Don’t be fooled; changes to IAS 16, IAS 38 and IFRS 11 will have a profound effect on some entities, explains Graham Holt
First published in the July/August 2014 UK edition of Accounting and Business magazine.
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In May 2014, the International Accounting Standards Board (IASB) issued two amendments to standards, entitled Clarification of Acceptable Methods of Depreciation and Amortisation (Amendments to IAS 16 and IAS 38) and Accounting for Acquisitions of Interests in Joint Operations (Amendments to IFRS 11). At first sight, these amendments may not seem to be of significance; however, to some entities they will have a profound effect.
"They will have a profound effect."
A variety of depreciation methods are used to allocate the depreciable amount of an asset over its useful life. These methods include the:
- straight-line method
- diminishing balance method
- units of production method.
The method used is selected on the basis of the expected pattern of consumption of the expected future economic benefits and is applied consistently, unless there is a change in the expected pattern of consumption.
The IASB decided to amend IAS 16, Property, Plant and Equipment, to address issues that had arisen over the use of a revenue-based method for depreciating an asset. This is a method that is based on revenues generated in an accounting period as a proportion of the total revenues expected to be generated over the asset’s useful economic life.
The total revenue takes into account any anticipated changes due to price inflation but the IASB felt that inflation has no bearing on the way in which an asset is consumed. The amendment came as a result of a request to clarify the meaning of ‘consumption of the expected future economic benefits embodied in the asset’ when deciding on the amortisation method to be used for intangible assets of service concession arrangements. IAS 16 requires the depreciation method to reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity.
Revenue may be a measurement of the output generated by the asset, but does not represent the way in which an item of PPE is used. Such methods reflect a pattern of generation of economic benefits that arise from the operation of the business of which an asset is part, rather than the pattern of consumption of an asset’s expected future economic benefits.
The IASB concluded that a method of depreciation that is based on revenue generated from an activity that includes the use of an asset is not appropriate, but that the diminishing balance method is an accepted depreciation method. This has the capability of reflecting accelerated consumption of the future economic benefits in the asset.
This latter conclusion regarding the diminishing balance method was a clarification due to concerns raised by Committee members who questioned whether the proposed amendment, given the influence of a pricing factor, would limit the ability to apply a diminishing balance depreciation method to manufacturing equipment.
The original exposure draft proposed that there might be circumstances in which a revenue-based method gave the same result as a ‘units-of-production’ method. This statement was thought to contradict the proposed amendments and so was dropped.
The principle in IAS 38, Intangible Assets, is that an amortisation method should reflect the pattern of consumption of the expected future economic benefits and not the pattern of generation of expected future economic benefits. IAS 38 is therefore amended to introduce a rebuttable presumption that a revenue-based amortisation method for intangible assets is inappropriate for the same reasons as in IAS 16. However, there are limited circumstances when this presumption can be overturned. They are where the intangible asset is expressed as a measurement of revenue and where it can be demonstrated that revenue and the consumption of the intangible asset is directly linked to the revenue generated from the asset.
Both standards now contain an explanation that expected future reductions in selling prices might be indicative of an increased rate of consumption of the future economic benefits of that asset. The amendments are effective for annual periods beginning on or after 1 January 2016 with earlier application permitted. Full retrospective application of the amendments would have been too onerous for some entities.
In 2011, the IASB issued IFRS 11, Joint Arrangements, which introduced several changes. Principally, there are now only two types of joint arrangements, which are joint ventures and joint operations.
"A key issue is accounting for the acquisition of an interest in a joint operation, which represents a business."
Further, proportionate consolidation is no longer permitted for arrangements classified as joint ventures, as equity accounting has to be applied. Although the standard deals with most issues arising out of the accounting for joint operations, there are certain matters that it does not address.
A key issue is accounting for the acquisition of an interest in a joint operation, which represents a business. As both IFRS 11 and its predecessor, IAS 31, Joint Ventures, did not deal with the issue, significant diversity in practice has occurred. The approaches used in practice in accounting for a joint operation, which constituted a business, were as follows:
- IFRS 3, Business Combinations, approach: identifiable assets and liabilities were normally measured at fair value and goodwill recognised. Additionally, transaction costs were not capitalised and deferred taxes were recognised on initial recognition of assets and liabilities. The guidance in IFRS 3 was not followed where it was not appropriate; for example, in this situation there would not be non-controlling interests.
- Cost approach: the total cost of acquiring the interest in the joint operation was allocated to the individual identifiable assets on the basis of their relative fair values. The premium paid, if any, was allocated to the identifiable assets and not recognised as goodwill. Transaction costs were capitalised and deferred taxes were not recognised as per the exception in IAS 12, Income Taxes.
- Hybrid approach: preparers in this group applied IFRS 3 and other IFRSs selectively with the result that mainly identifiable assets and liabilities were measured at fair value and goodwill was recognised.
Transaction costs were capitalised with contingent liabilities and deferred taxes generally not recognised.
This diversity has led to different treatments of any premium paid on acquisition, recognition or non-recognition of any deferred taxes arising on acquisition and acquisition costs being capitalised or expensed.
As a result of the above diversity, the IFRS Interpretations Committee was asked to clarify whether the acquirer of such interests in joint operations should apply the principles in IFRS 3 or whether the acquirer should account for it as a group of assets. The committee referred the matter to the IASB, suggesting that the most appropriate approach was to apply the relevant principles for business combinations in IFRS 3 and other IFRSs.
Defining a business
One of the key judgments is whether the activities of the joint operation, or the set of activities and assets contributed to the joint operation on its formation, represent a business as defined by IFRS 3.
IFRS 3 defines a business as ‘an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs or other economic benefits directly to investors or other owners, members or participants’.
Further guidance explains that a business is a series of inputs and processes applied to those inputs that have the ability to create outputs. However, outputs are not required for the activities to qualify as a business. An output should have the ability to provide a return in the form of dividends, lower costs or other economic benefits to owners.
The assessment of whether a set of activities and assets represent a business is still extremely judgmental.
As a result of the IASB’s deliberations, an amendment to IFRS 11 has been made. Accounting for Acquisitions of Interests in Joint Operations (Amendments to IFRS 11) requires that the acquirer of an interest in a joint operation which constitutes a business, as defined in IFRS 3, is required to apply all of the principles in IFRS 3 and other IFRSs with the exception of those principles that conflict with the guidance in IFRS 11. As a result, a joint operator that has acquired such an interest has to:
- measure most identifiable assets and liabilities at fair value
- expense acquisition-related costs (other than debt or equity issuance costs)
- recognise deferred taxes
- recognise any goodwill or bargain purchase gain
- perform impairment tests for the cash-generating units to which goodwill has been allocated
- disclose information required relevant for business combinations.
The amendments apply to the acquisition of an interest in an existing joint operation and also to the acquisition of an interest when a joint operation is formed. IFRS 1, First-time Adoption of International Financial Reporting Standards, has also been amended to extend the business combination exemptions. The amendments are effective for annual periods beginning on or after 1 January 2016 and apply prospectively.
"For some companies, the amendment will represent a significant change to current practice."
For some companies, the amendment will represent a significant change to current practice and will present a number of challenges as a result of having to apply business combinations accounting, while others relate to the nature of the proposed amendment itself.
For example, joint arrangements are common in the mining and metals sector; therefore any changes in the accounting can have wide-ranging implications. Some key implications for those companies are the increased time, cost and effort needed to determine fair values for the identifiable assets acquired and liabilities assumed. This in turn will lead to changes in the profiles of the financial statements and the need for more detailed record keeping.
Graham Holt is director of professional studies at the accounting, finance and economics department at Manchester Metropolitan University Business School.