Essentials of FA - Chapter 9

ESSENTIALS OF FINANCIAL ACCOUNTING BY ASISH K BHATTACHARYYA
Second Edition Chapter 9
Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA
Fixed Assets: Characteristics

1/22/2014
Entities acquire fixed assets with an intention to use them in production of goods or services or for rental or for administrative use. Usually, these provide economic benefits for more than one accounting period. Major spare parts and stand-by equipment qualify as PP&E when an entity expects to use them during more than one period. Similarly, insurance spares are accounted for as PP&E.

Spare parts and servicing equipment which can be used only in connection with an item of property, plant and equipment are called insurance spares.
429
Fixed Assets: Characteristics

1/22/2014
Classification of fixed assets

Fixed assets (Assets being used for production, rental or administration)
PP&E Examples: Land, building , railway siding, plant and machinery, furniture and fixtures, electric installation, ship , vehicle, and livestock
Intangible assets Examples: Software, goodwill, product brand, corporate brand, product patent, copy right, license, rights to use assets belonging to other entities, customer list, and masthead of a newspaper
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RECOGNITION AND MEASUREMENT OF PP&E

431
Recognition Criteria
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The cost of an item of property, plant and equipment (PP&E) is 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.
An entity evaluates under this recognition principle all its PP&E costs at the time they are incurred.
These costs include costs incurred initially to acquire or construct an item of PP&E and costs incurred subsequently to add to, replace part of, or service it.
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Items of PP&E may be acquired for safety or environmental reasons.
Such an item of PP&E qualifies for recognition as an asset.
433
Initial Measurement
1/22/2014
An item of property, plant and equipment that qualifies for recognition as an asset should initially be measured at its cost. The cost of an item of PP&E comprises:
its purchase price; any cost 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; and the initial estimate of the costs of dismantling and site restoration.
434
Purchase Price
1/22/2014
The cost of an item of property, plant and equipment is the cash price equivalent at the recognition date.
The difference between the cash price equivalent and the total payment is recognised as interest. If, the supplier charges a lower price for cash sales, that lower price is the purchase price even if the entity has purchased the asset on credit by paying a price higher than the cash sales price. Usually, if the payment is deferred beyond six months, the purchase price is the present value of price payable to the supplier. The present value is calculated using the market interest rate.
435
Exchange Difference
1/22/2014
The carrying amount of the fixed asset is not adjusted for exchange difference arising from settlement or restatement of a liability, denominated in a foreign currency, assumed on acquisition of the item of PP&E.
436
Directly Attributable Cost

1/22/2014
A cost, which would have been avoided had the asset not been acquired, is directly attributable to bringing the asset to the location and working condition for its intended use.
437
Directly Attributable Cost: Examples

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Costs of employee benefits arising directly from the construction or acquisition of the item of PP&E; Costs of site preparation; Initial delivery and handling costs; Installation and assembly costs; Costs of testing; and Professional fees.
438
Directly Attributable Cost: Examples of Cost Not Included in The Cost of PP&E
1/22/2014
Costs of opening a new facility; Costs of introducing a new product or service (including costs of advertising and promotional activities); 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.
439
Costs Which are Not Included in the Carrying Amount of an Item of PP&E
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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; Initial operating losses, such as those incurred while demand for the items output builds up; and Costs of relocating or reorganising part or all of an entitys operations.
440
Start-up Costs
1/22/2014
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.
Expenditure on start-up and commissioning incurred after the commencement of commercial production should not be capitalised. Often, it is difficult to determine the date of commencement of commercial production, because enterprises usually sell goods produced during test runs and experimental production. It is a matter of judgement.
441
Borrowing Costs
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Borrowing costs that are directly attributable to the acquisition of PP&E are included in the cost of production or construction of that item.
Borrowing costs for the period of construction or production should be capitalised. Capitalisation of borrowing costs should commence with commencement of the activities related to the production or construction of the asset and should cease when the asset is substantially complete. Borrowing cost for the period during which the production is suspended should not be included in the cost of the asset, provided that the temporary suspension is not normal to the production process.
442
Asset Retirement Obligation

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An entity should recognise a provision in the balance sheet for the estimated expenditure on dismantling of the asset, removing the same and restoration of the site and include the same in the acquisition cost of the asset.
The provision should be recognised at the present value of the estimated amount that will be required to settle the obligation. Usually, the probability-weighted expected value of the amount to be spent is discounted by the risk-free rate.
443
Asset Retirement Obligation: Unwinding of the Discount

1/22/2014
The carrying amount of the provision increases in each period to reflect the passage of time, and this increase is recognised a borrowing cost. Change in the provision due to any other reason, such as change in the estimated amount or the discounting rate, should be adjusted to the carrying amount of the asset.
444
Land Development Expenditure

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Cost of land development that provides enduring benefit to the business is capitalised.
In case of owned or leasehold land, the development expenditure should be added to the cost of the land and should not be shown separately. In case of lease-hold land, if the lease agreement provides for recovery of development expenditure from the lessor on termination of the lease, the net cost of the land should be amortised. The net cost is the cost including land development expenditure minus the recoverable amount, if any.
445
Demolition Cost
1/22/2014
Entities may purchase a land with a building which is to be demolished to construct a new building for its intended use.
If, this be the case, the cost of the land is the total of the purchase price for the land (with building) and the cost of demolishing the building. No portion of the purchase price is allocated to the building because the building is unusable. The cost of demolishing the building should be considered as the cost for making the land ready for use.
446
Expenditure to Bring the Asset Ready for Use

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Expenditure incurred to bring the fixed asset to its working condition is capitalised, provided the same was contemplated at the time of acquisition of the asset.
The underlying principle is that if the purchase price assumes that an additional expenditure would be incurred to make the asset ready for use, the additional expenditure should be a part of the acquisition cost.
447
Asset Acquired Through a Government Grant

1/22/2014
When the government grant is in the form of nonmonetary assets such as land or other resources, both the asset and the grant are recognised at fair value.
Alternatively, sometimes both the asset and the grant are recognised at a nominal amount.
If the grant meets only part of the cost of an asset, the same is recognised either as a deferred income or by deducting the grant in arriving at the carrying amount of the asset.
If an enterprise recognises a government grant as a deferred income, it should be allocated over the useful life of the asset on a systematic and rational basis.
448
Component Accounting
1/22/2014
Where several fixed assets are purchased for a consolidated price, the consideration should be apportioned to the various assets on a fair basis as determined by a competent valuer. An entity should allocate the cost of an item of PP&E to its significant parts and recognise them separately.
449
Significant Component
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The term significant part is not defined in the accounting standard (IAS 16).
Usually, a component is considered significant if its cost exceeds 10% of the total cost of the asset.
A significant part of an item of property, plant and equipment may have a useful life and a depreciation method that are the same as the useful life and the depreciation method of another significant part of that same item.
Such parts may be grouped in determining the depreciation charge.

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SELF-CONSTRUCTED ASSETS
451
Fundamental Principle
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The accumulation of costs commences when the management commits to the acquisition of the fixed asset. It ceases when the asset is substantially ready for use.
The phrase substantially ready for use implies that the capitalisation of cost should cease when only some administrative work is left to be completed or the production is complete except for some work which is not technically essential for completion of the production of the asset.
452
Preliminary Stage Costs

1/22/2014
Preliminary stage costs, which are in the nature of research expenses, should be charged to the profit and loss account for the period in which they are incurred.
Examples of preliminary stage costs are costs of exploration of opportunities for acquisition or construction of an asset, costs of feasibility studies, costs of engineering studies, and costs of design layouts.
If the entity purchases an option to acquire a fixed asset, the payment should be capitalised.
453
Pre-acquisition Costs
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The preliminary stage ends and the pre-acquisition stage begins when the acquisition of the asset is probable as evidenced by managements authorisation and allocation of fund. Pre-acquisition stage ends when the entity obtains ownership or control of the asset. Internal and external costs incurred in the preacquisition stage are charged to the profit and loss account for the period in which they are incurred unless those are directly attributable to the specific asset.
454
Expenditure During Construction Period

1/22/2014
Indirect expenditure essential to the construction activity are allocated to items of PP&E constructed during the construction period. Expenditures that are capitalised include the following:
General administration and office expenditure at the construction site Expenditure on running of vehicles Expenditure in connection with temporary structure and service facilities Depreciation of fixed assets used in construction activities
455
Expenditure During Construction Period

1/22/2014
Accumulation of costs against a specific project should commence from the date the management authorises and commits fund for the project. Often expenditures that are in the nature of preliminary stage expenditure are incurred in the pre-acquisition stage. For example:
After approval of the project, the project team prepares the detailed project report, conducts surveys and preliminary studies, and negotiates with collaborators on the terms and conditions of collaboration. They are directly attributable to the project and are capitalised as a part of the project cost.
456
Income During Construction Period

1/22/2014
Some operations occur in connection with the construction and development of an item of property, plant and equipment, but are not necessary for construction activities. The income and related expenses of incidental operations should be recognised as profit or loss for the period. However, income from operations that are necessary for construction activities should be deducted from construction cost.
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EXCHANGE TRANSACTION
458
PP&E Acquired in Exchange Transaction

1/22/2014
IAS-16 stipulates that the cost an item of PP&E property, plant or equipment acquired in exchange for non-monetary assets or a combination of monetary and non-monetary assets is measured at fair value. If an enterprise is able to determine reliably the fair value of either of the asset received or the asset given up, then the fair value of the asset given up should be used to measure the cost of the asset received unless the fair value of the asset received is more clearly evident.
459
PP&E Acquired in Exchange Transaction (cont.)

1/22/2014
The asset received in exchange is measured at the carrying amount of the asset given up if:
(a) The exchange transaction lacks commercial substance; or (b) The fair value of neither the asset received nor the asset given up is reliably measurable.
460
PP&E Acquired in Exchange Transaction: Commercial Substance

1/22/2014
An exchange transaction has commercial substance if:

(a) The configuration (risks, timing and amount) of the cash flows of the assets received differs from the configuration of the cash flows of the asset transferred. (b) The entity-specific value of the portion of the entitys operation affected by the transaction changes as a result of the exchange. (c) The difference in (a) or (b) is significant relative to the fair value of the assets exchanged.
461
PP&E Acquired in Exchange Transaction: Commercial Substance (cont.)

1/22/2014
For the purpose of determining whether an exchange transaction has commercial substance, the entity-specific value of the portion of the entitys operation affected by the transaction shall reflect post-tax cash flows.
An enterprise need not have to make detailed calculations if the result of these analyses is clear. In most situations, an exchange of similar assets does not have a commercial substance. Therefore, in exchange of similar assets, no gain or loss is recognised.
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SUBSEQUENT EXPENDITURE
463
General Principle
1/22/2014
Recognition criteria for the initial recognition of an item of PP&E should be applied in deciding whether expenditure on an existing item of PP&E should be capitalised.
If the expenditure fulfills the criteria, either the carrying amount of the item of the PP&E is adjusted or it is recognised as a separate component of the asset. An expenditure that fails to meet the recognition criteria should be recognised as an expense in the profit and loss account for the period in which the expenditure is incurred.
464
Examples of Costs That are Usually Capitalised

1/22/2014
The following examples of expenditure that are usually recognised in the carrying amount of an item of PP&E:
(a) Costs of modification of an item of PP&E to extend its remaining useful life; (b) Costs of modification of an item of PP&E to increase its capacity; (c) Costs of upgrading machine parts to achieve a substantial improvement in the quality of output; and (d) Costs for the development of a new production process enabling substantial reduction in operating costs.
465
Repair and Maintenance

1/22/2014
The costs of the day-to-day servicing of the item of PP&E are recognised in profit or loss as incurred.
Costs of day-to-day servicing are primarily the costs of labour and consumables, and may include the cost of small parts.
466
Replacement of Parts
1/22/2014
Parts of some items of PP&E may require replacement at regular intervals.

For example, a furnace may require relining after a specified number of hours of use Items of PP&E may also be acquired to make a less frequently recurring replacement, such as replacing the interior walls of a building
An entity recognises in the carrying amount of an item of PP&E, the cost of replacing part of such an item when that cost is incurred if the recognition criteria are met.
The carrying amount of those parts that are replaced is derecognised.

467
Inspection and Overhaul

1/22/2014
A condition of continuing to operate an item of property, plant and equipment (for example, an aircraft) may be performing regular major inspections for faults, regardless of whether parts of the item are replaced.
When each major inspection is performed, its cost is recognised in the carrying amount of the item of PP&E as a replacement if the recognition criteria are satisfied. Any remaining carrying amount of the cost of the previous inspection (as distinct from physical parts) is derecognised.
468
Relocation Costs
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Cost of re-deploying or relocating an item of PP&E should be recognised as an expense as it is incurred.
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SUBSEQUENT MEASUREMENT
470
Fundamental Principle
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An entity can choose either the cost model or the revaluation model as its accounting policy. Once the choice is made, and shall apply that policy to an entire class of PP&E. Most companies use the cost model for subsequent measurement of items off PP&E.
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Cost Model
1/22/2014
After recognition as an asset, an item of PP&E is carried at its cost less any accumulated depreciation and any accumulated impairment losses.
472
Revaluation Model
1/22/2014
Revaluation model can be used only for those items of PP&E whose fair value can be measured reliably. After recognition as an asset, an item of PP&E is 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. Items of PP&E should be revalued with sufficient regularity to ensure that the carrying amount does not differ materially from the fair value at the end of the reporting period.
473
Revaluation Model: Fair Value

1/22/2014
The fair value of land and buildings is usually determined from market-based evidence by appraisal that is normally undertaken by professionally qualified valuer. The fair value of items of plant and equipment is usually their market value determined by appraisal.

If there is no market-based evidence of fair value because of the specialised nature of the item of property, plant and equipment, an entity estimates the fair value using an income or a depreciated replacement cost approach.
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Revaluation Model: Frequency of Revaluation

1/22/2014
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.
475
Revaluation: Accounting Method

1/22/2014
If an assets carrying amount is increased as a result of a revaluation, the increase is recognised in other comprehensive income and accumulated in equity under the heading of revaluation reserve.
However, the increase is recognised in profit or loss to the extent that it reverses a revaluation decrease of the same asset previously recognised in profit or loss.
476
Revaluation: Accounting Method (cont.)

1/22/2014
If an assets carrying amount is decreased as a result of a revaluation, the decrease is recognised in profit or loss.
However, the decrease is recognised in other comprehensive income to the extent of any credit balance existing in the revaluation surplus in respect of that asset. The decrease recognised in other comprehensive income reduces the amount accumulated in equity under the heading of Revaluation Reserve.
477

1/22/2014
The revaluation reserve 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 revaluation reserve when the asset is retired or disposed of.
478

1/22/2014
However, some of the revaluation reserve 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 assets original cost. Transfers from revaluation surplus to retained earnings are not made through profit or loss.
479
Revaluation Reserve
1/22/2014
Revaluation reserve represents accumulated unrealised gain arising from revaluation of items of PP&E. The revaluation reserve is not available for distribution to shareholders either as dividend or as bonus shares. Although revaluation reserve is a component of reserves and surplus, financial analysts, while calculating financial ratios, reduce equity (net worth) and the carrying amount of PP&E by the amount of revaluation reserve in the balance sheet.
480
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PP&E HELD FOR SALE

481
Classification
1/22/2014
An entity classifies an item of PP&E as Held for Sale if its carrying amount can be recovered principally through a sale transaction rather than through continuing use.
The appropriate level of management must be committed to a plan to sell the asset and an active programme must have been initiated. The sale should be expected to qualify for recognition as a completed sale within one year from the date of classification. An entity continues to classify the asset as held for sale if events or circumstances that have extended the period to complete the sale beyond one year are not within the control of the entity.
482
Measurement
1/22/2014
An entity measures an item of PP&E classified as Held for Sale at the lower of its carrying amount and fair value less costs to sell. The carrying amount immediately before the classification should be determining applying the principles discussed above. The gain or loss arising from re-measurement of the asset at each balance sheet date should be recognised as gain or loss in the profit and loss account.
483
Presentation
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An entity presents an item of PP&E classified as Held for Sale separately from other assets in the balance sheet.
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INTANGIBLE ASSETS
485
Characteristics
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Common examples of intangible assets are computer software, patents, copyrights, motion picture, films, customer lists, mortgage servicing rights, fishing licences, import quotas, franchises, customer or supplier relationships, customer loyalty, market share and marketing rights.
Not all the items described above meet the definition of an intangible asset. Contemporary accounting practice does not allow recognition of internally generated intangible assets, except software. If no intangible asset is recognised from expenditure, it is recognised as an expense when it is incurred.
486
Definition
1/22/2014
An intangible asset is an identifiable non-monetary asset without physical substance.
The definition of an intangible asset requires an intangible asset to be identifiable to distinguish it from goodwill.
Intangible assets are fixed assets without physical substance.
They provide economic benefits to the entity only in combination with other assets being used for the business. They enhance the service potential of other assets.
487
Goodwill
1/22/2014
Goodwill is an amorphous asset that an entity creates in the course of its operation.
It arises from business connections, trade name, regular customers, a good reputation and efficient management. It subsumes intangibles like corporate brand (e.g. highly respected company), product brand, organisation culture, knowledge, high employee morale and customer relationship. It is the preeminent unidentifiable intangible asset.
488
Goodwill (cont.)
1/22/2014
Internally generated goodwill is not recognised in the balance sheet. Goodwill recognised in a business combination. It is measured at the difference between the amount of the purchase consideration and the fair value of assets acquired (net of the total amount of liabilities acquired).
489
Gain from a Bargain Purchase

1/22/2014
Occasionally, an acquirer makes a bargain purchase, which is a business combination in which the amount of the purchase consideration is less than the fair value (net of the amount of liabilities acquired) of identifiable assets acquired in the transaction. The acquirer recognises the excess of the fair value over the purchase consideration in the profit or loss for the period in which the acquisition occurred as gain on a bargain purchase.
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Identifiability of an Intangible Asset

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An intangible asset is identifiable when it:

(a) is separable from goodwill; or (b) arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the enterprise or from other rights and obligations.
An intangible asset is separable, if the entity could rent or dispose of the asset without also disposing of the business in which it is used.
491
Intangible Assets Contained in or on a Physical Substance

1/22/2014
Some intangible assets may be contained in or on a physical substance, but the cost of the physical substance containing the intangible asset is usually not significant. Therefore, the cost is commonly treated as a part of the intangible asset.

Examples are compact disk, legal documentation or film.
In case an intangible asset is an integral part of a tangible fixed asset, judgement is required on whether such an asset should be accounted for as an item of PP&E or as an intangible asset.
492
Control
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Control is an important element in the definition of an asset. Usually, the ability of an entity to control the future economic benefits flows from legal rights that are enforceable in the court of law.
However, legal enforceability of a right is not a necessary condition.
In many situations, the control over assets that could otherwise be classified as intangible assets is insufficient.
Therefore, many intangibles do not find place in the balance sheet as assets.
493
1/22/2014
An item that is identified as intangible asset should be recognised if and only if:
(a) It is probable that the future economic benefits that are attributable to the asset will flow to the enterprise; and (b) The cost of the asset can be measured reliably.
An entity should assess the probability of the future economic benefit using reasonable and supportable assumptions.
Those assumptions should represent best estimate of the set of economic conditions that will exist over the useful life of the asset.
494
Initial Measurement
1/22/2014
Intangible assets acquired separately are measured at cost. An intangible asset acquired free of charge by way of government grant should be recorded at the fair value of the asset or at a nominal value, say, at Re. 1. If an intangible asset is acquired in a business combination, the cost of that intangible asset is its fair value at the date of acquisition.
495
Internally Generated Goodwill

1/22/2014
Internally generated goodwill is not recognised as an asset.
Therefore, goodwill appears in the balance sheet of an entity only when it recognises goodwill in a business combination.
496
Expenditure During Research Phase

1/22/2014
No asset is recognised from expenditure incurred during the research phase.

Expenditure incurred during the research phase should be recognised as an expense for the period in which the expenditure is incurred. Expenditure on research includes payment to other parties for research activities carried out on behalf of the entity. If an item of property, plant and equipment that is purchased and used for use in research has alternative uses, it is accounted for like any other item of PP&E.
497
Expenditure During Development Phase

1/22/2014
An entity recognises an asset from development phase expenditure, only if the entity demonstrates the following:
(a) The technical feasibility of completing the intangible asset; (b) Its intention to complete the intangible asset and use or sell it; (c) Its ability to use or sell the intangible asset; (d) The commercial viability of the intangible asset; (e) The availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset; and (f) Its ability to measure the expenditure reliably
498
Expenditure During Development Phase (cont.)

1/22/2014
The accumulation of cost of an asset from the expenditure during the development phase should commence from the time when the intangible asset first meets the recognition criteria.
Usually, entities do not recognise asset from the development expenditure because it is often very difficult to demonstrate that the expenditure meets the recognition criteria.
Expenditure on an intangible item that was initially recognised as an expense should not be recognised as part of the cost of an intangible asset later.
499
Internally Generated Brands, etc.

1/22/2014
Internally generated brands, mastheads, publishing titles, customers-list and items similar in substance should not be recognised as intangible assets:
Expenditure on those items cannot be distinguished from the cost of developing the business as a whole.
Brands and similar assets acquired either individually or with other assets should be recognised in the balance sheet.
500
Software for Internal Use

1/22/2014
Preliminary stage costs should be recognised as expenses for the period in which those cost are incurred.
Cost capitalisation commences when an entity has completed the conceptual formulation, design, and testing of possible project alternatives, including the process of vendor selection for purchased software.
Costs incurred subsequent to the preliminary project stage, are capitalised if they are expected to provide economic benefits over a number of periods.
501
Software for Internal Use (cont.)

1/22/2014
Costs incurred during the application development stage are also capitalised. These include coding and testing activities and various implementation costs. These costs are limited to:
(a) External direct costs; (b) Employee costs to the extent of time directly spent on the project; and (c) Interest cost incurred while developing internal-use software.
General and administrative costs, overheads and training costs are expensed as incurred.
502
Web Site Development Costs

1/22/2014
An entitys own Web site that arises from development is an internally generated intangible asset. Development expenditure should be recognised as an intangible asset if and only if an entity can demonstrate how its Web site will generate probable future economic benefits.

For example, it may demonstrate that the Web site is capable of generating revenues, including direct revenues from enabling orders to be placed.
503
Expenditure on developing a Web site to be used for promoting its own products should be recognised as an expense when incurred.
Web Site Development Costs (cont.)

1/22/2014
Any internal expenditure on the development and operation of an entitys own Web site shall be accounted for in accordance with principles for accounting of development expenditure. The nature of each activity for which expenditure is incurred (e.g. training employees and maintaining the Web site) and the Web sites stage of development or post-development should be evaluated to determine the appropriate accounting treatment.
504
Web Site Development Costs (cont.)

1/22/2014
The following general guidelines may be followed:

(a) Expenditure incurred in the planning stage should be recognised as an expense. (b) Expenditure incurred in the application and infrastructure development stage, the graphical design stage and the content development stage should be included in the cost of a Web site recognised as an intangible asset. (d) Expenditure incurred in operating stage should be recognised as an expense when it is incurred.
505
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ANALYSTS PERSPECTIVE
506
Property, Plant and Equipment

1/22/2014
In most cases, items of PP&E are presented in the balance sheet at the acquisition cost less accumulated depreciation less accumulated impairment loss.
Therefore, the carrying amounts of PP&E in the balance sheet of comparable entities are not comparable. Consequently, financial ratios which use in the numerator a number from the profit and loss account, and in the denominator use a number from the balance sheet are not comparable even for comparable entities.
507
Property, Plant and Equipment (cont.)

1/22/2014
Analysts prefer not to adjust balance sheet figures for current cost of the items of PP&E for two reasons.
The first reason is that, as an outsider, they will have to incur significant costs to collect information required for replacing book values of items of PP&E for current costs. The second reason is that the distortion due to accounting choice is not very significant.
508

1/22/2014
An example
AL (Amount in Rs.) Year 2008 Sales 6,000 Year 2009 6,600 Year 2010 7,260 HL (Amount in Rs.) Year 2008 6,000 Year 2009 6,600 Year 2010 7,260
Earnings before interest and tax

Interest Income tax @ 30% Net profit
1,200
0 360 840
1,320
0 396 924
1,452
0 436 1016
1,200
0 360 840
1,320
0 396 924
1,452
0 436 1016
Net book value of PP&E (average

of opening and closing balances) Working capital Average invested capital Return on invested capital (%) Asset turnover
5,500
1500 7,000 12 0.86
4,500
1650 6,150 15.02 1.03
3,500
1815 5,315 19.12 1.37
12,750
1500 14.250 5.89 0.42
11,250
1650 12,900 7.16 0.51
9,750
1815 11,565 8.79 0.63
509

1/22/2014
Conclusions
The productivity of PP&E and other assets, in terms of sales and net operating profit less adjusted tax (NOPLAT), is the same for both AL and HL. However, the capital productivity of AL, in terms of return on invested capital (ROIC) and asset turnover, is higher for AL as compared to HL. Even the fair value of the items of PP&E held by AL should be lower than the fair value of those held by HL because the remaining useful life of items held by AL is lower than those held by HL. Therefore, even if fair value is used to measure items of PP&E, the benefit of lower investment by AL will get reflected in ROIC and asset turnover.
510
Expensed Investment
1/22/2014
GAAP does not allow recognition of any asset from advertising and sales promotion expenditure and also from research expenditure. Most entities do not recognise asset from development expenditure. Analysts consider those expenditures as investment. Accordingly, they adjust financial statements before analysis.
511
Expensed Investment: Steps for Adjustments

1/22/2014
The first step in capitalising the expenditure is to choose an amortisation period. The choice is guided by the product and industry characteristic. The choice is judgmental and hence is subjective. The next step is to take financial statements from say, five years (amortisation period) prior and make necessary adjustments. Capitalisation of those expenditures increases the invested capital, often without changing the reported profit. Income tax expense should not be adjusted because income tax law allows deduction those expenditures in full for calculating the taxable income.
512
Expensed Investment: Example

1/22/2014
Advertisement expenditure Rs. 5,000 per annum; Amortisation period five years.
Year Expenditure (Rs.) Amortisation (Rs.) Change in inves ted capital reported in th e Change in net profit reported in the profit and
balance sheet (Rs.) 1

2 3 4 5
loss account (Rs.) + 4,000

+ 3,000 + 2,000 + 1,000 0
513
5,000
5,000 5,000 5,000 5,000
1,000
2,000 3,000 4,000 5,000
+ 4,000
+7,000 + 9,000 +10,000 + 10,000
1/22/2014
END
514

Essentials of FA - Chapter 9

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ESSENTIALS OF FINANCIAL ACCOUNTING BY ASISH K BHATTACHARYYA

Second Edition Chapter 9

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Fixed Assets: Characteristics

Fixed Assets: Characteristics

Classification of fixed assets

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

RECOGNITION AND MEASUREMENT OF PP&E

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Items of PP&E may be acquired for safety or environmental reasons.

Such an item of PP&E qualifies for recognition as an asset.

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Directly Attributable Cost

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Directly Attributable Cost: Examples

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Asset Retirement Obligation

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Asset Retirement Obligation: Unwinding of the Discount

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Land Development Expenditure

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Expenditure to Bring the Asset Ready for Use

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Asset Acquired Through a Government Grant

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Such parts may be grouped in determining the depreciation charge.

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Preliminary Stage Costs

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Expenditure During Construction Period

Expenditure During Construction Period

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Income During Construction Period

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

PP&E Acquired in Exchange Transaction

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

PP&E Acquired in Exchange Transaction (cont.)

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

PP&E Acquired in Exchange Transaction: Commercial Substance

An exchange transaction has commercial substance if:

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

PP&E Acquired in Exchange Transaction: Commercial Substance (cont.)

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Examples of Costs That are Usually Capitalised

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Repair and Maintenance

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA