Asset-Based Accounting Standards

Weightage: Chapter 5 of ICAI's Paper 1 syllabus, roughly 14 marks. The largest standards group in the paper and the one most reliably examined, because each of its seven standards produces short application problems with a numerical answer.

The two-part shape

Every standard in this group has the same skeleton, and recognising it converts seven standards into seven pairs of rules rather than seven bodies of material.

Initial measurement. What amount does this asset first enter the books at, and specifically which costs are included and which are not?

Subsequent measurement. What happens to that amount afterwards — depreciation, amortisation, revaluation, impairment, reclassification, derecognition?

Read each standard by writing those two headings and filling them in. Almost every examination question on this group asks about one of the two, and knowing which one is being asked is usually half the answer.

AS 2 — Valuation of Inventories

The rule

Inventories are valued at the lower of cost and net realisable value. That single line contains a deliberate asymmetry: a fall in value is recognised, a rise is not. It is prudence expressed as a measurement rule, and it is why inventory is one of the few assets carried below cost as a matter of routine.

Net realisable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. Note ordinary course of business — a forced-sale price is not NRV.

Cost of inventories

Cost comprises cost of purchase, cost of conversion, and other costs incurred in bringing the inventories to their present location and condition.

Cost of purchase is the purchase price plus duties and taxes not subsequently recoverable, freight inwards and other directly attributable acquisition costs, less trade discounts, rebates, duty drawbacks and other similar items. GST that is recoverable as input tax credit is excluded, because it is not a cost at all.

Cost of conversion includes direct labour and a systematic allocation of fixed and variable production overheads. The allocation of fixed production overheads is where questions are set: it must be based on the normal capacity of the production facilities, not on actual output. In a period of abnormally low production, the unallocated overhead is charged to profit as an expense of the period and is not carried in inventory. In a period of abnormally high production, the fixed overhead per unit is decreased so that inventories are not measured above cost.

Costs expressly excluded and recognised as expenses of the period: abnormal amounts of wasted materials, labour or other production costs; storage costs unless necessary in the production process before a further production stage; administrative overheads that do not contribute to bringing inventories to their present location and condition; and selling and distribution costs.

Cost formulas

For items not ordinarily interchangeable, and for goods or services produced and segregated for specific projects, cost is assigned by specific identification.

For everything else, cost is assigned using FIFO or weighted average. LIFO is not permitted.

Techniques for convenience — standard cost and the retail method — may be used if the results approximate actual cost.

AS 10 — Property, Plant and Equipment

Recognition

The cost of an item of property, plant and equipment is recognised as an asset if, and only if, it is probable that future economic benefits associated with the item will flow to the enterprise, and the cost of the item can be measured reliably.

Spare parts, stand-by equipment and servicing equipment are recognised as PPE when they meet this definition; otherwise they are inventory. Major spare parts that an entity expects to use over more than one period, and spares that can be used only with a particular item of PPE, are typically PPE.

Elements of cost

Cost comprises the purchase price including import duties and non-refundable purchase taxes after deducting trade discounts and rebates; directly attributable costs of bringing the asset to the location and condition necessary for it to operate in the manner intended; and the initial estimate of dismantling, removing and site restoration costs where an obligation exists.

Directly attributable costs include site preparation, initial delivery and handling, installation and assembly, costs of testing whether the asset functions properly after deducting the net proceeds of selling items produced during testing, and professional fees.

Costs expressly excluded: costs of opening a new facility, costs of introducing a new product or service including advertising and promotion, costs of conducting business in a new location or with a new class of customer including staff training, and administration and other general overheads.

Recognition of costs ceases when the asset is in the location and condition necessary for it to be capable of operating in the manner intended by management — which is a different moment from when the asset is actually brought into use. Costs incurred while an asset capable of operating has yet to be used, or is operated at less than full capacity, are not capitalised. Nor are initial operating losses, nor the costs of relocating or reorganising part of the enterprise's operations.

Subsequent measurement

An enterprise chooses either the cost model — cost less accumulated depreciation and accumulated impairment losses — or the revaluation model, and applies the choice to an entire class of assets rather than to individual items.

Under the revaluation model an increase is credited to a revaluation surplus in reserves, except that it is recognised in profit to the extent it reverses a decrease of the same asset previously charged to profit. A decrease is charged to profit, except that it is debited to revaluation surplus to the extent of any existing credit for that same asset. The asymmetry, and its reversal rule, is examined.

Depreciation

The depreciable amount — cost less residual value — is allocated on a systematic basis over the asset's useful life. Depreciation begins when the asset is available for use, and ceases at the earlier of the date the asset is classified as held for sale and the date it is derecognised. Depreciation does not cease when the asset becomes idle or is retired from active use.

Each part of an item of PPE with a cost that is significant in relation to the total cost must be depreciated separately — component accounting, which is the change candidates most often overlook.

The residual value and useful life must be reviewed at least at each financial year end, and any change is accounted for as a change in accounting estimate under AS 5, applied prospectively. Likewise the depreciation method is reviewed periodically and a change is a change in estimate, not a change in policy — a distinction that is examined precisely because the intuition runs the other way.

AS 13 — Accounting for Investments

The classification that decides everything

Current investment is an investment that is by its nature readily realisable and intended to be held for not more than one year from the date it is made.

Long-term investment is an investment other than a current investment.

The classification governs the measurement, so it is always the first thing to establish.

Current investments are carried at the lower of cost and fair value, determined either on an individual investment basis or by category, but not on an overall basis. Any reduction, and any reversal of a reduction, goes to profit and loss.

Long-term investments are carried at cost. A provision for diminution is made only where the decline is other than temporary, and it is determined and made for each investment individually. A temporary fall is ignored.

Cost of an investment

Cost comprises the acquisition charges — brokerage, fees and duties. Where an investment is acquired by the issue of shares or other securities, the acquisition cost is the fair value of the securities issued. Where acquired in exchange for another asset, it is the fair value of the asset given up.

Interest, dividends and rentals receivable in connection with an investment are ordinarily income. But where the price paid includes an amount attributable to interest accrued or dividends declared before acquisition, the subsequent receipt of that pre-acquisition amount is a recovery of cost, not income, and is deducted from the cost of the investment.

Right shares: if the rights are subscribed for, the cost of the right shares is added to the carrying amount. If the rights are renounced — sold — the sale proceeds are taken to profit and loss. But where the investment was acquired cum-right and the market price falls ex-right below the cost at which the investment was acquired, the proceeds of renunciation are applied to reduce the carrying amount to the market value.

Disposal and reclassification

On disposal, the difference between carrying amount and net disposal proceeds goes to profit and loss.

On reclassification from long-term to current, the transfer is made at the lower of cost and carrying amount at the date of transfer. On reclassification from current to long-term, the transfer is made at the lower of cost and fair value at the date of transfer. Both are examined, and the two rules are easily confused; the common thread is that the transfer never increases the carrying amount.

AS 16 — Borrowing Costs

The core rule

Borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset are capitalised as part of the cost of that asset. All other borrowing costs are recognised as an expense in the period incurred.

A qualifying asset is an asset that necessarily takes a substantial period of time to get ready for its intended use or sale. Ordinarily twelve months is taken as a substantial period, unless a shorter or longer period can be justified.

Borrowing costs include interest and commitment charges on borrowings, amortisation of discounts or premiums relating to borrowings, amortisation of ancillary costs incurred in arranging borrowings, finance charges on finance leases, and exchange differences on foreign currency borrowings to the extent they are regarded as an adjustment to interest cost.

Specific and general borrowings

Where funds are borrowed specifically for a qualifying asset, the amount capitalised is the actual borrowing costs incurred on that borrowing during the period, less any income earned on the temporary investment of those borrowings.

Where funds are borrowed generally and used for a qualifying asset, the amount capitalised is determined by applying a capitalisation rate — the weighted average of the borrowing costs applicable to the enterprise's general borrowings outstanding during the period — to the expenditure on the asset. The amount capitalised in a period must not exceed the amount of borrowing costs incurred in that period.

The three timing rules

These produce most AS 16 questions.

Commencement. Capitalisation begins when all three conditions are met: expenditure for the asset is being incurred, borrowing costs are being incurred, and activities necessary to prepare the asset for its intended use or sale are in progress. Activities include technical and administrative work before construction, such as obtaining permits — but merely holding an asset with no production or development taking place is not.

Suspension. Capitalisation is suspended during extended periods in which active development is interrupted. It is not suspended for a period during which substantial technical and administrative work is being carried out, nor for a temporary delay that is a necessary part of the process of getting the asset ready — the standard's own example is high water levels delaying construction of a bridge in a region where such levels are common during the construction period.

Cessation. Capitalisation ceases when substantially all the activities necessary to prepare the asset for its intended use or sale are complete. Where construction is completed in parts and each part is capable of being used while construction continues on others, capitalisation ceases for each part as it is completed.

AS 19 — Leases

The classification

A lease is a finance lease if it transfers substantially all the risks and rewards incident to ownership; otherwise it is an operating lease. Classification is made at the inception of the lease and depends on the substance of the transaction rather than the form of the contract.

Situations that would normally lead to a lease being classified as a finance lease:

• the lease transfers ownership of the asset to the lessee by the end of the lease term;
• the lessee has an option to purchase at a price expected to be sufficiently lower than fair value at the exercise date that exercise is reasonably certain at inception;
• the lease term is for the major part of the economic life of the asset even if title is not transferred;
• at inception the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset;
• the asset is of such a specialised nature that only the lessee can use it without major modifications.

Accounting

Under a finance lease, the lessee recognises an asset and a liability at amounts equal to the fair value of the leased asset at inception, or if lower, the present value of the minimum lease payments, discounted at the interest rate implicit in the lease. Lease payments are apportioned between the finance charge and the reduction of the outstanding liability so as to produce a constant periodic rate of interest on the remaining balance. The asset is depreciated over its useful life if ownership will transfer, and otherwise over the shorter of the lease term and useful life.

Under an operating lease, the lessee recognises lease payments as an expense on a straight line basis over the lease term unless another systematic basis is more representative.

Initial direct costs of the lessee under a finance lease are added to the amount recognised as an asset.

AS 26 — Intangible Assets

Recognition

An intangible asset is an identifiable non-monetary asset without physical substance held for use in production or supply of goods or services, for rental to others, or for administrative purposes. It is recognised only if it is probable that expected future economic benefits attributable to it will flow to the enterprise, and its cost can be measured reliably.

Research expenditure is always an expense. No intangible arising from research may be recognised, because at the research stage the enterprise cannot demonstrate that an asset exists that will generate probable future benefits.

Development expenditure is capitalised only if all six conditions are met: technical feasibility of completing the asset so that it will be available for use or sale; intention to complete and use or sell it; ability to use or sell it; demonstration of how it will generate probable future economic benefits; availability of adequate technical, financial and other resources to complete it; and ability to measure reliably the expenditure attributable to it during development.

Never recognised as intangible assets: internally generated goodwill, brands, mastheads, publishing titles, customer lists and items similar in substance, because their cost cannot be distinguished from the cost of developing the business as a whole. Expenditure on start-up activities, training, advertising and promotional activities, and relocating or reorganising an enterprise is expensed as incurred.

Amortisation

The depreciable amount is amortised on a systematic basis over the best estimate of its useful life. AS 26 carries a rebuttable presumption that useful life will not exceed ten years from the date the asset is available for use. The presumption may be rebutted with persuasive evidence, and where it is, the enterprise must estimate the recoverable amount at least annually and disclose the reasons.

Amortisation begins when the asset is available for use. The residual value is presumed to be zero unless there is a commitment by a third party to purchase it at the end of its useful life, or an active market exists from which residual value can be determined and it is probable that the market will exist at the end of the useful life.

AS 28 — Impairment of Assets

The idea

Depreciation allocates cost over a life; it does not test whether the asset is still worth what the books say. AS 28 supplies that test: an asset must not be carried at more than its recoverable amount.

$\text{Recoverable amount}=\text{higher of (net selling price, value in use)}$

Net selling price is the amount obtainable from the sale of an asset in an arm's length transaction between knowledgeable, willing parties, less the costs of disposal.

Value in use is the present value of estimated future cash flows expected to arise from continuing use of the asset and from its disposal at the end of its useful life.

The choice of the higher is deliberate and should be explained rather than memorised: a rational enterprise will take whichever course yields more, so the asset is worth at least that much to it. An impairment loss is recognised only when the carrying amount exceeds both.

The assessment

At each balance sheet date an enterprise assesses whether there is any indication that an asset may be impaired. Indications are both external — a significant decline in market value beyond that expected from normal use, significant adverse changes in the technological, market, economic or legal environment, an increase in market interest rates that will materially affect value in use, the carrying amount of net assets exceeding market capitalisation — and internal — evidence of obsolescence or physical damage, significant adverse changes in the extent or manner of the asset's use including plans to discontinue or restructure, and evidence from internal reporting that economic performance is or will be worse than expected.

Cash-generating units

Where recoverable amount cannot be estimated for an individual asset, it is estimated for the cash-generating unit to which the asset belongs — the smallest identifiable group of assets that generates cash inflows from continuing use that are largely independent of the cash inflows from other assets or groups.

An impairment loss for a cash-generating unit is allocated first to reduce any goodwill allocated to the unit, and then to the other assets pro rata on the basis of their carrying amounts. No individual asset is reduced below the highest of its net selling price, its value in use, and zero.

Reversal

An impairment loss recognised in prior periods is reversed if, and only if, there has been a change in the estimates used to determine the recoverable amount since the last impairment loss was recognised. The increased carrying amount must not exceed the carrying amount that would have been determined, net of depreciation, had no impairment loss been recognised in prior years. An impairment loss recognised for goodwill is not reversed in a subsequent period unless it was caused by a specific external event of an exceptional nature not expected to recur and subsequent external events have reversed its effect.