With adoption of or convergence to International Financial Reporting Standards (IFRS) in the not so distant future, most U.S. publicly traded companies are starting to think about how to facilitate the transformation. At the end of the day and after the convergence projects, several differences between the respective accounting standards will remain. One of those remaining differences will be the definition for property, plant and equipment (PPE) and their respective useful lives (i.e., componentization). For publicly traded companies that are asset based enterprises or utilize significant fixed assets to generate goods or services, switching to IFRS will be more complex due to this particular accounting difference as the business may be affected from a variety of financial, tax and operational perspectives.
Componentization of fixed assets is a topic that is often mentioned as a key factor in IFRS transitions, that is, how large fixed assets should be broken down into significant component parts, which are then treated as separate individual items with potentially different useful lives. Disaggregation is the separation of an asset into its significant components. IFRS requires that each part of an item of PPE that has a cost significant in relation to the total cost of the item, be accounted for as separate assets for depreciation purposes. Under IFRS, if the major components of an item of PPE have significantly different patterns of consumption or economic benefits, an entity will need to allocate the initial cost of the asset to those major components and depreciate each such component separately over its respective useful life.
As an example, let us look at the energy industry to underline the potential impact of applying this concept. Large energy related assets can comprise a significant number of components, many of which will have differing useful lives. Examples of such assets include gas treatment installations, LNG terminals, refineries, major pipelines and offshore drilling platforms. An offshore drilling platform is a major installation that will require decommissioning at the end of its useful life. The platform has a number of components that will require replacement once or more during its working life. Another example of a component might be the lining of a blast furnace, where the lining has to be replaced periodically, and thus has a different useful life from the rest of the furnace. The cost of the significant components of these types of assets must be separately identified and depreciated to their residual values over their respective useful life. The application of componentization is complex and will be a major project for companies small and large as they wrestle with the idea of IFRS compliance.
Let us discuss further the meaning of the concept of PPE componentization as well as present some of our ideas on how to make this process more manageable. The objective of component accounting is to follow proper IFRS accounting practice by ensuring that PPE is accurately and fairly included on a company's balance sheet and the income statement properly reflects the consumption of economic benefits of those assets (i.e., the cost of their use) over their individual useful lives, through depreciation. In order to achieve this objective the overall value of an asset is fairly apportioned over significant components that need to be accounted for separately and their useful lives and the method of depreciation are determined on a reasonable and consistent basis. For example, it may be appropriate to depreciate separately the airframe and engines of an aircraft, whether owned or subject to finance leasing. Similarly, if an entity acquires PPE subject to an operating lease in which it is the lessor, it may be appropriate to depreciate separately amounts reflected in the cost of that item that are attributable to favorable or unfavorable lease terms relative to market terms.
While the rationale behind componentization is straightforward, it is not always the case that components of a fixed asset have the same useful lives. Furthermore, they may wear out or depreciate at different rates throughout their respective lives or have a high risk of impairment or obsolescence. Therefore, it is appropriate to depreciate each significant component separately over its useful life, in order that the income statement is fairly charged with the consumption of economic benefits of those assets. Where a significant component is expected to wear out more quickly than the overall asset, it is depreciated over a shorter period and any subsequent expenditure on restoring or replacing the component is capitalized. Where the cost of assets and components cannot be identified, best estimates are utilized.
Where it is not possible to determine the carrying amount of a replaced component the cost of the new component may be utilized as an indication of what the cost of the replaced component was at the time it was acquired or constructed, adjusted for depreciation and impairment, as appropriate. Therefore, where a component has been recognized as significant but the depreciated historic cost of the original component is not known, it should be estimated using a reasonable basis. This may involve using the replacement cost of the component, indexed back to the original component's inception and adjusted for any subsequent depreciation and impairment. It is important to maintain adequate records to support such calculations.
The need to identify component items of PPE will be influenced by the concept of materiality. A company must therefore consider the materiality of the impact upon the reported cost of service and carrying values of PPE in determining the levels of significance for recognition of components and in establishing robust de minimis thresholds. These de minimis thresholds are used to identify individual assets that can be disregarded for componentization. Once established, the threshold should be documented, used appropriately and applied consistently.
It should be noted that even if the cost of a component is significant in relation to the total cost of an item of PPE, from an accounting perspective, it is not necessary to identify the value of that component if its useful life and required method of depreciation is in line with the overall asset. In addition, componentization of an item of PPE is not required where depreciating the item as a single asset is unlikely to result in a material misstatement of either the depreciation charges or the carrying amount of PPE. However, entities will need to collect evidence to demonstrate that a material misstatement is unlikely.
As a result, it is essential that fixed asset subledgers be reviewed and adapted, where necessary, to ensure they can facilitate the changes required by PPE componentization guidelines under IFRS. At a minimum, asset subledgers should include sufficiently accurate records to comply with financial reporting requirements, which will include the ability to separately record significant components of a fixed asset or group of assets for valuation, enhancement, depreciation and derecognition purposes.
This process would entail a review of existing assets in PPE to identify:
- Individual assets that are below the de minimis level which can be disregarded for componentization on the basis that any adjustment to depreciation charges would not be material. It should be noted that groups of similar assets individually below
de minimis for componentization may collectively be material for componentization.
- Individual assets above the de minimis level require consideration of whether they contain significant components which have different useful lives and/or methods of depreciation to the overall asset.
- Groups of similar assets may be sample tested so typical components with differing useful lives or methods of depreciation can be identified. It may be possible to make a reasonable assumption that such component types are typical for the asset group and the assumptions can therefore be applied to all assets in a particular group.
When assessing the materiality of individual assets relative to overall assets, it may be more practical to use carrying values (instead of cost), as a basis upon which to determine materiality. (Note that cost must be used when determining the significance of components relative to an overall asset). Management of an enterprise should exercise judgment when considering which items of PPE are material. It is essential that the basis upon which to determine materiality, including any assumptions or estimates made, is clearly documented and supported by calculations or other relevant information. This process will set the criteria to be included in an entity's procedures for identifying material PPE components prospectively. Additionally, it's important to establish a policy to determine which components will be recognized and depreciated separately. Subsequent to identifying individual material assets or asset groups that require review in accordance with agreed de minimis thresholds, management can then begin to establish the principles upon which components are to be recognized (e.g., significance, useful lives and depreciation methods) and depreciated separately.
As discussed earlier, IAS 16 requires that each part (component) of an item of PPE be separately identified and depreciated where the cost is significant in relation to the overall total cost of the asset. Cost is defined as the amount of cash or cash equivalents paid or the fair value of the other consideration given to acquire an asset at the time of acquisition or construction.
Given the size and complexity, it is not clear how infrastructure assets are to be allocated to its significant parts. However, it is clear from IAS 16 that an infrastructure asset cannot be accounted for as one asset. The asset must be allocated to its significant parts- even if the depreciation charges for each part are the same. The factors below provide guidance on how to determine the significant parts of an asset to arrive at a reasonable allocation.
- The cost of the asset and materiality – The allocation of the asset to its "significant" parts – hence materiality of the cost of a part to the cost of the asset as a whole should be a guiding factor when determining significant parts. For example, a small length of pipe is unlikely to form a significant proportion of the cost of the overall infrastructure asset, and is, therefore, unlikely to represent a significant part of the infrastructure asset as a whole.
- Management's operational decisions – The way in which management makes operational decisions over whether to, for example, replace rather than repair certain sections of the network will give some guidance in determining how the infrastructure asset can be broken down to its significant parts.
- Physical location of the asset – Certain geographical areas have differing characteristics, such as population and soil type, which will impact on the asset's useful life. For example, the higher the population of an area, the greater the traffic vibration impact will be on the network in that area. Some soils are more corrosive than others, shortening the relative useful life of the network in a geographical area.
- Design and flow characteristics – Certain parts of the network may have been designed to work together in a particular way that is different from other parts.
It may be that the companies can use other reasonable means of defining the significant parts in combination with those factors above.
In addition, the changes required to comply with principles of asset componentization will have significant impact on taxes, tax strategies, systems design and create the demand for additional system functionality to facilitate the tracking of asset information.
Tax law defines the relevant unit of property more broadly, generally examining whether a component is functionally interdependent with another component. As a result, it is likely that the unit of property used for financial reporting purposes under IFRS will differ substantially from the unit of property used for tax purposes. Tracking fixed asset additions and disposals, as well as analyzing repairs to identify capital improvements based on different units of property, is expected to be extremely complex and administratively burdensome. Companies assessing the impact of IFRS on their organization should keep the tax accounting method implications in mind. Involving the tax department in the assessment of accounting policy options is essential to gaining a complete picture of the potential benefits and drawbacks of the accounting changes that will result from conversion to IFRS. A complete analysis of a company's current tax accounting methods and consideration of the tax variables resulting from the IFRS conversion can help identify opportunities to mitigate potential tax accounting method issues and manage cash taxes.
In addition, companies that have engaged in system migrations or modifications often discover these projects entail a corresponding change in the way information feeds into their systems. As companies convert to IFRS, information technology implications should be considered related to asset componentization. As previously discussed, when compared to U.S. GAAP, IFRS frequently mandates more detailed disclosures. For example, under U.S. GAAP rules, assets such as buildings are depreciated over an average anticipated life span. Under IFRS, buildings are not seen as standalone assets. Instead, the individual significant assets that comprise a building, such as its roof, its elevator system or its HVAC system are separately depreciated. To capture this level of detail, accounting systems capable of tracking more granular information across a range of new data fields will be a necessity.
In summary, a company should be able to answer the following questions as it traverses through establishing an approach for asset componentization to be in compliance with IFRS upon adoption:
- What is a component?
- How many components are there within an asset and which of these are significant?
- Which assets do we need to componentize?
- Who determines the value of these components?
- How is this valuation undertaken?
- What is a useful life of each category of asset component?
- Are there any tax implications?
- What, if any, information technology infrastructure and accounting system changes are necessary?
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