CHAPTER 5.pdf

Chapter 5 Non-current assets Chapter learning objectives Upon completion of this chapter you will be able to: evaluate and apply the recognition, derecognition and measurement of non-current assets including impairments and revaluations evaluate and apply the accounting requirements for the classifi...

Chapter 5 Non-current assets Chapter learning objectives Upon completion of this chapter you will be able to: evaluate and apply the recognition, derecognition and measurement of non-current assets including impairments and revaluations evaluate and apply the accounting requirements for the classification and measurement of non-current assets held for sale evaluate and apply the accounting treatment of investment properties including classification, recognition, measurement and change of use evaluate and apply the accounting treatment of intangible assets including the criteria for recognition and measurement subsequent to acquisition evaluate and apply the accounting treatment for borrowing costs evaluate and apply the accounting for, and disclosure of, government grants and other forms of government assistance. @1 PER KAPLAN PUBLISHING One of the PER performance objectives (P06) is to record and process transactions and events. You need to use the right accounting treatments for transactions and events. These should be both historical and prospective - and include non-routine transactions. Working through this chapter should help you understand how to demonstrate that objective. 1 j 87 Non-current assets INTANGIBLE ASSETS GOVERNMENT GRANTS PROPERTY, PLANT AND EQUIPMENT BORROWING COSTS...... INVESTMENT PROPERTY ASSETS HELD FOR SALE.... IMPAIRMENT m Progression The IFRS Standards in this chapter were also examined in Financial Reporting. The SBR exam will feature more open-ended questions and real-life scenarios. 1 IAS 16 Property, Plant and Equipment Definition IAS 16 defines property, plant and equipment as tangible items that: 'are held tor use in the production or supply of goods or services, tor rental to others, or tor administrative purposes are expected to be used during more than one period' (IAS 16, para 6). Tangible items have physical substance. Initial recognition An item of property, plant and equipment should be recognised as an asset when: 88 it is probable that the asset's future economic benefits will flow to the entity the cost of the asset can be measured reliably. KAPLAN PUBLISHING Chapter 5 ~ 1----------------------------------l The revised Conceptual Framework says that elements are recognised if recognition results in: relevant information a faithful representation of the asset or liability, and resulting income, expenses or equity movements. The recognition criteria in IAS 16, and most other IFRS and IAS Standards, differ from the above because the standards were based on previous versions of the Conceptual Framework and were not updated when the Conceptual Framework was reissued. The Conceptual Framework does not override the requirements of individual IFRS and IAS Standards. The recognition of property, plant and equipment is therefore determined by reference to the criteria in IAS 16. Property, plant and equipment should initially be measured at its cost. According to IAS 16, the cost comprises: the purchase price costs that are directly attributable to bringing the asset to the location and condition necessary to operate the estimated costs of dismantling and removing the asset, including any site restoration costs. This might apply where, for example, an entity has to recognise a provision for the cost of decommissioning an oil rig or a nuclear power station. IAS 16 says that the following costs should never be capitalised: administration and general overheads abnormal costs (repairs, wastage, idle time) costs incurred after the asset is physically ready for use (unless these costs increase the economic benefits the asset brings) costs incurred in the initial operating period (such as initial operating losses and any further costs incurred before a machine is used at its full capacity) costs of opening a new facility, introducing a new product (including advertising and promotional costs) and conducting business in a new location or with a new class of customer (including training costs) costs of relocating/reorganising an entity's operations. As a result of testing recently purchased or constructed PPE, product samples might be produced that are sold. IAS 16 has been amended to require proceeds from such sales, as well as the associated costs, to be recognised in the statement of profit or loss as income (previously IAS 16 required these proceeds to be deduced from the carrying amount of the PPE). KAPLAN PUBLISHING 89 Non-current assets Measurement models IAS 16 allows a choice between: the cost model the revaluation model. The Conceptual Framework outlines two measurement bases: historical cost current value (such as fair value). If an accounting standard permits a choice of measurement base, such as is the case with IAS 16, the Conceptual Framework notes that preparers of the financial statements must aim to maximise relevance. To do this, the preparers should consider: the characteristics of the asset and/or liability the ways in which the asset and/or liability contribute to future cash flows. Many items of property, plant and machinery generate cash flows indirectly, by being used in combination with other assets to produce goods for customers. As such, the Conceptual Framework notes that historical cost is likely to provide the most relevant information. However, some items of property, plant and equipment - such as land and buildings - are highly sensitive to market factors. Over time, particularly when prices rise, the fair value of land and buildings may materially differ from the purchase price. As such, it may be that a measurement based on current value provides more relevant information about the financial position of the reporting entity. Such decisions are judgemental. Preparers must ensure that the qualitative characteristics of useful information are maximised as far as possible. Cost model Under the cost model, property, plant and equipment is held at cost less any accumulated depreciation and impairment losses. Revaluation model Under the revaluation model, property, plant and equipment is carried at fair value less any subsequent accumulated depreciation and impairment losses. 90 KAPLAN PUBLISHING Chapter 5 If the revaluation model is adopted, then IAS 16 provides the following rules: Revaluations must be made with 'sufficient regularity' to ensure that the carrying amount does not differ materially from the fair value at each reporting date. If an item is revalued, the entire class of assets to which the item belongs must be revalued. If a revaluation increases the value of an asset, the increase is presented as other comprehensive income (and disclosed as an item that will not be recycled to profit or loss in subsequent periods) and held in a 'revaluation surplus' within other components of equity. If a revaluation decreases the value of the asset, the decrease should be recognised immediately in profit or loss, unless there is a revaluation surplus already in existence on the same asset. Depreciation The key principles with regards to depreciation are as follows: All property, plant and equipment with a finite useful life must be depreciated. The depreciable amount of an asset is its cost less its residual value. Residual value is an estimate of the net selling proceeds received if the asset was at the end of its useful life and was disposed of today. Depreciation is charged to the statement of profit or loss, unless it is 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. Depreciation must be allocated on a systematic basis, reflecting the pattern in which the asset's future economic benefits are expected to be consumed. In practice, many entities depreciate property, plant and equipment on a straight-line basis over its estimated useful life. Depreciation methods based on the revenue generated by an activity are not appropriate. This is because revenue reflects many factors, such as inflation, sales prices and sales volumes, rather than the economic consumption of an asset. The depreciation method, residual value and the useful life of an asset should be reviewed annually and revised if necessary. Any adjustments are accounted for as a change in accounting estimate. KAPLAN PUBLISHING 91 Non-current assets Componentisation ------------------------ Some parts of an asset may require regular replacement (e.g. the seats in an aircraft). The replacement parts should be capitalised and the carrying amount of the part being replaced (e.g. the old seats) should be derecognised. If the carrying amount of the replaced part is not known, then the cost of the new part can be used to estimate the cost of the old part when it was originally acquired. Some assets, such as aircrafts, can only be operated if regular inspections for faults are carried out. The cost of these inspections can be capitalised. Any remaining carrying amount relating to the previous inspection should be derecognised. Depreciation should be charged separately on each significant component part of an item of PPE. Parts which have the same useful life can be grouped together. Derecognition ------------------- --------- --- ------------------ --- -------- IAS 16 says that an asset should be derecognised when disposal occurs, or if no further economic benefits are expected from the asset's use or disposal. The gain or loss on derecognition of an asset is the difference between the net disposal proceeds, if any, and the carrying amount of the item. When a revalued asset is disposed of, any revaluation surplus may be transferred directly to retained earnings, or it may be left in the revaluation surplus within other components of equity. Disclosures -------------------------------------------------- IAS 16 requires entities to disclose: measurement bases used useful lives and depreciation rates a reconciliation of carrying amounts at the beginning and end of the period. If items of property, plant and equipment are stated at revalued amounts, information about the revaluation should also be disclosed. 92 KAPLAN PUBLISHING Chapter 5 Test your understanding 1 - Cap Cap bought a building on 1 January 20X1. The purchase price was $2.9m, associated legal fees were $0.1 m and general administrative costs allocated to the purchase were $0.2m. Cap also paid sales tax of $0.5m, which was recovered from the tax authorities. The building was attributed a useful life of 50 years. It was revalued to $4.6m on 31 December 20X4 and was sold for $5m on 31 December 20X5. Cap purchased a machine on 1 January 20X3 for $100,000 and attributed it with a useful life of 10 years. On 1 January 20X5, Cap reduced the estimated remaining useful life to 4 years. Required: Explain how the above items of property, plant and equipment would have been accounted for in all relevant reporting periods up until 31 December 20X5. 2 Government grants Definitions IAS 20 Accounting for Government Grants and Disclosure of Government Assistance defines the following terms: Government grants are transfers of resources to an entity in return for past or future compliance with certain conditions. They exclude government assistance that cannot be valued (see below) and normal trade with governments. Government assistance is government action designed to provide an economic benefit to a specific entity. It does not include indirect help such as infrastructure development. Recognition ---------------------------------------------------IAS 20 says that government grants should not be recognised until the conditions for receipt have been complied with and there is reasonable assurance that the grant will be received. Grants should be matched with the expenditure towards which they are intended to contribute in the statement of profit or loss: Income grants given to subsidise expenditure should be matched to the related costs. Income grants given to help achieve a non-financial goal (such as job creation) should be matched to the costs incurred to meet that goal. KAPLAN PUBLISHING 93 Non-current assets Presentation of grants related to income IAS 20 allows such grants to either be: presented as a credit in the statement of profit or loss, or deducted from the related expense. The presentation of the grant income has no overall impact on profit. Companies will need to choose which presentation method they deem to be more appropriate. It may be argued that the first method of presentation is more appropriate, as it enables users of the financial statements to compare the expenses of one entity to another, without being affected by the grant income. In addition, if the related expense is reduced by the grant income, then the entity may appear to have better cost control and operational efficiency, which may not enable a fair comparison to other entities. However, the second presentation method may be seen as more appropriate if the related expenses have only been incurred as a result of the grant being made available. Therefore, in this case, it could be argued that it makes sense to present the net impact of the income and related expense in the profit or loss. Grants related to assets Grants for purchases of non-current assets should be recognised over the expected useful lives of the related assets. IAS 20 provides two acceptable accounting policies for this: deduct the grant from the cost of the asset and depreciate the net cost (the capitalised method) treat the grant as deferred income and release to profit or loss over the life of the asset (the deferred income method). Either treatment is acceptable and capable of giving a fair presentation. The overall impact on profit and net assets is nil. However the choice of treatment could affect the conclusions made in an investor's analysis of the financial statements. The capitalised method is simpler to record and will show a lower level of noncurrent assets. This treatment may make the entity look more efficient at generating profits when compared to an entity using the deferred income method (e.g. lower asset base but unaffected profits creates a higher ROCE). The deferred income method has the advantage of ensuring that assets acquired at different times and in different locations are recorded on a uniform basis, regardless of changes in government policy. This will mean the entity shows a higher level of non-current assets when compared to an entity not using this method. However, it will also show a higher level of liabilities, so the entity may appear riskier and investors may be deterred from investing. 94 KAPLAN PUBLISHING Chapter 5 Repayments ------------------------------------------- A government grant that becomes repayable is accounted for as a revision of an accounting estimate. Income-based grants (a) Firstly, debit the repayment to any liability for deferred income. Any excess repayment must be charged to profits immediately. (b) Capital-based grants deducted from cost Increase the cost of the asset with the repayment, which will also increase the amount of depreciation that should have been charged in the past. This cumulative extra depreciation should be recognised and charged immediately. (c) Capital-based grants treated as deferred income Firstly, debit the repayment to any liability for deferred income. Any excess repayment must be charged against profits immediately. Government assistance - - - ---------------------- ---------------- As implied in the definitions set out earlier, government assistance helps businesses through advice, procurement policies and similar methods. It is not possible to place reliable values on these forms of assistance, so they are not recognised in the financial statements. Disclosures -------------------------------------------------------------------IAS 20 requires the following disclosures: the accounting policy and presentation methods adopted the nature of government grants recognised in the financial statements unfulfilled conditions relating to government grants that have been recognised. !II Test your understanding 2 - Clock On 1 June 20X1, Clock received written confirmation from a local government agency that it would receive a $1 million grant towards the purchase price of a new office building. The grant becomes receivable on the date that Clock transfers the $10 million purchase price to the vendor. On 1 October 20X 1 Clock paid $10 million in cash for its new office building, which is estimated to have a useful life of 50 years. By 1 December 20X1, the building was ready for use. Clock received the government grant on 1 January 20X2. KAPLAN PUBLISHING 95 Non-current assets Required: Discuss the possible accounting treatments of the above in the financial statements of Clock for the year ended 31 December 20X1. 3 IAS 23 Borrowing Costs Definition -------------------------------------------Borrowing costs are defined as 'interest and other costs that an entity incurs in connection with the borrowing of funds' (IAS 23, para 5). Recognition ·----------------------------------------------------------------------------------· Borrowing costs should be capitalised if they relate to the acquisition, construction or production of a qualifying asset. IAS 23 defines a qualifying asset as one that takes a substantial period of time to get ready for its intended use or sale. Capitalisation period ------ Borrowing costs should only be capitalised while construction is in progress. IAS 23 stipulates that: Capitalisation of borrowing costs should commence when all of the following apply: expenditure for the asset is being incurred borrowing costs are being incurred activities that are necessary to get the asset ready for use are in progress. Capitalisation of borrowing costs should cease when substantially all the activities that are necessary to get the asset ready for use are complete. Capitalisation of borrowing costs should be suspended during extended periods in which active development is interrupted. _Specific and general borrowings -----------------------------· Where a loan is taken out specifically to finance the construction of an asset, IAS 23 says that the amount to be capitalised is the interest payable on that loan less income earned on the temporary investment of the borrowings. If construction of a qualifying asset is financed from an entity's general borrowings, the borrowing costs eligible to be capitalised are determined by applying the weighted average general borrowings rate to the expenditure incurred on the asset. 96 KAPLAN PUBLISHING Chapter 5 Disclosures IAS 23 requires the following disclosures: the value of borrowing costs capitalised during the period the capitalisation rate. Test your understanding 3 - Hi-Rise On 1 January 20X1, Hi-Rise obtained planning permission to build a new office building. Construction commenced on 1 March 20X1. To help fund the cost of this building, a loan for $5 million was received from the bank on 1 April 20X1. The interest rate on the loan was 10% per annum. Construction of the building ceased during the month of July due to an unexpected shortage of labour and materials. By 31 December 20X1, the building was not complete. Costs incurred to date were $12 million (excluding interest on the loan). Required: Discuss the accounting treatment of the above in the financial statements of Hi-Rise for the year ended 31 December 20X1. 4 Investment property Definitions IAS 40 Investment Property relates to 'property (land or buildings) held (by the owner or by the lessee as a right-of-use asset) to earn rentals or for capital appreciation or both' (IAS 40, para 5). Examples of investment property are: land held for capital appreciation land held for undecided future use buildings leased out under an operating lease. The following are not investment property: property held for use in the production or supply of goods or services or for administrative purposes (IAS 16 Property, Plant and Equipment applies) property held for sale in the ordinary course of business or in the process of construction of development for such sale (IAS 2 Inventories applies) property being constructed or developed on behalf of third parties (IFRS 15 Revenue from Contracts with Customers applies) owner-occupied property (IAS 16 applies) property leased to another entity under a finance lease (IFRS 16 Leases applies). KAPLAN PUBLISHING 97 Non-current assets Measurement On recognition, investment property is recognised at cost. After recognition an entity may choose either: the cost model the fair value model. The policy chosen must be applied to all investment properties. Cost model If the cost model is chosen, investment properties are held at cost less accumulated depreciation. No revaluations are permitted. Fair value model Under the fair value model, the entity remeasures its investment properties to fair value each year. No depreciation is charged. All gains and losses on revaluation are reported in the statement of profit or loss. If, in exceptional circumstances, it is impossible to measure the fair value of an individual investment property reliably then the cost model should be adopted. Transfers Transfers to or from investment property can only be made if there is a change of use. There are several possible situations in which this might occur and the accounting treatment for each is set out below: Transfer from investment property to owner-occupied property Use the fair value at the date of the change for subsequent accounting under IAS 16. Transfer from investment property to inventory Use the fair value at the date of the change for subsequent accounting under IAS 2 Inventories. Transfer from owner-occupied property to investment property to be carried at fair value Normal accounting under IAS 16 (cost less depreciation) will have been applied up to the date of the change. On adopting fair value, there is normally an increase in value. This is recognised as other comprehensive income and credited to the revaluation surplus in equity in accordance with IAS 16. If the fair valuation causes a decrease in value, then it should be charged to profits. Transfer from inventories to investment property to be carried at fair value Any change in the carrying amount caused by the transfer should be recognised in profit or loss. 98 KAPLAN PUBLISHING Chapter 5 ~ 1---------------------------------l Lavender owns a property, which it rents out to some of its employees. The property was purchased for $30 million on 1 January 20X2 and had a useful life of 30 years at that date. On 1 January 20X7 it had a market value of $50 million and its remaining useful life remained unchanged. Management wish to measure properties at fair value where this is allowed by accounting standards. Required: How should the property be treated in the financial statements of Lavender for the year ended 31 December 20X7. rI1 Solution Property that is rented out to employees is deemed to be owneroccupied and therefore cannot be classified as investment property. Management wish to measure the property at fair value, so Lavender adopts the fair value model in IAS 16 Property, Plant and Equipment, depreciating the asset over its useful life and recognising the revaluation gain in other comprehensive income. Before the revaluation, the building had a carrying amount of $25m ($30m x 25/30). The building would have been revalued to $50m on 1 January 20X7, with a gain of $25m ($50m - $25m) recognised in other comprehensive income. The building would then be depreciated over its remaining useful life of 25 years (30 - 5), giving a depreciation charge of $2m ($50m/25) in the year ended 31 December 20X7. The carrying amount of the asset as at 31 December 20X7 is $48m ($50m - $2m). fe~ 1 -~·- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - l ABC owns a building that it used as its head office. On 1 January 20X1, the building, which was measured under the cost model, had a carrying amount of $500,000. On this date, when the fair value of the building was $600,000, ABC vacated the premises. However, the directors decided to keep the building in order to rent it out to tenants and to potentially benefit from increases in property prices. ABC measures investment properties at fair value. On 31 December 20X1, the property has a fair value of $625,000. Required: Discuss the accounting treatment of the building in the financial statements of ABC for the year ended 31 December 20X1. KAPLAN PUBLISHING 99 Non-current assets rI1 Solution When the building was owner-occupied, it was an item of property plant and equipment. From 1 January 20X1, the property was held to earn rental income and for capital appreciation so it should be reclassified as investment property. Per IAS 40, if owner occupied property becomes investment property that will be carried at fair value, then a revaluation needs to occur under IAS 16 at the date of the change in use. The building must be revalued from $500,000 to $600,000 under IAS 16. This means that the gain of $100,000 ($600,000- $500,000) will be recorded in other comprehensive income and held in a revaluation surplus within equity. Investment properties measured at fair value must be revalued each year end, with the gain or loss recorded in profit or loss. At year end, the building will therefore be revalued to $625,000 with a gain of $25,000 ($625,000 - $600,000) recorded in profit or loss. Investment properties held at fair value are not depreciated. Disclosures -----------------------------· In respect of investment properties, IAS 40 says that an entity must disclose: whether the cost or fair value model is used amounts recognised in profit or loss for the period a reconciliation between the carrying amounts of investment property at the beginning and end of the period the fair value of investment property if the entity uses the cost model. ~ ~ The Board believes that information about the fair value of investment properties is highly relevant. However, to reduce the cost and burden of producing financial statements, entities are permitted a choice between a cost model and a fair value. IAS 40 requires entities to reconcile the carrying amount of investment properties year-on-year. However, if an entity uses the cost model, IAS 40 requires that the aggregate fair value of investment property is disclosed. 100 KAPLAN PUBLISHING Chapter 5 An example of this reconciliation is provided below: $m Cost: At beginning of year Additions Reclassification Disposals 150 20 (10) (7) End of year 153 $m Accumulated depreciation and impairment: At beginning of year: Depreciation charge Impairment charge Reclassification Disposals 75 2 1 (2) (5) End of year 71 Net carrying amount at end of year 82 'The estimated fair value of the Group's investment property is $210 million (20X6: $240 million). This fair value has been determined by applying an appropriate rental yield to the rentals earned by the investment property. A valuation has not been performed by an independent surveyor.' From the disclosure above, investors can determine that the carrying amount of investment properties is below their fair value. In other words, the financial statements of this entity understate its value. Disclosure of the fair value of investment properties enhances the ability of investors to compare this entity with entities that use the fair value model. The disclosure also informs investors that the fair value of its investment properties has been estimated using a judgemental methodology and without the use of an independent expert - this may mean that the valuation is more susceptible to bias and manipulation. KAPLAN PUBLISHING 101 Non-current assets Test your understanding 4 - Howl The directors of Howl are considering purchasing investment property for the first time in order to benefit from capital appreciation. Property prices are rising and the directors believe that substantial returns could be made from these investments. The directors are aware that IAS 40 Investment Property offers entities a choice in how investment property is measured after initial recognition. However, the directors are unsure as to the factors that should be considered when selecting a measurement basis. Required: With reference to investment properties, discuss the factors that should be considered when preparers of financial statements are required to choose a measurement basis. Your answer should refer to the Conceptual Framework. 5 IAS 38 Intangible Assets H u Definition --- ----- - - -- ------ An intangible asset is defined as 'an identifiable non-monetary asset without physical substance' (IAS 38, para 8). Examples of intangible assets ----------- ---- Intangible assets include: 102 goodwill acquired in a business combination computer software import quotas franchises marketing rights. patents copyrights motion picture films customer list mortgage servicing rights licences customer and supplier relationships KAPLAN PUBLISHING Chapter 5 Recognition criteria --------------------------------------------- An entity should recognise an intangible asset if all of the following criteria are met: The asset is identifiable The asset is controlled by the entity The asset will generate future economic benefits for the entity The cost of the asset can be measured reliably. An intangible asset is identifiable if it: 'is separable (capable of being separated and sold, transferred, licensed, rented, or exchanged, either individually or as part of a package), or it arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations' (IAS 38, para 12). If an intangible asset does not meet the recognition criteria, expenditure should be charged to the statement of profit or loss as it is incurred. Once the expenditure has been charged as an expense, it cannot be capitalised at a later date. Note that the accounting treatment of goodwill arising on a business combination is dealt with in IFRS 3 Business Combinations rather than IAS 38 Intangible Assets. Initial recognition When an intangible asset is initially recognised, it is measured at cost. Subsequent recognition ___________________ After recognition, an entity must choose either the cost model or the revaluation model for each class of intangible asset. Cost model The cost model measures the asset at cost less accumulated amortisation and impairment. Revaluation model The revaluation model measures the asset at fair value less accumulated amortisation and impairment. The revaluation model can only be adopted if fair value can be determined by reference to an active market. An active market is one where the products are homogenous, there are willing buyers and sellers to be found at all times, and prices are available to the public. KAPLAN PUBLISHING 103 Non-current assets Active markets for intangible assets are rare. Due to being homogeneous, an active markets may exist for intangible assets such as: milk quotas stock exchange seats. Active markets are unlikely to exist for brands, newspaper mastheads, music and film publishing rights, patents or trademarks. Revaluations should be made with sufficient regularity such that the carrying amount does not differ materially from actual fair value at the reporting date. Gains and losses on remeasurement to fair value are accounted for in the same way as revaluation gains and losses of tangible assets held in accordance with IAS 16 Property, Plant and Equipment. Amortisation An entity must assess whether the useful life of an intangible asset is finite or indefinite. An asset with a finite useful life must be amortised on a systematic basis over that life. Normally the straight-line method with a zero residual value should be used. Amortisation starts when the asset is available for use. An asset has an indefinite useful life when there is no foreseeable limit to the period over which the asset is expected to generate net cash inflows. It should not be amortised, but be subject to an annual impairment review. Test your understanding 5- Innovate Ten years ago, Innovate developed a video game called 'Our Sports'. This game sold over 10 million copies around the world and was extremely profitable. Due to its popularity, Innovate release a new game in the Our Sports series every year. The games continue to be best-sellers. The directors have produced cash flow projections for the Our Sports series over the next five years. Based on these projections, the directors have prudently valued the Our Sports brand at $20 million and wish to recognise this in the statement of financial position as at 30 September 20X3. On 30 September 20X3, Innovate also paid $1 million for the rights to the 'Pets & Me' videogame series after the original developer went into administration. Required: Discuss the accounting treatment of the above in the financial statements of Innovate for the year ended 30 September 20X3. 104 KAPLAN PUBLISHING Chapter 5 Test your understanding 6 - JonJon JonJon's statement of financial position includes an intangible asset. This asset is a portfolio of individual customers acquired from a similar business which had gone into liquidation two years ago. The accountant has asked the finance director why the asset has not been amortised in the current period. The finance director replied that they changed the assessment of the useful life of this intangible asset from 'finite' to 'indefinite'. They justified this on the grounds that it is impossible to foresee the length of this intangible asset's useful life due to a number of factors, such as technological evolution and changing consumer behaviour. Required: Discuss whether the accounting treatment of the intangible asset is in accordance with IFRS Standards. Research and development expenditure --------------------------------------------Research is defined as 'original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding' (IAS 38, para 8). Research expenditure cannot be recognised as an intangible asset (although tangible assets used in research should be recognised as property, plant and equipment). 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' (IAS 38, para 8). IAS 38 says that development expenditure must be recognised as an intangible asset if the entity can demonstrate that: the project is technically feasible the entity intends to complete the intangible asset, and then use it or sell it the intangible asset will generate future economic benefits it has adequate resources to complete the project it can reliably measure the expenditure on the project. KAPLAN PUBLISHING 105 Non-current assets Test your understanding 7 - Scone During the year ended 31 December 20X1, Scone spent $2 million on researching and developing a new product. The entity has recognised all $2 million as an intangible asset. A breakdown of the expenditure is provided below: $m Research into materials Market research Employee training Development activities 0.5 0.4 0.2 0.9 The expenditure on development activities was incurred evenly over the year. It was not until 1 May 20X1 that market research indicated that the product was likely to be profitable. At the reporting date, the product development was not yet complete. Required: Discuss the correct accounting treatment of the research and development expenditure in the year ended 31 December 20X1. Disclosures IAS 38 states that an entity must disclose: 106 The amount of research and development expenditure expensed in the period The amortisation methods used For intangible assets assessed as having an indefinite useful life, the reasons supporting that assessment The date of any revaluations, if applicable, as well as the methods and assumptions used A reconciliation of the carrying amount of intangibles at the beginning and end of the reporting period. KAPLAN PUBLISHING Chapter 5 6 IAS 36 Impairment of Assets JjJ Definition Impairment is a reduction in the recoverable amount of an asset or cashgenerating unit below its carrying amount. 11 IAS 36 Impairment of Assets says that an entity should carry out an impairment review at least annually if: an intangible asset is not being amortised because it has an indefinite useful life goodwill has arisen on a business combination. Otherwise, an impairment review is required only where there is an indication that impairment may have occurred. Indications of impairment IAS 36 lists the following indications that an asset is impaired: External sources of information: unexpected decreases in an asset's market value significant adverse changes have taken place, or are about to take place, in the technological, market, economic or legal environment increased interest rates have decreased an asset's recoverable amount the entity's net assets are measured at more than its market capitalisation. Internal sources of information: evidence of obsolescence or damage there is, or is about to be, a material reduction in usage of an asset evidence that the economic performance of an asset has been, or will be, worse than expected. Calculating an impairment loss ----·------------------- An impairment occurs if the carrying amount of an asset is greater than its recoverable amount. fl The recoverable amount is the higher of fair value less costs to sell and value in use. Fair value is defined in IFRS 13 Fair Value Measurement as the price received when selling an asset in an orderly transaction between market participants at the measurement date. KAPLAN PUBLISHING 107 Non-current assets Costs to sell are incremental costs directly attributable to the disposal of an asset. Value in use is calculated by estimating future cash inflows and outflows from the use of the asset and its ultimate disposal, and applying a suitable discount rate to these cash flows. With regards to estimates of cash flows, IAS 36 stipulates that: the cash flow projections should be based on reasonable assumptions and the most recent budgets and forecasts the cash flow projections should relate to the asset's current condition and should exclude expenditure to improve or enhance it for periods in excess of five years, management should extrapolate from earlier budgets using a steady, declining or zero growth rate management should assess the accuracy of their budgets by investigating the reasons for any differences between forecast and actual cash flows. The discount rate used to calculate value in use should reflect: 'the time value of money, and the risks specific to the asset for which the future cash flow estimates have not been adjusted' (IAS 36, para 55). Carrying out an impairment test Compare Recoverable amount: higher of Carrying amount Fair value less costs to sell Value in use If fair value less costs to sell is higher than the carrying amount, there is no impairment and no need to calculate value in use. 108 KAPLAN PUBLISHING Chapter 5 Test your understanding 8 - Impairment review The finance director has asked the accountant to perform an impairment test of the assets of JonJon for the year ended 31 December 20X5, using the most recent financial forecasts as the basis for value in use calculations. The realised cash flows for the entity were negative in 20X5 and far below forecasted cash flows for that period. The directors have significantly raised cash flow forecasts for 20X6 with little justification. The projected cash flows have been calculated by adding back depreciation charges to the budgeted result for the period with expected changes in working capital and capital expenditure not taken into account. Required: Discuss whether the above impairment review is in accordance with IFRS Standards. Recognising impairment losses in the financial statements ------------------------------------------------------------An impairment loss is normally charged immediately in the statement of profit or loss and other comprehensive income. If the asset has previously been revalued upwards, the impairment is recognised as a component of other comprehensive income and is debited to the revaluation surplus until the surplus relating to that asset has been reduced to nil. The remainder of the impairment loss is recognised in profit or loss. The remaining carrying amount of the asset is then depreciated/amortised over its remaining useful life. Test your understanding 9 - Impaired asset On 31 December 20X1, an entity noticed that one of its items of plant and machinery is often left idle. On this date, the asset had a carrying amount of $500,000 and a fair value of $325,000. The estimated costs required to dispose of the asset are $25,000. If the asset is not sold, the entity estimates that it would generate cash inflows of $200,000 in each of the next two years. Assume that the cash flows occur at the end of each year. The discount rate that reflects the risks specific to this asset is 10%. Required: KAPLAN PUBLISHING (a) Discuss the accounting treatment of the above in the financial statements for the year ended 31 December 20X1. (b) How would the answer to part (a) be different if there was a balance of $10,000 in other components of equity relating to the prior revaluation of this specific asset? 109 Non-current assets Cash-generating units ------- ---------------------------- It is not usually possible to identify cash flows relating to particular assets. For example, a factory production line is made up of many individual machines, but the revenues are earned by the production line as a whole. In these cases, value in use must be calculated for groups of assets (rather than individual assets). These groups of assets are called cash-generating units (CGUs). Jtl A cash-generating unit is the smallest group of assets that generates independent cash flows. Test your understanding 10 - Cash-generating units An entity has three stages of production: A - growing and felling trees B - creating parts of wooden furniture C - assembling the parts from B into finished goods. The output of A is timber that is partly transferred to B and partly sold in an external market. If A did not exist, B could buy its timber from the market. The output of B has no external market and is transferred to C at an internal transfer price. C sells the finished product in an external market and the sales revenue achieved by C is not affected by the fact that the three stages of production are all performed by the entity. Required: Identify the cash-generating unit(s). Allocating assets to cash-generating units ---------The carrying amount of a cash-generating unit includes the carrying amount of assets that can be attributed to the cash-generating unit and will generate the future cash inflows used in determining the cash-generating unit's value in use. There are two problem areas: Corporate assets: assets that are used by several cash-generating units (e.g. a head office building or a research centre). Corporate assets do not generate their own cash inflows, so do not individually qualify as cashgenerating units. Goodwill which does not generate cash flows independently of other assets and often relates to a whole business. Corporate assets and goodwill should be allocated to cash-generating units on a reasonable and consistent basis. A cash-generating unit to which goodwill has been allocated must be tested for impairment annually. 110 KAPLAN PUBLISHING Chapter 5 Allocation of an impairment to the unit's assets --- ----- If an impairment loss arises in respect of a cash-generating unit, IAS 36 requires that it is allocated among the assets in the following order: goodwill other assets in proportion to their carrying amount. However, the carrying amount of an asset cannot be reduced below the highest of: fair value less costs to sell value in use nil. re:] 1 - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - 1 Tinud has identified an impairment loss of $41 m for one of its cashgenerating units. The carrying amount of the unit's net assets was $150m, whereas the unit's recoverable amount was only $109m. The draft values of the net assets of the unit are as follows: Goodwill Property Machinery Vehicles Patents Net monetary assets $m 13 20 49 35 14 19 150 The net selling price of the unit's assets were insignificant except for the property, which had a market value of $35m. The net monetary assets will be realised in full. Required: How is the impairment loss allocated to the assets within the cash-generating unit? KAPLAN PUBLISHING 111 Non-current assets rI1 Solution Firstly, the impairment loss is allocated to the goodwill, reducing its carrying amount to nil. The impairment loss cannot be set against the property because its net selling price is greater than its carrying amount. Likewise, the impairment loss cannot be set against the net monetary assets (receivables, cash etc.) because these assets will be realised in full. The balance of the impairment loss of $28 million ($41 m - $13m) is allocated between the remaining assets in proportion to their carrying amounts. So, for example, the impairment allocated to the machinery is $14 million ((49/(49 + 35 + 14)) x 28m). The table below shows how the impairment will be apportioned. Goodwill Property Machinery Vehicles Patents Net monetary assets Draft values $m 13 20 49 35 14 19 150 - Impairment loss $m (13) Revised value $m (14) (10) (4) 20 35 25 10 19 (41) 109 Test your understanding 11 - Factory explosion There was an explosion in a factory. The carrying amounts of its assets were as follows: Goodwill Patents Machines Computers Buildings $000 100 200 300 500 1,500 2,600 112 KAPLAN PUBLISHING Chapter 5 The factory operates as a cash-generating unit. An impairment review reveals a net selling price of $1.2 million for the factory and value in use of $1.95 million. Half of the machines have been blown to pieces but the other half can be sold for at least their carrying amount. The patents have been superseded and are now considered worthless. Required: Discuss, with calculations, how any impairment loss will be accounted for. ~ > - - - -..- - - - - - - - - - - - - - - - - - - - - - - - - < If no reasonable allocation of corporate assets or goodwill is possible, then a group of cash-generating units must be tested for impairment together in a two-stage process. Example An entity acquires a business comprising three cash-generating units, D, E and F, but there is no reasonable way of allocating goodwill to them. After three years, the carrying amount and the recoverable amount of the net assets in the cash-generating units and the purchased goodwill are as follows: Carrying amount Recoverable amount D E F Goodwill Total $000 $000 $000 $000 $000 240 360 420 420 150 1,170 300 360 1,080 Step 1: Review the individual units for impairment. F is impaired. A loss of $60,000 is recognised and its carrying amount is reduced to $360,000. Step 2: Compare the carrying amount of the business as a whole, including the goodwill, with its recoverable amount. The total carrying amount of the business is now $1,110,000 ($1,170,000 - $60,000). A further impairment loss of $30,000 must then be recognised in respect of the goodwill ($1,110,000 $1,080,000). KAPLAN PUBLISHING 113 Non-current assets Reversal of an impairment loss ----------------------- The calculation of impairment losses is based on predictions of what may happen in the future. Sometimes, actual events turn out to be better than predicted. If this happens, the recoverable amount is re-calculated and the previous write-down is reversed. Impaired assets should be reviewed at each reporting date to see whether there are indications that the impairment has reversed. A reversal of an impairment loss is recognised immediately as income in profit or loss. If the original impairment was charged against the revaluation surplus, it is recognised as other comprehensive income and credited to the revaluation surplus. The reversal must not take the value of the asset above the amount it would have been if the original impairment had never been recorded. The depreciation that would have been charged in the meantime must be taken into account. The depreciation charge for future periods should be revised to reflect the changed carrying amount. II An impairment loss recognised for goodwill cannot be reversed in a subsequent period. Test your understanding 12 - Boxer Boxer purchased a non-current asset on 1 January 20X1 at a cost of $30,000. At that date, the asset had an estimated useful life of ten years. Boxer does not revalue this type of asset, but accounts for it on the basis of depreciated historical cost. At 31 December 20X2, the asset was subject to an impairment review and had a recoverable amount of $16,000. At 31 December 20X5, the circumstances which caused the original impairment to be recognised have reversed and are no longer applicable, with the result that recoverable amount is now $40,000. Required: Explain, with supporting computations, the impact on the financial statements of the two impairment reviews. 114 KAPLAN PUBLISHING Chapter 5 Test your understanding 13 - CGUs and impairment reversals On 31 December 20X2, an impairment review was conducted on a cash-generating unit and the results were as follows: Asset Carrying amount pre-impairment Goodwill Property, plant and equipment Impairment Carrying amount postimpairment $000 Nil $000 100 $000 (100) 300 (120) 180 400 (220) 180 The property, plant and equipment was originally purchased for $400,000 on 1 January 20X1 and was attributed a useful life of 8 years. At 31 December 20X3, the circumstances which caused the original impairment have reversed and are no longer applicable. The recoverable amount of the cash-generating unit is now $420,000. Required: Explain, with supporting computations, the impact of the impairment reversal on the financial statements for the year ended 31 December 20X3. Disclosures IAS 36 requires disclosure of the following: impairment losses recognised during the period impairment reversals recognised during the period. For each material loss or reversal: the amount of loss or reversal and the events causing it the recoverable amount of the asset (or cash-generating unit) the level of fair value hierarchy (per IFRS 13) used in determining fair value less costs to sell the discount rate(s) used. KAPLAN PUBLISHING 115 Non-current assets 7 Non-current assets held for sale (IFRS 5) fl Definitions ·----------------------------------------------------- -------------------------· IFRS 5 Non-current Assets Held for Sale and Discontinued Operations says that a non-current asset or disposal group should be classified as 'held for sale' if its carrying amount will be recovered primarily through a sale transaction rather than through continuing use. tjJ A disposal group is a group of assets (and possibly liabilities) that the entity intends to dispose of in a single transaction. Classification as 'held for sale' ------------------------------ IFRS 5 requires the following conditions to be met before an asset or disposal group can be classified as 'held for sale': The item is available for immediate sale in its present condition. The sale is highly probable. Management is committed to a plan to sell the item. An active programme to locate a buyer has been initiated. The item is being actively marketed at a reasonable price in relation to its current fair value. The sale is expected to be completed within one year from the date of classification. It is unlikely that the plan will change significantly or be withdrawn. Assets that are to be abandoned or gradually wound down cannot be classified as held for sale because their carrying amounts will not be recovered principally through a sale transaction. Test your understanding 14 - Hyssop Hyssop is preparing its financial statements for the year ended 31 December 20X7. (a) On 1 December 20X7, the entity became committed to a plan to sell a surplus office property and has already found a potential buyer. On 15 December 20X7, a survey was carried out and it was discovered that the building had dry rot and substantial remedial work would be necessary. The buyer is prepared to wait for the work to be carried out, but the property will not be sold until the problem has been rectified. This is not expected to occur until summer 20X8. Required: Can the property be classified as 'held for sale'? 116 KAPLAN PUBLISHING Chapter 5 (b) A subsidiary entity, B, is for sale at a price of $3 million. There has been some interest from prospective buyers but no sale as of yet. One buyer has made an offer of $2 million but the directors of Hyssop rejected the offer. The directors have just received advice from their accountants that the fair value of the business is $2.5 million. They have decided not to reduce the sale price of B at the moment. Required: Can the subsidiary be classified as 'held for sale'? Measurement of assets and disposal groups held for sale ---------- II ----- ---'-------------- Items classified as held for sale should, according to IFRS 5, be measured at the lower of their carrying amount and fair value less costs to sell. Where fair value less costs to sell is lower than carrying amount, the item is written down and the write down is treated as an impairment loss. If a non-current asset is measured using a revaluation model and it meets the criteria to be classified as being held for sale, it should be revalued to fair value immediately before it is classified as held for sale. The asset is then revalued again at the lower of the carrying amount and the fair value less costs to sell. The difference is the selling costs and should be charged against profits in the period. When a disposal group is being written down to fair value less costs to sell, the impairment loss reduces the carrying amount of assets in the order prescribed by IAS 36. A gain can be recognised for any subsequent increase in fair value less costs to sell, but not in excess of the cumulative impairment loss that has already been recognised, either when the assets were written down to fair value less costs to sell or previously under IAS 36. An asset held for sale is not depreciated, even if it is still being used by the entity. Test your understanding 15 -AB On 1 January 20X1, AB acquires a building for $200,000 with an expected life of 50 years. On 31 December 20X4 AB puts the building up for immediate sale. Costs to sell the building are estimated at $10,000. Required Outline the accounting treatment of the above if the building had a fair value at 31 December 20X4 of: KAPLAN PUBLISHING (a) $220,000 (b) $110,000. 117 Non-current assets Test your understanding 16- Nash Nash purchased a building for its own use on 1 January 20X1 for $1 m and attributed it a 50-year useful life. Nash uses the revaluation model to account for buildings. On 31 December 20X2, this building was revalued to $1.2m. On 31 December 20X3, the building met the criteria to be classified as held for sale. Its fair value was deemed to be $1.1 m and the costs necessary to sell the building were estimated to be $50,000. Nash does not make a reserves transfer in respect of excess depreciation. Required: Discuss the accounting treatment of the above. Presentation in the statement of financial position IFRS 5 states that assets classified as held for sale should be presented separately from other assets in the statement of financial position. The liabilities of a disposal group classified as held for sale should be presented separately from other liabilities in the statement of financial position. The major classes of assets and liabilities classified as held for sale must be separately disclosed either on the face of the statement of financial position or in the notes. Where an asset or disposal group is classified as held for sale after the reporting date, but before the issue of the financial statements, details should be disclosed in the notes (this is a non-adjusting event after the reporting period). fe':';] \:i -,_~- 1-----------------------------i Statement of financial position (showing non-current assets held for sale) ASSETS Non-current assets Property, plant and equipment Goodwill Financial assets 118 20X2 $m 20X1 $m X X X X X X X X KAPLAN PUBLISHING Chapter 5 Current assets Inventories Trade receivables Cash and cash equivalents Non-current assets classified as held for sale Total assets X X X X X X X X X X X X Cha'!ge~ to a plan of sale If a sale does not take place within one year, IFRS 5 says that an asset (or disposal group) can still be classified as held for sale if: the delay has been caused by events or circumstances beyond the entity's control there is sufficient evidence that the entity is still committed to the sale. If the criteria for 'held for sale' are no longer met, then the entity must cease to classify the assets or disposal group as held for sale. The assets or disposal group must be measured at the lower of: 'its carrying amount before it was classified as held for sale adjusted for any depreciation, amortisation or revaluations that would have been recognised had it not been classified as held for sale its recoverable amount at the date of the subsequent decision not to sell' (IFRS 5, para 27). Any adjustment required is recognised in profit or loss as a gain or loss from continuing operations. Disclosures ------------------------------------------------------- In the period in which a non-current asset or disposal group has been classified as held for sale, or sold, IFRS 5 says that the entity must disclose: a description of the non-current asset (or disposal group) a description of the facts and circumstances of the sale or expected sale any impairment losses or reversals recognised. KAPLAN PUBLISHING 119 Non-current assets 8 Chapter summary r ' GOVERNMENT GRANTS...... ~ Property, plant and equipment Recognition criteria Recognition Examples Cost model and fair value model Measurement Depreciation Useful life/ amortisation Intangible assets Derecognition Internally-generated assets ~ \,.. BORROWING COSTS....................... :...........................: Assets held for sale Criteria Measurement Presentation in the financial statements Impairment When/indications Calculation Investment property Definition Cash-generating units Goodwill Reversals Cost model and fair value model 120 KAPLAN PUBLISHING Chapter 5 Test your understanding answers !Ii Test your understanding 1 - Cap The building The building would have been recognised on 1 January 20X1 at a cost of $3m ($2.9m purchase price+ $0.1 m legal fees). Recoverable sales tax is excluded from the cost of property, plant and equipment. General administrative costs of $0.2m will have been expensed to profit or loss as incurred. Depreciation of $0.06m ($3m/50 years) would have been charged to profit or loss in each of the years ended 31 December 20X1, 20X2, 20X3 and 20X4. Prior to the revaluation on 31 December 20X4, the carrying amount of the building was $2.76m (46/50 x $3m). In the year ended 31 December 20X4, a gain on revaluation of $1.84m ($4.6m - $2.76m) would have been recognised in other comprehensive income and held within equity. In the year ended 31 December 20X5, the building would have been depreciated over its remaining useful life of 46 (50 - 4) years. The depreciation charge in the year ended 31 December 20X5 would therefore have been $0.1 m ($4.6m/46) leaving a carrying amount at the disposal date of $4.5m ($4.6m - $0.1 m). On 31 December 20X5, a profit on disposal of $0.5m ($5m - $4.5m) would be recorded in the statement of profit or loss. The revaluation gains previously recognised within OCI and held within equity are not reclassified to profit or loss on the disposal of the asset. However, Cap could do a transfer within equity as follows: Dr Other components of equity $1.84m Cr Retained earnings $1.84m The machine The machine would be recognised on 1 January 20X3 at $100,000 and depreciated over 10 years. Depreciation of $10,000 ($100,000/10) will be charged in the years ended 31 December 20X3 and December 20X4. On 1 January 20X5, Cap changes its estimate of the machine's useful life. This is a change in accounting estimate and therefore dealt with prospectively. The carrying amount of the asset at the date of the estimate change is $80,000 (8/10 x $100,000). This remaining carrying amount will be written off over the revised life of 4 years. This means that the depreciation charge is $20,000 ($80,000/4) in the year ended 31 December 20X5. KAPLAN PUBLISHING 121 Non-current assets Test your understanding 2 - Clock Government grants should be recognised when there is reasonable assurance that: the entity will comply with any conditions attached, and the grant will be received. The only condition attached to the grant is the purchase of the new building. Therefore, the grant should be accounted for on 1 October 20X1. A receivable will be recognised for the $1 m due from the local government. Clock could then choose to either: (a) Reduce the cost of the building by $1 m In this case, the building will have a cost of $9m ($1 Om - $1 m). This will be depreciated over its useful life of 50 years. The depreciation charge in profit or loss for the year ended 31 December 20X1 will be $15,000 (($9m/50 years) x 1/12) and the building will have a carrying amount of $8,985,000 ($9m $15,000) as at 31 December 20X1. (b) Recognise deferred income of $1m. In this case, the building is recognised at its cost of $10m. This will be depreciated over its useful life of 50 years. The depreciation charge in profit or loss for the year ended 31 December 20X1 will be $16,667 (($10m/50 years) x 1/12) and the building will have a carrying amount of $9,983,333 ($1 Om $16,667) as at 31 December 20X1. The deferred income will be amortised to profit or loss over the building's useful life. Therefore, income of $1,667 (($1m/50) x 1/12) will be recorded in profit or loss for the year ended 31 December 20X1. The carrying amount of the deferred income balance within liabilities on the statement of financial position will be $998,333 ($1 m - $1,667) as at 31 December 20X1. 122 KAPLAN PUBLISHING Chapter 5 Test your understanding 3 - Hi-Rise An entity must capitalise borrowing costs that are directly attributable to the production of a qualifying asset. The new office building is a qualifying asset because it takes a substantial period of time to get ready for its intended use. Hi-Rise should start capitalising borrowing costs when all of the following conditions have been met: It incurs expenditure on the asset - 1 March 20X1. It incurs borrowing costs - 1 April 20X1. It undertakes activities necessary to prepare the asset for intended use - 1 January 20X1. Capitalisation of borrowing costs should therefore commence on 1 April 20X1. Capitalisation of borrowing costs ceases for the month of July because active development was suspended. In total, 8 months' worth of borrowing costs should be capitalised in the year ended 31 December 20X1. The total borrowing costs to be capitalised are $333,333 ($5m x 10% x 8/12). These will be added to the cost of the building, giving a carrying amount of $12,333,333 as at 31 December 20X1. The building is not ready for use, so no depreciation is charged. Test your understanding 4 - Howl Investment property IAS 40 Investment Property allows a choice between the following models: Cost: cost less depreciation and impairment losses Fair value: the property is remeasured to fair value at each reporting period with the gain or loss reported in profit or loss. Objective of financial reporting The objective of financial reporting is to provide information to the primary users of the financial statements that will help them to make investment decisions. When selecting a measurement base, the information needs of users should be prioritised. Relevance Preparers of financial statements should consider which of the measurement bases offered would provide the most relevant information. To achieve this, consideration should be given to the characteristics of the element being measured as well as how it will contribute to future cash flows. KAPLAN PUBLISHING 123 Non-current assets The fair values of many properties rise over time. As such, if a cost model is used, the carrying amount of the property is likely to diverge from its fair value over time. Moreover, under the cost model, changes in the fair value of the investment property would not be recognised until disposal. In contrast, under the fair value model, fair value changes would be recognised annually. Howl's business model would seem to be based on selling investment property. As such, the fair value model may provide more relevant information about the future cash flows expected from the eventual sale. Faithful representation A measurement basis should not be selected simply because the resulting financial statement impact would be received more favourably. However, a key factor to be considered when selecting a measurement basis is the degree of measurement uncertainty. The Conceptual Framework states that, for some estimates, a high level of measurement uncertainty may outweigh other factors to such an extent that the resulting information may have little relevance. The Board believes that the level of uncertainty associated with the measurement of an item should be considered when assessing whether a particular measurement basis provides relevant information. For most buildings, it would normally be possible to determine fair values through the use of level 2 inputs (quoted prices for similar assets in active markets). If the buildings purchased are unique, then level 3 inputs (unobservable inputs) may need to be used to determine fair value. Even if fair value is determined through the use of level 3 inputs, this measurement may still provide more relevant information than one based on historical cost as long as the estimate uses the best information available and the measurement uncertainty is adequately disclosed. Comparability Useful financial information can be compared to other entities, enabling users to make economic decisions. As such, financial statement preparers might pick a measurement basis because it is used by others in the same industry. It should be noted that entities that account for investment property using the cost model are still required to disclose the fair value at the reporting date. 124 KAPLAN PUBLISHING Chapter 5 Test your understanding 5 - Innovate According to IAS 38, an intangible asset can be recognised if: it is probable that expected future economic benefits attributable to the asset will flow to the entity the cost of the asset can be measured reliably. Cash flow projections suggest that the Our Sports brand will lead to future economic benefits. However, the asset has been internally generated and therefore the cost of the asset cannot be measured reliably. This means that the Our Sports brand cannot be recognised in the financial statements. The Pets & Me brand has been purchased for $1 million. Therefore, its cost can be measured reliably. An intangible asset should be recognised in respect of the Pets & Me brand at its cost of $1 million. In subsequent periods, the Pets & Me brand will be amortised over its expected useful life. Test your understanding 6 - JonJon IAS 38 Intangible Assets states that an intangible asset has an indefinite useful life only if there is no 'foreseeable' limit to its useful life. Difficulties in accurately determining an intangible asset's useful life do not provide a basis for regarding that useful life as indefinite. In the case of JonJon, the customer relationship is with individuals so there is, is by definition, a time limit to that relationship. Therefore JonJon is contravening IAS 38 and must amortise the intangible over its estimated useful life. Failing to do so will overstate profits and assets in the current period. Test your understanding 7 - Scone Expenditure on research, market research and employee training cannot be capitalised and so must be written off to profit or loss. In relation to development activities, $0.3 million (4/12 x $0.9m) was incurred before the product was known to be commercially viable. This amount must also be written off to profit or loss. In total, $1.4 million ($0.5m + $0.4m + $0.2m + $0.3m) must be written off from intangible assets to profit or loss: Dr Profit or loss $1.4m Cr Intangible assets $1.4m The intangible asset recognised on the statement of financial position will be $0.6 million ($2m - $1.4m). No amortisation will be charged because the product is not yet complete. KAPLAN PUBLISHING 125 Non-current assets Test your understanding 8 - Impairment review IAS 36 Impairment of Assets states that cash flow projections used in measuring value in use should be based on reasonable and supportable assumptions which represent management's best estimate of the range of economic conditions which will exist over the remaining useful life of the asset. IAS 36 also states that management must assess the reasonableness of the assumptions by examining the causes of differences between past cash flow projections and actual cash. Management should ensure that the assumptions on which its current cash flow projections are based are consistent with past actual outcomes. Despite the fact that the realised cash flows for 20X5 were negative and far below projected cash flows, the directors significantly raised forecasted cash flows for 20X6 without justification. There are serious doubts about JonJon's ability to produce realistic and reliable forecasts. According to IAS 36, estimates of future cash flows should include: projections of cash inflows from the continuing use of the asset projections of cash outflows which are necessarily incurred to generate the cash inflows from continuing use of the asset, and net cash flows to be received (or paid) for the disposal of the asset at the end of its useful life. IAS 36 states that projected cash outflows should include those required for the day-to-day servicing of the asset, which includes future cash outflows to maintain the level of economic benefits expected to arise from the asset in its current condition. It is highly unlikely that no investments in working capital or operating assets would need to be made to maintain the assets in their current condition. It would seem that the cash flow projections that the finance director of JonJon wants the accountant to use do not comply with IAS 36. These projections will most likely over-state the recoverable amount of the assets, potentially reducing (or eliminating) the amount of any impairment loss. 126 KAPLAN PUBLISHING Chapter 5 Test your understanding 9 - Impaired asset (a) The value in use is calculated as the present value of the asset's future cash inflows and outflows Year1 Year2 Cash flow $000 200 200 Discount rate 1/1.10 1/1.102 PV $000 182 165 347 The recoverable amount is the higher of the fair value less costs to sell of $300,000 ($325,000 - $25,000) and the value in use of $347,000. The carrying amount of the asset of $500,000 exceeds the recoverable amount of $347,000. Therefore, the asset is impaired and must be written down by $153,000 ($500,000 -$347,000). This impairment loss would be charged to the statement of profit or loss. (b) Dr Profit or loss $153,000 CrPPE $153,000 The asset must still be written down by $153,000. However, $10,000 of this would be recognised in other comprehensive income and the remaining $143,000 ($153,000 - $10,000) would be charged to profit or loss. Dr Profit or loss Dr Other comprehensive income CrPPE $143,000 $10,000 $153,000 Test your understanding 10 - Cash generating units A forms a cash-generating unit and its cash inflows should be based on the market price for its output. B and C together form one cashgenerating unit because there is no market available for the output of B. In calculating the cash outflows of the cash-generating unit B + C, the timber received by B from A should be priced by reference to the market, not any internal transfer price. KAPLAN PUBLISHING 127 Non-current assets Test your understanding 11 - Factory explosion The patents have been superseded and have a recoverable amount of $nil. The patents therefore should be written down to $nil and an impairment loss of $200,000 must be charged to profit or loss. Half of the machines have been blown to pieces. Therefore, half of the carrying amount of the machines should be written off. An impairment loss of $150,000 will be charged to profit or loss. The recoverable amount of the other assets cannot be determined so therefore they must be tested for impairment as part of their cash generating unit. The total carrying amount of the CGU after the impairment of the patents and machines is $2,250,000 (see working below), whereas the recoverable amount is $1,950,000. A further impairment of $300,000 is therefore required. This is firstly allocated to goodwill and then to other assets on a prorata basis. No further impairment should be allocated to the machines as these have already been written down to their recoverable amount. Allocation of impairment loss to CGU Goodwill Patents Machines Computers Buildings Draft $000 100 nil 150 500 1,500 Impairment $000 (100) 2,250 (300) (50) (150) Revised $000 Nil Nil 150 450 1,350 1,950 The total impairment charged to profit or loss is $650,000 ($200,000 + $150,000 + $300,000). 128 KAPLAN PUBLISHING Chapter 5 Test your understanding 12 - Boxer Year ended 31 December 20X2 $ 24,000 16,000 Asset carrying amount ($30,000 x 8/10) Recoverable amount Impairment loss 8,000 The asset is written down to $16,000 and the loss of $8,000 is charged to profit or loss. The depreciation charge per annum in future periods will be $2,000 ($16,000 x 1/8). Year ended 31 December 20X5 $ 10,000 40,000 Asset carrying amount ($16,000 x 5/8) Recoverable amount nil Impairment loss There has been no impairment loss. In fact, there has been a complete reversal of the first impairment loss. The asset can be reinstated to its depreciated historical cost i.e. to the carrying amount at 31 December 20X5 if there never had been an earlier impairment loss. Year 5 depreciated historical cost (30,000 x 5/10) = $15,000 Carrying amount: $10,000 Reversal of the loss: $5,000 The reversal of the loss is now recognised. The asset will be increased by $5,000 ($15,000 - $10,000) and a gain of $5,000 will be recognised in profit or loss. It should be noted that the whole $8,000 original impairment cannot be reversed. The impairment can only be reversed to a maximum amount of depreciated historical cost, based upon the original cost and estimated useful life of the asset. KAPLAN PUBLISHING 129 Non-current assets Test your understanding 13 - CGUs and impairment reversals The goodwill impairment cannot be reversed. The impairment of the PPE can be reversed. However, this is limited to the carrying amount of the asset had no impairment loss been previously recognised. The carrying amount of the PPE as at 31 December 20X3 is $150,000 ($180,QQQ X 5/6). If the PPE had not been impaired, then its value at 31 December 20X3 would have been $250,000 ($400,000 x 5/8). Therefore, the carrying amount of the PPE can be increased from $150,000 to $250,000. This will give rise to a gain of $100,000 in profit or loss. 130 Test your understanding 14 - Hyssop (a) IFRS 5 states that in order to be classified as 'held for sale' the property should be available for immediate sale in its present condition. The property will not be sold until the work has been carried out, demonstrating that the facility is not available for immediate sale. Therefore, the property cannot be classified as 'held for sale'. (b) The subsidiary B does not meet the criteria for classification as 'held for sale'. Although actions to locate a buyer are in place, the subsidiary is not for sale at a price that is reasonable compared with its fair value - the fair value of the subsidiary is $2.5 million, but it is advertised for sale at $3 million. It cannot be classified as 'held for sale' until the sales price is reduced. KAPLAN PUBLISHING Chapter 5 Test your understanding 15 -AB Until 31 December 20X4, the building is a non-current asset and its accounting treatment is prescribed by IAS 16. The annual depreciation charge was $4,000 ($200,000/50). The carrying amount at 31 December 20X4, prior to reclassification, was $184,000 ($200,000 (4 X $4,000)), (a) On 31 December 20X4, the building is reclassified as a noncurrent asset held for sale. It is measured at the lower of carrying amount ($184,000) and fair value less costs to sell ($220,000 $10,000 = $210,000). This means that the building will continue to be measured at $184,000. (b) On 31 December 20X4, the building is reclassified as a noncurrent asset held for sale. It is measured at the lower of carrying amount ($184,000) and fair value less costs to sell ($110,000 $10,000 = $100,000). Therefore, the building will be measured at $100,000 as at 31 December 20X4. An impairment loss of $84,000 ($184,000 - $100,000) will be charged to the statement of profit or loss. Test your understanding 16 - Nash The building would have been recognised on 1 January 20X1 at its cost of $1 m and subsequently depreciated over its 50-year life. By 31 December 20X2, the carrying amount of the building would have been $960,000 ($1 m - (($1 m/50) x 2 years)). The building was revalued on 31 December 20X2 to $1.2m, giving a gain on revaluation of $240,000 ($1.2m - $960,000). This gain would have been recorded in other comprehensive income and held within a revaluation surplus (normally as a part of other components of equity). The building would then have been depreciated over its remaining useful life of 48 years. Depreciation in the year ended 20X3 was therefore $25,000 ($1.2m/48). The building had a carrying amount at 31 December 20X3 of $1,175,000 ($1.2m - $25,000). At 31 December 20X3, the building is held for sale. As it is held under the revaluation model, it must initially be revalued downwards to its fair value of $1,100,000. This loss of $75,000 ($1,175,000-$1,100,000) is recorded in other comprehensive income because there are previous revaluation gains relating to this asset within equity. The building is then revalued to fair value less costs to sell. Therefore, the asset must be reduced in value by a further $50,000. This loss is charged to the statement of profit or loss. KAPLAN PUBLISHING 131 Non-current assets 132 KAPLAN PUBLISHING