identifiable non-monetary asset without physical substance

• An asset is identifiable when it is separable (it can be sold as a single item) or it arises from contractualrights

• IAS 38 requires that an intangible asset meeting the definition is recognised only where:

• It is probable that the expected economic benefits that are attributable to the asset will flow to the entity,and

• The cost of the asset can be measured reliably

• Most internally generated intangible assets do not meet the recognition criteria, as their cost can not bedistinguished from the costs of developing a business as a whole (e.g brands, mastheads, customer lists)

• Intangible assets which are recognised in the financial statements are measured initially at cost

• Where an intangible asset has a finite useful life, it is amortised over that useful life, beginning when the

asset is available for use

• Where an intangible asset has an indefinite useful life, then it is not amortised, but is tested for

impairment annually, and in between if there are indications of impairment

• The revaluation model may be adopted for intangible assets only where a fair value can be established byreference to an active market

• An active market is a market in which all of the following conditions exist:

1 items traded are homogenous;

2 willing buyers and sellers are available;

3 prices are available to the public

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Research and Development

• Research is defined as original and planned investigation undertaken with the prospect of gaining newscientific or technical knowledge and understanding

• Research costs are expensed to profit or loss as incurred

• Development is defined as the application of research findings or other knowledge to a plan or design forthe production of new or substantially improved materials, devices, products, processes, systems or servicesbefore the start of commercial production or use

• Development costs are recognised as an intangible asset where they meet the SECTOR criteria Otherwise they are expensed to profit or loss:

1 ability to use or Sell the intangible asset;

2 ability to measure reliably the Expenditure on the intangible asset;

3 intention to Complete the intangible asset and use or sell it;

4 Technical feasibility of completing the intangible asset so that it will be available for use or sale;

5 Overall probable future economic benefits;

6 The availability of adequate technical, financial and other Resources to complete the development.

• Development costs are amortised in line with the revenues they generate Amortisation begins whencommercial production or sales commence

Goodwill

• Purchased positive goodwill is recognised as an intangible asset in the statement of financial position It isnot amortised but is tested for impairment annually

• Purchased negative goodwill is expensed immediately to profit or loss

• Internally generated goodwill can not be capitalised as an intangible asset

Relevant Accounting Standards

IFRS 3 Business combinationsIAS 38 Intangible assets

Technical Articles

The following article explains IAS 38 in respect of R & D and is available on ACCA’s website

http://www.accaglobal.com/pubs/students/publications/student_accountant/archive/sa_sep07_retallack.pdf

INTANGIBLE ASSETS

1 Intangible Assets – an Introduction

Accounting guidance relating to intangible assets is provided within a number of accounting standards

Of particular relevance to F7 are:

• IAS 38 Intangible assets (which does not include guidance on goodwill)

• IFRS 3 Business Combinations (which does include guidance on goodwill)

2 IAS 38 Intangible Assets

In order for an intangible asset to be recognised in the financial statements it must:

- meet the IAS 38 definition of an intangible asset;

- meet the IAS 38 recognition criteria

2.1 DEFINITION OF AN INTANGIBLE ASSET

An intangible asset is defined as:

An identifiable 1 non-monetary 2 asset 3 without physical substance

1 An asset is identifiable when it

• It is separable; in other words it can be sold as a single item, or

• It is not separable, but arises from contractual rights

2 A non-monetary asset is any asset other than cash or an asset to be settled in a fixed amount of cash

(such as a receivable)

3 An asset is a resource:

• Controlled by an entity as a result of past events, and

• From which future economic benefits are expected to flow to the entity

Learning Example 6.1

Which of the following examples of potential intangible assets do not meet the IAS 38 definition of anintangible asset?

• Goodwill

• The skills of the workforce

• The rights to produce a particular item to sell

• A brand name developed by a company2.2 RECOGNITION CRITERIA FOR AN INTANGIBLE ASSET

IAS 38 requires that an intangible asset meeting the definition above is recognised only where:

• It is probable that the expected economic benefits that are attributable to the asset will flow to theentity; and

• The cost of the asset can be measured reliably

Learning Example 6.2

Consider the assets which did meet the IAS 38 definition of an intangible asset in learning example 6.1

Which of these meet the IAS 38 recognition criteria and can therefore be capitalised in the statement offinancial position?

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2.2.1 INTERNALLY GENERATED INTANGIBLE ASSETS

Generally speaking, most internally generated intangible assets do not meet the recognition criteria, as theircost can not be distinguished from the costs of developing a business as a whole

Such assets, which IAS 38 specifically prohibits from being capitalised include:

• Internally generated brands

• Mastheads (the title at the top of the front page of a newspaper)

• Publishing titles

• Customer listsIAS 38 also considers internally generated intangible assets in the form of research and development Theseare dealt with in section 3

2.3 ACCOUNTING TREATMENT OF INTANGIBLE ASSETS

2.3.1 INITIAL MEASUREMENT

Intangible assets which are recognised in the financial statements are measured initially at cost

Where they are acquired as part of a business combination, they are initially measured at fair value Where fairvalue can not be established, the intangible is not recognised separately and its value is subsumed within goodwill

2.3.2 AMORTISATION

Where an intangible asset has a finite useful life, it is amortised over that useful life, beginning when the

asset is available for use

Amortisation should reflect the pattern in which the asset’s benefits arise, or where this can not be established,should be on a straight line basis

The residual value of an intangible asset is taken to be nil unless:

• There is a commitment by a third party to purchase the asset at the end of its life

• There is an active market for the asset which is likely to exist at the end of its useful life

An active market is defined as:

A market in which all of the following conditions exist:

1 items traded are homogenous

2 willing buyers and sellers are available

3 prices are available to the public

Where an intangible asset has an indefinite useful life, then it is not amortised, but is tested for impairment

annually, and in between if there are indications of impairment

The useful life should also be assessed each period and if it is no longer indefinite, then it must be amortised.This represents a change in accounting policy in accordance with IAS 8 (chapter 14)

2.3.3 IMPAIRMENT

Intangible assets with a finite life are tested for impairment where indications of an impairment are evident.Intangible assets with an indefinite life are tested for impairment annually and where there are indications of animpairment

Impairments are accounted for in line with IAS 36 (see Chapter 7)

INTANGIBLE ASSETS

In practice examples of assets which are part of an active market are:

• Taxi cab licenses

• Airport landing rights

• Fishing and milk quotas

By definition, however, most intangible assets are unique and therefore do not qualify as belonging to an activemarket and so can not be revalued

Where revaluations are allowed, they should be made sufficiently regularly that the carrying value of the asset

is not materially different from its fair value

Learning Example 6.3

Amadeo, a drinks manufacturer and distributor has prepared its draft financial statements for the year ended

31 July 20X9 showing a profit for the year of $869,000 and total comprehensive income of $1.34 million,after accounting for the following:

1 At the insistence of the Brand Director, a new brand name ‘Red SquareVodka’ has been capitalised in thefinancial statements at $100,000 This measurement is based on costs incurred during the year to developand market the brand The asset is being amortised over a period of 10 years, with a full year’s charge inthe current year

2 Five year distribution rights over Asia were acquired at a cost of $58,000 during the year The financemanager was unsure of how to treat these and so has capitalised them as a tangible non-current asset

at cost, and taken no further action

3 In the light of the sale of a soft drinks brand ‘fruitfizz’ to a competitor for $450,000, the finance managerrevalued a similar soft drinks brand ‘lemoneasy’ to $450,000 at the start of the year This brand waspurchased 3 years ago from another company at a cost of $320,000, and recognised as an intangibleasset amortised over 20 years

What advice would you give to the Finance manager of Amadeo in respect of the above items?

3 Research and Development

IAS 38 provides guidance for accounting for research and development, as costs incurred on these activitiesmay meet the definitions of an intangible asset

Research is defined as:

Original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding.

Development is defined as:

The application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services before the start of commercial production or use.

3.0.1 ACCOUNTING FOR RESEARCH COSTS

Research costs are sufficiently distant from commercial production to represent an asset Therefore researchcosts should be charged as an expense in the income statement as incurred

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3.0.2 ACCOUNTING FOR DEVELOPMENT COSTS

Development costs are expensed in the income statement unless all of the following can be demonstrated:

1 The technical feasibility of completing the intangible asset so that it will be available for use or sale

2 The intention to complete the intangible asset and use or sell it

3 The ability to use or sell the intangible asset

4 How the intangible asset will generate probable future economic benefits, including the existence of amarket (when the asset is to be sold externally)

5 The availability of adequate technical, financial and other resources to complete the development

6 The ability to measure reliably the expenditure on the intangible asset

Where these criteria are met, development costs are capitalised as an intangible non-current asset

Exam Hint

The acronym SECTOR may help you to remember the development criteria:

S Sell or use (point 3)

E Expenditure measurable (point 6)

C will Complete (point 2)

T Technically feasible (point 1)

O Overall economic benefits (point 4)

R Resources available (point 5)

Amortisation

Development costs must be amortised in line with the rules of IAS 38 as laid out in section 2.3.2

Amortisation begins when commercial production or sales commence

on staff costs A competitor is also developing a similar project and is thought to be 13 months fromcommercial production If the competitor’s product reaches the market first, Drummond is unlikely toachieve sales

3 An ongoing project to develop a cure for dengue fever The project was undertaken a number of years agoand meets the capitalisation criteria of IAS 38.To date, $378,000 has been capitalised During the year thefollowing amounts related to the project:

$176,000 staff costs

$90,000 materials costs

$450,000 to build and equip a dedicated laboratory

$22,500 depreciation of the laboratory and equipment

In December 2007, question 5 on the exam paper concentrated on development costs In the first part ofthe question candidates were required to discuss the definition of an asset and accounting concepts indeciding whether development costs should be expensed or capitalised In the second part of the question,the requirement was to adjust the accounts of a company which had applied the wrong treatment todevelopment costs, using a prior year adjustment The examiner commented that this question was clearlyattempted last and produced some poor answers In particular candidates recited the definition of an asset

in part (a), and separately listed the IAS 38 recognition criteria, however did not link the two In part (b)candidates rarely mentioned the prior year adjustment despite its being specifically mentioned in thequestion

3.0.3 APPLICATION OF CONCEPTS TO ACCOUNTING FOR R&D

The following accounting concepts are applied in accounting for R&D:

The resulting goodwill (where positive) represents assets not recognised in the statement of financial position

of the acquired company, such as its:

FINANCIAL REPORTING (INTERNATIONAL)

These items do not meet the IAS 38 definition or recognition criteria of an intangible asset and so are notrecognised in the consolidated statement of financial position Instead, their value is absorbed within the over-all value of goodwill

Purchased goodwill may also arise on the acquisition of an unincorporated business In this case, goodwillarises in individual company accounts

4.1.1 ACCOUNTINGTREATMENT OF POSITIVE PURCHASED GOODWILL

IFRS 3 Business Combinations provides accounting guidance on accounting for goodwill:

Where purchased goodwill is positive (i.e the value of the investment exceeds the net assets of the acquiree):

• goodwill is recognised in the statement of financial position

• the goodwill is not amortised

• instead it is tested for impairment annually as part of a cash generating unit in accordance with IAS 36 (seechapter 7)

4.1.2 ACCOUNTINGTREATMENT OF NEGATIVE PURCHASED GOODWILL

Negative purchased goodwill, or a ‘bargain purchase’ arises where the acquired company is loss making, or forsome other reason, sold at price less than the value of its net assets

The difference between the value of the acquiree and the value of its net assets is recognised in profit or loss

in the period in which it arises

4.2 INTERNALLY GENERATED GOODWILL

Where a company has not been the subject of an acquisition, it may still possess the component assets ofgoodwill, such as a good reputation or customer base

This internally generated goodwill can not, however, be recognised in the financial statements as it does notmeet the recognition criteria for an asset as detailed within the Framework (see chapter 14)

In particular the cost of internally generated goodwill cannot be measured reliably

INTANGIBLE ASSETS

Solution 6.1

Goodwill

Goodwill is a non-monetary asset, however it is not separable, as it is can not be sold as a stand alone asset

Therefore it does not meet the IAS 38 definition of an intangible asset

Goodwill is, however an intangible asset, dealt with by IFRS 3 Business Combinations

The Skills of the Workforce

The skills of the workforce are non-monetary, however they are not identifiable, as they can not be sold, andthey are not controlled, as an employee may resign and leave the company.Therefore these skills do not meetthe IAS 38 definition of an intangible asset and can not be recognised on the statement of financial position

The Rights to Produce a Particular Item to Sell

This is an identifiable non-monetary asset and can therefore be capitalised in the statement of financial position,assuming that it meets the IAS 38 recognition criteria

It is identifiable as the right, although it may not be separable, is contractual

A Brand Name Developed by a Company

This is an identifiable non-monetary asset and can therefore be capitalised in the statement of financial position,assuming that it meets the IAS 38 recognition criteria

Solution 6.2

The Rights to Produce a Particular Item to Sell

This can be recognised in the statement of financial position, since:

• It is probable that expected benefits will flow to the entity, and

• The cost of the asset can be measured reliably (being the price paid for the rights)

A Brand Name Developed by a Company

This can not be recognised in the statement of financial position, since its cost can not be established reliably

Solution 6.3

Red Square Vodka

IAS 38 specifically prohibits the capitalisation of internally generated brand names as an intangible asset

Although such an asset does meet the definition of an intangible asset, it falls foul of the recognition criteria, asthe cost of such a brand cannot be reliably measured

Therefore the $100,000 should be written off to profit

The amortisation charged of $10,000 should be added back to profit, and therefore a net adjustment of

$90,000 is required to profit

Distribution rights

Distribution rights meet the IAS 38 definition of an intangible asset, and also meet the recognition criteria, asthey will result in probable economic benefits and the cost can be measured reliably They should therefore becapitalised as an intangible asset

Currently, they are capitalised as a tangible asset The reclassification to intangibles will not effect profit

The distribution rights are for five years and should therefore be amortised over this period They are rently not being amortised, so assuming a policy of a full year’s charge in the year of acquisition, profits and thecarrying value of the asset will reduce by $11,600

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Lemoneasy is a purchased brand and IAS 38 therefore allows its capitalisation at cost and subsequentamortisation Intangible assets may only be revalued where a fair value can be established by reference to anactive market An active market requires:

- the asset to be part of an homogenous population, and

- willing buyers and sellers, and

- publicly available prices

A brand is unique and therefore not part of an homogenous population Therefore revaluation is not allowed.The revaluation gain recorded in other comprehensive income of $162,000 ($450,000 – ($320,000 x 18/20))should therefore be reversed

Depreciation charged for the year, based on the revalued amount, of $25,000 ($450,000/18years) should bereversed and a charge of $16,000 based on historical cost recognised

The carrying value of the asset in the statement of financial position should therefore be $272,000 ($320,000 x17/20)

In addition any reserves transfer of the excess $9,000 from the revaluation reserve to retained earnings should

Plant Species Project

This project meets the IAS 38 definition of research, being investigation into a plant species with the aim ofdeveloping knowledge and understanding about its properties The associated costs must therefore beexpensed to profit or loss

Pandemic Flu Vaccine

This is a development project, as it involves the application of research findings to the manufacture of a newdrug

It does not however meet all of the IAS 38 development expenditure recognition criteria In particular, therelative proximity of the competitor to commercial production which will render Drummond’s drug unsaleablemeans that economic benefits are not probable

Therefore the associated costs of $183,000 should be written off to profit or loss in the year

FINANCIAL REPORTING (INTERNATIONAL)

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Dengue Fever Cure

This is a development project which already meets the IAS 38 criteria for capitalisation Therefore the followingexpenses incurred in the year may be capitalised and increased the existing intangible asset:

$176,000 staff costs

$90,000 materials costs

$22,500 depreciation of the laboratory and equipment

$288,600The $450,000 incurred on a new laboratory and equipment should be capitalised as a tangible non-currentasset Depreciation thereon is capitalised as part of the intangible asset (as shown above) rather than expensed

to profit or loss

Learning Summary

• Learn and ensure that you understand the IAS 38 definition and recognition criteria for an intangible asset

• Ensure that you understand the difference between research and development

• Learn the recognition criteria for development costs

• Familiarise yourself with the accounting requirements of IAS 38 regarding intangible assets and research anddevelopment

• Ensure that you understand the difference between goodwill and intangible assets, and know how toaccount for goodwill

INTANGIBLE ASSETS

ACCOUNTANT IN BUSINESS

7 Impairment

of Assets

FINANCIAL REPORTING (INTERNATIONAL)

IMPAIRMENT OF ASSETS

Context

This chapter introduces a new topic, not previously seen at the F3 level

An impairment is a fall in the value of an asset below its carrying value It is a topic that is extremely relevant

to a number of companies in the current economic climate

The chapter covers:

• When to test for impairments

• How to test for impairments, and

• How to account for an impairment

The topic is related in particular to Chapter 5 Non-current assets:Tangible and Chapter 6 Intangible assets

Exam Hints

This area of the syllabus is examined either as part of the published accounts question (Q2) or in its own rightwithin question 4 or 5 of the paper The topic has not been examined in the first three sittings of the F7 paper

Key Learning Points

• An impairment loss is the amount by which the carrying amount of an asset or cash-generating unit exceedsits recoverable amount

• An impairment test is required for all assets when there is an indication of impairment at the reportingdate, and annually for :

o Goodwill acquired in a business combination

o Intangible assets with an indefinite useful life

o Intangible assets which are not yet available for use

• Internal indications of impairment include:

o Evidence of obsolescence or damage to the asset

o A current period operating loss or net cash outflow from operating activities

o A commitment by management to undergo a significant reorganisation

o A major loss of key employees

• External indications of impairment include:

o A significant decline in the market value of an asset during the period

o A significant adverse change in the commercial environment in which the entity operates

• An impairment test therefore involves calculating recoverable amount for comparison with carrying value

• Recoverable amount is the higher of fair value less costs to sell and value in use

• Value in use is the present value of the future cash flows expected to be generated by an asset, including itsultimate disposal

• Where an asset is held at historical cost, an impairment loss is charged to the income statement

• Where an asset is held at a revalued amount, an impairment loss is charged to other comprehensiveincome to the extent that a revaluation surplus relating to the asset exists Any excess loss is charged tothe income statement

• The impaired value of the asset (less any residual value) is depreciated over the remaining useful life

• Where it is impossible to calculate recoverable amount for a single asset, an impairment test must beperformed for the cash generating unit (CGU) to which the asset belongs

• Corporate (shared) assets should be allocated to CGUs on a reasonable basis

• Goodwill should be allocated to the CGU(s) expected to benefit from the business combination

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• An impairment is allocated to a CGU in the following order:

1 to goodwill

2 to other assets on a pro rata basis

• An impairment loss on goodwill can never be reversed

• An impairment loss on other assets or a CGU can be reversed where the recoverable amount hasincreased because of a change in economic conditions or expected use of the asset

• An impairment loss can be reversed to the extent that the increased carrying amount of an individual assetdoes not exceed the amount that the asset would have been carried at had there been no initial impairment

Relevant Accounting Standards

IAS 36 Impairment of assetsFINANCIAL REPORTING (INTERNATIONAL)

1 Impairments – An Introduction

IAS 36 Impairment of Assets deals with the issue of assets being overstated in the statement of financial position

Where the carrying value of an asset in the financial statements is greater than its value to the business (known

as recoverable amount), then the standard requires that the carrying value is reduced

This reduction in carrying value is known as an impairment loss IAS 36 defines it as:

The amount by which the carrying amount of an asset or cash-generating unit exceeds its recoverable amount.

Cash-generating units are considered in detail later in the chapter

1.1 THE OBJECTIVES OF IAS 36

IAS 36 aims to ensure that:

• Non-current assets and goodwill are recorded in the financial statements at no more than their recoverableamount

• Any resulting impairment loss is measured and recognised on a consistent basis

• Sufficient information is disclosed in the financial statements to enable users to understand the impact ofthe impairment on the financial position and performance of the reporting entity

In order to achieve this aim, the standard provides guidance on:

1 How often to test assets for impairment

2 How to test assets for impairment, and

3 How to account for any impairment1.2 ASSETS OUTSIDE THE SCOPE OF IAS 36

The following assets are outside the scope of the standard:

o Inventories

o Assets arising from construction contracts (chapter 9)

o Deferred tax assets (chapter 11)

o Financial assets within the scope of IAS 39 (chapter 16)

o Investment property measured at fair value

o Non-current assets classified as held for sale in accordance with IFRS 5 (chapter 10)

2 When to Test for Impairments

An impairment test is required:

• for all assets when there is an indication of impairment at the reporting date

• annually for certain other assets:

o Goodwill acquired in a business combination

o Intangible assets with an indefinite useful life

o Intangible assets which are not yet available for use

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IMPAIRMENT OF ASSETS

FINANCIAL REPORTING (INTERNATIONAL)

2.1 INDICATIONS OF IMPAIRMENT

Indications of impairment may be internal to a company or external IAS 36 suggests the following indicationsshould be considered:

o Evidence of obsolescence or damage o A significant decline in the market

to the asset value of an asset during the period

o A current period operating loss or net o A significant adverse change in thecash outflow from operating activities commercial environment in which the

o A commitment by management to entity operatesundergo a significant reorganisation

o A major loss of key employees

If any of these indications is noted, then an impairment test should be carried out

3 How to Test for Impairments

An asset is impaired if its carrying value is greater than its recoverable amount An impairment test thereforeinvolves calculating recoverable amount for comparison with carrying value

3.1 DEFINITIONS

IAS 36 defines recoverable amount as:

The higher of fair value less costs to sell and value in use.

Fair value less costs to sell is:

The amount obtainable from the sale of an asset in an arm’s length transaction between knowledgeable, willing parties, less the costs of disposal.

Value in use is:

The present value of the future cash flows expected to be generated by an asset, including its ultimate disposal.

o Future cash flows should be based on the most recent budgets and are generally for a maximum offive years

o The discount rate used should be a pre tax rate reflecting current assessments of the time value ofmoney

Learning Example 7.1

Vue owns an asset which is budgeted to generate income of $100,000 per annum for the foreseeable future.The asset also needs a budgeted $20,000 in maintenance spending on it next year and then every other year

An appropriate discount rate is 8%

What is the value in use of the asset?