CHAPTER THIRTEEN 13
Control of Fixed Assets under International Financial Reporting Standards
THE INITIAL RECOGNITION AND measurement of Property, Plant, and Equipment (PP&E) is generally the same under International Financial Reporting Standards (IFRS) as it is in the United States under generally accepted accounting principles (GAAP). Assets to be capitalized must have future benefit to the firm, and must be reliably measurable. Equipment required to meet legal and environmental regulations, even though it may not generate specific cash flows or direct future benefit, can still be capitalized because without them other assets could not be used.
According to a recent book1 the initial capitalized cost for IFRS includes:
• Purchase Price
• Purchase taxes, including duty
• Less supplier discounts and rebates
• Transportation inbound
• Installation and assembly
Ordinarily the cash price paid is the cost, but in the case of an exchange, the transaction is to be measured at fair value of the acquired asset or the net book value of the asset(s) given up. If any government grants are involved, reducing the net cost to the acquirer, only the reduced net amount can be capitalized.
IFRS permits expensing of items under a certain minimum amount, similar to what GAAP permits and we recommend in this book.
Essentially, the IFRS rules parallel those of U.S. GAAP. At this point using the barebones definition, there are few practical differences between accounting for PP&E as between GAAP and IFRS. But here is where significant changes start to appear.
There are two major differences under IFRS. First, component depreciation is required. Second, with certain limitations, companies are permitted to revalue PP&E.
COMPONENT DEPRECIATION
This topic is covered in Chapter 14 and for those just dealing with IFRS issues we repeat conceptually some of what is discussed there. In the United States we recommended cost segregation as a means of speeding up depreciation expense for taxes, thus providing a present value benefit for the cash flows that are involved. In the United States the cost segregation methodology and approach is functionally equivalent to the IFRS’s “component depreciation.” In the United States, for tax purposes, componentization is essentially limited to buildings, and not generally used for financial reporting. In IFRS the rules specify that whenever the components of a larger asset have differing lives, each component must be set up as a separate asset and depreciated separately. Thus, the IFRS rules apply for financial reporting to major pieces of machinery and equipment, as well as buildings.
For U.S. taxes, component depreciation speeds up the timing of depreciation expense for determining taxable income. The greater the depreciation expense recognized earlier, the greater will be the present value of cash flow due to taxes being paid later. Component depreciation does not provide a total increase in depreciation. What it does is speed up the deduction, so on a time value of money basis, the earlier you can claim depreciation expense, the sooner you get the benefit of the depreciation.
However, it must always be remembered that at the end of the asset’s life, the total deductions for depreciation remains the same; it is only the timing that changes. But if a company has a ten percent cost of capital, getting a deduction in year three is markedly better than taking that same deduction in year 33.
In U.S. tax accounting, by separating out major components of a building, one can get substantial savings. The biggest savings can come from an analysis of the electrical system and components, followed by land improvements, millwork, finishes, plumbing, and heating, ventilation, and air conditioning (HVAC). Getting a 15-year life for land improvements is better than a 39-year life for the total building.
Under U.S. GAAP, there is no requirement that the component depreciation taken for taxes be used to financial reporting, other than for the impact of timing differences on deferred tax assets and liabilities. One does not have to depreciate electrical components for financial reporting based on the schedule determined for tax return purposes.
In IFRS, however, component depreciation is mandatory for financial reporting, irrespective of what a company does for its tax returns. This concept of component depreciation for financial reporting at one time was proposed in the United States by the American Institute of Certified Public Accountants (AICPA). However, there was concerted push-back from companies and the proposal went nowhere.
The reason was simple. Not only was there potentially significant cost involved in “carving up” a single total cost from the contractor to arrive at the component depreciation. There would be substantial additional expense in the property record system. Instead of a single line item for “Building at 1000 Main St. . . . $2,000,000,” there might have to be ten or more separate line items in the property register for each component, with its own separate life.
Remember, earlier in the book we recommended having as high as possible a minimum capitalization level. This was to reduce the number of assets being controlled; in turn this reduced effort in the accounting department and made it easier to control the truly important assets. Component depreciation for financial reporting goes in the opposite direction, adding complexity.
On a theoretical basis, component depreciation is preferable to a single life assigned to the total building. Elements of an HVAC or plumbing system undoubtedly will need to be replaced long before the foundation or the structural steel has worn out. If depreciation expense and charges are supposed to reflect diminution in value, the concept of component depreciation makes sense. Some parts of a building do wear out faster than others and one can argue that financial reporting should follow the economics and physical life.
Relatively few U.S. companies have used component depreciation for taxes, and virtually none use it for financial reporting. This is the reason for the pushback against the U.S. proposal several years ago.
If IFRS is adopted in the United States then component depreciation will be mandatory for financial reporting. Companies might as well use it then for taxes and get the cash flow benefits that component depreciation does provide. So it will be perceived as a “two-edged sword” favorable on taxes and unfavorable on financial reporting.
There is, however, a further impact. In the U.S. component depreciation is used almost exclusively for buildings, with the construction cost of buildings deconstructed to maximize tax benefits. But in IFRS the concept is based on “proper” reflection of anticipated lives and economics, not only for buildings but for machinery and equipment.
The implications are clear. If you buy a complex numerically controlled milling machine, you might have to assign separate amounts, and lives, to the software, the computer, the electrical hook-up, and the foundation. This could easily double the size of any property record, and make it much more difficult to control the asset(s). Further, it is not clear whether the Internal Revenue Code, and IRS interpretations, would permit component depreciation for machinery and equipment.
Keep in mind that internal control requires periodic verification that assets are still there and in use. It is relatively easy to assign a single radio frequency identification (RFID) property tag to a $500,000 machine tool and then take an inventory of all RFID tags once every three years or even once every year. But if you have to break down the machine tool, where do you put the tag for the software? How do you identify the foundation separate from the machine itself?
These may only be “straw men” arguments against component depreciation, but depending on company policy, and auditor involvement, there is no question that costs will increase if and when IFRS component depreciation becomes mandatory. One can argue that the financial reporting will be more accurate and will more closely reflect real-world economics. But the fact is that the present U.S. system seems to have been working pretty well for most companies for as long as internal control and auditor involvement has taken place (i.e., since the 1930s!).
Mandatory adoption of component depreciation for buildings and machinery and equipment will be seen as costly, and arguments will be heard that change to practice is being forced on U.S. companies simply for the sake of conforming to IFRS (i.e., what the French want us to do). Do we really want the French determining our financial reporting requirements? Many will argue in the negative.
The advantage, of course, to mandatory component depreciation will come in the tax benefits, but at the expense of more bookkeeping, more auditing, and higher operating expenses. There probably would be a net benefit, but the problem is that the costs will be all too visible, and the benefits hard to tease out of an overall tax provision.
ASSET REVALUATION
When the author was studying accounting, back in the pre-computer era, there were a couple of mantras that were taken as gospel. One of them was:
“Take your losses immediately but don’t recognize gains until the asset is sold.”
The reason for this was simple, and intuitive. There are enough uncertainties in business that until cash is realized you do not really know if you have a gain or not. Further, if one could recognize gains—income that is—simply by a stroke of the pen through writing up a journal voucher, the potential for manipulation might be hard to resist.
Yet, this is what is permitted/required under IFRS. The ability to write up assets, in the absence of a sale, may well be one of the greatest changes if the United States were to adopt IFRS. That this is likely to happen is supported by a recent addition by Financial Accounting Standards Board (FASB) to their agenda wherein the Board is contemplating permitting in the United States a rule for investment property comparable to what exists in IFRS. Here is the relevant paragraph (¶31 of International Accounting Standards (IAS) 16) governing asset write-up in IFRS:
“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.”
Reading these words, the key phrase is “whose fair value can be measured reliably.” Inasmuch as valuation specialists determine the fair value of PP&E in (1) every purchase price allocation; (2) in every property tax appeal; and (3) in every valuation of security as collateral for a loan, it would be hard to argue that PP&E cannot be “measured reliably.”
The problem for appraisers, auditors, and of course corporate financial officers is that the fair value of an asset for allocation of a purchase price may differ from fair value for property tax appeal as well as the fair value of the same asset used as collateral. Finally, the value of that specific asset for placement of insurance and proof of loss is still a different amount. This problem of valuing PP&E is covered in Chapter 12.
Keep in mind that even if the same set of assumptions is made by two different appraisers, the fair value determination will likely only be within 10% of each other. So there are really two separate problems in asset revaluation. First, what is the “correct” fair value of the asset? The second problem is that even if everyone agrees on the proper premise of value, valuation simply is not that precise!
Every appraiser will agree, at least in an informal setting after a drink or two that two equally competent appraisers are likely to come up with somewhat different answers. The degree of precision will most likely be plus or minus ten percent. Specifically, therefore, if a company obtains a fair value estimate from an outside valuation specialist, and then for whatever reason gets a second opinion, it is almost certain that the second appraiser’s values will not be identical with the first. Remember, if you contact two different realtors to put your house on the market, you are likely to get two different estimates of what the house could be sold for.
Valuation is reliable, but only within certain parameters. It simply is not possible to get two independent appraisers to come up with identical answers. Each will have a range, and the two ranges undoubtedly will overlap, but in accounting we cannot book a range, we must use a specific dollar amount. As many valuation specialists have expressed it, “valuation is not an exact science.”
Now if a company revalues PP&E one year, and then two or three years later has to undertake a new valuation, but it is by a different appraiser, the potential for a substantial increase, or decrease, in value is obvious. In any year, a 10% swing in the fair value of PP&E could double, or cut in half, the reported earnings for most companies. Is this the kind of variability in income that CFOs (chief financial officers), and investors, are looking for?
IAS 16 goes on to say that PP&E used as part of a continuing business may have to be valued using an income or a depreciated replacement cost approach. Without going into excruciating nuances of valuation theory, suffice it to say that an income approach applied to PP&E will show increased values when business is good, and profits are growing, and will show decreased profits when business slows and income is down.
In a word, the IAS 16 approach, if utilized in the United States, will magnify swings in income and reported values. Accelerated growth in good times and accelerated declines in poor times may not be what the proponents of fair value accounting have in mind.
Of course, as a sidebar, the determination of the fair value of a liability, say bonds outstanding, will go down as the company’s debt rating goes down and vice versa. So if a company is not doing well and is downgraded by Moody’s and S&P the company will show a gain! Then when conditions improve and the old credit rating is restored upward, the company will have to show a loss. Just try to explain this to someone who is not an accounting geek.
Now one may question, if these problems exist with IAS 16, why have the problems not showed up in countries that already use IFRS. The answer is pretty clear that most companies have not taken advantage of or utilized the ability to choose a revaluation model, keeping in mind that it is a choice, not a requirement.
So one might argue that if existing countries are not burdened with accelerated gains and losses, why should we worry in the United States? The reason that U.S. companies might well take advantage of the revaluation model, even if it has not happened elsewhere, is the compensation policies common in U.S. firms. If management is going to be rewarded for meeting or beating estimates, and revaluing assets would permit such a gain, then at least some companies might be tempted to “choose” revaluation in an otherwise down, or even level year.
Keep in mind that the first time the revaluation model is applied, values certainly will be increased from the date of the assets’ acquisition. So, even in a down year, substantial revaluation “profits” can be recognized. Worse, once one company in an industry adopts a revaluation model, it is highly likely that security analysts, in the interest of “true comparability,” will request other companies to do the same thing.
Now we can get into all sorts of discussions about measuring income for compensation, and comparing two similarly situated companies. The fact remains that “Gresham’s Law of Accounting” (bad accounting drives out good accounting) suggests that few companies want to be left out if their direct competitors do something that will increase reported income and net worth. It is very easy to foresee a true “race to the bottom.”
INVESTMENT PROPERTY
IFRS distinguishes between land and buildings owned and operated by companies for production, warehousing, or offices from so-called investment property, which is defined in IAS 40 as:
“Property (land or a building—or part of a building—or both) held (by the owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both, rather than for:
a. Use in the production or supply of goods or services or for administrative purposes
b. Sale in the ordinary course of business”
When first acquired, under IAS 40, investment property is recorded at cost and includes “any directly attributable expenditure.” Directly attributable expenditures, likewise, includes professional fees, property transfer taxes, and other transaction costs. But the “cost” does not include so-called startup costs, that is operating losses attained, before achieving a planned level of occupancy and abnormal amounts of wasted material, labor, or other resources incurred in constructing or developing the property. Outside the scope of this book, the International Accounting Standards Board (IASB) recently amended IAS 40 to include leased property and being able to be consider investment property by a lessee.
In requiring that investment property be valued at “fair value” IAS 40 provides a discussion of the determination of fair value that closely approximates what is now in Accounting Standards Codification (ASC) 820, as developed in Statement of Financial Accounting Standard (SFAS) 157. As in U.S. GAAP, the IASB distinguishes fair value from value in-use. The former is based on market conditions and the latter is “entity specific” to the present owner. Disclosure in financial statements has to be fair value, and not value in-use. IAS 40 also provides guidance about a transfer from and to investment property of assets to be used directly by the business. Essentially, the fair value at the time of transfer is to be used.
The major difference between the accounting for investment property and other PP&E used in a business and revalued under IAS 16 is very simple. All changes in the fair value of investment property go directly to the profit and loss statement (P&L), with no upper or lower limits. Under IAS 16’s revaluation model, gains for most assets go into other comprehensive income and are accumulated in surplus under the heading of revaluation surplus. If, however, an increase merely reverses a prior decrease or impairment charge, then the increase in fair value can be reflected in current income.
As might be expected, net decreases in fair value under IAS 16, and IAS 40, both go directly to P&L.
The differences between IAS 40 and accounting for real estate investment trusts (REITs) are probably not material, so U.S. adoption of IFRS would not impact REITs. Certainly, as discussed previously, if IFRS were to be adopted in the United States there would be potentially major changes in accounting for PP&E. At a minimum companies would have the option of going to a revaluation model and we predict that this likely would happen.
WHAT IS THE “COST” OF PROPERTY, PLANT, AND EQUIPMENT?
Remember that under IFRS the following costs are to be capitalized as part of the initial cost of acquiring PP&E:
• Purchase price
• Purchase taxes, including duty
• Less supplier discounts and rebates
• Transportation inbound
• Installation and assembly
As in GAAP, these costs are included in the initial cost.
When accounting for a business combination, GAAP precludes legal and accounting costs paid by the acquirer. Many observers feel that the investment banking fees, legal, and accounting costs associated with a business combination are similar conceptually to inbound transportation and assembly, in that without them the asset could not be used.
The Financial Accounting Standards Board (FASB) argued that its definition of fair value (ASC 820) when applied to a business combination says that a subsequent buyer would not pay for the original legal, accounting, and investment banker fees. By the same token a company selling a previously installed machine tool will not recover its inbound transportation, installation, and assembly costs, but these latter can be capitalized under both GAAP and IFRS.
If we had to make a prediction, at some point in the future the IASB and FASB will “rationalize” PP&E accounting; companies may not then be able to capitalize transportation, installation, and assembly. Until then, these costs must be capitalized and depreciated subsequently.
SUMMARY
Whether IFRS will be adopted in the United States is an open question as this book is being written. The drumbeat of advocates wishing the United States to join the rest of the world is getting louder and louder, and is being driven by the major accounting firms. That the Big 4 would derive literally billions of dollars of additional consulting and auditing fees when IFRS is adopted here, neither supports nor condemns the concept. It may, however, call into question the objectivity of the loudest proponents.
There are two major differences to accounting as we know it under GAAP. Companies would be required to use component depreciation. This will be costly in certain circumstances, but in the long run may be a good thing in terms of faster tax depreciation and deductions. Perhaps for the first time companies will truly realize that they do not have to use the same lives for books as for taxes, and that tax lives should be chosen to maximize tax deductions, irrespective of what is shown in the GAAP financial statements.
The second major change will be the potential for companies to revalue PP&E and investment property. This will often boost net income and/or net worth. If adopted, it would be a major step toward fair value accounting, the pride and joy of academics and security analysts who think that all the new fair value information will somehow help investors and creditors.
No secrets are disclosed by revealing that more than 40 years of experience in valuation has convinced this appraiser that fair value accounting would be a disaster. This position goes against our self-interest because were fair value to be adopted, our industry’s work (and revenue) would more than double. But, it would not provide better information and could easily lead to manipulation, and possibly even outright fraud.
NOTE
1 Nandakumar Ankarath, Salpesh J. Mehta, T.P. Ghosh, and Yass A. Alkafaji, Understanding IFRS Fundamentals: International Financial Reporting Standards (New York, NY: John Wiley & Sons, 2010), Chapter 10.
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