Property, plant and equipment (PPE) represent assets that the enterprise uses for production or administration. It does not intend to sell those assets in the normal course of business. Examples of PPE are land, building, machinery, furniture, vehicles, and computer. Fundamental principles stipulated in the Indian GAAP (AS -10) for the accounting of PPE are not significantly different from accounting principles stipulated in the international financial reporting standards (IAS-16). But there is a gap between the principles stipulated in AS-10 and the practice being followed by many enterprises including listed companies in India.
Therefore, the pain in transition from the Indian GAAP to IFRS will vary between enterprises. There are some significant differences between AS-10 and IAS-16, but those may not pose much problem in transition to IFRS.
The first challenge in implementing IFRS is to apply the principle of component accounting. Component accounting requires that if an asset has several components, which can be physically separated from the principal asset and which have significantly different useful life . These should be recognised separately and should be depreciated based on their respective useful lives. Component accounting aims to improve depreciation accounting and thus improves the measurement of operating result. It also facilitates accounting for replacements.
When a component is replaced, the written down value of the component replaced should be charged off to the income statement and the cost of the new component should be capitalised, that is, should be recognised as an item of PPE. Component accounting requires allocation of the cost of the asset to different components based on their respective fair values at the date of acquisition. IFRS requires that component accounting should be applied retrospectively.
The challenge is to determine the extent to which the asset should be broken down into components for the purpose of separate recognition. We should apply the concept of 'materiality' in arriving at a decision. The most appropriate method for evaluating the materiality is to consider the cost of the component relative to the total cost of the asset.
For example, the engine of a vehicle should be recognised separately from the vehicle, because the cost of the engine is significant relative to the cost of the vehicle. Application of this method will require recognition of a large number of components separately, because enterprises use large number of such assets (items of PPE), which together constitute a significant proportion (in terms of number) of the total number of items classified as PPE, but in terms of cost they together may not constitute a significant proportion of total cost of PPE.
We may take another approach to facilitate transition to IFRS. We may evaluate 'materiality' in two stages. First stage should be to evaluate materiality by estimating the estimated impact on the gross profit or EBIT of not applying component accounting to less costly items of PPE, which together may not constitute a significant proportion of total cost of PPE . Those items may be excluded from component accounting. At the second stage, materiality should be assessed using the relative cost approach to identify components of assets to which component accounting will be applied. Auditors will prefer the apply component accounting to all the assets on the ground of higher accuracy.
This should not pose much problem while accounting for newly acquired assets. But, application of component accounting to all assets acquired much earlier (and still on the balance sheet) will involve huge work and some difficulties in estimating fair value of components. The two-stage approach will reduce the work significantly without impairing the true and fair view of the operating result materially. The Institute of Chartered Accountants of India (ICAI) should issue guidelines in this regard.
Under IAS-16 an enterprise may choose either the cost model or the revaluation model to measure PPE subsequent to the initial recognition. If, an enterprise chooses the revaluation model, it must ensure that the assets are carried in the balance sheet at an amount close to the current value at the balance sheet date. IAS-16 does not stipulate the frequency of revaluation.
AS-10 does allow revaluation of PPE but does not consider it as a model alternative to the cost model. Therefore, under the Indian GAAP, an enterprise can revalue the assets once in a while and continue with the cost model. IFRS -1, which stipulates principles for the first time adoption of IFRS, allows an enterprise, which revalued assets earlier, to select the cost model. In that situation the revalued amount reduced by accumulated depreciation will be deemed as acquisition cost.
But, if an enterprise selects the revaluation model, it has to revalue the asset at the balance sheet date of the first balance sheet prepared using IFRS. Therefore, transition to IFRS will not be difficult even for an enterprise, which revalued its PPE earlier.
The schedule XIV of the Companies Act provides rates and methods of depreciation for computing depreciation to be charged to calculate divisible profit and profit that will form the basis for the calculation of managerial remuneration. ICAI and the government have taken the view that a company should recognise depreciation at an amount equal to or higher than the amount of depreciation calculated in accordance with schedule XIV.
If, the government decides to retain schedule XIV, it will become irrelevant for the preparation of financial statements after the implementation of IFRS. IFRS requires that depreciation should be charged based on the best estimate of the management of the useful life and residual value of the asset.
Therefore, companies that are charging depreciation calculated in accordance with schedule XIV may like to revise depreciation rates/methods. IAS-16 considers change in depreciation rates and depreciation method as a change in estimate. Therefore, new rates and methods should not be applied retrospectively. Thus, transition to IFRS, so far the depreciation accounting is concerned, will not be difficult.
Whenever, I meet professional accountants in any forum, I get the confidence that we are quickly gearing up to face the challenges. I am sure that the government and regulators will bring necessary changes in the legal environment well in time to ensure seamless transition. In this column, for next few months, we shall continue to discuss in transition to IFRS.
