SECTION VI. ACCOUNTING FOR FIXED ASSETS

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1 SECTION VI. ACCOUNTING FOR FIXED ASSETS A. IAS 16, 23, 36 IAS 16 concerns Property, Plant and Equipment. IAS 36 concerns impairments of assets. IAS 23 concerns borrowing costs for certain qualifying assets. IAS 16 Property, Plant and Equipment Property, plant and equipment are tangible assets owned by an enterprise for use in production, supply of goods or services, rental, or administration purposes. They are expected to be used for more than one period (year). Examples of property, plant and equipment are land, buildings, machinery used in a factory, fixtures in a shop, office equipment, furniture, and motor vehicles. IAS 16 describes: Criteria for recognizing items as property, plant and equipment assets; How to value property, plant and equipment; How to account for subsequent expenditures relating to property, plant and equipment; Depreciation charges to be recognized in relation to their value; Retirement of assets Disclosure required in financial statements. Criteria for recognition Items are recognized as Property, plant and equipment if: It is probable that future economic benefits will flow to the enterprise from their use; and The cost of the asset can be reliably measured; and It is expected that they will be used for more than one year (period). The following principles are applied when grouping or separating assets: Insignificant items like molds and dies can be aggregated as a single asset. Specialized spare parts and servicing equipment are recognized as property, plant and equipment. (Most non-specialized spare parts are considered inventory and are expensed as they are consumed.) Component parts are treated as separate items only if the related assets have different useful lives or provide economic benefits in a different pattern. (An example would be an aircraft and its engines.) Value Property, plant and equipment should be recorded at cost. Cost includes all costs necessary to bring the asset to working condition for its intended use. Components of necessary costs include purchase price, delivery costs, costs to prepare the site, installation costs, and related professional fees for engineers and architects. General and administrative expenses relating to acquisition and start-up costs are not included. Self-constructed assets are valued at cost including materials, labor and other inputs. No profit is recognized on self-constructed assets. When the property, plant or equipment is acquired in exchange for another asset, the cost should be recorded as either: 84

2 Exchange involving dissimilar assets: the fair value of the asset acquired or Exchange involving similar assets: the carrying amount of the asset given up. Benchmark treatment in IAS 16 is to continue to carry property, plant and equipment at historical cost less accumulated depreciation. An allowed alternative treatment is to carry assets at revalued amounts less subsequent depreciation. Revaluations: Subsequent to initial recognition of an asset at cost, classes of property, plant and equipment may be carried at revalued amounts. The revalued amount should be the fair value at the date of the revaluation less any subsequent accumulated depreciation or subsequent accumulated impairment losses. Fair value is usually the market price determined by appraisal. If the allowed alternative treatment is used, revaluations should be made regularly so that the carrying amount of the asset does not differ materially from fair value at the Balance Sheet date. When an asset is revalued the accumulated depreciation at that date is either restated proportionately with the change in the gross carrying amount of the asset or it is eliminated against the carrying amount of the asset and the net amount is restated to the revalued amount of the asset. When an item of property, plant and equipment is revalued, the entire class of assets must be revalued. Examples of classes of assets are buildings, furniture, machinery, and office equipment. When a class of assets is revalued upwards, the increase should be credited directly to equity (as revaluation surplus). When a class of assets is revalued downwards, the decrease should be recognized as an expense unless it reverses a previous revaluation of the same asset. In that case it should first reduce the amount of the revaluation surplus included in equity; the amount remaining should be recognized as expense. Subsequent Expenditure Subsequent expenditure relating to an item of property, plant and equipment should be expensed in the period unless it is probable that it substantially improves the performance of the existing asset. If it does substantially improve the performance of the asset, the cost of the improvement is added to the cost of the asset. Useful life and depreciation for the asset should be reviewed and adjusted as required. Depreciation (see Section 6 of Guidelines) Land is a fixed asset but is not depreciated. If the cost of land is included in the purchase price of the building, the purchase price should be allocated between the land and the building. The building is a depreciable asset. As the economic benefits of property, plant and equipment are consumed, the carrying amount of the asset is reduced to show this consumption by recording an expense for depreciation. The depreciable amount of an asset is determined after deducting the estimated residual value of the asset. The depreciable amount of each item of property, plant and equipment should be allocated over its useful life in a systematic manner based on its pattern of use. Allowable depreciation methods are: o Straight-line 85

3 o Diminishing balance o Sum-of-the-units (Since the straight-line method is authorized by Mongolian tax regulations, it is the one most likely to be chosen.) Depreciation is an expense on the Income Statement or if the asset is used to produce other assets (e.g. inventory), depreciation is included in the cost of the assets produced. The useful life of the assets should be reviewed periodically and if conditions have changed the estimated useful life, then the depreciation charge for the current and future periods should be adjusted. The depreciation method used should be reviewed periodically. If there has been a significant change in the pattern of economic benefits expected from an asset then the depreciation method should be changed. The depreciation charge for the current and future periods should be adjusted. Retirement Property, plant and equipment should be carried on the Balance Sheet until permanent retirement or disposal. When an asset is retired or disposed of the difference between net carrying amount of the asset less disposal costs should be considered as a gain or loss and shown on the Income Statement. Disclosure IAS 16 requires disclosure in the financial statements for each class of property, plant and equipment. See summary of IAS 16. IAS 36 Impairment of Assets IAS 36 describes the procedures to ensure that assets are carried at no more than their recoverable amount. Impairment losses may be indicated by either external or internal factors. IAS 36 applies to all assets except inventories, financial assets, assets arising from construction contracts and some other specialized cases. Periodically assets should be reviewed to see whether or not there is an indication that the asset may be impaired. An asset is impaired if the book value exceeds the recoverable amount or value in use. Recoverable amount is the higher of an asset s net selling price or value in use. Net selling price is the amount obtainable from the sale of an asset less incremental costs of disposal. Value in use is the present value of estimated future cash flows expecting to arise from continuing use of the asset. Information regarding estimates of future cash flows and discount rates can be found in IAS 36. An impairment loss occurs whenever the carrying amount of the asset exceeds its recoverable amount or value in use. The asset should be adjusted (credit entry) to reflect its lower value. Impairment loss for assets carried at historical cost (less depreciation if applicable) should be recognized on the Income Statement in non-operating expense. Impairment loss for revalued assets should first be applied to the revaluation surplus as a revaluation decrease until the surplus for that asset is exhausted. After the recognition of an impairment loss, future depreciation should be adjusted to reflect the revised carrying amount of the asset. In rare instances an impairment loss recognized in prior years can be reversed. Details can be found in IAS

4 Disclosure See summary of IAS 36. IAS 23 Borrowing Costs IAS 23 prescribes the accounting treatment for borrowing costs. Borrowing costs are interest costs on short or long-term loans or overdrafts as well as amortization of discounts or premiums related to borrowing and other costs of borrowing. Benchmark treatment in IAS 23 is that all borrowing costs should be expensed in the period in which they are incurred regardless of the purpose of the borrowings. An allowed alternative treatment is to include borrowing costs that relate to the purchase, construction and production of qualifying assets in the cost of these qualifying assets. This treatment can be applied in the case of self-constructed assets that qualify. Qualifying assets are assets that necessarily take a substantial period of time (more than a year) to get ready for their intended use or sale. (Examples include property, plant and equipment under construction and made-to-order inventories in process.) IAS 23 specifies which costs to capitalize (add to the cost of the asset), when capitalization should begin and end, and when it should be suspended. As specified in IAS 36 above, when the carrying value of an asset, including the amount of borrowing costs capitalized, exceeds its the recoverable amount or value in use, the asset should be written down in accordance with IAS 36. Disclosure See summary of IAS

5 Fixed Asset Accounting Case Study The following situation addresses accounting issues relating to property, plant and equipment where the Balance Sheet date is 31 December 2001: On 1 January 2001, Altai Company acquired production equipment for Tog 2,500,00. The following further costs were incurred: Togrog Delivery 180,000 Installation 245,000 General administrative costs 30,000 The installation and set up period took 3 months, and another Tog 210,000 was spent on start-up costs directly related to bringing the asset to its working condition. Monthly managerial reports indicated that for the first 5 months, the production quantities from this equipment resulted in an initial operating loss of Tog 150,000 because of small quantities produced. The months afterwards show much more positive results. The equipment has an estimated useful life of 14 years. The residual value of the equipment is estimated to be Tog 180,000; estimated costs to dismantle the equipment are 125,000. ISSUES: What value should be recorded as the historical cost of the asset? What are the annual charges in the Income Statement related to the consumption of economic benefits embodied in the asset? Adapted from International Standards A Practical Guide, 2 nd edition by Hennie van Greuning and Marius Koen, published by The World Bank,

6 Fixed Asset Accounting Case Study SOLUTION Historical Cost of the Asset Togrog Invoice price 2,500,000 Delivery 180,000 Installation 245,000 Start-up costs 210,000 Total 3,135,000 Annual Charges related to the Equipment Calculation of Net residual value Estimated residual value 180,000 Less costs to dismantle (125,000) Net residual value 55,000 Historical Cost above 3,135,000 Less est. residual value (55,000) Depreciable amount 3,080,000 The annual charge to the Income Statement is Tog 220,000 (3,080,000/ 14 yrs). Note that in the first year the charge will be 165,000 (9/12 X 220,000) because the equipment was put into service on 1 April 2001 after installation and set-up. Adapted from International Standards A Practical Guide, 2 nd edition by Hennie van Greuning and Marius Koen, published by The World Bank,

7 B. METHODOLOGY ON CONVERSION OF FIXED ASSET ACCOUNTING Main Issues In order to convert the fixed asset system of a company, accountants should have knowledge of the following subjects: Depreciation methods. Such concepts as salvage value, book value, accumulated depreciation, and historical cost of assets. Accounting for repair, maintenance, and capital expenditure for fixed assets. Methods to record depreciation expenses. Methods to record fixed asset depreciation. Methods to record fixed asset acquisition and disposal. The accountant should learn about these issues by studying IAS and the guidelines approved by the Ministry of Finance and Economy. This knowledge will be a prerequisite for converting the fixed asset accounting system at an enterprise that intends to implement IAS. Main Problems and Weaknesses in Fixed Asset Accounting The following problems and weaknesses are likely to be noticed in terms of fixed asset accounting at an enterprise: Problems and Weaknesses No subsidiary ledger is kept for fixed assets. The depreciation expenses are calculated directly based on the total fixed asset amount reported on the Balance Sheet rather than by individual asset. The depreciation expenses are not charged for a certain time period although fixed assets are in use and are shown on the Balance Sheet. No consistent application of the useful lives and the depreciation rates for fixed assets. Improper allocation of depreciation expenses. This will result in errors in the cost of goods sold as well as in administrative and selling expenses. Impact on Financial Statements It is likely that the balance for fixed assets is incorrect in the accounting records as well as on the Balance Sheet. Reported depreciation expense and accumulated depreciation is not correct. Both the Balance Sheet and Income Statement are misstated. Due to the understated depreciation expenses (on the Income Statement), the book values of fixed assets are overstated on the Balance Sheet. Increased likelihood of errors in calculation. The cost of goods sold or cost of goods produced will not be reported correctly. Inventory cost will also be incorrect. Since the above weaknesses impair the fairness of financial statements, the correction of the above weaknesses will be the major result of converting the accounting system for fixed assets.. 90

8 Suggested Steps for Converting the Accounting System It is suggested that the following major steps be followed for converting fixed asset accounting. It is useful to remember that the scope of work to convert the fixed assets accounting system may differ from one enterprise to another depending on the number and nature of fixed assets, procedures already in place, and whether the fixed assets accounting has been systematically organized or maintained. 1. Review the status of the source documentation and fixed assets subsidiary ledgers; 2. Ensure the fairness or reliability of the basic information necessary for the fixed asset accounting. Included here are the historical cost, salvage value, depreciation method, and useful life of the asset; 3. Select the depreciation method and the depreciation rates to be used; 4. Define the cost centers that depreciation expenses are to be charged to; 5. Ensure whether the new main and sub accounts for the fixes assets, depreciation expenses and accumulated depreciation are set up properly, are included in the Chart of Accounts, and are reflected correctly in the subsidiary ledgers; 6. Analyze the information for the fixed assets; 7. Ensure the fairness or correctness of the beginning balance of accumulated depreciation; and define necessary adjustments and record them. If there is high likelihood of calculation errors in the past, the accumulated depreciation for the prior periods can be recalculated and a correct amount for the beginning balance of accumulated depreciation can be established. The adjustment to the beginning balance of accumulated depreciation should be made in the General Journal, and can also be reflected on the sheet for beginning balance adjustments, if it is used. 8. Prepare new subsidiary ledgers for fixed assets. The specific use of fixed assets needs to be reviewed so that fixed assets are identified and classified according to their cost centers and locations (responsibility centers). The correct balances for the beginning balance of accumulated depreciation are indicated in the subsidiary ledgers in order to prepare the ledger for the next accounting period. 9. Estimate the depreciation expenses for the current accounting period. The depreciation expenses are calculated in accordance with IAS and reflected in subsidiary ledgers. The journal entries to record and allocate depreciation expenses are made in the General Journal. A more detailed explanation for the above steps has been attached at the end of this section. Specific considerations: It is useful to consider the following conditions when the accounting system for fixed assets is being converted. It may become necessary to conduct a physical count of fixed assets to ensure fairness of the fixed assets records in order to fully comply with IAS. A physical count is more likely to be needed in enterprises that have not subsidiary ledgers or initial records for fixed asset acquisition. As a result of the physical count, the recorded amount of fixed assets may need to be 91

9 increased or decreased. It is a good practice to conduct a physical count of fixed assets at least once a year. Also for the purpose of the identification of assets to be recorded as fixed assets, the enterprise may need to establish some kind of a threshold for the cost of assets. There are some cases where enterprises have recorded low value supply items as fixed assets. Some entities may have performed fixed asset revaluation. In this case, the revalued amounts would be the basic information to rely on in the future accounting for fixed assets. It may become necessary to review the depreciation charge for the periods after the revaluation. Results of Converting Fixed Assets Accounting to Comply with IAS An enterprise will achieve the following results from converting its fixed assets accounting system: Fixed assets are controlled through subsidiary ledgers. The subsidiary ledger and other forms for fixed assets are kept in complete and correct order. The depreciation percentage, useful lives and depreciation method are applied consistently. Depreciation expenses are estimated correctly and allocated properly between product and period costs. The names and codes of accounts for fixed assets, accumulated depreciation, and depreciation expenses are defined systematically and used properly. Steps for Converting Payroll Accounting Indications that Conversion is Required Objectives and outcomes 1. Review the status of the source documentation and fixed assets subsidiary ledgers Weak documentation. This is likely to The source documents and result in misstatement of asset value ledgers need to be kept in and depreciation. complete and correct form in the future. 2. Ensure the fairness or reliability of the basic information Calculation errors occur due to inconsistent and incorrect application of historical cost, book value, and deprecation rates. Correct the fixed assets information, and make it available for accounting in the future. 3. Select the depreciation method and the depreciation rates The depreciation method and rates Select the depreciation method are not consistently applied and there and depreciation rate that may be confusion between rates used ensures compliance with IAS for for tax reporting and financial financial reporting and apply it reporting. consistently. 4. Define the cost centers that depreciation expenses are to be charged to 92

10 Due to misunderstanding concerning asset utilization, depreciation expenses may be misallocated among cost centers. 5. Revise accounts 6. Analyze the information on fixed assets The fact that a subsidiary ledger is not used and depreciation expense is calculated roughly may result in calculation errors and misstated accumulated depreciation on the Balance Sheet. A review needs to be done to see whether depreciation expenses are allocated correctly in the prior periods. Determine asset use and make correct allocation of depreciation expenses. The subsidiary ledgers for fixed assets need to be kept in such a way that facilitates proper allocation of depreciation expenses among cost centers. New main and sub accounts need to be defined. Verify consistency between the amount of accumulated depreciation on the Balance Sheet and depreciation expenses on the Income Statement. Examine any differences and make correcting (adjusting) entries. 7. Ensure the fairness or correctness of the beginning balance of accumulated depreciation; and define necessary adjustments and record adjustments. Errors in calculation or recording may have been made. 8. Prepare new subsidiary ledgers for fixed assets Subsidiary ledgers may be incorrect, incomplete or missing. The subsidiary ledgers for fixed assets form a sound foundation for a correct estimation of an asset s book value and depreciation. If there is high probability of errors in calculation or recording, the depreciation charge for certain prior periods should be recalculated and a correct balance for the accumulated depreciation defined. Asset information such as historical cost and beginning balance of accumulated depreciation need to be reflected in the subsidiary ledger correctly. This will form the basis of correct accounting information to be used in future periods. 9. To record depreciation expenses for the current accounting period Depreciation expenses may not be allocated properly among cost centers. Based on the allowed depreciation method and useful lives (a) the depreciation for the current period needs to be estimated correctly, (b) reflected in the subsidiary ledger, and (c) correct journal entries need to be made to allocate depreciation expense to the proper center. 93

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