IAS 16 – Property Plant and Equipment – Institute of Chartered Accountants of Pakistan

1. Query on Liquidated Damages

Enquiry:

Following are the two enquiries pertaining to liquidated damages:

Query 1:

A company is engaged in telecommunication. It awards contracts for jobs of capital nature which involve purchase of equipment and its installation. The equipment is normally handed over to the company after the trail runs and final acceptance. The equipment is normally capitalised once the final acceptance is signed off. The price of the equipment is governed mainly in line with the price book agreed with the vendor and the company’s parent company group frame work agreement.

The purchase agreements generally contain following type of penalties:

– Penalties for delayed installation.
– Actual revenue loss during installation prior to final acceptance based on estimate.
– Actual revenue loss after acceptance and capitalization of the equipment caused by any issue relating to equipment.

IFRS is not very clear about the treatment of these damages/ penalties. We will appreciate if guidance is provided, how each such type of penalties should be treated. Company is currently booking all the above as other revenue.

Query 2:

A telecommunication company has outsourced its network maintenance job. The maintenance contract has performance bench marks. The contract contains bonus or additional payment for performance better than the set bench marks and penalties for the performance below the set targets.

The company is currently charging the normal payment and additional bonus to cost and booking penalties for under performance as other income. Is the mentioned treatment correct? Will the situation /treatment would be different if the under performance penalty is calculated based on the actual revenue loss resulting from the under performance.

Opinion:

Committees response to the queries is as follows:

Query 1:

The Committee would like to refer following paragraphs of IAS 16 ‘Property plant & Equipment’ (underline is ours):

“15 An item of property, plant and equipment that qualifies for recognition as an asset shall be measured at its cost.”

“Cost as defined in IAS 16 is the amount of cash or cash equivalents paid or the fair value of the other consideration given to acquire an asset at the time of its acquisition or construction or, where applicable, the amount attributed to that asset when initially recognised in accordance with the specific requirements of other IFRSs, e.g. IFRS 2, Share-based Payment.”

The paras of IAS 16 relating to the elements of cost are reproduced as under:

“16 The cost of an item of property, plant and equipment comprises:
(a) its purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates.
(b) any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management.
(c) the initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located, the obligation for which an entity incurs either when the item is acquired or as a consequence of having used the item during a particular period for purposes other than to produce inventories during that period.”

“17 Examples of directly attributable costs are:
(a) costs of employee benefits (as defined in IAS 19 Employee Benefits) arising directly from the construction or acquisition of the item of property, plant and equipment;
(b) costs of site preparation;
(c) initial delivery and handling costs;
(d) installation and assembly costs;
(e) 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); and
(f) Professional fees.”

“21 Some operations occur in connection with the construction or development of an item of property, plant and equipment, but are not necessary to bring the item to the location and condition necessary for it to be capable of operating in the manner intended by management. These incidental operations may occur before or during the construction or development activities. For example, income may be earned through using a building site as a car park until construction starts. Because incidental operations are not necessary to bring an item to the location and condition necessary for it to be capable of operating in the manner intended by management, the income and related expenses of incidental operations are recognized in profit or loss and included in their respective classifications of income and expense.”

The Committee’s response to the enquired scenarios is as follows:

a) Penalties/ liquidated damages for delayed installation

Purchasing fixed assets does not give rise to income. Therefore, in the absence of specific reference to compensating for losses in a liquidated damage clause, the liquidated damages received are deducted from the cost of the related assets.
The rationale for this approach is consistent with the conclusion that, rather than damages for delay, the contract provides for an additional payment in the event of early completion.
For example, if rather than a Rs. 100 penalty for late delivery on a Rs. 1,000 contract after 1 January 200X, as the contract had a value of Rs. 900 but provided for an additional payment of Rs. 100 for an early completion before 1 January 200X. Therefore, the cost of the asset is the total price paid to acquire it, including the premium for early completion (i.e., Rs. 1,000 if finished before 1 January 200X and Rs. 900 if finished after 1 January 200X). This gives the same result as with liquidated damages.

b) Penalties for actual revenue loss during installation prior to final acceptance based on estimate

However, when the liquidated damages clause in a contract refers to compensating the affected party for any revenue lost or reimbursement of specific costs incurred because of delay in the completion of the project, then recognizing as revenue or deducting against specifically reimbursed costs is more consistent with the purpose of the liquidated damages clause.

c) Penalties for actual revenue loss after acceptance and capitalization of the equipment caused by any issue relating to equipment

At the date of acceptance, the Company has determined that the asset capable of operating in the manner intended by management and accordingly has also estimated the amount payable to vendor. If, however, this estimate is revised, subsequent to the year end, the effect of revision in amount payable to vendor will be taken to profit and loss account, as an adjustment in estimate, in accordance with IAS 8.

Query 2:

The Committee is of the view that additional payment made by the Company in case of better performance than the set benchmark, should be part of the maintenance cost. Further, the penalties imposed on the vendor due to performance below the set benchmark should be adjusted against the maintenance cost as these refers the compensation for the below standard maintenance job.

(May 19, 2017)

2. Presentation of Financial Statements

Enquiry:

Our Company is public unlisted company, registered under Companies Ordinance, 1984, since 1991. We are Economically Significant Company and stakeholders of our financial statements are shareholders, creditors, debtors and commercial Banks.

Our Company has revalued its non-current assets comprise of land, building and plant & machinery. Revaluation was carried out in May, 2014 and incorporated the revaluation surplus amounting to Rs.1.8M in financial statements of 2014. However, the incremental depreciation on revaluation surplus is so high that it converts Company’s operating profit into operating loss. As incremental depreciation is initially included in cost of sales and added back in other comprehensive income subsequently.

Based on the information provided, the operating loss amounting to Rs. 3M and loss before WWF amounting to Rs. 8M, resulting from the presentation mentioned above is not presenting the true picture of our operating activities. The factual position is that the Company has earned operating profit amounting to Rs. 133M and profit before WWF is amounting to Rs. 128M. Furthermore, this situation is creating a very uncomfortable position for our banks as they mostly use operating profit for assessment of company’s performance.

It is requested to please guide us whether in our opinion; deviation from International Accounting Standards appears to be only solution here. Your response in this regard will help us to ensure the compliances, with all the applicable laws in time.

Opinion:

The Committee would like to refer paragraph No. 19 and 20 of IAS 1 ‘Presentation of Financial Statements’ which permits departure under extremely rare circumstances where management concludes that compliance with a requirement in IFRS is very much misleading.

In the inquired scenario, it is opined that departure will not be applicable because it was an accounting policy choice of the Company to go for the revaluation model.

Further, the Committee is also of the view that depreciation will be charged on revalued amount as per requirements of IAS 16 ‘Property, Plant and Equipment’. Accounting for revalued Property, Plant and Equipment as prescribed under IAS 16 gives a true reflection of use of asset under revaluation model; therefore, the same should be adopted.

Based on the information provided, the presentation of the incremental depreciation as an item of other comprehensive income, is incorrect. The revaluation surplus included in equity in respect of an item of property, plant and equipment may be transferred directly to retained earnings when the asset is derecognised. This may involve transferring the whole of the surplus when the asset is retired or disposed of. However, some of the surplus may be transferred as the asset is used by an entity. In such a case, the amount of the surplus transferred would be the difference between depreciation based on the revalued carrying amount of the asset and depreciation based on the asset’s original cost. Transfers from revaluation surplus to retained earnings are not made through profit or loss.

(December 26, 2016)

3. Presentation of Capital Advances

Enquiry:

The Company has been incorporated last year to establish two power plants. These projects are fully sponsored by the Federal Government. The Company has entered into EPC agreements with two different international companies. One of them has opted for 15% advance payment. After advance, all payments will be based on work completion certificates. Every subsequent payment will be subject to 15% adjustment on account of advance payment. This EPC agreement includes erection, procurement of machinery, turbines (whole plant equipment), construction and full commissioning of the plant.

We need your technical advice as to how these advances will be presented in the balance sheet of the Company on reporting dates where these advances represent millions of dollars and will be adjusted over a period of 27 months.

We have enquired from different sources and came up with different options, for example (i) to classify these advances in CWIP; or (ii) to present these advances as long term advance in balance sheet before current assets.

Opinion:

The Committee considered your query and would like to draw your attention to the following paragraphs of IAS 16 ‘Property, Plant & Equipment’:

Para 6 defines cost as follows:

“Cost is the amount of cash or cash equivalents paid or the fair value of the other consideration given to acquire an asset at the time of its acquisition or construction …… in accordance with the specific requirements of other IFRSs, e.g. IFRS 2 Share-based Payment.”

“Elements of cost

16 The cost of an item of property, plant and equipment comprises:

(a) its purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates.
(b) any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management.
(c) the initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located, the obligation for which an entity incurs either when the item is acquired or as a consequence of having used the item during a particular period for purposes other than to produce inventories during that period.”

“17 Examples of directly attributable costs are:

(a) costs of employee benefits (as defined in IAS 19 Employee Benefits) arising directly from the construction or acquisition of the item of property, plant and equipment;
(b) costs of site preparation;
(c) initial delivery and handling costs;
(d) installation and assembly costs;
(e) 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); and
(f) professional fees.”

As per conceptual framework “asset” is recognized in the balance sheet when it is probable that the future economic benefits will flow to the entity and it is a resource controlled by the entity. Therefore, the Committee feels that presentation of advance to contractor either as CWIP or Advance in financial statements depends upon the specific terms of the contract. CWIP would normally correspond with physical completion of work in progress, whereas mobilization advance represents a payment to contractor to facilitate CWIP as per contractual terms. Risk and reward of ownership of “asset under construction” must be looked into with reference to terms of contract in order to determine the presentation. If risk and reward of ownership passes to Company with partial delivery then advance must be reclassified to CWIP accordingly.

4th and 5th Schedule of the Companies Ordinance 1984 requires CWIP (including significant item wise detail) to be presented as item of Property, Plant & Equipment (PPE). While para 74(b) of IAS 16 also requires disclosure of amount of expenditure recognized in the carrying amount of an item of PPE in the course of its construction.

In the light of above, the Committee is of the view that advances are required to be classified as long term Advance and they will be transferred to CWIP when the transfer of risk and reward in the under construction assets takes place and an identifiable asset is created. Such advance would remain as non-current till it is transferred to CWIP, as in the normal circumstances, it is not expected to realize into working capital of the company.

(July 04, 2016)

4. Technical Opinion on Class of Assets

Enquiry:

It has been noted that in case of a textile Company, building on freehold land, generators and electric installations relating to Power House were revalued while assets of the same class (i.e. building on freehold land, electric installations & plant and machinery) not belonging to Power House were stated at historical costs.

The Company’s auditor is of the opinion that Power House which included building, electrical installations do constitute a separate class of assets as their use is distinct to other assets. However, in our opinion para 37 of lAS 16 “Property, plant and Equipment” specifically describes separate class of assets and for constituting a separate class of assets the asset must be of a similar nature and use and for the subject case, the stated assets of Power House are not of a similar nature but use. Hence group of assets forming part of Power House do not constitute a separate class of assets.

Hence selective revaluation done by the Company which resulted in reporting of amounts in the financial statements that are a mixture of costs and their values as at different dates is in contravention with the requirements of IAS-16. Specific paras of lAS 16 are stated below for ready reference.

Para 36 of the International Accounting Standard 16 “Property, Plant and Equipment” (“IAS-16”) states that;

“ If an item of property, plant & equipment is revalued, the entire class of property, plant & equipment to which that assets belongs shall be revalued” (Emphasis Added)

Para 37 of the IAS-l6 states that:

“A class of property, plant and equipment is a grouping of assets of a similar nature and use in an entity’s operations. The following are examples of separate classes:
(a) land;
(b) land and buildings;
(c) machinery;
(d) ships,
(e) aircraft;
(f) motor vehicles;
(g) furniture and fixtures; and
(h) office equipment. ” (Emphasis Added)

and whereas, para 38 of the IAS-16 states that:
“The items within a class of property, plant and equipment are revalued simultaneously to avoid selective revaluation of assets and the reporting to amounts in the financial statements that are a mixture of costs and values as at different dates.However, a class of assets may be revalued on a rolling basis provided revaluation of the class of assets is completed within a short period and provided the revaluations are kept up to date” (Emphasis Added)

In view of the above, ICAP is requested to provide technical advice on the above stated matter.

Opinion:

The Committee considered your enquiry and is of the view that determining the class of assets according to their nature and use is an area involving significant estimates and judgment. There may be instances where management intends to put assets of similar nature to dis-similar use. Accordingly, such assets may be grouped as separate class of assets.

However, in the instant case, the Committee could not reach to a conclusion that the assets comprising land, building and power generators forming part of Power House do not constitute a separate class of assets as all facts which may have been considered by the management in considering the assets as separate class are not available with the Committee.

(September 05, 2014)

5. Capitalization of Assets

Enquiry:

Initially, we are foreseeing the following circumstances;

1.       First Gas Production (FGP) has started.
2.       Title has not been transferred in the name of Company
3.       Provisional or Final Acceptance Certificate (PAC/FAC) is yet to be given to   Contractor

But over the period of two months the whole scenario has been changed. As of December 31, 2013 year ending it is now clear that we shall not transfer the cost from CWIP to Plant and Machinery. Reason being the trial production is scheduled in January 2014 and acceptance certificate will be issued in mid of 2014.

We would really appreciate if you can give your opinion whether we have to decide whether to transfer cost from CWIP to P&M or not.

Opinion:

The Committee considered your enquiry and would like to refer following paragraphs of IAS 16 Property, Plant and Equipment:

20. Recognition of costs in the carrying amount of an item of property, plant and equipment ceases when the item is in the location and condition necessary for it to be capable of operating in the manner intended by management. Therefore, costs incurred in using or redeploying an item are not included in the carrying amount of that item. For example, the following costs are not included in the carrying amount of an item of property, plant and equipment:

(a) costs incurred while an item capable of operating in the manner intended by management has yet to be brought into use or is operated at less than full capacity;
(b) initial operating losses, such as those incurred while demand for the item’s output builds up; and
(c) costs of relocating or reorganising part or all of an entity’s operations.

55. Depreciation of an asset begins when it is available for use, i.e. when it is in the location and condition necessary for it to be capable of operating in the manner intended by management. Depreciation of an asset ceases at the earlier of the date that the asset is classified as held for sale (or included in a disposal group that is classified as held for sale) in accordance with IFRS 5 and the date that the asset is derecognised. Therefore, depreciation does not cease when the asset becomes idle or is retired from active use unless the asset is fully depreciated. However, under usage methods of depreciation the depreciation charge can be zero while there is no production.

The Committee is of the view that an item will be capitalized once it is in the location and condition necessary for it to be capable of operating in the manner intended by management. Recognised asset will be depreciated according to paragraph 43-49 of IAS 16.

(March 19, 2014)

6. Enquiry on paragraph 17(e) of IAS 16

Enquiry:

Generally mining or petrochemical company which has several plants, some ready for use by management and producing goods that are sold in the market and substantial revenue is derived from the same while other plants are still in the commissioning phase and not yet ready for production. The products that are sold in the market cannot be utilized internally as other plants where such products will be used as input are still not ready for use. Based on the above, generally, the proceeds from sale of products (produced from plants which are ready) with the overall capital costs of all plants netted off in accordance with paragraph 17(e) of IAS 16.

Paragraph 17(e) of IAS 16 states that:

“Examples of directly attributable costs are:

(e) 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)”

Paragraph 24 of IAS 23 states: “When an entity completes the construction of a qualifying asset in parts and each part is capable of being used while construction continues on other parts, the entity shall cease capitalizing borrowing costs when it completes substantially all the activities necessary to prepare that part for its intended use or sale.”

It is not uncommon in the mining or petrochemical industry for there to be a long commissioning period, sometimes over 12 months. In these situations, a key question which arises under IFRS is how the revenues and costs incurred during the commissioning period should be accounted for.

IAS 16 ‘Property, Plant and Equipment’ requires that costs can only be capitalized if they are “directly attributable” to the asset, and it also states that revenue from saleable material produced during the testing phase should be deducted from the cost of constructing the asset. So what does this mean for a company with an extended commissioning period?

It is also questionable whether all revenues earned during the commissioning period, particularly if they are substantial, should be deducted from the cost of developing the plant. This would only be appropriate if it can clearly be shown that they are directly attributable to bringing the asset to the condition necessary for it to be capable of operating in the manner intended by management. The example in IAS 16 of what might fall into this category is revenues earned from sales of samples produced when testing equipment. This would suggest that the IASB may not have envisaged a situation where more than an insignificant amount of revenue would be treated in this way.

In our view IAS 16.17(e) applies to each individual plant. Goods sold on the market are produced once the asset is operating in the manner intended by management. Revenue from those products should not give rise to ‘net proceeds’ to be offset against the costs of testing other plants that are part of the complex; rather it should be recognised in profit or loss for the period as it reflects the operations of the entity for the period.

For ease of understanding, the above matter has been illustrated through figures as follows:

Situation A

Costs of testing – 100
Other capital costs – 100
Revenue from sales during commissioning period- 50

Situation B

Costs of testing – 100
Other capital costs – 100
Revenue from sales during commissioning period – 150

Situation C

Costs of testing – 100
Other capital costs – 100
Revenue from sales during commissioning period – 250

What should be the correct accounting treatment of revenue earned and costs (including depreciation of the plant) during commissioning period in each of the above situations?

Opinion:

The Committee considered your enquiry and is of the view that paragraph 17(e) of IAS- 16 deals with capitalization of cost of testing. These costs are incurred while checking that the asset capitalized is functioning properly and are recognized after deducting the net proceeds from selling any items produced such as samples produced while testing such asset.

The Committee agrees with your views that IAS 16.17(e) apply to each individual plant. Revenue from sale of products from plants which are in operation should not netted off against the costs of testing other plants; rather cost of operation/cost of testing of plant which are not in operation and having an extended commissioning period should be capitalized after netting off with revenue of that plant (if any), if they are directly attributable to the asset as required in IAS 16.17(e). Further the Committee is also of the view that the cost of capitalization of plant should not be more than the fair value of the plant as required in paragraph 19 of IAS 36.

(May 20, 2011)

7. Clarification regarding other general Construction Costs

Enquiry:

Clarification is sought regarding the Guidelines for Accounting & Financial Reporting for NGOs/NPOs. On page 56 of the Guidelines, para 6.9.38 says:

“In case of self-constructed buildings, the cost would comprise those costs that relate directly to the construction of the building and an appropriate portion of other general construction costs.”

Can you please clarify what does other general construction cost mean?

Also please confirm will the cost of Finance and HR personnel involved in the financials and hiring of personnel related to the project such as construction of a University or Hospital will be capitalized in the cost of Capital work-in-progress (CWIP) or will it be expensed out.

Opinion:

The Committee is of the view that ‘other general construction costs’ may refer to costs which are not a component of the cost of property, plant and equipment but they can be directly attributed to the acquisition or construction of the asset or bringing the asset to the location and condition necessary for it to be capable of operating in the matter intended by the management.

With regard to cost of Finance and HR personnel, the Committee is of the view that it does not appear to be directly attributed to the construction of Project.

(November 8, 2010)

8. Desktop Revaluations in terms of IAS 16 (Property, Plant And Equipment)

Enquiry:

(a) Case in Point:

It has been found, though in exceptional, that surplus / deficit based on desktop revaluations are taken in the financial statements. Recently, a large listed company preferred to go for desktop revaluations of its major properties (land and buildings only), through the firms of professional valuers. This department sought clarification from the company and the reply was that in 2008 there was a sharp decline in the market value of land and buildings, therefore, in order to incorporate the decline in market value, the major land and buildings were revalued (this time only desktop).

(b) Technical Opinion sought

In this connection, we wish to seek a technical opinion as to:
(i)      Whether desktop revaluations are specifically allowed in terms of IAS-16 (Property, Plant and Equipment);
(ii)     In what case and in what form, method, manner or procedure the desktop revaluation may be conducted;
(iii)    How the desktop revaluations of land and buildings could be different from the generally accepted revaluations on market based evidence by appraisal; and
(iv)     Role of the auditors of the company with regard to such desktop revaluations;
(v)      Any comments that you desire to made with respect to our role as a regulator.

Opinion:

IAS 16 requires the revaluation to be done with sufficient regularity to ensure that the carrying amount does not differ materially from that which would be determined using fair value at the end of the reporting period. Following paragraphs of IAS-16 further clarifies the objective of valuation. Further, IAS 16 also adds that such frequent revaluations are unnecessary for items of property, plant and equipment with only insignificant changes in fair value. Instead, it may be necessary to revalue the item only every three or five years.

Relevant paragraphs of IAS 16 are reproduced below:

31 After recognition as an asset, an item of property, plant and equipment whose fair value can be measured reliably shall be carried at a revalued amount, being its fair value at the date of the revaluation less any subsequent accumulated depreciation and subsequent accumulated impairment losses. Revaluations shall be made with sufficient regularity to ensure that the carrying amount does not differ materially from that which would be determined using fair value at the end of the reporting period.

34 The frequency of revaluations depends upon the changes in fair values of the items of property, plant and equipment being revalued. When the fair value of a revalued asset differs materially from its carrying amount, a further revaluation is required. Some items of property, plant and equipment experience significant and volatile changes in fair value, thus necessitating annual revaluation. Such frequent revaluations are unnecessary for items of property, plant and equipment with only insignificant changes in fair value. Instead, it may be necessary to revalue the item only every three or five years.

We understand that the concept of ‘Desktop Revaluation’ emanates from Annexure IV (R-11) of the Prudential Regulations which defines ‘Desktop Evaluation’ as “an Interim Brief Review of Full-scope Evaluation, so that any significant change in the factors, on which the full-scope valuation was based, is accounted for and brought to the notice of the lending bank / DFI.”

The valuation process, for the purposes of provisioning, prescribed under Annexure IV (R-11) of Prudential Regulations includes conducting a ‘Full-scope Valuation’ of the securities and collateral in the first year and then followed by ‘Desktop Valuations’ in the second and third year. Full scope valuation shall be valid for three years from the date of last valuation.

Based on above, the Committee is of the view that IAS 16 does not prescribe any particular method (Full Scope / Desktop). It is management responsibility to report the appropriateness of Company Assets at fair value, based on its judgment.

(November 5, 2009)

9. Accounting Treatment for income earned on equity raised specifically for Qualifying Asset

Enquiry:

The Company is expanding its production capacity by adding a new cement line. The financing arrangement of this expansion project (qualifying asset) has been mix of debt and equity. The project has been kicked off and Equity (through right issue) has been raised up front and been utilized for the project payments. The equity funds are in the bank accounts and company is earning income on these funds.

What will be accounting treatment of the income earned on equity raised specifically for the qualifying asset (If company had taken decision not to expand then the company would not have raised this equity). Can it be capitalized in the CWIP or it will be charged to Profit and Loss account.

Opinion:

We would like to reproduce the following paragraphs from IAS-16 Property, Plant and Equipment:

21 Some operations occur in connection with the construction or development of an item of property, plant and equipment, but are not necessary to bring the item to the location and condition necessary for it to be capable of operating in the manner intended by management. These incidental operations may occur before or during the construction or development activities. For example, income may be earned through using a building site as a car park until construction starts. Because incidental operations are not necessary to bring an item to the location and condition necessary for it to be capable of operating in the manner intended by management, the income and related expenses of incidental operations are recognized in profit or loss and included in their respective classifications of income and expense.

In view of the above, the Committee is of the opinion that interest income earned on the temporary investment of funds raised through equity are in the nature of earnings from incidental operations as referred to in the above paragraph of IAS-16 and hence should be recognized in the profit and loss account in the period in which such income is earned.

(August 9, 2008)

10. Capitalisation Of Borrowing Cost

Enquiry:

We are conducting an internal audit of a Public sector medium size company operating a hospital. The facts are as under.

During the year, the company undertook to construct another hospital with a Grant received from Government of Punjab.
During the year, the company constructed a boundary wall and stopped the construction at this stage due to some disputes with Government departments not related to this project.
The company invested the Grant received from Government with a bank on short term basis and earned a profit during the year and the same amount was capitalized in CWIP, resulting in CWIP amount in negative.
The company got prepared the technical drawings and other workings for the construction of hospital at that place.
The company could not start construction of hospital building due to those disputes and due to current political havoc it is not possible that the project will be started within next 4 to 5 months.

Questions?

1. Can company capitalize the interest earned?

Upto June 30, 2008
After and up to February 28, 2008

2. Can CWIP be presented as negative figure in balance sheet?

Opinion:

We would like to reproduce the following paragraphs from IAS-16 Property, Plant and Equipment:

In view of the above, the Committee is of the opinion that interest income earned on the temporary investment of funds received through government grant are in the nature of earnings from incidental operations as referred to in the above paragraph of IAS-16 and hence should be recognized in the profit and loss account in the period in which such income is earned.

(March 13, 2009)

11. Particular method for providing depreciation in the Accounts

Enquiry:

Reference is made to para 62 of IAS 16 which is reproduced here under:

62 A variety of depreciation methods can be used to allocate the depreciable amount of an asset on a systematic basis over its useful life. These methods include the straight-line method, the diminishing balance method and the units of production method. Straight-line depreciation results in a constant charge over the useful life if the asset’s residual value does not change. The diminishing balance method results in a decreasing charge over the useful life. The units of production method results in a charge based on the expected use or output. The entity selects the method that most closely reflects the expected pattern of consumption of the future economic benefits embodied in the asset. That method is applied consistently from period to period unless there is a change in the expected pattern of consumption of those future economic benefits.

In the light of above, it can be validly concluded that there is no binding as regards to application of any particular method for providing depreciation in the accounts. In the hotel industry depreciation in respect of “crockery, cutlery and linen” is being provided on replacement cost method whereby initially an asset is recorded at cost and subsequent purchases thereof is charged to profit and loss account however, an exercise is carried out every year in order to assess that whether the amount recoded at historical cost without providing any depreciation should not be materially differ as compared to inventory of crockery, cutlery and linen in hand.

We, therefore, request you to please advice us as regards to allowability of above method especially for hotel industry in relation to assets classified under crockery, cutlery and Lenin in the light of IAS and related guidelines.

Opinion:

At the outset, the Committee would like to draw your attention to the following requirements of IAS-16”Property, Plant and Equipment”

50 The depreciable amount of an asset shall be allocated on a systematic basis over its useful life

60 The depreciation method should reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity. (underline is ours)

The Committee has considered that replacement cost method does not result in systematic allocation of depreciable amount of an asset over its useful life and hence is not a proper method of depreciation. Therefore, for the purpose of charging depreciation in respect of assets in the hotel industry such as crockery, cutlery and Linen, an appropriate depreciation method should be selected that reflects the expected pattern of consumption of future economic benefits embodied in such assets through their usage.

The Committee also recognizes that in view of the nature of the above referred assets, the estimation of their useful life may involve a significant amount of judgment. However, in this regard the management should consider factors such as physical wear and tear, commercial obsolescence, asset management policy of an entity that may involve replacement of such assets after a specified period etc. Accordingly, the useful life of each item should be estimated separately. While determining the useful life of an asset the factors that have been given in paragraph 56 of IAS 16 should be taken into account.

The depreciation charge as determined above, should be recognized in profit and loss account on a systematic basis over the useful life of the asset.

(July 4, 2008)

12. Treatment of start-up costs in the case of Medium-Sized Entities

Enquiry:

I am concerned with the accounting treatment of start-up costs in the case of medium-sized companies, in view of the newly issued “Accounting and Financial Reporting Standards for Medium-sized Entities” and the amendments in the fifth Schedule to the Companies Ordinance, 1984.

The revised fifth schedule does not contain any heading for “Deferred Cost” under the umbrella of which start-up cost can be capitalized and shown on the balance sheet. Section 5 of the “Accounting and Financial Reporting Standards for Medium-Sized Entitles”, that is “Intangible Assets”, also clearly states in paragraph 5.11, that expenditure on start-up activities is recognized as expense when incurred, unless this expenditure is included in the cost of an item of property, plant and equipment. This section of the standard includes establishment cost (i.e. preliminary expenses) and pre-operating expenses, which obviously includes certain operating and overhead expenses, in the definition of start-up costs. But section 5 does not lay down any criteria for the inclusion of start up expenditure in the cost of an asset.

However if we go through section 3 “Property, Plant and Equipment”, paragraph 3.5 clearly mentions that administrative and general overhead costs are not costs of an item of properly, plant and equipment.

These provisions create confusion, kindly elaborate whether general administrative and overhead costs can be capitalized under any circumstances and if so, what is the criteria.

Please also note that the Income Tax Ordinance, 2001 allows capitalization of pre-business commencement expenses. Therefore if a company expenses out start-up costs because the accounting standards do not allow that, so how it will be able to take advantage of tax laws. Kindly provide some guideline.

Opinion:

For ready reference we would like to reproduce the following paragraphs of Section 3 of Accounting and Financial Reporting Standards for Medium-Sized Entities (MSEs) and Small Sized Entities (SSEs).

Measurement at Initial Recognition

3.3 An item of property, plant and equipment that qualifies for recognition as an asset shall initially be measured at its cost.

a) The cost of an item of property, plant and equipment comprises its purchase price, including import duties and non-refundable purchase taxes after deducting trade discounts and rebates;

b) Any directly attributable costs of bringing the asset to working condition for its intended use the initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located, the obligation for which an entity incurs either when the item is acquired or as a consequence of having used the item during a particular period for purposes other than to produce inventories during that period.

3.4 Examples of directly attributable costs include the following:

(a) costs of employee benefits (as defined in Section 17 Employee Benefits) arising directly from the construction or acquisition of the item of property, plant and equipment;

(b) costs of site preparation;

(d) installation and assembly costs;

(f) professional fees .

3.5 Examples of costs that are not costs of an item of property, plant and equipment are:

(a) costs of opening a new facility;

(b) costs of introducing a new product or service (including costs of advertising and promotional activities);

(c) costs of conducting business in a new location or with a new class of customer (including costs of staff training); and

administration and other general overhead costs.

Further your attention is also drawn to the following paragraph of IAS 16 which is not part of MSE Standard:

21 Some operations occur in connection with the construction or development of an item of property, plant and equipment, but are not necessary to bring the item to the location and condition necessary for it to be capable of operating in the manner intended by management. These incidental operations may occur before or during the construction or development activities. For example, income may be earned through using a building site as a car park until construction starts. Because incidental operations are not necessary to bring an item to the location and condition necessary for it to be capable of operating in the manner intended by management, the income and related expenses of incidental operations are recognised in profit or loss and included in their respective classifications of income and expense.

In view of the above, the Committee is of the opinion that any cost or overhead which is directly attributable to any asset should be capitalized and the administration, other general overhead costs or any other expense which cannot be directly attributed to the property, plant and equipment should be charged to profit and loss since they do not meet the definition of assets.

With regard to your concern on amortization of pre-commencement expenditure as allowed in section 25 of the Income Tax Ordinance, 2001, the Committee is of the view that charging of whole amount of start-up cost to profit and loss account would not put a company at disadvantage while calculating tax profit.

(August 9, 2008)

13. Treatment of incremental depreciation arising out of revaluation of Fixed Assets

Enquiry:

Suppose if a Company in its financial statements has disclosed that it has revalued its fixed assets 3 months before the year end. The said revaluation has resulted in surplus amounting to Rs.900 million in certain items of plant and machinery and deficit of amounting to Rs.600 million in case of certain other items leading to net surplus of Rs.300 million which was reported in the balance sheet as net Surplus on Revaluation of Fixed Assets Account.

Depreciation rates for plant and machinery items were in the range of 6% to 20%. While computing incremental depreciation on plant and machinery items it was noticed that those items which have resulted in deficit were charged with higher rate of depreciation and thus resulted in reduction in depreciation charge for the year amounted to Rs. 9 million.

If we assume following results:

Incremental
Applicable Depreciation
Rs. in million Dep. Rate Rs. in millions

Plant A – Surplus on revaluation                                  900               9% Avg                    81
Plant B – Deficit on revaluation                                  (600)           15% Avg                  (90)
——————                                   ————-
Net result (Surplus) 300 (9)
—————— ————-

It can also be understood as following:
Depreciation

	Cost	Surplus/ deficit	Revalued Amount	Dep Rate	Before Revalue	After Revalue	Incremental Depreciation
Plant A	1000	900	1900	9%	90	171	81
Plant B	1000	(600)	400	15%	150	60	(90)
							(9)

Accounting Treatment adopted by the Company:

The depreciation charge for the current year was reduced by Rs.9 million due to major impact of depreciation on deficit items and no adjustment has been made to the value of surplus on revaluation of fixed assets.

In pursuance of section 235 of the Companies Ordinance, 1984 which provides that:

Quote

“(1) Where a company revalues its fixed assets, the increase in, or sums added by writing up of, the value of such assets as appearing in the books of accounts of the company shall be transferred to an account to be called “Surplus on revaluation of Fixed Assets Account” and shown in the balance-sheet of the company after Capital and Reserves.

(2) Except and to the extent actually realized on disposal of the assets which are revalued, the surplus on revaluation of fixed assets shall not be applied to set off or reduce any deficit or loss, whether past, current or future, or in any manner applied, adjusted or treated so as to add to the income, profit or surplus of the company, or utilized directly or indirectly by way of dividend or bonus:

Provided that the surplus on revaluation of fixed assets may be applied by the company in setting off or in diminution of any deficit arising from the revaluation of any other fixed asset of the company:

Provided further that incremental depreciation arising out of revaluation of fixed assets may be charged to surplus on revaluation of fixed assets account” Unquote

Items which have resulted in deficit on revaluation, had an impact of reduction in the depreciation charge for the year in Profit and Loss Accounts and thus increased the amount of profit made available for distribution to the shareholders just because of revaluation of fixed assets.

The accounting treatment adopted by the Company appears to be in violation of the requirement of the Ordinance and IAS-16 as no adjustment with surplus on revaluation of fixed assets has been accounted for. We shall be grateful for your valuation comments on the accounting treatment adopted by the said Company.

Opinion:

The Committee noted that the issue has arisen because Section 235 of the Companies Ordinance allows companies to set-off revaluation of surplus of fixed assets against the deficit of any other fixed assets (which may have different useful live/depreciation rate) which IAS 16 does not permit. Paragraph 40 of IAS 16 states that:

If an asset’s carrying amount is decreased as a result of a revaluation, the decrease shall be recognized in profit or loss. However, the decrease shall be recognized in other comprehensive income to the extent of any credit balance existing in the revaluation surplus in respect of that asset. The decrease recognized in other comprehensive income reduces the amount accumulated in equity under the heading of revaluation surplus (underlining is ours).

However, notwithstanding the above the Committee deliberated the matter and is of the view that the accounting treatment adopted by the company is in accordance with Section 235 of the Companies Ordinance, 1984 read with SRO 45(I)/2003 dated January 13, 2003 except that the company should also transfer each year an amount, equal to the decrease in depreciation charge, from the retained earnings/unappropriate profit to the surplus on revaluation account. .

(October 18, 2008)

14. Accounting for project development expenditure and costs related thereto

Enquiry:

We would like to draw your attention to the capitalization of “Project Development Expenditure”, which is covered under IAS 16 Property, Plant and Equipment. This standard does not deal specifically with Project Development Expenditure as TR 20 did and has very narrow application compared with any infrastructure Project Development activity, especially Power Projects (hydro or thermal) which normally takes a number of years to develop.

Power Generation project are developed under the specific concessions given by the Government in accordance the Power Policy of the Government. The concession/licenses are either under Build-Own and Operate (BOO) or under Build own operate and transfer (BOOT) concept. Such projects are being developed under a Special Purpose Company whose Sole Purpose is to develop, design, construct, own, finance, operate and maintain specific facility, hence all the development expenditure being incurred by the Company is for the sole purpose to develop, design, construct, finance and bring the power generating facility to operation for which it is intended, therefore all the expenditure is directly attributable to preparing the assets for its intended use.

The Project Development Costs are well defined and identified for infrastructure projects, normally these are based on estimates and budgets which comprise of all such elements of cost and expenditure as given in Para 16 and 17 of IAS and also include administrative and general overhead costs which are incurred prior to Commercial Operation Date (COD) and are necessary to achieve the purpose for which the company is set up. These administrative and general overhead costs include office rent, utility bills, motor vehicle running costs, traveling, salaries of driver, secretaries, accountants etc.

Para 19 of IAS 16 gives examples that are not costs of an item of property, plant and equipment, which includes administration and other general overhead costs. This may be applicable for the acquisition or construction of plant and equipment by an existing or ongoing company already in operation but for Special Purpose Company whose sole purpose is to construct a facility all costs including the administrative costs are directly attributable to such facility as development costs and has to be Capitalized as the benefits relating to such costs arise after the commercial operation date.

If these costs are not development cost then the question arises how can a Special Purpose Company operate without an office, its related facilities and office staff to fulfill its Sole Purpose of setting up a specific project. Obviously, there are costs related to such administrative functions e.g. office rent, utility bills, staff salaries, traveling etc. and such costs are incurred directly as a consequence of the project development. The revenue and economic benefit of which are derived upon commercial operation of the project complex.

Furthermore, in case of infrastructure projects the project development costs are recognized as part of the total project cost for the purposes of computing DSCR, IRR and fixation of tariff therefore it cannot be expensed/ charged to profit & loss account.

In light of the above facts, we believe that the administrative and general costs incurred by the “Infrastructure Projects” are directly attributable to the “Project Development Expenditure” and should be capitalized. Previously, it was not the issue as it was covered under TR 20, upon withdrawal of TR 20 by the Institute on August 24, 2006, this has left a big question mark which needs to be resolved. Hence a clarification is required from the technical committee on this particular issue.

Opinion:

First the Committee would like to apprise that the reason for withdrawing TR-20 by the Council of the Institute through Circular No. 07/2006 dated August 24, 2006 was the revision in IAS 16 since treatment of indirect costs referred to in the TR was not in compliance with the revised version of IAS 16.

Now your attention is drawn to the following paragraphs of IAS 16:-

16 The cost of an item of property, plant and equipment comprises:

(a)its purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates.

(b)any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management.

17 Examples of directly attributable costs are:

(a) costs of employee benefits (as defined in IAS 19 Employee Benefits) arising directly from the construction or acquisition of the item of property, plant and equipment;

(b) costs of site preparation;

(d) installation and assembly costs;

(f) professional fees.

19 Examples of costs that are not costs of an item of property, plant and equipment are:

(a) costs of opening a new facility;
(b) costs of introducing a new product or service (including costs of advertising and promotional activities);

(c) costs of conducting business in a new location or with a new class of customer (including costs of staff training); and
(d) administration and other general overhead costs.

21 Some operations occur in connection with the construction or development of an item of property, plant and equipment, but are not necessary to bring the item to the location and condition necessary for it to be capable of operating in the manner intended by management. These incidental operations may occur before or during the construction or development activities. For example, income may be earned through using a building site as a car park until construction starts. Because incidental operations are not necessary to bring an item to the location and condition necessary for it to be capable of operating in the manner intended by management, the income and related expenses of incidental operations are recognised in profit or loss and included in their respective classifications of income and expense.

In view of the above, the Committee is of the opinion that any cost which is directly attributable to the project should be capitalized and the administration, other general overhead costs or any other expense which cannot be directly attributed to the property, plant and equipment should be charged to profit and loss since they do not meet the definition of assets

For further clarification your attention is drawn to the following paragraph of the Framework of IFRS which is self explanatory:

95 Expenses are recognised in the income statement on the basis of a direct association between the costs incurred and the earning of specific items of income. This process, commonly referred to as the matching of costs with revenues, involves the simultaneous or combined recognition of revenues and expenses that result directly and jointly from the same transactions or other events; for example, the various components of expense making up the cost of goods sold are recognised at the same time as the income derived from the sale of the goods. However, the application of the matching concept under this Framework does not allow the recognition of items in the balance sheet which do not meet the definition of assets or liabilities.

The Committee appreciates your concerns that earlier TR-20 used to allow charging of indirect cost to property, plant and equipment but as you are well aware that accounting framework for corporate entities in Pakistan is IFRS therefore it would not be appropriate to deviate from the accounting principles which have been laid down in IFRS.

Further, the Committee appreciates that there are costs that are necessary to incur to achieve the objectives of the company and these cost may not necessarily relate to revenue generating activities. However, in the light of Paragraph 95 of the framework these cost would need to be charged to profit and loss as these do not meet the criteria set for recognition of these as either intangibles or property plant and equipment or any other asset.

(January 5, 2007)

15. Accounting Treatment of Tools and Parts

Enquiry:

I work in the automotive sector where we are involved in automotive assembly/manufacturing. Our cost of components for assembly operation is built up of two main areas:

Cost of imported parts
Cost of local parts

As far as imported parts are concerned, the case is very simple. We import parts from our principal and include the same in our cost of inventory by adding C&F value, all taxes, insurance and related costs.

As far as local parts are concerned, we need to clarify the proceedings and one typical issue.

In Pakistan, automotive companies are required to follow a compulsory deletion program (the same has been dispensed with in the new budget of 2006-07 and replaced by Tariff Based System-TBS but there has been heavy investment in this regard by automotive companies) in which companies need to compulsory localize 59% of their total parts at the time of initiation of assembly operation. If such local parts are not procured and produced locally and instead imported, there is a penalty duty of extra 15% imposed on their import from outside Pakistan. These local parts development is based on certain processes. I will explain this through an example:

Under the deletion program, we need to compulsorily localize (or produce locally) car bumpers which cannot be imported without the imposition of penalty. We need to approach a local vendor who is a producer of car bumpers to build the part for our car. Now the vendor says that the bumper for our XYZ car is a specific one and requires special tools and moulds to prepare it for our specifications and quality standards. Every car has its own specifications and our car would require a specific mould and tool. To prepare such a mould, the vendor requires a specific amount of money which in this example we can take as PKR 3 million. Now there are three scenarios in which this amount could be provided to the vendor:

Vendor makes his/her own investment and prepares the mould and tool for development of our car bumper
Our company makes full investment and provides the PKR 3 million to the vendor for development of tool and mould
Both the parties i.e. vendor and us share the cost of investment in a pre-agreed ratio. In this example we take it as 50% each.

It should also be remembered that there is a separate cost of the bumper on which the same is provided to our company by the vendor. We take the cost to be PKR 2,000 in this case.

In first and third scenarios, there is a threshold that is set for the advance amount to be amortized. It is usually on a quantity of that particular part produced for that tool/mould, in this case, a quantity of 15,000 units is taken over a period of three years. This would come up to PKR 200 per unit produced.

In the first scenario, the vendor will charge the amount of PKR 200/unit tooling advance in their bill of parts cost issued. For 100 units of bumpers supplied they will charge an amount of PKR 220,000 (cost + amortization of tooling advance). This tooling advance will be included in the bill till such time the 15,000 agreed volume of amortization is not reached.

In the second scenario, there would be no impact in the bill of vendor and we would be amortizing the amount of PKR 3 million in our own books based on the number of units supplied.

In the third scenario, a mixture of the above two treatments would take place and we would be amortizing our own commitment of PKR 1.5 million over the number of units and vendor would be charging us PKR 100 for each bumper unit provided.

Please also note that in all these cases, the mould would be our company’s property (in case of second scenario, it will always be our property) but in cases 1 and 3, it will become our company’s property after the completion of the amortization period.

Accounting Treatment:

Now comes the problem of accounting treatment. The cost of the part is simple. It will be charged to the cost of sales, but we need a clarification of the tooling advance paid to the vendor in all cases. Please note that the life of the mould/tool is much more than the amortization period. We can take the advance paid by us as a CWIP for the advance period and capitalize this as an asset after the completion of the advance period or should we charge it to the P&L account. We take jigs & fixtures which are used to assemble the car as fixed assets and if we look in substance, these tools and moulds are also used to produce parts for car assembly, therefore it might not be the case to take the cost of building these tools and moulds to profit & loss account. Please advise on this issue.

Opinion

The enquiry raised has three aspects:

Recognition of moulds and tools as assets
Amount of cost to be recognized
Depreciation charge and period

Recognition of moulds and tools as assets

Since moulds and tools developed are tangible assets and the ownership of the same will remain with the automotive company in all cases, guidance from IAS 16 should be sought on all the issues involved.

IAS 16 paragraph 7 states:

The cost of an item of property, plant and equipment shall be recognised as an asset if, and only if:

(a) it is probable that future economic benefits associated with the item will flow to the entity; and

(b) the cost of the item can be measured reliably.

In your case both conditions appear to be met and the moulds and tools qualify for recognition as an item of property, plant and equipment.

Further, in accordance with the requirements of IAS-16, an item of property, plant and equipment should be recognized and the depreciation charge should commence from the date when it is available for use, i.e. when it is in the location and condition necessary for it to be capable of operating in the manner intended by management.

Accordingly, in scenarios 1 and 3, it appears to be appropriate to capitalize the moulds and tools even before the advance amortization period by recording a corresponding liability for the cost of asset towards the vendor at the time the asset is ready for use. The subsequent payments made for the asset referred to in your letter as amortization charge included in the cost of parts should be applied to reduce the aforesaid liability.

In scenario 2, the payments made for the development of moulds and tools should be treated as advance until the moulds and tools are ready for use at which the same should be capitalized as operating fixed asset.

Amount of cost to be recognized

As per IAS 16 paragraph 23:

The cost of an item of property, plant and equipment is the cash price equivalent at the recognition date.

Under scenario 2 it is clear that all the investment would be made outright by the company, therefore, the cash price equivalent is Rs 3,000,000. However, under scenarios 1 and 3, the local vendor may have some hidden cost of financing involved over and above the cash price. In such a situation, guidance should be sought from IAS 39 for allocation of the amounts between principal and interest.

Depreciation charge and period

Depreciation charge for any item of property, plant and equipment is based on its useful life to the entity. If the useful life of these moulds and tools, to your entity, extends beyond the three year period, the useful life should be used as a base for charging depreciation rather than the three year period. Also the difference between useful life and economic life should be considered before making any decision.

(December 9, 2006)

16. Impact of withdrawal of TR-20

Enquiry:

One of our clients is facing problem in applying requirements of IAS -16 which have become effective due to withdrawal of TR-20. The client has not yet commenced its business activities and has not earned any income. All expenses incurred are classified as precommencement expenditure and shown as an asset in the financial statements. Prior to withdrawal of TR – 20, it was being understood that direct attributable expenses shall be allocated to the respective asset and indirect expenses shall be allocated to land and building proportionately according to their respective costs.

Now as a result of withdrawal of TR – 20, paragraph 19 of IAS 16, Property, Plant and Equipment becomes effective. This paragraph requires recognition of indirect precommencement expenses as expense in the period in which these are incurred rather than allocating these expenses to the cost of land and building.

Now the questions arise as follows:

a) Since the company has not commenced its operations and there is no income against which these indirect expenses will be matched. So whether preparing profit and loss account without income is necessary as a fundamental matching concept will not be complied with if we decide to prepare profit and loss account?

b) if profit and loss account is prepared, what will be its presentation since all expenses indirect expenses are in the nature of administrative expenses?

c) What would happen if the company has not commenced its business activities but is earning income through other sources e.g. interest income on deposit accounts? Can the indirect pre-commencement expenses be matched with the other income earned in a period?

d) Whether adopting para 19 of IAS – 16 and foregoing the application of TR – 20 constitutes a change in accounting policy.

Opinion:

With regard to your first concern on matching principle, the Committee would like to draw your attention to the following paragraph of the Framework of IFRS which is self explanatory:

With regard to your queries (b) and (c) the Committee wishes to draw your attention to the following paragraph of IAS 16:

21 Some operations occur in connection with the construction or development of an item of property, plant and equipment, but are not necessary to bring the item to the location and condition necessary for it to be capable of operating in the manner intended by management. These incidental operations may occur before or during the construction or development activities. For example, income may be earned through using a building site as a car park until construction starts. Because incidental operations are not necessary to bring an item to the location and condition necessary for it to be capable of operating in the manner intended by management, the income and related expenses of incidental operations are recognised in profit or loss and included in their respective classifications of income and expense. (underlining is ours)

In view of the above paragraphs the Committee is of the opinion that though there would not be any revenue or turnover until the commercial production is started or business is commenced, the profit and loss account would have to be prepared as IAS/IFRS do not exempt any entity from preparing profit and loss account. The income e.g. interest income and expenses which are not directly attributable to property plant and equipment should be recognised in the profit or loss account in their relevant heads.

However, while recognizing the interest income you are advised to take cognizance of the following paragraphs of IAS 23 ‘Borrowing Cost’:

15 To the extent that funds are borrowed specifically for the purpose of obtaining a qualifying asset, the amount of borrowing costs eligible for capitalisation on that asset shall be determined as the actual borrowing costs incurred on that borrowing during the period less any investment income on the temporary investment of those borrowings.

16 The financing arrangements for a qualifying asset may result in an entity obtaining borrowed funds and incurring associated borrowing costs before some or all of the funds are used for expenditures on the qualifying asset. In such circumstances, the funds are often temporarily invested pending their expenditure on the qualifying asset. In determining the amount of borrowing costs eligible for capitalisation during a period, any investment income earned on such funds is deducted from the borrowing costs incurred.

As previously TR-20 used to allow charging of indirect expenses to property, plant and equipment therefore the Committee is of the opinion that subsequent to withdrawal of TR-20 the change in the treatment of indirect expenses would be considered as change in accounting policies and dealt with as per IAS 8 ‘Accounting policies, Changes in Accounting Estimates and Errors’.

(January 5, 2007)

17. Initial Public Offer (IPO) Expenses – Treatment in Financial Statements

Enquiry:

One of our clients has gone public and has incurred IPO expenses for arrangement of equity to directly finance enhancement of its production facilities. The client is currently extracting profit and loss account to reflect the results of its existing operations. The entire funds raised through the IPO are intended to be used for the expansion of the project. We require clarifications of the accounting treatment of IPO expenses in light of the revised 4th Schedule to the Companies Ordinance, 1984, provisions of Companies Ordinance itself and the revised International Accounting Stanard-16 (property plant and equipment).

Para – 17 of IAS-16, Property, Plant and Equipment (Revised 1998) states:

“Administration and other general overhead costs are not a component of the cost of property, plant and equipment unless they can be directly attributed to the acquisition of the asset or bringing the asset to its working condition. Similarly, start-up and similar pre-production costs do not form part of the cost of an asset unless they are necessary to bring the asset to its working condition. Initial operating losses incurred prior to an asset achieving planned performance are recognized as an expense”

Technical Committee Recommendations under Accounting TR-20 (Reformatted 2000)

In the light of Para 17 of the IAS 16 (revised 1998), TR-20 made the following recommendations. An extract of the said TR is reproduced as under:-

“Expenditure incurred during project implementation may be grouped under the following broad heads”

Expenditure Examples

Formation expense Preliminary expenses, expenses incurred on issue of shares or TFCs including any sums paid by way of commission or brokerage on the issue of shares or TFCs and other formation expenses…..

Formation expenses shall be written off during a period not exceeding five years commencing from the financial year in which the costs are incurred as provided in paragraph 5(C) of Part II of the Fourth Schedule to the Companies Ordinance, 1984.

IAS 16 Property, Plant and Equipment (Revised December 2003)

Para – 19(d) of the revised IAS 16 excludes administrative and other general overheads giving rise to the presumption that any such costs incurred do not qualify for capitalization and should be charged to profit and loss account.

Companies Ordinance, 1984

Section 234 (1)

The said Section allows that where any item of expenditure, which may in fairness be distributed over several years, has been incurred in any one financial year, the whole amount of such expenditure shall be stated with the addition of the reasons why only a portion of such expenditure is charged against the income of the financial year.

Related 4th Schedule to the Companies Ordinance, 1984

The repealed 4th Schedule to the Companies Ordinance, 1984 allowed the deferred costs to be amortized over a period of five years.

Revised 4th Schedule to the Companies Ordinance, 1984

The concept of deferred cost has been deleted in the revised 4th Schedule to the Companies Ordinance, 1984 thereby any cost incurred during the year not qualifying the criteria of capitalization should be charged to profit and loss account.

Issue

The relevant provisions of the Companies Ordinance, 1984, the revised 4th Schedule to the Companies Ordinance, treatment recommended by TR-20 and the revised International Accounting Standards have become contradictory as there is no concept of deferred cost in the revised 4th Schedule.

Keeping in view the above, following issues have arisen:

1) What is the status of applicability of TR-20 in relation to IPO expenses considering that the concept of deferred cost has been eliminated in the revised 4th Schedule to the Companies Ordinance, 1984?

2) Whether the company is justified to capitalize IPO expenses by transferring it to property, plant and equipment as the funds have been specifically arranged and utilized for the expansion in project.

3) Should the entire amount be expensed despite the fact these expenses are not related to results of existing operations of the Company.

We would also like the Institute’s opinion, for where a Company is a green field project, the general practice has been to maintain a trial run profit and loss account while the Company achieves its optimal production process. The entire trial run loss including all general and administrative expenses is capitalized as part of property plant and equipment. In light of the revised IAS 16, whether Company is required to draw a separate profit and loss account to show the general and administrative expenses even though it has not yet commenced commercial production.

Opinion:

First of all the Committee would like to inform you that there is no contradiction between IAS and the Companies Ordinance, 1984 with regard to deferred cost. Instead the Committee is of the view that sub-section (1) of section 234 only refers to distribution of an item of expenditure over several years subject to fairness of the reasons why only a portion of expenditure should be charged against income of the financial year. Fairness of the said distribution has to be judged in the light of accounting framework which in case of Pakistan is International Accounting Standards and such Accounting Standards no longer carry the concept of deferred cost. Therefore any deferment of expenditure by an entity will not be according to International Accounting Standards which have been notified by SECP.

Now we come to the three issues raised by you in the above enquiry and our views on them are as follows:

(1) As TR-20 refers to paragraph 5(C) of Part II of the superseded Fourth Schedule to the Companies Ordinance, 1984 which no more exists in revised Fourth Schedule, therefore, the Committee is of the view that TR-20 related to ‘formation expenses’ or deferred cost is not applicable anymore.

Further the Committee is also considering withdrawal of TR-20 as all three issues addressed in it have been either superseded or covered in IAS/IFRS.

(2) With regard to capitalization of IPO expenses the Committee would like to draw your attention to the following paragraphs of IAS 16 Property, Plant and Equipment‘:

16 The cost of an item of property, plant and equipment comprises:

(a) its purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates.

(b) any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management.

(c) the initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located, the obligation for which an entity incurs either when the item is acquired or as a consequence of having used the item during a particular period for purposes other than to produce inventories during that period.

17 Examples of directly attributable costs are:

In view of the above paragraphs the Committee is of the opinion it would not be appropriate to capitalize IPO expenses as they do not appear to be directly attributable costs.

(3) For your third issue the Committee would like to draw your attention to the following paragraph of IAS 32, Financial Instruments: Disclosure and Presentation which is self explanatory:

37 An entity typically incurs various costs in issuing or acquiring its own equity instruments. Those costs might include registration and other regulatory fees, amounts paid to legal, accounting and other professional advisers, printing costs and stamp duties. The transaction costs of an equity transaction are accounted for as a deduction from equity (net of any related income tax benefit) to the extent they are incremental costs directly attributable to the equity transaction that otherwise would have been avoided. The costs of an equity transaction that is abandoned are recognized as an expense.

With regard to your query relating to preparation of Profit and Loss Account before commencement of commercial production, the Committee is of the opinion that though commercial production has not yet started, you would be required to prepare profit and loss as IAS/IFRS do not exempt any entity from preparing profit and loss account just because it has not yet started its commercial production.

(February 4, 2006)

18. Revaluation of Fixed Assets and Treatment of Pagree

Enquiry:

Your attention is drawn to the following matters:

Revaluation of Fixed Assets:

At inception, the Company had only one unit, which asset was revalued with the passage of time. After few years the company has installed more units in different provinces and locations all over Pakistan. The assets that were revalued have been disposed off and surplus on revaluation on these assets has also been adjusted accordingly except land and remaining assets.

If the Company gets its assets revalued by a valuer again to meet the requirements of International Accounting Standard 16 Property, Plant and Equipment as reproduced below:

As per Paragraph no. 31:

“Revaluations shall be made with sufficient regularity to ensure that the carrying amount does not differ materially from that which would be determined using fair value at the balance sheet date”, and;

As per Paragraph No. 34

“The frequency of revaluations depends upon the changes in fair values of the items of property, plant and equipment being revalued. When the fair value of a revalued asset differs materially from its carrying amount, a further revaluation is required. Some items of property, plant and equipment experience significant and volatile changes in fair value, thus necessitating annual revaluation. Such frequent revaluations are unnecessary for items of property, plant and equipment with only insignificant changes in fair value. Instead, it may be necessary to revalue the item only every three or five years”.

Based on above paragraphs reference and keeping in view the fact of first unit’s revaluation, your opinion is sought for the following:

Q.1 Either related class of assets of all units needs to be revalued or that particular unit’s assets that were previously revalued should be revalued?

Q.2 What is meant by significant variation, is there any percentage of book value?

Q.3 Except land almost all of the prior revalued assets were sold. Is it necessary to revalue the replaced assets?

As per Para No. 36

“If an item of property, plant and equipment is revalued, the entire class of property, plant and equipment to which that asset belongs shall be revalued”

Q.4 Is there any provision in company law and International Accounting Standards available by which we could make reversal of revaluation of fixed assets and state revalued assets at cost or carrying amount in balance sheet after considering any possible depreciation or impairment if required?

Treatment of Pagree

Q. 5 We intend to purchase a corporate office at one of the premier locations of the city but the space available over there is under PAGREE scheme. As nothing is available in IAS 38 Intangible Assets, however in Income Tax Ordinance, 2001 the treatment of un-adjustable amount is mentioned. According to the matching principle, matching cost should be amortized accordingly. Therefore your opinion is sought about the proper treatment and disclosure of PAGREE in the financial statements.

Opinion:

Answer 1

Apart from the paragraphs reproduced in the above enquiry your attention is also drawn to the following paragraphs of IAS 16:

37 A class of property, plant and equipment is a grouping of assets of a similar nature and use in an entity’s operations. The following are examples of separate classes:

(a) land;
(b) land and buildings;
(c) machinery;
(d) ships;
(e) aircraft;
(f) motor vehicles;
(g) furniture and fixtures; and
(h) office equipment.

38 The items within a class of property, plant and equipment are revalued simultaneously to avoid selective revaluation of assets and the reporting of amounts in the financial statements that are a mixture of costs and values as at different dates. However, a class of assets may be revalued on a rolling basis provided revaluation of the class of assets is completed within a short period and provided the revaluations are kept up to date.

In view of the above the Committee is of the view that the entire class of assets of all the units should be revalued.

Answer 2

As far as interpretation of term “significant” is concerned, IAS has neither defined it nor enunciated any criterion for it; rather it is up to the management to decide whether change in fair value of assets is material and important after taking into account the circumstances of the entity and nature and value of asset.

Answer 3

Once an accounting policy regarding the revaluation of assets and frequency thereof has been adopted by an entity, it should be applied consistently to all assets in that class of assets.

Answer 4

In reply to question 4 your attention is drawn to the following paragraph 31 of IAS-16, Property, Plant and Equipment

31. After recognition as an asset, an item of property, plant and equipment whose fair value can be measured reliably shall be carried at a revalued amount, being its fair value at the date of the revaluation less any subsequent accumulated depreciation and subsequent accumulated impairment losses. Revaluations shall be made with sufficient regularity to ensure that the carrying amount does not differ materially from that which would be determined using fair value at the balance sheet date.

In view of the above paragraph the Committee is of the opinion that once an entity undertakes revaluations, these must continue to be made with sufficient regularity so that the carrying amounts in any subsequent balance sheet are not materially at variance with the current fair values. In other words, if an entity adopts the allowed alternative treatment, it cannot report balance sheets that contain obsolete fair values, since that would not only obviate the purpose of the allowed treatment, but would actually make it impossible for the user to meaningfully interpret the financial statements.

Further your attention is also drawn towards the following section sub-section (2) of section 235 of the Companies Ordinance, 1984,

Provided further that incremental depreciation arising out of revaluation of fixed assets may be charged to surplus on revaluation of fixed assets account.

It may be pertinent to note that IAS 16 does not prohibit companies from changing accounting policies i.e. from allowed alternative treatment to benchmark treatment or vice versa. However, the condition precedent remains there.

From the above it can also be inferred that once the revaluation surplus is recognized in the financial statements, Section 235 of the Companies Ordinance, 1984 does not appear to allow its reversal or its use for any other purpose other than the purpose described in the above sub-section.

However, if the management is of the opinion that an asset may be impaired and its carrying amount needs to be written downward then it should do so as per guidance provided in IAS-36 Impairment of Assets.

Answer 5

The system of pagree is more prevalent in Pakistan and India. Pagree, in common parlance, is an amount given to landlord by the pagree-tenant. Payment of such amount gives an entitlement to the pagree-tenant to the reduced or nominal rental amounts but also gives a right to receive a major portion of pagree at the time of the change of tenant from the successor tenant.

As far as form and documentation of pagree is concerned, usually it is undocumented and has no legal cover; however, the customary practices result in emanation of aforesaid rights in vogue. Analysis of nature of the rights associated with the payment of pagree exhibits that it entitles the payer to enjoy all the benefits of the property for an unascertainable period of time.

Though there is no treatment given in any IAS/IFR with regard to pagree, the Committee is of the view that it may be appropriate to disclose it as an intangible asset if the criterion given in paragraphs 107 and 108 of IAS 38 is met.

(December 10, 2005)

19. Change In Accounting Policy For Valuing Fixed Assets

Enquiry:

We seek your opinion / guidance on the treatment of a change in accounting policies. The issue and facts of the case are as under: –

ISSUE

Whether change in accounting policy for valuing the fixed assets from “Allowed Alternative Treatment” (Revaluation of Fixed Assets) to “Benchmark Treatment” (Historical Cost Convention) is allowed as per IAS 16, IAS 8, and other applicable provisions of the Companies Ordinance, 1984.

FACTS

We have adopted Allowed Alternative Treatment in accordance with IAS 16 (Property, Plant and Equipment) for our land, building, and plant and machinery. Accordingly revaluation was carried out and incorporated in books of account.

Now management of the Company is of the opinion that Benchmark Treatment of IAS 16 shall give better presentation of financial statements. Accordingly the change in policy for stating fixed assets from “Valuation” to “Historical Cost Convention” is desired.

Now you are requested to please give your opinion as to:

i) Whether the change in accounting policy in valuing the fixed assets from “Allowed Alternative Treatment” (Revaluation of fixed assets) to “Bench mark treatment” (Historical cost convention) is allowed as per IAS 16, IAS 8, and other applicable provisions of the Companies Ordinance, 1984; and

ii) If the change mentioned above (i) is allowed then, the following entry is justified along with other required disclosure of the effects of change in policy as mentioned in IAS 8.

Opinion:

You attention is drawn to the following paragraph 29 of IAS-16, Property, Plant and Equipment: –

29. Subsequent to initial recognition as an asset, an item of property, plant and equipment should be carried at a revalued amount, being its fair value at the date of the revaluation less any subsequent accumulated depreciation and subsequent accumulated impairment losses. Revaluations should be made with sufficient regularity such that the carrying amount does not differ materially from that which would be determined using fair value at the balance sheet date.

Further your attention is also drawn towards the following section sub-section (2) of section 235 of the Companies Ordinance, 1984,

Provided further that incremental depreciation arising out of revaluation of fixed assets may be charged to surplus on revaluation of fixed assets account

From the above it can also be inferred that once the revaluation surplus is recognized in the financial statements, the law does not appear to allow its reversal or its use for any other purpose other than the purpose described in the above sub-section.

However if the management is of the opinion that an asset may be impaired and its carrying amount needs to be written downward then it should do so as per guidance provided in IAS-36 Impairment of Assets.

(July 28, 2004)

20. Surplus on Revaluation of Fixed Assets

Enquiry:

In accordance with the recent revaluation report from an independent valuer it has transpired that our fixed assets value, which was estimated at higher amount previously, has now gone down due to various reasons. In view of this, we request you to please clarify the following questions emanating from the above situation:

1. Can the company bring down surplus on revaluation of fixed assets, recorded earlier under section 235 of the Companies Ordinance, 1984?
2. If the answer to the above is in affirmative, then there may be two different approaches to deal with the matter in accordance with IAS 16:
i) directly reverse the surplus on revaluation of fixed assets account and credit to book value of fixed assets, or
ii) release incremental depreciation amount to un-appropriated profit/accumulated losses account through statement of changes in equity relating to the surplus on revaluation of fixed assets charged earlier and also follow the entry as suggested in paragraph (I) above.

We request you to advise us on the matter in the light of SRO 45(1)/2003 dated January 13, 2003.

Opinion:

1. The appropriate Committee of the Institute would like to draw your attention to the following first Proviso to Sub-section (2) of section 235 of the Companies Ordinance, 1984 read with paragraph 38 of IAS-16:-

Sub-section (2) of section 235
Provided that the surplus on revaluation of fixed assets may be applied by the company in setting off or in diminution of any deficit arising from the revaluation of any other fixed asset of the company.

Paragraph 38 of IAS-16
When an asset’s carrying amount is decreased as a result of a revaluation, the decrease should be recognized as an expense. However, a revaluation decrease should be charged directly against any related revaluation surplus to the extent that the decrease does not exceed the amount held in the revaluation surplus in respect of that same asset.

2. (i) please refer to paragraph 38 of IAS-16 as quoted above.
(ii) Please refer to the following paragraph 3 of SRO No. 45(I)/2003 dated January 13, 2003.

3. an amount equal to incremental depreciation charged in previous years may be transferred from “Surplus on Revaluation of Fixed Assets Account” to un-appropriated profit / accumulated loss through Statement of Changes in Equity.

(September 13, 2003)

21. Surplus on Revaluation of Fixed Assets whether or not a Part of Equity

Enquiry:

We have received an enquiry from one of our clients, seeking our opinion on whether or not surplus on revaluation of fixed assets is to be considered as part of the equity in the light of the relevant provisions of the Companies Ordinance, 1984 and the applicable International Accounting Standard-16 which is understood by a rating company as not being a part of equity owing to its reflection in the financial statement after capital and reserves as per the requirement of Section 235(2) of the Companies Ordinance, 1984. The rating agency also considers that clause 2 of section 235 has the effect of overriding para 37 of IAS-16.

We shall hence appreciate your comments on the matter referred to in (a) below in the light of definition of equity given in IASC framework for the preparation and presentation of financial statements and the notification in SRO 777(1)/86 dated August 6, 1986 relating to IAS-16:

(a) Whether or not section 235(2) of the Companies Ordinance, 1984 overrides paragraph 37of IAS-16 and as such restricts the treatment of revaluation surplus as a part of equity.

It is pertinent to draw your attention to SRO 777(1)/86 dated August 06, 1986 directing listed companies to follow IAS-16 in regard to their accounts and preparation of the balance sheet and profit and loss account followed simultaneously by insertion of clause 7A in the Fourth Schedule. Prior to the notification “surplus on revaluation of fixed assets” appeared after share premium account in the sub-heading of RESERVES in the Fourth Schedule.

Opinion:

To deal with the query raised by you, the appropriate Committee of the Institute would like to discuss IAS 16.37, section 235 and other pertinent provisions of IAS and Companies Ordinance, 1984: –

IAS 16.37 When an asset’s carrying amount is increased as a result of a revaluation, the increase should be credited directly to equity under the heading of revaluation surplus. However, a revaluation increase should be recognized as income to the extent that it reverses a revaluation decrease of the same asset previously recognized as an expense.

However, the word equity as used in IAS 16.37 should be read in the context of paragraph 65 of the International Accounting Standards Board’s Framework for the Preparation and Presentation of Financial Statements as reproduced below:

65. Although equity is defined in paragraph 49 as a residual, it may be sub-classified in the balance sheet. For example, in a corporate enterprise, funds contributed by shareholders, retained earnings, reserves representing appropriations of retained earnings and reserves representing capital maintenance adjustments may be shown separately. Such classifications can be relevant to the decision-making needs of the users of financial statements when they indicate legal or other restrictions on the ability of the enterprise to distribute or otherwise apply its equity. They may also reflect the fact that parties with ownership interests in an enterprise have differing rights in relation to the receipt of dividends or the repayment of capital.

Section 235 of the Companies Ordinance, 1984

235. Treatment of surplus arising out of revaluation of fixed assets. – (1) Where a company revalues its fixed assets, the increase in, or sums added by writing up of, the value of such assets as appearing in the books of accounts of the company shall be transferred to an account to be called “Surplus on Revaluation of Fixed Assets Account” and shown in the balance-sheet of the company after Capital and Reserves.

(2) Except and to the extent actually realized on disposal of the assets which are revalued, the surplus on revaluation of fixed assets shall not be applied to set-off or reduce any deficit or loss, whether past, current or future, or in any manner applied, adjusted or treated so as to add to the income, profit or surplus of the company, or utilized directly or indirectly by way of dividend or bonus:

Provided that the surplus on revaluation of fixed assets may be applied by the company in setting-off or in diminution of any deficit arising from the revaluation of any other fixed assets of the company:

Provided further that incremental depreciation arising out of revaluation of fixed assets may be charged to Surplus on Revaluation of Fixed Assets Account.

Thus the appropriate Committee of the Institute is of the opinion that the provisions of IAS 16 are over-ridden by the provisions of section 235 of the Companies Ordinance, 1984 on the basis of unwritten law that local legal requirements would have precedence over the provision of IAS.

To further elaborate the matter we reproduce below an extract from Selected Opinion No. 1.15 of Selected Opinions Volume IV issued by this Committee in 1996-97: –

Opinion:

1. Revaluation of Fixed Assets

Section 235(1) of the Companies Ordinance, 1984, provides that “surplus on revaluation of fixed assets account” should be shown in the balance sheet of the company after capital and reserves. Sub-section (2) further prescribes that such surplus shall not be applied to set off or reduce any deficit or loss. The revaluation surplus cannot therefore be shown and boxed with Capital and Reserves.

(June 5, 2004)

IAS 16 – Property Plant and Equipment

1. Query on Liquidated Damages

a) Penalties/ liquidated damages for delayed installation

b) Penalties for actual revenue loss during installation prior to final acceptance based on estimate

c) Penalties for actual revenue loss after acceptance and capitalization of the equipment caused by any issue relating to equipment

2. Presentation of Financial Statements

3. Presentation of Capital Advances

4. Technical Opinion on Class of Assets

5. Capitalization of Assets

6. Enquiry on paragraph 17(e) of IAS 16

7. Clarification regarding other general Construction Costs

8. Desktop Revaluations in terms of IAS 16 (Property, Plant And Equipment)

9. Accounting Treatment for income earned on equity raised specifically for Qualifying Asset

10. Capitalisation Of Borrowing Cost

11. Particular method for providing depreciation in the Accounts

12. Treatment of start-up costs in the case of Medium-Sized Entities

13. Treatment of incremental depreciation arising out of revaluation of Fixed Assets

14. Accounting for project development expenditure and costs related thereto

15. Accounting Treatment of Tools and Parts

Enquiry:

16. Impact of withdrawal of TR-20

17. Initial Public Offer (IPO) Expenses – Treatment in Financial Statements

18. Revaluation of Fixed Assets and Treatment of Pagree

19. Change In Accounting Policy For Valuing Fixed Assets

20. Surplus on Revaluation of Fixed Assets

21. Surplus on Revaluation of Fixed Assets whether or not a Part of Equity

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