Adam Deller looks at the proposed changes to the accounting for testing an asset before it becomes available for use, which should end the arguments about capitalisation
Studying this technical article and answering the related questions can count towards your verifiable CPD if you are following the unit route to CPD and the content is relevant to your learning and development needs. One hour of learning equates to one unit of CPD. We'd suggest that you use this as a guide when allocating yourself CPD units.
This article was first published in the September 2017 international edition of Accounting and Business magazine.
IAS 16, Property, Plant and Equipment, has long been a cornerstone of IFRS Standards, being applicable to the vast majority of organisations that apply the international financial reporting standards.
The International Accounting Standards Board (IASB) has identified two key areas where there is a diversity of application of the capitalisation of costs as part of a non-current asset. Both these areas are addressed in the IASB’s work plan for 2017.
The first area relates to IAS 23, Borrowing Costs, rather than IAS 16, but is still very much linked to which costs are eligible for capitalisation. The change was discussed in the May 2017 edition of Accounting and Business, as part of looking at the IASB’s annual improvements process, so the topic won’t be examined in depth again here. In summary, the IASB’s proposed change is to look more at the interest rates that are eligible for capitalisation, rather than whether costs qualify as an asset or not.
The second issue relates to the most recent exposure draft issued by the IASB, in June, which relates to the testing of an asset before it becomes available for use. Unlike the proposed amendment to IAS 23, this exposure draft looks specifically at whether or not items should qualify as an asset.
The question of whether items qualify for capitalisation has provoked lively discussion in many a company, with management and auditors often thrashing out whether items can or cannot be capitalised in accordance with the IAS 16 standard.
Any debate about whether items are of such a capital nature tends to revolve around paragraph 16 of IAS 16, which states that any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating must be capitalised. This phrase requires the application of sound judgment as to what costs are directly attributable, and whether those costs really bring the asset into a state of being available for use.
Typical qualifying costs
To provide further assistance, paragraph 17 gives examples of some of the more common costs likely to be classed as directly attributable, and so eligible for capitalisation. Within paragraph 17 (e) is the statement that is the subject of the exposure draft. The current position is that examples of directly attributable costs should include ‘costs of testing whether the asset is functioning properly, after deducting the net proceeds from selling any items produced while bringing the asset to that location and condition (such as samples produced when testing equipment)’.
For service industries, these costs (and therefore this change) are unlikely to be significant, but certain manufacturing entities, extractive industries and the petrochemical industry may have to undertake a substantial amount of testing of equipment before it is deemed to be available for use.
One of the problems is that it could be possible for these proceeds to be significant or actually exceed the cost of testing. This has led to varying treatments, with some believing that the entire proceeds should be deducted, leading to an overall deduction in the asset cost. Others believe that the amount of proceeds to be deducted from the asset should be capped at the testing costs, with the excess going to profit or loss.
A further problem is that the IASB found that paragraph 17 was being applied in several ways, with some entities deducting proceeds only from the sale of items produced during the testing phase, while others deducted all sales proceeds until the asset was capable of operating in the manner intended by management (ie available for use).
To address these issues, the exposure draft proposes two amendments. First, paragraph 17(e) will clarify the definition of testing, referring to it as ‘an assessment of the technical and physical performance’ of the asset. The costs associated with the testing of an asset will still be capitalised in accordance with IAS 16.
Profit and loss
Second, and much more importantly, it removes the standard’s requirement for the net proceeds to be deducted from the cost of the item. Instead, the exposure draft proposes the insertion of an additional paragraph (paragraph 20A) in IAS 16, stating that any proceeds and costs associated with items produced in the process of bringing an asset to the location and condition necessary to be available for use should be recognised in profit or loss.
This proposed change will remove the need for judgment about which proceeds to deduct from an asset and whether these should be capped at the cost of testing. Instead, all items produced during this process would be recognised in revenue and cost of sales, in accordance with IFRS 15, Revenue from Contracts with Customers, and IAS 2, Inventories. No depreciation will be incorporated in the cost of the items produced, as these will occur before the asset is available for use and therefore before any depreciation is applied to the asset.
The IASB believes that this change is the simplest way to remove diversities in application, and believes it is more in line with the recognition of elements in the financial statements.
It also believes that whether or not these elements are produced as part of the construction process, they fundamentally meet the definitions of income and expenses and should be recorded in profit or loss accordingly. Currently an entity’s total revenue could be misunderstood (and understated) as the sales made during this process are net of the cost of the asset rather than being included in revenue.
For entities where this is likely to be significant, such as businesses in the extraction and petrochemical industries, the application of this change to the standard will be likely to result in increases to non-current assets, and increases to revenue and cost of sales.
As the example in the box on the opposite page shows, it is likely that an entity will now record an element of profit in the construction period. As the asset value will also be higher, this will result in higher depreciation and therefore lower profits in future periods compared with the existing treatment. Effectively the proposed change means that income generated from these sales is recorded immediately rather than spread over the life of the asset in the form of a lower depreciation expense based on the reduced asset cost.
If this narrow-scope amendment were to be made to IAS 16, no additional disclosures would have to be made beyond the existing requirements. The IASB believes that the existing disclosures in relation to IFRS 15 and IAS 2 are sufficient, and the income or expenses relating to items produced before the asset is available for use will be covered under these.
The proposal under the exposure draft is that this amendment will be applied retrospectively, but only in relation to assets becoming available for use on or after the beginning of the earliest period presented in the financial statements. The cumulative effect of initially applying these amendments will be recognised as an adjustment to the opening balance of retained earnings.
The deadline for comments on the exposure draft is 19 October 2017.
A mining entity is in the process of constructing and testing equipment that is not yet available for use. The details of this are as follows:
Swipe to view table
Construction cost to date
Costs associated with the testing process to date
US$11m (US$6m testing the equipment, US$5m cost of samples produced during the testing process)
|Proceeds from selling items produced during the testing phase||US$9m|
Under the existing IAS 16 treatment, all costs would be capitalised, net of the proceeds from selling items produced during the testing phase. This would mean the asset would be recorded at a cost of US$302m (US$300m + US$11m - US$9m).
Under the proposed treatment, the asset would be capitalised at US$306m – the construction costs plus the US$6m costs associated with testing the equipment.
The US$9m proceeds would be recorded in revenue, with the US$5m costs of producing the samples included in the cost of sales. Any samples produced but unsold at the reporting date would be included within closing inventory.
The summary below shows the difference in the current and proposed treatment under IAS 16.
Swipe to view table
Statement of financial position
|Existing treatment||Proposed treatment|
|Property, plant and equipment||US$302m||US$306m|
Swipe to view table
Statement of profit or loss
|Cost of sales||(US$5m)|
Adam Deller is a financial reporting specialist and lecturer
CPD technical article
"It is possible that the revenue from the samples produced by the equipment-testing could exceed the costs"