Asset-Based Accounting Standards — Practice

Question 1

State whether each of the following forms part of the cost of inventories: abnormal spoilage of ₹4 lakh; storage of finished goods awaiting despatch; storage of partly processed wine that must mature before the next stage; the head office finance department's salaries; freight inwards; GST recoverable as input tax credit.

Accepted Answer

Abnormal spoilage is excluded and charged to profit as an expense of the period, because AS 2 excludes abnormal amounts of wasted materials, labour or other production costs; carrying them in inventory would defer a loss that has already crystallised. Storage of finished goods awaiting despatch is excluded, since storage costs are excluded unless necessary in the production process before a further production stage. Storage of partly processed wine is included, because it falls squarely within that exception — the maturation is part of the production process and a further stage follows it. Head office finance salaries are excluded, being administrative overheads that do not contribute to bringing the inventories to their present location and condition. Freight inwards is included, being a directly attributable cost of purchase. GST recoverable as input tax credit is excluded, and for a reason worth stating precisely: it is not excluded as a matter of policy but because it is not a cost at all, the enterprise recovering it in full, whereas duties and taxes that are not subsequently recoverable are included.

Question 2

A factory has normal capacity of 50,000 units and fixed production overhead of ₹25,00,000. In a year disrupted by a labour dispute it produced 30,000 units. Compute the fixed overhead absorbed into inventory per unit and the amount charged to profit, and explain the rule. How would the answer differ if production had been 60,000 units?

Accepted Answer

AS 2 requires the allocation of fixed production overheads to be based on the normal capacity of the production facilities, not on actual output. Normal capacity is 50,000 units, so the rate is 25,00,000 divided by 50,000, that is 50 per unit. Production was 30,000 units, so 30,000 times 50, that is 15,00,000, is absorbed into the cost of units produced, and the unallocated balance of 10,00,000 is recognised as an expense of the period. The reasoning is that the 10,00,000 buys idle capacity, not units, and capitalising it would carry the cost of a labour dispute forward into next year's cost of sales as though it were a cost of making goods. Had production been 60,000 units, the rule reverses direction: the standard provides that in periods of abnormally high production the amount of fixed overhead allocated per unit is decreased so that inventories are not measured above cost. The rate becomes 25,00,000 divided by 60,000, that is 41.67 per unit, and the whole 25,00,000 is absorbed. Note the asymmetry — normal capacity is a floor for the per-unit rate but not a ceiling — and its justification is that inventory may never be carried above what was actually spent.

Question 3

A company buys a machine for ₹80 lakh, pays ₹3 lakh import duty and ₹2 lakh non-refundable purchase tax, ₹4 lakh for installation, ₹1.5 lakh to train operators, ₹2 lakh advertising the new product it will make, and ₹1 lakh testing the machine, during which it sold test output for ₹0.3 lakh. It also has an obligation to dismantle the machine at the end of its life, estimated at ₹5 lakh. Compute the initial carrying amount.

Accepted Answer

Include the purchase price of 80, import duties of 3 and non-refundable purchase taxes of 2, since AS 10 includes import duties and non-refundable purchase taxes after deducting trade discounts and rebates. Include installation of 4, a directly attributable cost of bringing the asset to the location and condition necessary for it to operate as intended. Include testing costs of 1 less the net proceeds of items produced during testing of 0.3, giving 0.7, the standard requiring costs of testing to be net of such proceeds. Include the initial estimate of dismantling and site restoration costs of 5, an obligation having been incurred. Exclude the operator training of 1.5, since costs of staff training are expressly excluded, as are costs of introducing a new product. Exclude the advertising of 2 on the same footing. The initial carrying amount is therefore 80 plus 3 plus 2 plus 4 plus 0.7 plus 5, that is 94.7 lakh, with 3.5 lakh charged to profit. The organising idea behind the exclusions is that training and advertising create no controlled resource attaching to the machine — a trained operator can resign and an advertisement is consumed on broadcast.

Question 4

A plant is mechanically complete and capable of operating as management intended on 1 September, but is not brought into use until 1 December because a customer contract was delayed. During those three months the company incurs ₹6 lakh of maintenance and security costs and ₹9 lakh of operating losses on a trial run at 30% capacity. Advise on the treatment, and state when depreciation begins.

Accepted Answer

None of the 15 lakh is capitalised. AS 10 provides that 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, and that moment arrived on 1 September. The standard is explicit that costs incurred while an asset capable of operating in the manner intended has yet to be brought into use, or is operated at less than full capacity, are not capitalised, and that initial operating losses are likewise excluded. So the 6 lakh of holding costs and the 9 lakh of operating losses are both charged to profit as incurred. The distinction the standard is drawing is between costs that make the asset capable of operating and costs that arise because a capable asset is not yet being used commercially, the latter being a consequence of the company's commercial circumstances rather than a cost of the asset. Depreciation begins on 1 September, the date the asset became available for use, and not on 1 December, since AS 10 ties the start of depreciation to availability rather than to actual use.

Question 5

A company has depreciated its machinery on the written down value method and wishes to move to the straight line method from the current year, on the basis that the new method better reflects the pattern of consumption. Its auditor says this is a change in accounting policy requiring retrospective recomputation. Advise.

Accepted Answer

The auditor is applying the older position and is now wrong. AS 10 provides that the depreciation method applied to an asset shall be reviewed at least at each financial year end and, if there has been a significant change in the expected pattern of consumption of the future economic benefits embodied in the asset, the method shall be changed to reflect the changed pattern; and that such a change shall be accounted for as a change in an accounting estimate in accordance with AS 5. It is therefore applied prospectively, the revised method being applied to the carrying amount as it stands at the date of change over the remaining useful life, with no recomputation of earlier years and no restatement of comparatives. The intuition that runs the other way is worth naming, because it is why this is examined: choosing between straight line and reducing balance feels like choosing a rule, which is the language of policy. The standard's reasoning is that the method is not a free choice at all but an estimate of the pattern in which benefits are consumed, so changing it is revising a judgement in the light of new information, exactly as revising a useful life is. The change and its effect must be disclosed.

Question 6

At the year end a company holds: current investments costing ₹40 lakh with fair value ₹34 lakh; a long-term investment costing ₹60 lakh whose market value has fallen to ₹52 lakh because of a temporary market correction; and a long-term investment costing ₹25 lakh in a company that has entered liquidation, now worth ₹3 lakh. State the carrying amounts and the charge to profit.

Accepted Answer

Classification governs measurement, so establish it first. Current investments are carried at the lower of cost and fair value, so the first holding is written down from 40 to 34, with 6 lakh charged to profit. AS 13 permits the lower of cost and fair value to be determined on an individual investment basis or by category but not on an overall basis, so declines cannot be netted against appreciations elsewhere in the portfolio. Long-term investments are carried at cost, and a provision is made only for a decline that is other than temporary, determined for each investment individually. The second holding has fallen because of a temporary market correction, so no provision is made and it remains at 60; the fall is real but the standard deliberately does not recognise it, on the view that a long-term holder will not realise it. The third holding has fallen because the investee has entered liquidation, which is plainly other than temporary, so a provision of 22 lakh is made and it is carried at 3. The total charge to profit is 6 plus 22, that is 28 lakh.

Question 7

State the two reclassification rules in AS 13 and the common thread between them. Separately, a company holding shares acquired cum-right receives rights it does not wish to take up; the ex-right market price has fallen below the cost of the original acquisition. State the treatment of the renunciation proceeds and contrast it with the ordinary case.

Accepted Answer

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. The common thread is that a reclassification may never increase the carrying amount: whichever direction the transfer runs, the standard takes the lower of two measures, so an enterprise cannot generate a gain by relabelling an investment. That matters because the two categories are measured on different bases, and without the rule reclassification would be an obvious device for recognising unrealised gains. On the rights question, the ordinary rule is that where rights are renounced rather than subscribed, the sale proceeds are taken to profit and loss. But where the investment was acquired cum-right and the market price of the investment falls ex-right below the cost at which it was acquired, the proceeds of renunciation are applied to reduce the carrying amount of the investment to its market value, and only any excess beyond that goes to profit. The reasoning is that in that situation the rights had value only because it was embedded in the cum-right price the company paid, so realising it is a partial recovery of cost rather than a gain.

Question 8

A company borrowed ₹15 crore at 10% specifically to build a plant. Construction ran from 1 April to 31 March. Work was interrupted for four months from 1 July by a contractual dispute, during which nothing was done. For two months from 1 December, work was halted by high water levels, which are a normal seasonal feature of the site and were allowed for in the construction programme. ₹1.2 crore of surplus borrowings was invested for three months, earning ₹9 lakh. Compute the borrowing cost to be capitalised.

Accepted Answer

The interest for the full year is 15 crore at 10 per cent, that is 1.5 crore, or 12.5 lakh a month. AS 16 requires capitalisation to be suspended during extended periods in which active development is interrupted, so the four months of the contractual dispute do not qualify: 50 lakh is expensed. The two months of high water levels are treated differently, and the contrast is the point of the question. The standard provides that capitalisation is not suspended for a temporary delay that is a necessary part of the process of getting an asset ready for its intended use, and its own illustration is precisely high water levels delaying construction of a bridge in a region where such levels are common during the construction period. That delay is anticipated, is part of building on this site, and does not represent an interruption of the activity of getting the asset ready, so those two months continue to be capitalised. Capitalisable interest is therefore eight months at 12.5 lakh, that is 1 crore. From this the income earned on the temporary investment of the specific borrowings, 9 lakh, must be deducted, since AS 16 requires the amount capitalised on specific borrowings to be the actual borrowing costs incurred less any income on their temporary investment. The amount capitalised is 91 lakh, and 59 lakh is charged to profit.

Question 9

State the three conditions that must all be satisfied before capitalisation of borrowing costs commences, and explain why holding land on which no development has begun does not qualify even though the land was bought with borrowed money and interest is accruing.

Accepted Answer

Capitalisation commences when, and only when, all three of the following are met: expenditure for the asset is being incurred; borrowing costs are being incurred; and activities that are necessary to prepare the asset for its intended use or sale are in progress. The land case fails only the third condition, which is exactly why it is instructive. Expenditure has been incurred, since the land was bought, and borrowing costs are accruing on the loan that funded it, so two of the three are plainly satisfied. But merely holding an asset when no production or development that changes the asset's condition is taking place is not an activity necessary to prepare it for its intended use, and AS 16 says so expressly. Interest on land held without development is therefore expensed. The condition is drawn more widely than physical construction, and a good answer says so: activities necessary to prepare the asset include technical and administrative work prior to the commencement of physical construction, such as obtaining permits, so capitalisation can begin before the first brick is laid. The line the standard draws is between working towards readiness and simply waiting.

Question 10

A lessee takes a five-year lease of a machine with an economic life of six years. The present value of the minimum lease payments is ₹92 lakh against a fair value of ₹95 lakh. There is no transfer of title and no purchase option. The lessee argues that the absence of a purchase option and of title transfer makes this an operating lease. Advise, and state the general principle.

Accepted Answer

It is a finance lease. AS 19 classifies a lease as a finance lease if it transfers substantially all the risks and rewards incident to ownership, and the classification depends on the substance of the transaction rather than the form of the contract; the situations the standard lists are indicators that would normally lead to that classification, not a set of conditions all of which must be met. Two of them are satisfied here. The lease term of five years is for the major part of the economic life of six years, and the standard states this leads to finance lease classification even if title is not transferred. And the present value of the minimum lease payments of 92 amounts to substantially all of the fair value of 95, at about 97 per cent. The lessee's argument mistakes the absence of two indicators for the absence of all of them, which is the error the question is set to expose. On these terms the lessee will use the machine for five of its six years and will pay in present value terms almost its whole price, so it bears substantially all the risks and rewards of ownership whatever the contract says about title. The lessee must therefore recognise an asset and a liability at the lower of fair value and the present value of minimum lease payments, that is 92 lakh, and depreciate the asset over the shorter of the lease term and useful life, since ownership will not transfer.

Question 11

A pharmaceutical company spends ₹80 lakh investigating whether a compound has therapeutic effect, and a further ₹120 lakh after establishing efficacy, developing a manufacturing process for a product it intends to sell and has the resources to complete. State the treatment of each and list the conditions that must be satisfied.

Accepted Answer

The 80 lakh is research expenditure and must be charged to profit as incurred. AS 26 permits no intangible arising from research to be recognised, and the reason is definitional rather than cautionary: at the research stage the enterprise cannot demonstrate that an asset exists which will generate probable future economic benefits, since establishing whether a benefit is achievable at all is precisely what the research is for. The 120 lakh is development expenditure and may be capitalised, but only if the enterprise can demonstrate all six of the following: the technical feasibility of completing the intangible asset so that it will be available for use or sale; its intention to complete the asset and use or sell it; its ability to use or sell it; how the asset will generate probable future economic benefits, including demonstrating the existence of a market for the output or for the asset itself, or the asset's usefulness if it is to be used internally; the availability of adequate technical, financial and other resources to complete the development and to use or sell the asset; and its ability to measure reliably the expenditure attributable to the intangible asset during its development. The facts state efficacy is established, that there is an intention to sell, and that resources are available, so the conditions appear satisfied and the 120 lakh is capitalised, subject to the enterprise being able to measure it reliably and separately.

Question 12

A company has built a widely recognised brand and a valuable customer list through years of marketing. It obtains a valuation of ₹200 crore for the brand and wishes to recognise it, arguing that the value is demonstrable and that a purchaser would pay for it. Advise, and explain why a purchased brand may be recognised when an internally generated one may not.

Accepted Answer

The brand and the customer list cannot be recognised. AS 26 expressly provides that internally generated goodwill, brands, mastheads, publishing titles, customer lists and items similar in substance shall not be recognised as intangible assets. The reason is not that they lack value — the valuation may well be sound — but that expenditure on them cannot be distinguished from the cost of developing the business as a whole. A brand is built by advertising, by service quality, by pricing, by hiring, and by the passage of time, all of which are also ordinary costs of trading, so there is no reliable way to say what the brand cost as distinct from what the business cost. That fails the recognition condition requiring cost to be measured reliably. A purchased brand is different in exactly that respect and in no other: an arm's length transaction has fixed what a knowledgeable buyer paid specifically for it, so a reliable cost exists. The apparent inconsistency of two identical brands, one on the balance sheet and one not, is therefore a deliberate consequence of insisting on reliable measurement, and it is the same reasoning that keeps internally generated goodwill off the balance sheet while permitting goodwill arising on an acquisition.

Question 13

An asset has a carrying amount of ₹90 lakh. Its net selling price is ₹72 lakh and its value in use is ₹85 lakh. Compute the impairment loss and explain why the standard takes the higher of the two measures rather than the lower.

Accepted Answer

Recoverable amount is the higher of net selling price and value in use, that is the higher of 72 and 85, which is 85 lakh. The carrying amount of 90 exceeds it, so an impairment loss of 5 lakh is recognised and the asset is carried at 85. The choice of the higher is deliberate and follows from what recoverable amount is trying to measure. The enterprise has two courses open to it: sell the asset, realising 72 net of disposal costs, or keep using it, realising cash flows whose present value is 85. A rational enterprise will take whichever course yields more, so the asset is worth at least 85 to it, and writing it down below that would understate the enterprise's position and recognise a loss that will not occur. Taking the lower would in effect assume the enterprise will choose the worse of the two courses, which is not prudence but pessimism. Note the corollary that produces most errors in this area: no impairment arises unless the carrying amount exceeds both measures, so an asset whose market has collapsed is not impaired at all if it remains worth more in use than its carrying amount.

Question 14

A cash-generating unit has a carrying amount of ₹500 lakh comprising goodwill ₹80 lakh, a building ₹220 lakh and plant ₹200 lakh. Its recoverable amount is ₹390 lakh. The building's net selling price is ₹200 lakh. Allocate the impairment loss.

Accepted Answer

The impairment loss is 500 less 390, that is 110 lakh. AS 28 requires it to be allocated first to reduce the carrying amount of any goodwill allocated to the cash-generating unit, and then to the other assets of the unit pro rata on the basis of their carrying amounts. So goodwill absorbs 80 in full and is reduced to nil, leaving 30 to allocate between the building and the plant in the ratio of their carrying amounts, 220 to 200. That gives the building 30 times 220 over 420, which is 15.71, and the plant 30 times 200 over 420, which is 14.29. The building would fall to 204.29 and the plant to 185.71. Now apply the floor: the standard provides that the carrying amount of an asset shall not be reduced below the highest of its net selling price, its value in use if determinable, and zero. The building's net selling price is 200, and 204.29 is above it, so no adjustment is needed and the allocation stands. Had the floor bitten, the excess would have been reallocated to the other assets of the unit pro rata. Goodwill is written off first because it is the least separable asset in the unit and the one whose value is most directly a claim about the unit's future earnings, which is exactly what the impairment has shown to be overstated.

Question 15

An asset costing ₹100 lakh with a ten-year life was impaired to ₹56 lakh at the end of year 2, when its remaining life was eight years. At the end of year 5 the conditions causing the impairment have reversed and its recoverable amount is ₹80 lakh. Compute the reversal, stating the ceiling and its rationale. Would your answer differ if the impaired asset were goodwill?

Accepted Answer

After the impairment the asset was carried at 56 with eight years remaining, so depreciation is 7 a year and by the end of year 5, three years later, the carrying amount is 56 less 21, that is 35 lakh. Recoverable amount is now 80, so a reversal is indicated, but AS 28 caps it: 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. Without any impairment the asset would have been depreciated at 10 a year for five years, giving 100 less 50, that is 50 lakh. The ceiling is therefore 50, and the reversal is 50 less 35, that is 15 lakh, recognised in profit. The rationale for the ceiling is that a reversal restores an asset that was written down too far; it does not permit an upward revaluation through the profit and loss account, which would let an enterprise book a gain on an asset it still holds at historical cost. A reversal is permitted only where there has been a change in the estimates used to determine recoverable amount since the last impairment loss was recognised, not merely because the passage of time has made the earlier estimate look pessimistic. For goodwill the answer differs sharply: 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. The reason is that an apparent recovery in goodwill is almost always internally generated goodwill, which may not be recognised at all.

Practice — Asset-Based Accounting Standards

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