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FINA
RELIA
PROBLEMS WITH
EXPENSE
Financial Statement Reliability under IFRS: Problems with Expense Recognition
ANCIAL STATEME
ABILITY UNDER IF
PROBLEMS WITH
EXPENSE RECOGNITION
Dr Jacek Welc:
0
: Problems with Expense Recognition
ENT
FRS:
PROBLEMS WITH
RECOGNITION
Dr Jacek Welc:
RECOGNIZING EXPENSES
RELATED TO INVENTORY AND
RECEIVABLE ACCOUNTS
Financial Statement Reliability under IFRS: Problems with Expense Recognition
PART 1:
RECOGNIZING EXPENSES
RELATED TO INVENTORY AND
RECEIVABLE ACCOUNTS
1
: Problems with Expense Recognition
RECOGNIZING EXPENSES
RELATED TO INVENTORY AND
RECEIVABLE ACCOUNTS
ACCOUNTING FOR INVENTORY
According to IAS 2 (Inventory),
historical cost (either a purchase or a production).
Par. 10 of IAS 2 specifies three components of inventory cost:
���� Costs of purchase,
���� Costs of conversion,
���� Other costs incurred in bringing the inventories to their present location and condition.
Par. 11 of IAS 2 states that the
and other taxes (other than those subsequently recoverable by t
authorities), transport, handling and other costs directly attributable to the acquisition of
finished goods, materials and services.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
FOR INVENTORY UNDER IFRS
), inventories are accounted for primarily on the basis of their
(either a purchase or a production).
Par. 10 of IAS 2 specifies three components of inventory cost:
Other costs incurred in bringing the inventories to their present location and condition.
Par. 11 of IAS 2 states that the costs of purchase comprise the purchase price, import duties
and other taxes (other than those subsequently recoverable by the entity from the taxing
authorities), transport, handling and other costs directly attributable to the acquisition of
finished goods, materials and services.
2
: Problems with Expense Recognition
are accounted for primarily on the basis of their
Other costs incurred in bringing the inventories to their present location and condition.
comprise the purchase price, import duties
he entity from the taxing
authorities), transport, handling and other costs directly attributable to the acquisition of
ACCOUNTING FOR INVENTORY UNDER IFRS
According to par. 12 of IAS 2, the
production (e.g. direct labor and direct m
manufacturing costs (fixed and variable production overheads) that are incurred in
converting materials into finished goods.
Inclusion of the overheads in inventory costs calls for an
into various items of inventory. However,
production levels. This means that in periods, when the production volume is unusually low,
the costs of unused capacity should be
within the carrying value of inventory).
Other costs can be included in inventory only if they are incurred in bringing the inventories
to their present location and condition (e.g. some borrowing costs, related to inventories
with unusually long production periods). For example, according to par. 16 of IAS
of “inefficiencies” (e.g. abnormal amounts of wasted materials or labor)
included in the inventory cost.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
ACCOUNTING FOR INVENTORY UNDER IFRS
According to par. 12 of IAS 2, the costs of conversion are directly related to the units of
production (e.g. direct labor and direct materials) plus a systematic
manufacturing costs (fixed and variable production overheads) that are incurred in
converting materials into finished goods.
Inclusion of the overheads in inventory costs calls for an allocation of the total overheads
into various items of inventory. However, the cost allocation should be based on
. This means that in periods, when the production volume is unusually low,
used capacity should be expensed as incurred (instead of being capitalized
within the carrying value of inventory).
can be included in inventory only if they are incurred in bringing the inventories
to their present location and condition (e.g. some borrowing costs, related to inventories
with unusually long production periods). For example, according to par. 16 of IAS
of “inefficiencies” (e.g. abnormal amounts of wasted materials or labor)
PROBLEM 1: Allocation of c
the basis of “normal produ
observable and objectively determinable
PROBLEM 1 (cont.): Misallocation (e.g. over
inventory) of those costs may result in serious distortions of
reported inventories and earnings3
: Problems with Expense Recognition
are directly related to the units of
allocation of indirect
manufacturing costs (fixed and variable production overheads) that are incurred in
of the total overheads
allocation should be based on normal
. This means that in periods, when the production volume is unusually low,
(instead of being capitalized
can be included in inventory only if they are incurred in bringing the inventories
to their present location and condition (e.g. some borrowing costs, related to inventories
with unusually long production periods). For example, according to par. 16 of IAS 2 the costs
of “inefficiencies” (e.g. abnormal amounts of wasted materials or labor) should not be
n of costs of conversion must be done on
roduction levels”, which are not directly
observable and objectively determinable
Misallocation (e.g. over-capitalization in
inventory) of those costs may result in serious distortions of
reported inventories and earnings
ACCOUNTING FOR INVENTORY UNDER IFRS
Thus, the inventory cost (including direct costs and allocated indirect costs) constitutes the
first basis for the carrying amount of inventory. However, according to par. 9 of IAS 2,
inventories should be measured at the
realizable value is defined as estimated selling price
the estimated costs of completion and t
If the estimated net realizable value
inventory must be written down
28 of IAS 2, according to which “
to be realized from their sale or use
PROBLEM 2 (cont.): As a result, mis-estimation of net
realizable value may result in serious distortions of
reported inventories and earnings
Financial Statement Reliability under IFRS: Problems with Expense Recognition
ACCOUNTING FOR INVENTORY UNDER IFRS
Thus, the inventory cost (including direct costs and allocated indirect costs) constitutes the
first basis for the carrying amount of inventory. However, according to par. 9 of IAS 2,
inventories should be measured at the lower of cost and net realizable v
realizable value is defined as estimated selling price in the ordinary course of business
costs of completion and the estimated costs necessary to make the sale.
estimated net realizable value is lower than the historical cost, the carrying amount of
written down (to its net realizable value). The reason is explained in par.
28 of IAS 2, according to which “assets should not be carried in excess of amounts
to be realized from their sale or use”.
PROBLEM 2: Net realizable value calls for estimating probable
selling prices of inventory, which in many circumstanc
subjective and difficult to verify
PROBLEM 2 (cont.): Net realizable value of unfinished
calls also for estimating probable costs of completion and sale,
which also is subjective and difficult to verify
estimation of net
realizable value may result in serious distortions of
reported inventories and earnings
4
: Problems with Expense Recognition
Thus, the inventory cost (including direct costs and allocated indirect costs) constitutes the
first basis for the carrying amount of inventory. However, according to par. 9 of IAS 2,
lower of cost and net realizable value, where net
ordinary course of business less
costs necessary to make the sale.
is lower than the historical cost, the carrying amount of
ts net realizable value). The reason is explained in par.
assets should not be carried in excess of amounts expected
Net realizable value calls for estimating probable
selling prices of inventory, which in many circumstances is
subjective and difficult to verify
Net realizable value of unfinished inventory
calls also for estimating probable costs of completion and sale,
which also is subjective and difficult to verify
ACCOUNTING FOR INVENTORY UNDER IFRS
The most common reasons for a decline of the inventory’s realizable value are:
���� Obsolescence or physical deterioration,
���� Declining demand,
���� Over-production of inventories,
���� Declining market prices,
���� Technological progress,
���� Changes of customer’s tastes or habits,
���� Other reasons (e.g. climate factors
Financial Statement Reliability under IFRS: Problems with Expense Recognition
ACCOUNTING FOR INVENTORY UNDER IFRS
The most common reasons for a decline of the inventory’s realizable value are:
Obsolescence or physical deterioration,
production of inventories,
Changes of customer’s tastes or habits,
Other reasons (e.g. climate factors, natural disasters).
Many of those factors may impact inventory simultaneously,
which multiplies the difficulties of estimating net realizable
values (e.g. when the cyclical company over
fast technological progress just before an economic slowdown)
5
: Problems with Expense Recognition
The most common reasons for a decline of the inventory’s realizable value are:
Many of those factors may impact inventory simultaneously,
which multiplies the difficulties of estimating net realizable
values (e.g. when the cyclical company over-produces goods of
fast technological progress just before an economic slowdown)
ACCOUNTING FOR INVENTORY UNDER IFRS
The exception from the “lower-
agricultural production (e.g. trees, fruits, animals), which (according to IAS 41
to be measured at fair value less estimated point
the fair value cannot be measured rel
is reported as profit or loss.
IAS 2 permits the following methods of inventory costing (applied in transferring the costs of
inventory to costs of goods sold):
���� Specific identification,
���� First-in-first-out (FIFO),
���� Weighted-average cost,
���� Other methods (e.g. retail method).
Financial Statement Reliability under IFRS: Problems with Expense Recognition
ACCOUNTING FOR INVENTORY UNDER IFRS
-of-cost-and-net-realizable-value principle” is the inventory of
agricultural production (e.g. trees, fruits, animals), which (according to IAS 41
fair value less estimated point-of-sale costs at the point of harvest (unless
cannot be measured reliably). The change in fair value of such biological assets
IAS 2 permits the following methods of inventory costing (applied in transferring the costs of
inventory to costs of goods sold):
Other methods (e.g. retail method).
PROBLEM 3: Inventories of
are reported at estimated fair values, which call for estimates
with subjective inputs and limited verifiability
PROBLEM 4: FIFO and weighted
distort reported earnings in periods featured by significant
changes of market prices
6
: Problems with Expense Recognition
ple” is the inventory of
agricultural production (e.g. trees, fruits, animals), which (according to IAS 41 Agriculture) is
at the point of harvest (unless
). The change in fair value of such biological assets
IAS 2 permits the following methods of inventory costing (applied in transferring the costs of
Inventories of biological (e.g. agricultural) goods
are reported at estimated fair values, which call for estimates
with subjective inputs and limited verifiability
FIFO and weighted-average cost may seriously
distort reported earnings in periods featured by significant
changes of market prices
SELECTED PRACTICAL
INVENTORY UNDER IFRS
Practical problems related to inventory, resulting directly from IFRS regulations
���� PROBLEM 1: allocation of indirect costs of conversion, based on
production levels – if the production volume is unusually low (significantly
below the normal level), the increased unit manufacturing costs, resulting from
unused capacity, should be expensed as incurred (instead of being capitalized
in a carrying amount of inventory). If, i
such costs, it may temporarily overstate reported inventory and earnings (as
illustrated in Example 1).
directly observable and must be determined, which may be pr
companies with highly variable production volumes.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
SELECTED PRACTICAL PROBLEMS WITH ACCOUNTING FOR
INVENTORY UNDER IFRS
Practical problems related to inventory, resulting directly from IFRS regulations
allocation of indirect costs of conversion, based on
if the production volume is unusually low (significantly
), the increased unit manufacturing costs, resulting from
unused capacity, should be expensed as incurred (instead of being capitalized
in a carrying amount of inventory). If, in such periods, the company
such costs, it may temporarily overstate reported inventory and earnings (as
illustrated in Example 1). The problem is that normal production levels are not
directly observable and must be determined, which may be pr
companies with highly variable production volumes.
7
: Problems with Expense Recognition
PROBLEMS WITH ACCOUNTING FOR
Practical problems related to inventory, resulting directly from IFRS regulations:
allocation of indirect costs of conversion, based on normal
if the production volume is unusually low (significantly
), the increased unit manufacturing costs, resulting from
unused capacity, should be expensed as incurred (instead of being capitalized
n such periods, the company capitalizes
such costs, it may temporarily overstate reported inventory and earnings (as
The problem is that normal production levels are not
directly observable and must be determined, which may be problematic for
SELECTED PRACTICAL PROBLEMS WITH ACCOUNTING FOR
INVENTORY UNDER IFRS
Practical problems related to inventory, resulting directly from IFRS regulations
���� PROBLEM 2: estimation of
values of inventories fall below their carrying amounts
must be written down to net realizable values
an income statement).
reported inventories and earnings
illustrated in Example 2
future selling prices are not directly observable
multiple subjective inputs) and are difficult to verify
Financial Statement Reliability under IFRS: Problems with Expense Recognition
SELECTED PRACTICAL PROBLEMS WITH ACCOUNTING FOR
INVENTORY UNDER IFRS
Practical problems related to inventory, resulting directly from IFRS regulations
estimation of net realizable values – if estimated net realizable
of inventories fall below their carrying amounts, the
must be written down to net realizable values (with resulting loss reported in
. If estimated net realizable values are overstated
reported inventories and earnings will be temporarily overstated as well
2). The problem is that for many goods the probable
are not directly observable, must be estimated (often wi
multiple subjective inputs) and are difficult to verify.
8
: Problems with Expense Recognition
SELECTED PRACTICAL PROBLEMS WITH ACCOUNTING FOR
Practical problems related to inventory, resulting directly from IFRS regulations:
estimated net realizable
, the carrying amounts
(with resulting loss reported in
alues are overstated, the
overstated as well (as
for many goods the probable
estimated (often with
SELECTED PRACTICAL PROBLEMS WITH ACCOUNTING FOR
INVENTORY UNDER IFRS
Practical problems related to inventory, resulting directly from IFRS regulations
���� PROBLEM 3: accounting for
agricultural industries) are reported at their
to-period changes in fair values
fair values are overstated, the reported inventories and earnings will be
temporarily overstated as well. The problem is that for many
agricultural goods (e.g. a young forest, which will be commercially marketable
far in the future, e.g. in 25
must be estimated (usually
verify.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
SELECTED PRACTICAL PROBLEMS WITH ACCOUNTING FOR
INVENTORY UNDER IFRS
Practical problems related to inventory, resulting directly from IFRS regulations
accounting for biological assets – the biological inventories (e.g. in
agricultural industries) are reported at their estimated fair values
period changes in fair values reported in an income statement. If estimated
are overstated, the reported inventories and earnings will be
temporarily overstated as well. The problem is that for many
(e.g. a young forest, which will be commercially marketable
far in the future, e.g. in 25-30 years) the fair values are not directly observable,
usually with multiple subjective inputs) and are difficult to
9
: Problems with Expense Recognition
SELECTED PRACTICAL PROBLEMS WITH ACCOUNTING FOR
Practical problems related to inventory, resulting directly from IFRS regulations:
the biological inventories (e.g. in
fair values, with period-
reported in an income statement. If estimated
are overstated, the reported inventories and earnings will be
temporarily overstated as well. The problem is that for many unfinished
(e.g. a young forest, which will be commercially marketable
are not directly observable,
with multiple subjective inputs) and are difficult to
SELECTED PRACTICAL PROBLEMS WITH ACCOUNTING FOR
INVENTORY UNDER IFRS
Practical problems related to inventory, resulting
���� PROBLEM 4: impact of FIFO and weighted
inventories and earnings
significantly and fast, and these growth
mismatch between a measurement bases for sales revenues and cost of goods
sold emerges (particularly under FIFO and when there are many “layers” of
inventories from prior purchases). This is so because sales revenues may
already reflect increased
be based on lower (old) prices from purchases made long ago.
effect is a temporary overstatement of reported earnings (which fades away
when “fresher” layers of inventories become the costs o
Financial Statement Reliability under IFRS: Problems with Expense Recognition
SELECTED PRACTICAL PROBLEMS WITH ACCOUNTING FOR
INVENTORY UNDER IFRS
Practical problems related to inventory, resulting directly from IFRS regulations
impact of FIFO and weighted-average cost on reported
inventories and earnings – when the purchase prices of inventories
and these growths are reflected in rising sales prices,
mismatch between a measurement bases for sales revenues and cost of goods
sold emerges (particularly under FIFO and when there are many “layers” of
inventories from prior purchases). This is so because sales revenues may
reflect increased (new) market prices, while cost of goods sold may still
be based on lower (old) prices from purchases made long ago.
effect is a temporary overstatement of reported earnings (which fades away
when “fresher” layers of inventories become the costs of goods sold).
10
: Problems with Expense Recognition
SELECTED PRACTICAL PROBLEMS WITH ACCOUNTING FOR
directly from IFRS regulations:
average cost on reported
when the purchase prices of inventories grow
are reflected in rising sales prices, the
mismatch between a measurement bases for sales revenues and cost of goods
sold emerges (particularly under FIFO and when there are many “layers” of
inventories from prior purchases). This is so because sales revenues may
market prices, while cost of goods sold may still
be based on lower (old) prices from purchases made long ago. The resulting
effect is a temporary overstatement of reported earnings (which fades away
f goods sold).
SELECTED PRACTICAL PROBLEMS WITH ACCOUNTING FOR
INVENTORY UNDER IFRS
Other problems related to inventory (not resulting directly from IFRS)
���� PROBLEM 5: computation of unit product costs
with a mass production, the initial cost of inventory (and then the cost of goods
sold) is computed by dividing total manufacturing costs (
costs of conversion) by a production volume.
data are derived from internal do
the company deliberately (or by a mistake) overstate the
volume, the resulting unit costs will be understated (with the
understatement of cost of goods sold and related overstatement of reported
earnings), until the physical inventory count
recorded inventories.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
SELECTED PRACTICAL PROBLEMS WITH ACCOUNTING FOR
INVENTORY UNDER IFRS
Other problems related to inventory (not resulting directly from IFRS)
computation of unit product costs – in manufacturing industries
production, the initial cost of inventory (and then the cost of goods
sold) is computed by dividing total manufacturing costs (costs of purchase +
costs of conversion) by a production volume. However, the production volume
data are derived from internal documents (e.g. weekly production reports).
the company deliberately (or by a mistake) overstate the reported
volume, the resulting unit costs will be understated (with the
understatement of cost of goods sold and related overstatement of reported
physical inventory count detects the non
11
: Problems with Expense Recognition
SELECTED PRACTICAL PROBLEMS WITH ACCOUNTING FOR
Other problems related to inventory (not resulting directly from IFRS):
in manufacturing industries
production, the initial cost of inventory (and then the cost of goods
costs of purchase +
However, the production volume
cuments (e.g. weekly production reports). If
reported production
volume, the resulting unit costs will be understated (with the following
understatement of cost of goods sold and related overstatement of reported
the non-existent but
SELECTED PRACTICAL PROBLEMS WITH ACCOUNTING FOR
INVENTORY UNDER IFRS
Other problems related to inventory (not resulting directly from IFRS)
���� PROBLEM 6: recording cost of goods sold
company records two events: recognizes revenues (with corresponding
increase in receivables or cash) and recognizes cost of goods sold associated
with the goods that were sold (with corresponding decrease in inventory). The
failure (deliberate or by e
recognizing sales revenues
expenses and overstating earnings
the non-existent but recorded inventories
Financial Statement Reliability under IFRS: Problems with Expense Recognition
SELECTED PRACTICAL PROBLEMS WITH ACCOUNTING FOR
INVENTORY UNDER IFRS
her problems related to inventory (not resulting directly from IFRS)
recording cost of goods sold – when products are sold
company records two events: recognizes revenues (with corresponding
increase in receivables or cash) and recognizes cost of goods sold associated
with the goods that were sold (with corresponding decrease in inventory). The
(deliberate or by en error) to record costs of goods sold
revenues, results in overstating inventory, understating
expenses and overstating earnings (until the physical inventory count
existent but recorded inventories), as illustrated in Example 3.
12
: Problems with Expense Recognition
SELECTED PRACTICAL PROBLEMS WITH ACCOUNTING FOR
her problems related to inventory (not resulting directly from IFRS):
hen products are sold, the
company records two events: recognizes revenues (with corresponding
increase in receivables or cash) and recognizes cost of goods sold associated
with the goods that were sold (with corresponding decrease in inventory). The
to record costs of goods sold, while
results in overstating inventory, understating
physical inventory count detects
d in Example 3.
SELECTED PRACTICAL PROBLEMS WITH ACCOUNTING FOR
INVENTORY UNDER IFRS
Other problems related to inventory (not resulting directly from IFRS)
���� PROBLEM 7: artificial sale
artificially and temporarily
a “friendly” company, it
inventories (with immediate profit
the same price (so that
company, but may bring the temporary overstatement of earnings reported
a selling company). This is illustrated in Example 4.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
SELECTED PRACTICAL PROBLEMS WITH ACCOUNTING FOR
INVENTORY UNDER IFRS
Other problems related to inventory (not resulting directly from IFRS)
artificial sale-and-buyback transactions – if a
and temporarily boost its reported earnings, and if
“friendly” company, it may arrange a two-way transaction
with immediate profit) and then a buyback of
(so that the transaction may be neutral for a “friendly”
company, but may bring the temporary overstatement of earnings reported
a selling company). This is illustrated in Example 4.
13
: Problems with Expense Recognition
SELECTED PRACTICAL PROBLEMS WITH ACCOUNTING FOR
Other problems related to inventory (not resulting directly from IFRS):
company wants to
and if it finds or creates
way transaction: a sale of
buyback of this inventory for
may be neutral for a “friendly”
company, but may bring the temporary overstatement of earnings reported by
EXAMPLES OF IMPACT OF MIS
RELIABILITY OF FINANCIAL STATEMENTS
EXAMPLE 1: MISALLOCATION OF
Basic data about company X are as follows:
• „normal” production level equals 100.000 units per year,
• fixed indirect manufacturing costs equal 50.000 EUR per year,
• variable (direct and indirect) manufacturing costs equal 0,50 EUR per unit,
• „standard” unit production costs equal 1 EUR (0,50 + 50.000 / 100.000),
• volume of production is: 100.000 units in period t and 50.000 units in period t+1
(when the company entered a cyclical economic slo
• actual unit costs in period t+1 equal 1,
• the unit selling price is 1,
“poor times” (periods t+1 and t+2),
• in period t+1 the company sold 100.000 units of
• in period t+2 the company sold 50.000 units of goods manufactured in
Financial Statement Reliability under IFRS: Problems with Expense Recognition
EXAMPLES OF IMPACT OF MIS-REPORTED INVENTORIES ON
RELIABILITY OF FINANCIAL STATEMENTS
ALLOCATION OF INDIRECT MANUFACTURING (CONVERSION) COSTS
Basic data about company X are as follows:
„normal” production level equals 100.000 units per year,
fixed indirect manufacturing costs equal 50.000 EUR per year,
direct) manufacturing costs equal 0,50 EUR per unit,
„standard” unit production costs equal 1 EUR (0,50 + 50.000 / 100.000),
volume of production is: 100.000 units in period t and 50.000 units in period t+1
(when the company entered a cyclical economic slowdown),
actual unit costs in period t+1 equal 1,50 EUR (0,50 + 50.000 / 50.000),
the unit selling price is 1,40 EUR in “good times” (period t), but drops to 1,
s t+1 and t+2),
in period t+1 the company sold 100.000 units of goods manufactured in period t,
in period t+2 the company sold 50.000 units of goods manufactured in
14
: Problems with Expense Recognition
REPORTED INVENTORIES ON
INDIRECT MANUFACTURING (CONVERSION) COSTS
direct) manufacturing costs equal 0,50 EUR per unit,
„standard” unit production costs equal 1 EUR (0,50 + 50.000 / 100.000),
volume of production is: 100.000 units in period t and 50.000 units in period t+1
50 EUR (0,50 + 50.000 / 50.000),
0 EUR in “good times” (period t), but drops to 1,20 EUR in
goods manufactured in period t,
in period t+2 the company sold 50.000 units of goods manufactured in period t+1.
Correct booking entries:
Period t
Inventory (BS) 100.000
Cash (BS) -100.000
Net sales (IS)
Cost of goods sold (IS)
Pre-tax profit (IS)
Incorrect booking entries:
Period t
Inventory (BS) 100.000
Cash (BS) -100.000
Net sales (IS)
Cost of goods sold (IS)
Pre-tax profit (IS)
* -100.000 (inventory from period t) + 50.000 (inventory produced in period t+1)
** 100.000 (inventory from period t) + 25.000 (costs of unused capacity: 50.000 units x 0,50 EUR)
*** -100.000 (inventory from period t) + 75.000 (inventory produced in
Overstatement of earnings, caused by capitalization (in
Financial Statement Reliability under IFRS: Problems with Expense Recognition
Period t+1
100.000
Inventory (BS)* -50.000
100.000
Cash (BS) 140.000
-
Net sales (IS) 140.000
-
Cost of goods sold (IS)** 125.000
0
Pre-tax profit (IS) 15.000
Period t+1
100.000
Inventory (BS)*** -25.000
100.000
Cash (BS) 140.000
-
Net sales (IS) 140.000
-
Cost of goods sold (IS) 100.000
0
Pre-tax profit (IS) 40.000
100.000 (inventory from period t) + 50.000 (inventory produced in period t+1)
** 100.000 (inventory from period t) + 25.000 (costs of unused capacity: 50.000 units x 0,50 EUR)
100.000 (inventory from period t) + 75.000 (inventory produced in period t+1, including costs of unused capacity)
overstatement of earnings
Overstatement of earnings, caused by capitalization (in
inventory) of costs of unused capacity
15
: Problems with Expense Recognition
Period t+2
Inventory (BS)**** -50.000
Cash (BS) 60.000
Net sales (IS) 60.000
Cost of goods sold (IS) 50.000
Pre-tax profit (IS) 10.000
Period t+2
Inventory (BS) -75.000
Cash (BS) 60.000
Net sales (IS) 60.000
Cost of goods sold (IS) 75.000
Pre-tax profit (IS) -15.000
period t+1, including costs of unused capacity)
The reversal of prior
overstatement of earnings
EXAMPLES OF IMPACT OF MIS
RELIABILITY OF FINANCIAL STATEMENTS
EXAMPLE 2: MIS-ESTIMATION OF NET REALIZABLE VALUE
Company X is a distributor of mobile phones (products that are genera
deflation of market prices). In period t company
At the moment of purchase the retail market price of these phones was 120 EUR per unit. At
the end of period t the company still had in its inventory unsold phones, bought in period t.
Before the end of period t the market price of those phones declined to 90 EUR per unit.
However, given the amount of unsold inventory in company’s stores, the company expected
that in order to sell all those inventories in period t+1, their price should b
(but how much: to 70 EUR? 40 EUR?).
Suppose that the market data suggest
to sell the obsolete inventory in period t+1
that it will be able to sell it for more that the purchase cost of 100 EUR.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
EXAMPLES OF IMPACT OF MIS-REPORTED INVENTORIES ON
RELIABILITY OF FINANCIAL STATEMENTS
ESTIMATION OF NET REALIZABLE VALUE
Company X is a distributor of mobile phones (products that are genera
). In period t company purchased mobile phones for 100 EUR each.
At the moment of purchase the retail market price of these phones was 120 EUR per unit. At
the end of period t the company still had in its inventory unsold phones, bought in period t.
Before the end of period t the market price of those phones declined to 90 EUR per unit.
However, given the amount of unsold inventory in company’s stores, the company expected
that in order to sell all those inventories in period t+1, their price should b
(but how much: to 70 EUR? 40 EUR?).
market data suggest that the unit price must be reduced to 70 EUR
to sell the obsolete inventory in period t+1. However, the company is optimistic and claims
sell it for more that the purchase cost of 100 EUR.
16
: Problems with Expense Recognition
REPORTED INVENTORIES ON
Company X is a distributor of mobile phones (products that are generally characterized by
mobile phones for 100 EUR each.
At the moment of purchase the retail market price of these phones was 120 EUR per unit. At
the end of period t the company still had in its inventory unsold phones, bought in period t.
Before the end of period t the market price of those phones declined to 90 EUR per unit.
However, given the amount of unsold inventory in company’s stores, the company expected
that in order to sell all those inventories in period t+1, their price should be lowered further
that the unit price must be reduced to 70 EUR, in order
. However, the company is optimistic and claims
Correct booking entries
(per unit):
Period t
Inventory (BS)
Cash / receivables(BS)
Net sales (IS)
Operating expenses (IS)
Pre-tax profit (IS)
Incorrect booking entries
(per unit):
Period t
Inventory (BS)
Cash / receivables(BS)
Net sales (IS)
Operating expenses (IS)
Pre-tax profit (IS)
Financial Statement Reliability under IFRS: Problems with Expense Recognition
Period t+1
-30
Inventory (BS)* -70
-
Cash / receivables(BS) 70
-
Net sales (IS) 70
30
Cost of goods sold (IS) 70
-30
Pre-tax profit (IS) 0
Period t+1
0
Inventory (BS)*** -100
0
Cash / receivables(BS) 70
-
Net sales (IS) 70
-
Cost of goods sold (IS) 100
0
Pre-tax profit (IS) -30
The reversal of prior
overstatement of earnings
Overstatement of earnings, caused by
overstated net realizable value
17
: Problems with Expense Recognition
The reversal of prior
overstatement of earnings
Note that:
The company must take
into account the EXPECTED
selling prices (when the
products are sold), not the
actual ones from e.g. a year
end.
The higher the over-supply
of inventory (as compared
to the market demand), the
higher must be the
REQUIRED future price cut.
If the company is TOO
PESSIMISTIC in year t (and
write downs inventory to
e.g. 50 EUR), it understated
t-period earnings and
OVERSTATES the future
earnings.
EXAMPLES OF IMPACT OF MIS
RELIABILITY OF FINANCIAL STATEMENTS
EXAMPLE 3: NON-RECOGNITION OF COST OF GOODS SOLD
In period t the company purchased 1.000 units of merchandise for 10
t+1 the company sold 500 units of this inventory for 12
Financial Statement Reliability under IFRS: Problems with Expense Recognition
EXAMPLES OF IMPACT OF MIS-REPORTED INVENTORIES ON
RELIABILITY OF FINANCIAL STATEMENTS
RECOGNITION OF COST OF GOODS SOLD
In period t the company purchased 1.000 units of merchandise for 10 EUR per unit. In period
0 units of this inventory for 12 EUR per unit (for cash).
18
: Problems with Expense Recognition
REPORTED INVENTORIES ON
EUR per unit. In period
EUR per unit (for cash).
Correct booking entries:
Period t
Inventory (BS) 10.000*
Cash / receivables(BS) -10.000
Net sales (IS)
Cost of goods sold (IS)
Pre-tax profit (IS)
Incorrect booking entries :
Period t
Inventory (BS) 10
Cash / receivables(BS) -10.000
Net sales (IS)
Cost of goods sold (IS)
Pre-tax profit (IS)
* 1.000 units x 10 EUR ** 500 units x 12 EUR *** 500 units x 10 EUR
Financial Statement Reliability under IFRS: Problems with Expense Recognition
Period t+1
10.000*
Inventory (BS)* -5.000***
10.000*
Cash / receivables(BS) 6.000**
-
Net sales (IS) 6.000**
-
Cost of goods sold (IS) 5.000***
0
Pre-tax profit (IS) 1.000
Period t+1
0.000
Inventory (BS)*** -
10.000
Cash / receivables(BS) 6.000**
-
Net sales (IS) 6.000**
-
Cost of goods sold (IS) -
0
Pre-tax profit (IS) 6.000
** 500 units x 12 EUR *** 500 units x 10 EUR
Overstatement of earnings, caused by non
recognition of cost of goods sold.
19
: Problems with Expense Recognition
Overstatement of earnings, caused by non-
recognition of cost of goods sold.
Note that:
This is the outright
accounting fraud, because
the company reports in its
assets the non-existent
inventory (which has
already been transferred to
a customer).
Such overstatement of
earnings must be reversed
sooner or later (when a
physical inventory count is
done).
EXAMPLES OF IMPACT OF MIS
RELIABILITY OF FINANCIAL STATEMENTS
EXAMPLE 4: ARTIFICIAL SALE-AND
The company PC is a public company, but controlled by
70% share in PC’s equity (the remaining 30% is free floating on the stock market). John has
also controlling (100%) equity interest in other company (OC), but this is private company,
not listed on any stock exchange
Free Float
(minority investors)
30%
Financial Statement Reliability under IFRS: Problems with Expense Recognition
EXAMPLES OF IMPACT OF MIS-REPORTED INVENTORIES ON
RELIABILITY OF FINANCIAL STATEMENTS
AND-BUYBACK TRANSACTIONS
The company PC is a public company, but controlled by a private person, John, who holds
remaining 30% is free floating on the stock market). John has
also controlling (100%) equity interest in other company (OC), but this is private company,
not listed on any stock exchange. These relationships look as follows.
company, owned by
John
PC (public company)
30%
70% 100%
John
20
: Problems with Expense Recognition
REPORTED INVENTORIES ON
private person, John, who holds
remaining 30% is free floating on the stock market). John has
also controlling (100%) equity interest in other company (OC), but this is private company,
OC
(a “friendly”
company, owned by
John or his relatives
or his friends)
EXAMPLES OF IMPACT OF MIS
RELIABILITY OF FINANCIAL STATEMENTS
John serves also as CEO at PC.
the accounting point of view, the results of OC are not consolidated with the results of PC
(because the results and dividends of OC are not associated with the shareholders of PC).
Let’s assume that:
• at the end of period t inventory of PC (valued at 10.000 EUR) includes obsolete inventory
(valued at 5.000 EUR),
• in order to boost the PC’s earnings for period t, PC sold in period t all the obsolete
inventory to OC for 12.000 EUR (making the
• however, John wants this transaction to be cash
all this inventory back to PC for 12.000 EUR (
PC and OC, resulting from these two
• if this inventory is obsolete and if it was sold by PC to OC at overstated prices, the sale of
those inventories to the third party (for, say, below their reproduction cost, that is for
2.000 EUR) entails a loss for PC in the
Financial Statement Reliability under IFRS: Problems with Expense Recognition
EXAMPLES OF IMPACT OF MIS-REPORTED INVENTORIES ON
RELIABILITY OF FINANCIAL STATEMENTS
John serves also as CEO at PC. All this means that OC is related-party to PC. However, from
the accounting point of view, the results of OC are not consolidated with the results of PC
(because the results and dividends of OC are not associated with the shareholders of PC).
at the end of period t inventory of PC (valued at 10.000 EUR) includes obsolete inventory
in order to boost the PC’s earnings for period t, PC sold in period t all the obsolete
inventory to OC for 12.000 EUR (making the artificial gross profit of 7.000 EUR),
however, John wants this transaction to be cash-neutral for OC, so in period t+1 OC sold
all this inventory back to PC for 12.000 EUR (thus, the receivables and payables between
, resulting from these two-way transactions, cancel-out),
if this inventory is obsolete and if it was sold by PC to OC at overstated prices, the sale of
those inventories to the third party (for, say, below their reproduction cost, that is for
a loss for PC in the following periods.
21
: Problems with Expense Recognition
REPORTED INVENTORIES ON
party to PC. However, from
the accounting point of view, the results of OC are not consolidated with the results of PC
(because the results and dividends of OC are not associated with the shareholders of PC).
at the end of period t inventory of PC (valued at 10.000 EUR) includes obsolete inventory
in order to boost the PC’s earnings for period t, PC sold in period t all the obsolete
gross profit of 7.000 EUR),
neutral for OC, so in period t+1 OC sold
, the receivables and payables between
if this inventory is obsolete and if it was sold by PC to OC at overstated prices, the sale of
those inventories to the third party (for, say, below their reproduction cost, that is for
EXAMPLES OF IMPACT OF MIS
RELIABILITY OF FINANCIAL STATEMENTS
PC (public company)
2) Transaction
repurchase of inventory by PC from OC
for
with book value of 5.000 EUR for 12.000 EUR
Third party
3) Transaction in period t+1 or later
sale of inventory by PC to
with book value of 12.000 EUR for
Financial Statement Reliability under IFRS: Problems with Expense Recognition
EXAMPLES OF IMPACT OF MIS-REPORTED INVENTORIES ON
RELIABILITY OF FINANCIAL STATEMENTS
fully
Transaction in period t+1 (or even in period t):
repurchase of inventory by PC from OC,
for the same 12.000 EUR
1) Transaction in period t:
sale of inventory by PC to OC,
with book value of 5.000 EUR for 12.000 EUR
in period t+1 or later:
sale of inventory by PC to a third party,
.000 EUR for 2.000 EUR
22
: Problems with Expense Recognition
REPORTED INVENTORIES ON
OC
(private company,
fully-owned by John)
with book value of 5.000 EUR for 12.000 EUR
Effect of this related-party transaction of PC’s results:
Period t
Net sales to OC (IS) /
Receivables (BS) 12.000
Costs of goods sold (IS) /
Inventory (BS) 5.000
Profit before taxes (IS) 7.000
Impact on inventory -5.000
PC’s results without this related-party transaction:
Period t
Net sales to OC (IS) /
Receivables (BS) 0
Costs of goods sold (IS) /
Inventory (BS) 0
Profit before taxes (IS) 0
Impact on inventory 0
Artificial sale of inventory
results in
overstatement by 7.000
Financial Statement Reliability under IFRS: Problems with Expense Recognition
party transaction of PC’s results:
Period t+1
12.000
Inventory (IS) /
Payables (BS) 12.000
5.000
Costs of goods sold (IS) /
Inventory (BS) -
Costs of goods sold (IS) /
7.000
Profit before taxes (IS) 0
Profit before taxes (IS)
5.000
Impact on inventory 12.000
party transaction:
Period t+1
Inventory (IS) /
Payables (BS) 0
Costs of goods sold (IS) /
Inventory (BS) -
Costs of goods sold (IS) /
Profit before taxes (IS) 0
Profit before taxes (IS)
Impact on inventory 0
Artificial sale of inventory
results in earnings
overstatement by 7.000
Buyback of inventory brings
it back to the balance sheet
(at overstated value)
23
: Problems with Expense Recognition
Period t+2
Net sales (IS) /
Receivables (BS) 2.000
Costs of goods sold (IS) /
Inventory (BS) 12.000
Profit before taxes (IS) -10.000
Impact on inventory -12.000
Period t+2
Net sales (IS) /
Receivables (BS) 2.000
Costs of goods sold (IS) /
Inventory (BS) 5.000
Profit before taxes (IS) -3.000
Impact on inventory -5.000
Reversal of prior
overstatement of earnings
(by 7.000)
EXAMPLES OF IMPACT OF MIS
RELIABILITY OF FINANCIAL STATEMENTS
NOTE THAT:
� the result of this artificial “sale
PC’s earnings by 7.000 EUR,
� if the inventory is later repurchased (in t+1 in this case) for the same price, at which the sale in
period t was arranged, it does not have
is only reflected in balance-sheet: the increase in inventory
in payables),
� the negative impact on earnings of the artificial sale made in period t is postponed until the
moment when the inventories are sold further to
be reported at those inflated values (so the write
� this is a typical accounting gimmick that creates an “asset bubble”, which usually ends up with
the dramatic and unexpected (for analysts and investors) collapse of future earnings.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
PLES OF IMPACT OF MIS-REPORTED INVENTORIES ON
RELIABILITY OF FINANCIAL STATEMENTS
the result of this artificial “sale-and-buy-back” transaction is the overstatement of t
if the inventory is later repurchased (in t+1 in this case) for the same price, at which the sale in
period t was arranged, it does not have any impact on earnings in period t+1 (this repurchase
sheet: the increase in inventory is offset by corresponding increase
the negative impact on earnings of the artificial sale made in period t is postponed until the
moment when the inventories are sold further to a third party or the inventories can no longer
those inflated values (so the write-down follows),
gimmick that creates an “asset bubble”, which usually ends up with
the dramatic and unexpected (for analysts and investors) collapse of future earnings.
24
: Problems with Expense Recognition
REPORTED INVENTORIES ON
back” transaction is the overstatement of t-period
if the inventory is later repurchased (in t+1 in this case) for the same price, at which the sale in
impact on earnings in period t+1 (this repurchase
is offset by corresponding increase
the negative impact on earnings of the artificial sale made in period t is postponed until the
third party or the inventories can no longer
gimmick that creates an “asset bubble”, which usually ends up with
the dramatic and unexpected (for analysts and investors) collapse of future earnings.
REAL-LIFE EXAMPLE –
OF RENAULT AND PEUGEOT
The following descriptive information may be found in the Annual Report
“Inventories are stated at the lower of cost or net realizable value. Cost corresponds
acquisition cost or production cost, which includes direct and indirect production expenses,
and a share of manufacturing overheads based on a normal level of activity. The normal
level of activity is assessed site by site, in order to determine the sha
excluded in the event of below
Inventories are valued under the FIFO (First In First Out) method.
When the net realizable value is lower than the value under the FIFO method, impairment
equal to the difference is recorded.”
The inventory-related numerical data, disclosed in the annual reports
following analysis of company’s revenues, earnings and inventories:
Financial Statement Reliability under IFRS: Problems with Expense Recognition
– INVENTORY IMPAIRMENT ALLOWANCES
AND PEUGEOT
information may be found in the Annual Report of Renault
“Inventories are stated at the lower of cost or net realizable value. Cost corresponds
acquisition cost or production cost, which includes direct and indirect production expenses,
and a share of manufacturing overheads based on a normal level of activity. The normal
level of activity is assessed site by site, in order to determine the share of fixed costs to be
excluded in the event of below-normal activity.
Inventories are valued under the FIFO (First In First Out) method.
When the net realizable value is lower than the value under the FIFO method, impairment
recorded.”
related numerical data, disclosed in the annual reports of Renault Group
following analysis of company’s revenues, earnings and inventories:
25
: Problems with Expense Recognition
INVENTORY IMPAIRMENT ALLOWANCES
of Renault for 2009:
“Inventories are stated at the lower of cost or net realizable value. Cost corresponds to
acquisition cost or production cost, which includes direct and indirect production expenses,
and a share of manufacturing overheads based on a normal level of activity. The normal
re of fixed costs to be
When the net realizable value is lower than the value under the FIFO method, impairment
of Renault Group, enable the
REAL-LIFE EXAMPLE –
OF RENAULT AND PEUGEOT
RENAULT: data in million
Sales of goods and services
Cost of goods and services sold
Operating income
Inventory of finished products
Inventories, gross
Impairment
Inventories, net
Revenue growth
CoGS / Sales
Growth of gross inventory
Inventory allowance / Gross inventory
In 2008 the company’s sales and gross margins
declined. Despite a decline of gross inventory,
the company increased its inventory allowance
(to tailor it to the falling demand, after the
outburst of global economic crisis)
Financial Statement Reliability under IFRS: Problems with Expense Recognition
– INVENTORY IMPAIRMENT ALLOWANCES
AND PEUGEOT
millions of EUR 2006 2007 2008
Sales of goods and services 38 901 39 190 36 241
Cost of goods and services sold (CoGS) 31 343 31 408 29 659
Operating income 877 1 238 -117
Inventory of finished products:
Inventories, gross 5 785 6 428 5 945
-476 -496 -679
Inventories, net 5 309 5 932 5 266
Revenue growth - 0,7% -7,5%
80,6% 80,1% 81,8%
Growth of gross inventory - 11,1% -7,5%
Inventory allowance / Gross inventory -8,2% -7,7% -11,4%
In 2008 the company’s sales and gross margins
declined. Despite a decline of gross inventory,
the company increased its inventory allowance
demand, after the
outburst of global economic crisis)
In 2009 the company’s sales and gross margins declined
further. Thus, despite a significant decline of gross
inventory, the company again increased its inventory
allowance (however, it is unverifiable if the allowance is
ADEQUATE to the current economic conditions)26
: Problems with Expense Recognition
INVENTORY IMPAIRMENT ALLOWANCES
2008 2009
36 241 32 415
29 659 26 978
117 -955
5 945 4 450
679 -518
5 266 3 932
7,5% -10,6%
81,8% 83,2%
7,5% -25,1%
11,4% -11,6%
In 2009 the company’s sales and gross margins declined
further. Thus, despite a significant decline of gross
inventory, the company again increased its inventory
unverifiable if the allowance is
ADEQUATE to the current economic conditions)
REAL-LIFE EXAMPLE –
OF RENAULT AND PEUGEOT
The following descriptive information may be found in the Annual Report
“Inventories are stated at the lower of cost and net realizable value, in accordance with
IAS 2 - Inventories.
Cost is determined by the first
indirect variable production expenses, plus fixed production expenses based on the normal
capacity of the production facility. As inventories do not take a substantial period of time
to get ready for sale, their cost does not include any borrowing costs.
The net realizable value of inventories intended to be sold corresponds to their selling
price, as estimated based on market conditions and any relevant external information
sources, less the estimated costs necessary to complete the sale (such as variable direct
selling expenses, refurbishment costs not billed to customers for used vehicles and other
goods).”
As in Renault’s case, the inventory
Peugeot enable the following analysis of company’s revenues, earnings and inventories:
Financial Statement Reliability under IFRS: Problems with Expense Recognition
– INVENTORY IMPAIRMENT ALLOWANCES
LT AND PEUGEOT
information may be found in the Annual Report of Peugeot
at the lower of cost and net realizable value, in accordance with
Cost is determined by the first-in-first-out (FIFO) method and includes all direct and
indirect variable production expenses, plus fixed production expenses based on the normal
capacity of the production facility. As inventories do not take a substantial period of time
for sale, their cost does not include any borrowing costs.
The net realizable value of inventories intended to be sold corresponds to their selling
estimated based on market conditions and any relevant external information
imated costs necessary to complete the sale (such as variable direct
selling expenses, refurbishment costs not billed to customers for used vehicles and other
he inventory-related numerical data, disclosed in the annual
enable the following analysis of company’s revenues, earnings and inventories:
The company uses wide range of information (also
with a qualitative nature) when estimating the net
realizable values for its products
27
: Problems with Expense Recognition
INVENTORY IMPAIRMENT ALLOWANCES
of Peugeot for 2009:
at the lower of cost and net realizable value, in accordance with
out (FIFO) method and includes all direct and
indirect variable production expenses, plus fixed production expenses based on the normal
capacity of the production facility. As inventories do not take a substantial period of time
The net realizable value of inventories intended to be sold corresponds to their selling
estimated based on market conditions and any relevant external information
imated costs necessary to complete the sale (such as variable direct
selling expenses, refurbishment costs not billed to customers for used vehicles and other
related numerical data, disclosed in the annual reports of
enable the following analysis of company’s revenues, earnings and inventories:
The company uses wide range of information (also
with a qualitative nature) when estimating the net
realizable values for its products
REAL-LIFE EXAMPLE –
OF RENAULT AND PEUGEOT
PEUGEOT: data in million
Sales of goods and services
Cost of goods and services sold
Operating income
Inventory of finished products
Inventories, gross
Impairment
Inventories, net
Revenue growth
CoGS / Sales
Growth of gross inventory
Inventory allowance / Gross inventory
Similarly as Renault, in 2008 the Peugeot’s sales and gross margins declined. However, in contrast to Renault, despite a HIGH GROWTH of
gross inventory (19,1%), at declining sales (-7,7%), the company DECREASED its inventory allowance as percent of gross inventory (fro
3,9% to 3,6%). Given the economic conditions at that time (global economic crisis) such optimism seems to be exaggerated.
In the following year, when the company suffered from further drop of revenues and margins, it had to increase its relative
allowance (to 5% of gross inventories). However, it was still much lower than in Renault’s case.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
– INVENTORY IMPAIRMENT ALLOWANCES
OF RENAULT AND PEUGEOT
millions of EUR 2006 2007 2008
Sales of goods and services 53 789 57 132 52 705
Cost of goods and services sold (CoGS) 44 002 46 909 44 146
Operating income -293 512 -950
Inventory of finished products:
Inventories, gross 4 123 4 158 4 952
-160 -162 -180
Inventories, net 3 963 3 996 4 772
Revenue growth - 6,2% -7,7%
81,8% 82,1% 83,8%
Growth of gross inventory - 0,8% 19,1%
Inventory allowance / Gross inventory -3,9% -3,9% -3,6%
Renault, in 2008 the Peugeot’s sales and gross margins declined. However, in contrast to Renault, despite a HIGH GROWTH of
7,7%), the company DECREASED its inventory allowance as percent of gross inventory (fro
3,9% to 3,6%). Given the economic conditions at that time (global economic crisis) such optimism seems to be exaggerated.
In the following year, when the company suffered from further drop of revenues and margins, it had to increase its relative
allowance (to 5% of gross inventories). However, it was still much lower than in Renault’s case.28
: Problems with Expense Recognition
INVENTORY IMPAIRMENT ALLOWANCES
2008 2009
52 705 46 885
44 146 40 156
950 -1 912
4 952 3 530
180 -176
4 772 3 354
7,7% -11,0%
83,8% 85,6%
19,1% -28,7%
3,6% -5,0%
Renault, in 2008 the Peugeot’s sales and gross margins declined. However, in contrast to Renault, despite a HIGH GROWTH of
7,7%), the company DECREASED its inventory allowance as percent of gross inventory (from
3,9% to 3,6%). Given the economic conditions at that time (global economic crisis) such optimism seems to be exaggerated.
In the following year, when the company suffered from further drop of revenues and margins, it had to increase its relative inventory
allowance (to 5% of gross inventories). However, it was still much lower than in Renault’s case.
ACCOUNTING FOR RECEIVABLE ACCOUNTS UNDER IFRS
Accounts receivable (receivables) are defined as amounts due from customers for goods or
services provided in the normal course of business.
accounts are credit sales transactions (i.e. sales with deferred payment terms)
that the receivables-related accounting abuses are often twin to revenue
(discussed in Module 1), such as
brought about by premature revenue recognition or
However, receivables (like other assets)
exceed their recoverable amounts.
collection problems, e.g. delays or total defaults,
by its customers. These estimates, often labeled as
extent similar in nature to allowances for impaired inventories
extent exposed to subjective judgments, because usually no any observable inputs are
available (such as current market prices
inventories). As a result, allowances for bad debts
compared to impairments of other assets
Financial Statement Reliability under IFRS: Problems with Expense Recognition
ACCOUNTING FOR RECEIVABLE ACCOUNTS UNDER IFRS
(receivables) are defined as amounts due from customers for goods or
services provided in the normal course of business. Thus, the main source for receivable
sales transactions (i.e. sales with deferred payment terms)
related accounting abuses are often twin to revenue
(discussed in Module 1), such as overstatements of revenues (and related receivables)
premature revenue recognition or by recognizing fictitious sales.
(like other assets) should not be reported at carrying
exceed their recoverable amounts. Thus, accountants must make estimates of expected
, e.g. delays or total defaults, related to receivables
. These estimates, often labeled as “allowance for bad debts
similar in nature to allowances for impaired inventories. However, they are to a larger
extent exposed to subjective judgments, because usually no any observable inputs are
available (such as current market prices or price forecasts, which are available
allowances for bad debts are much more prone to manipulations, as
compared to impairments of other assets.
PROBLEM 8: Accounting for receivable accounts calls
for estimating uncollectible accounts, which usually
is heavily subjective and difficult
29
: Problems with Expense Recognition
ACCOUNTING FOR RECEIVABLE ACCOUNTS UNDER IFRS
(receivables) are defined as amounts due from customers for goods or
Thus, the main source for receivable
sales transactions (i.e. sales with deferred payment terms). This means
related accounting abuses are often twin to revenue-recognition abuses
overstatements of revenues (and related receivables)
recognizing fictitious sales.
should not be reported at carrying values which
estimates of expected
related to receivables owed to a company
d debts”, are to some
However, they are to a larger
extent exposed to subjective judgments, because usually no any observable inputs are
or price forecasts, which are available for many
are much more prone to manipulations, as
Accounting for receivable accounts calls
for estimating uncollectible accounts, which usually
is heavily subjective and difficult to verify
ACCOUNTING FOR RECEIVABLE ACCOUNTS UNDER IFRS
It is also worth noting that not all the overdue accounts must be automatically written down
(e.g. when the company cooperates with a customer for a long time and it always pay after a
deadline). In contrast, some receivables which are not overdue, may qua
write-off (e.g. “fresh” receivable accounts from a sale to a bankrupt customer).
If accountants are too optimistic and
assets (receivables) and earnings will be overstated.
excessive write-downs of receivables
(“cookie-jar reserves”)
The two methods are usually applied in adjusting the gross values of receivable accounts to
their recoverable amounts:
(1) Aging-the-accounts method
uncollectible accounts receivable based on the length of time the end
outstanding accounts have been unpaid,
(2) Percentage-of-sales method
uncollectible accounts receivable based on the historical relationship between bad
debts and gross credit sales.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
ACCOUNTING FOR RECEIVABLE ACCOUNTS UNDER IFRS
It is also worth noting that not all the overdue accounts must be automatically written down
(e.g. when the company cooperates with a customer for a long time and it always pay after a
In contrast, some receivables which are not overdue, may qua
off (e.g. “fresh” receivable accounts from a sale to a bankrupt customer).
accountants are too optimistic and underestimate the values of the
and earnings will be overstated. However, similarly as for inventories,
downs of receivables in “good times” may be easily reverted in bad periods
The two methods are usually applied in adjusting the gross values of receivable accounts to
accounts method – procedure for the computation of the adjustment for
uncollectible accounts receivable based on the length of time the end
outstanding accounts have been unpaid,
sales method – procedure for computing the adjustment for
uncollectible accounts receivable based on the historical relationship between bad
debts and gross credit sales. 30
: Problems with Expense Recognition
ACCOUNTING FOR RECEIVABLE ACCOUNTS UNDER IFRS
It is also worth noting that not all the overdue accounts must be automatically written down
(e.g. when the company cooperates with a customer for a long time and it always pay after a
In contrast, some receivables which are not overdue, may qualify for a full-blown
off (e.g. “fresh” receivable accounts from a sale to a bankrupt customer).
the bad-debt reserves,
However, similarly as for inventories,
be easily reverted in bad periods
The two methods are usually applied in adjusting the gross values of receivable accounts to
procedure for the computation of the adjustment for
uncollectible accounts receivable based on the length of time the end-of-period
dure for computing the adjustment for
uncollectible accounts receivable based on the historical relationship between bad
REAL-LIFE EXAMPLE
VOLKSWAGEN GROUP
The following descriptive information may be found in the Annual Report of Volk
2009:
“Default risk on loans and receivables in the financial services business is accounted for by
recognizing specific valuation allowances
More specifically, in the case of
receivables and fleet customers)
accordance with Group-wide standards in the amount of the incurred loss. A potential
impairment is assumed in the case of a
over a certain period, the institution of enforcement measures, the
over-indebtedness, application for or the opening of
failure of reorganization measures.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
LIFE EXAMPLE – BAD-DEBT ALLOWANCES OF
VOLKSWAGEN GROUP
The following descriptive information may be found in the Annual Report of Volk
Default risk on loans and receivables in the financial services business is accounted for by
specific valuation allowances and portfolio-based valuation allowances
More specifically, in the case of significant individual receivables (e.g. dealer finance
receivables and fleet customers) specific valuation allowances are recognized in
wide standards in the amount of the incurred loss. A potential
impairment is assumed in the case of a number of situations such as
over a certain period, the institution of enforcement measures, the threat of insolvency or
, application for or the opening of bankruptcy proceedings
failure of reorganization measures.
The company applies two different approaches
for estimating bad
and a size of a receivable account
The company estimates specific valuation allowances for
significant (in amount) receivables, with a use of detailed
information regarding these individual receivables (with an
intent to increase the accuracy of estimates)
31
: Problems with Expense Recognition
DEBT ALLOWANCES OF
The following descriptive information may be found in the Annual Report of Volkswagen Group for
Default risk on loans and receivables in the financial services business is accounted for by
based valuation allowances.
(e.g. dealer finance
are recognized in
wide standards in the amount of the incurred loss. A potential
such as delayed payment
threat of insolvency or
bankruptcy proceedings, or the
The company applies two different approaches
for estimating bad-debts, depending on a type
e of a receivable account
cific valuation allowances for
significant (in amount) receivables, with a use of detailed
information regarding these individual receivables (with an
intent to increase the accuracy of estimates)
REAL-LIFE EXAMPLE
VOLKSWAGEN GROUP
In the case of non-significant receivables
valuation allowances are recognized using a generalized procedure
been identified.
Portfolio-based valuation allowances
receivables and significant individual receivables for which there is no indication of
impairment into homogenous portfolios on the basis of comparable credit risk features
and allocating them by risk class. As long as no definite information is available as to
which receivables are in default,
concerned are used to calculate the amount of the valuation allowances.
Small (in amount) receivables are bundled into
portfolios, which group all receivables
COMPARABLE credit risk characteristics, and then the
impairment adjustments are estimated on a portfolio
level basis (instead of individual-account basis)
Financial Statement Reliability under IFRS: Problems with Expense Recognition
LIFE EXAMPLE – BAD-DEBT ALLOWANCES OF
VOLKSWAGEN GROUP
significant receivables (e.g. customer finance receivables)
are recognized using a generalized procedure once a default has
based valuation allowances are recognized by grouping together non
and significant individual receivables for which there is no indication of
into homogenous portfolios on the basis of comparable credit risk features
and allocating them by risk class. As long as no definite information is available as to
receivables are in default, average historical default probabilities
concerned are used to calculate the amount of the valuation allowances.
Smaller (in amount) receivables are adjusted for
individually (specifically) in the case of a default (i.e. the
customer delays with a payment through a long period)
Small (in amount) receivables are bundled into
portfolios, which group all receivables with
COMPARABLE credit risk characteristics, and then the
impairment adjustments are estimated on a portfolio-
account basis)
For such portfolios of homogenous receivables the
company estimated bad-debt allowances on
its historical information (e.g. percentages of defaults
experienced IN THE PAST)
32
: Problems with Expense Recognition
DEBT ALLOWANCES OF
(e.g. customer finance receivables) specific
once a default has
grouping together non-significant
and significant individual receivables for which there is no indication of
into homogenous portfolios on the basis of comparable credit risk features
and allocating them by risk class. As long as no definite information is available as to
average historical default probabilities for the portfolio
concerned are used to calculate the amount of the valuation allowances.”
Smaller (in amount) receivables are adjusted for
individually (specifically) in the case of a default (i.e. the
customer delays with a payment through a long period)
For such portfolios of homogenous receivables the
debt allowances on the basis of
its historical information (e.g. percentages of defaults
experienced IN THE PAST)
REAL-LIFE EXAMPLE
VOLKSWAGEN GROUP
The following numerical information may be extracted from the balance sheet of Volkswagen
Group for 2008 (page 189):
Financial services receivables (noncurrent assets)
Trade receivables (current assets)
Financial services receivables (current assets)
Total operating receivables
Financial Statement Reliability under IFRS: Problems with Expense Recognition
LIFE EXAMPLE – BAD-DEBT ALLOWANCES OF
VOLKSWAGEN GROUP
The following numerical information may be extracted from the balance sheet of Volkswagen
2008
Financial services receivables (noncurrent assets) 31 855
Trade receivables (current assets) 5 969
Financial services receivables (current assets) 27 035
Total operating receivables 64 859
In the VW’s case the financial services receivables, despite their label, should be
treated as operating receivables (i.e. resulting from its operating activities), because
they reflect loans granted to VW’s customers to support sales.
33
: Problems with Expense Recognition
DEBT ALLOWANCES OF
The following numerical information may be extracted from the balance sheet of Volkswagen
2008 2007
31 855 27 522
5 969 5 691
27 035 24 914
64 859 58 127
In the VW’s case the financial services receivables, despite their label, should be
treated as operating receivables (i.e. resulting from its operating activities), because
they reflect loans granted to VW’s customers to support sales.
REAL-LIFE EXAMPLE
VOLKSWAGEN GROUP
The notes to the balance sheet provide the following more detailed information (page 230)
Receivables from financing business
customer financing
dealer financing
direct banking
Receivables from operating lease business
Receivables from finance lease business
Financial Statement Reliability under IFRS: Problems with Expense Recognition
LIFE EXAMPLE – BAD-DEBT ALLOWANCES OF
VOLKSWAGEN GROUP
The notes to the balance sheet provide the following more detailed information (page 230)
NONCURRENT AND CURRENT
FINANCIAL SERVICES RECEIVABLES
current non-
current
Carrying
amount,
Dec. 31,
2008
current
Receivables from financing business
9 534 20 302 29 836 9 531
10 147 981 11 128 9 791
133 0 133 94
19 814 21 283 41 097 19 416
Receivables from operating lease business 125 0 125 103
business 7 096 10 572 17 668 5 395
27 035 31 855 58 890 24 914
In the VW’s case, the financial services
receivables reflect loans granted to VW’s
customers to support sales
34
: Problems with Expense Recognition
DEBT ALLOWANCES OF
The notes to the balance sheet provide the following more detailed information (page 230):
NONCURRENT AND CURRENT
FINANCIAL SERVICES RECEIVABLES
current non-
current
Carrying
amount,
Dec. 31,
2007
531 18 471 28 002
9 791 774 10 565
94 0 94
19 416 19 245 38 661
103 0 103
5 395 8 277 13 672
24 914 27 522 52 436
the VW’s case, the financial services
receivables reflect loans granted to VW’s
customers to support sales
REAL-LIFE EXAMPLE
VOLKSWAGEN GROUP
In another footnote (on page 256
receivable accounts may be found
Neither
past due
nor
impaired
Past due
and not
impaired
Financial services
receivables
55 838
Trade receivables 4 724
Other receivables 11 158
71 720
Financial Statement Reliability under IFRS: Problems with Expense Recognition
LIFE EXAMPLE – BAD-DEBT ALLOWANCES OF
VOLKSWAGEN GROUP
n page 256) the following data about the gross values
may be found:
Past due
and not
impaired
Impaired Dec. 31,
2008
Neither
past due
nor
impaired
Past due
and not
impaired
2 587 1 923 60 348 50 298 2 254
1 136 388 6 248 4 747 873
161 242 11 561 14 402 205
3 884 2 553 78 157 69 447 3 332
The amount of already past due but still
not impaired receivables grew
significantly (by 16,6% y/y) in 2008
35
: Problems with Expense Recognition
DEBT ALLOWANCES OF
gross values of the VW Group’s
Past due
and not
impaired
Impaired
Dec.
31,
2007
2 254 1 782 54 334
873 286 5 906
205 406 15 013
3 332 2 474 75 253
REAL-LIFE EXAMPLE
VOLKSWAGEN GROUP
On the ground of the above information the following ratios may be computed
All past due (impaired and not impaired) /
total receivables
Past due and impaired / total past due
* (3.884 + 2.553) / 78.157
** (3.332 + 2.474) / 75.253
*** 2.553 / (3.884 + 2.553)
**** 2.474 / (3.332 + 2.474)
The notes (on page 257) offer
receivables which are past due and not impaired:
Financial Statement Reliability under IFRS: Problems with Expense Recognition
LIFE EXAMPLE – BAD-DEBT ALLOWANCES
VOLKSWAGEN GROUP
On the ground of the above information the following ratios may be computed
2008
All past due (impaired and not impaired) /
total receivables 8,2%*
Past due and impaired / total past due 39,7%***
** (3.332 + 2.474) / 75.253
*** 2.553 / (3.884 + 2.553)
**** 2.474 / (3.332 + 2.474)
the following more insightful data about the age structure of
receivables which are past due and not impaired:
The share of past due accounts in total
receivables grew in 2008. Despite it, the share
of past due and impaired in total past due fell.
36
: Problems with Expense Recognition
DEBT ALLOWANCES OF
On the ground of the above information the following ratios may be computed:
2008 2007
8,2%* 7,7%**
39,7%*** 42,6%****
more insightful data about the age structure of
The share of past due accounts in total
receivables grew in 2008. Despite it, the share
of past due and impaired in total past due fell.
REAL-LIFE EXAMPLE
VOLKSWAGEN GROUP
up to 30 days
Financial services receivables
Trade receivables
Other receivables
up to 30 days
Financial services receivables
Trade receivables
Other receivables
Financial Statement Reliability under IFRS: Problems with Expense Recognition
LIFE EXAMPLE – BAD-DEBT ALLOWANCES OF
VOLKSWAGEN GROUP
PAST DUE BY:
up to 30 days 30 to 90 days more than 90 days
1 898 351 5
589 145 139
122 27 56
2 609 523 200
PAST DUE BY:
up to 30 days 30 to 90 days more than 90 days
1 843 584 160
668 278 190
74 29 58
2 585 891 408
The amount of receivables which are past due by more than 30 days grew from
723 (523 + 200) to 1.299 (891 + 408). In contrast, the amount of “younger” pa
due accounts (past due by less than 30 days) fell from 2.609 to 2.585.
37
: Problems with Expense Recognition
ALLOWANCES OF
GROSS CARRYING
AMOUNT
more than 90 days Dec. 31, 2007
2 254
873
205
3 332
GROSS CARRYING
AMOUNT
more than 90 days Dec. 31, 2008
2 587
1 136
161
3 884
amount of receivables which are past due by more than 30 days grew from
723 (523 + 200) to 1.299 (891 + 408). In contrast, the amount of “younger” past
than 30 days) fell from 2.609 to 2.585.
REAL-LIFE EXAMPLE
VOLKSWAGEN GROUP
Again, on the ground of the above information the following ratios may be computed
Past due and not impaired / total receivables
Past due by up to 30
Past due by more than 30 days / total past due
* 3.884 / 78.157
** 2.585 / 3.884
*** (891 + 408) / 3.884
Financial Statement Reliability under IFRS: Problems with Expense Recognition
LIFE EXAMPLE – BAD-DEBT ALLOWANCES OF
VOLKSWAGEN GROUP
Again, on the ground of the above information the following ratios may be computed
2008
Past due and not impaired / total receivables 5,0%*
Past due by up to 30 days / total past due 66,6%**
Past due by more than 30 days / total past due 33,4%***
The share of past due but not yet impaired
accounts in total receivables grew in 2008. It
happened despite the
age of the past due accounts.
38
: Problems with Expense Recognition
DEBT ALLOWANCES OF
Again, on the ground of the above information the following ratios may be computed:
2008 2007
5,0%* 4,4%
66,6%** 78,3%
33,4%*** 21,7%
The share of past due but not yet impaired
accounts in total receivables grew in 2008. It
happened despite the increase of the average
age of the past due accounts.
REAL-LIFE EXAMPLE
VOLKSWAGEN GROUP
CONCLUSIONS:
� In 2008 the Group probably faced significant demand
ageing receivables (which means that rising portion of operating receivables was at risk
of being uncollected),
� In 2008 the Group experienced
total receivables (from 7,7% in 2007 to 8,2% in 2008)
overdue by more than 30 days in total overdue receivables (from 21,7% in 2007 to 33,4%
in 2008),
� despite all these facts, the management apparently was becoming
compared to 2007) in terms of the estimated credit qu
and reduced the share of impaired receivables (in total overdue receivables) from 42,6%
in 2007 to 39,7% in 2008.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
LIFE EXAMPLE – BAD-DEBT ALLOWANCES OF
VOLKSWAGEN GROUP
In 2008 the Group probably faced significant demand-pressures, resulting in rising and
receivables (which means that rising portion of operating receivables was at risk
experienced simultaneously: rising share of overdue receivables in
m 7,7% in 2007 to 8,2% in 2008) and rising
overdue by more than 30 days in total overdue receivables (from 21,7% in 2007 to 33,4%
despite all these facts, the management apparently was becoming
compared to 2007) in terms of the estimated credit quality of the Group’s receivables,
and reduced the share of impaired receivables (in total overdue receivables) from 42,6%
39
: Problems with Expense Recognition
DEBT ALLOWANCES OF
pressures, resulting in rising and
receivables (which means that rising portion of operating receivables was at risk
simultaneously: rising share of overdue receivables in
rising share of receivables
overdue by more than 30 days in total overdue receivables (from 21,7% in 2007 to 33,4%
despite all these facts, the management apparently was becoming more optimistic (as
ality of the Group’s receivables,
and reduced the share of impaired receivables (in total overdue receivables) from 42,6%
RECOGNIZING EXPENSES
RELATED TO
AND EQUIPMENT
Financial Statement Reliability under IFRS: Problems with Expense Recognition
PART 2:
RECOGNIZING EXPENSES
RELATED TO PROPERTY, PLANT
AND EQUIPMENT
40
: Problems with Expense Recognition
RECOGNIZING EXPENSES
PROPERTY, PLANT
ACCOUNTING FOR PP&E UNDER IFRS
According to par 7 of IAS 16 (Property, plant and equipment
plant and equipment (PPE) shall be recognized 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 item of property, plant and equipment that qualifies for recognition as an asset shall be
measured at cost. Par. 16 of IAS 16 specifies three components of cost:
���� Purchase price,
���� Directly attributable costs,
���� Initial estimate of the costs of dismantling and removing the item or restoring the site
on which it is located.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
ACCOUNTING FOR PP&E UNDER IFRS
Property, plant and equipment), the cost of an item of property,
shall be recognized as an asset if, and only if:
It is probable that future economic benefits associated with the item will flow to the
The cost of the item can be measured reliably.
An item of property, plant and equipment that qualifies for recognition as an asset shall be
measured at cost. Par. 16 of IAS 16 specifies three components of cost:
ributable costs,
Initial estimate of the costs of dismantling and removing the item or restoring the site
41
: Problems with Expense Recognition
the cost of an item of property,
shall be recognized as an asset if, and only if:
It is probable that future economic benefits associated with the item will flow to the
An item of property, plant and equipment that qualifies for recognition as an asset shall be
Initial estimate of the costs of dismantling and removing the item or restoring the site
ACCOUNTING FOR PP&E UNDER IFRS
The directly attributable costs
condition necessary for it to be capable of operating in the manner intended by
management, for example (par. 16
���� Costs of employee benefits arising directly from the construction or acquisition of the
item of property, plant and equip
���� Costs of site preparation,
���� Initial delivery and handling costs,
���� Installation and assembly costs,
���� Costs of testing whether the asset is functioning properly,
���� Professional fees,
���� Borrowing costs (directly related to a given assets).
Financial Statement Reliability under IFRS: Problems with Expense Recognition
ACCOUNTING FOR PP&E UNDER IFRS
directly attributable costs are costs incurred to bring the asset to the locatio
condition necessary for it to be capable of operating in the manner intended by
example (par. 16-17 of IAS 16):
Costs of employee benefits arising directly from the construction or acquisition of the
item of property, plant and equipment,
Initial delivery and handling costs,
Installation and assembly costs,
Costs of testing whether the asset is functioning properly,
Borrowing costs (directly related to a given assets).
PROBLEM 9: Some operating expenses may be
deliberately treated as directly attributable to PP&E,
while in reality they
assets (this may be done
recognition as operating costs in an income statements)
42
: Problems with Expense Recognition
are costs incurred to bring the asset to the location and
condition necessary for it to be capable of operating in the manner intended by
Costs of employee benefits arising directly from the construction or acquisition of the
Some operating expenses may be
deliberately treated as directly attributable to PP&E,
while in reality they may have nothing to do with fixed
this may be done in order to delay their
recognition as operating costs in an income statements)
ACCOUNTING FOR PP&E UNDER IFRS
According to par. 8 of IAS 23 (Borrowing costs
directly attributable to a qualifying asset
when that asset is ready for its intended use or sale).
Borrowing costs eligible for capitalization are those borrowing costs that would have been
avoided if the expenditure on this asset had not been made.
Capitalization of borrowing costs
completed (i.e. until the asset becomes
PROBLEM 10: IFRS require capitalization of
borrowing costs directly related to PP&E. As
a result, their recognition in income
statement is delayed (and asset’s carrying
values may be overstated).
Financial Statement Reliability under IFRS: Problems with Expense Recognition
FOR PP&E UNDER IFRS
Borrowing costs), borrowing costs (i.e. interest costs) that are
directly attributable to a qualifying asset must be capitalized as part of its initial cost (until
for its intended use or sale).
eligible for capitalization are those borrowing costs that would have been
avoided if the expenditure on this asset had not been made.
borrowing costs may be continued until the project
(i.e. until the asset becomes ready for its intended use or for sale to a customer
IFRS require capitalization of
borrowing costs directly related to PP&E. As
a result, their recognition in income
statement is delayed (and asset’s carrying
PROBLEM 10 (cont.): However, the
borrowing costs may be capitalized only
as long as the related asset is “unready”
(and that point in time may be difficult
to set and verify).
43
: Problems with Expense Recognition
(i.e. interest costs) that are
as part of its initial cost (until
eligible for capitalization are those borrowing costs that would have been
may be continued until the project is substantially
ready for its intended use or for sale to a customer).
However, the
borrowing costs may be capitalized only
as long as the related asset is “unready”
may be difficult
to set and verify).
ACCOUNTING FOR PP&E UNDER IFRS
If the costs of construction of the asset exceed its
construction inefficiencies), the
not to report an asset at overstated value). Also, according to par. 19
following examples of costs should not be included in the asset’s initial value:
���� Costs of opening a new facility (e.g. the opening ceremony or media annou
���� 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 customer (including costs
of staff training),
���� Costs incurred while an item
is operated at less than full capacity,
���� Initial operating losses,
���� Costs of relocating or reorganizing part or all of the entity’s operations.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
ACCOUNTING FOR PP&E UNDER IFRS
tion of the asset exceed its recoverable amount
construction inefficiencies), the excess should be recognized as an impairment loss
not to report an asset at overstated value). Also, according to par. 19
following examples of costs should not be included in the asset’s initial value:
Costs of opening a new facility (e.g. the opening ceremony or media annou
Costs of introducing a new product or service, including costs of advertising and
Costs of conducting business in a new location or with a new customer (including costs
Costs incurred while an item capable of operating […] has yet to be brought into use or
is operated at less than full capacity,
Costs of relocating or reorganizing part or all of the entity’s operations.
This is related to PROBLEM 9
if attributable to PP&E, should be expensed as incurred
instead of capitalized (and if they are capitalized, they
overstate reported earnings and assets)
44
: Problems with Expense Recognition
recoverable amount (e.g. because of
excess should be recognized as an impairment loss (in order
not to report an asset at overstated value). Also, according to par. 19-20 of IAS 16, the
following examples of costs should not be included in the asset’s initial value:
Costs of opening a new facility (e.g. the opening ceremony or media announcements),
Costs of introducing a new product or service, including costs of advertising and
Costs of conducting business in a new location or with a new customer (including costs
capable of operating […] has yet to be brought into use or
Costs of relocating or reorganizing part or all of the entity’s operations.
related to PROBLEM 9: some expenditures, even
if attributable to PP&E, should be expensed as incurred
instead of capitalized (and if they are capitalized, they
overstate reported earnings and assets)
ACCOUNTING FOR PP&E UNDER IFRS
If part or all of the cash payment (to purchase or construct an asset) is deferred, the initial
cost of that asset (i.e. its purchase pr
determined by measuring the cash payments on
flows). The resulting differences between nominal payments and their discounted values are
recognized as an interest expense.
In a non-cash exchange of assets, the item of PPE is acquired in return for other non
asset. In such circumstances the purchase price of the acquired asset should be determined
on the basis of the estimated fair value
when the fair values cannot be reliably estimated), where the fair value is defined as the
amount for which as asset could be exchanged between knowledgeable, willing parties in an
arm’s length transaction. If the est
(which is usually the case), an entity recognizes
statement) from such an exchange of non
Financial Statement Reliability under IFRS: Problems with Expense Recognition
ACCOUNTING FOR PP&E UNDER IFRS
If part or all of the cash payment (to purchase or construct an asset) is deferred, the initial
cost of that asset (i.e. its purchase price) is the cash price equivalent at the recognition date,
determined by measuring the cash payments on a present value basis
). The resulting differences between nominal payments and their discounted values are
interest expense.
cash exchange of assets, the item of PPE is acquired in return for other non
asset. In such circumstances the purchase price of the acquired asset should be determined
estimated fair value of the asset given up, (with some exceptions, e.g.
when the fair values cannot be reliably estimated), where the fair value is defined as the
amount for which as asset could be exchanged between knowledgeable, willing parties in an
arm’s length transaction. If the estimated fair value differs from the asset’s carrying value
(which is usually the case), an entity recognizes a gain or a loss (reported in its income
statement) from such an exchange of non-cash assets.
PROBLEM 11
appropriate discount rate, which is prone to
subjective judgments and estimation issues
PROBLEM 12: This calls for estimating fair value of
(which is subjective and difficult to verify). The distortion of this
estimate results in distorted earnings and assets.
45
: Problems with Expense Recognition
If part or all of the cash payment (to purchase or construct an asset) is deferred, the initial
ice) is the cash price equivalent at the recognition date,
(i.e. discounted cash
). The resulting differences between nominal payments and their discounted values are
cash exchange of assets, the item of PPE is acquired in return for other non-cash
asset. In such circumstances the purchase price of the acquired asset should be determined
given up, (with some exceptions, e.g.
when the fair values cannot be reliably estimated), where the fair value is defined as the
amount for which as asset could be exchanged between knowledgeable, willing parties in an
imated fair value differs from the asset’s carrying value
(reported in its income
PROBLEM 11: This calls for estimating an
appropriate discount rate, which is prone to
subjective judgments and estimation issues
This calls for estimating fair value of asset given up
(which is subjective and difficult to verify). The distortion of this
estimate results in distorted earnings and assets.
ACCOUNTING FOR PP&E UNDER IFRS
If a company acquires a bundle of assets (e.g. an organized and integrated business
often pays a single total amount for all the assets acquired (without determining the values
of individual assets). In such cases, the total amount paid must be
identifiable assets acquired (which must then be account
financial statements).
In such business transactions the par. 2 of IFRS 3 (
according to which the total cost “
and liabilities on the basis of their
As a result, a total purchase cost paid for a bundle of assets must be allocated into the
individual assets in proportion to their
Financial Statement Reliability under IFRS: Problems with Expense Recognition
ACCOUNTING FOR PP&E UNDER IFRS
If a company acquires a bundle of assets (e.g. an organized and integrated business
often pays a single total amount for all the assets acquired (without determining the values
of individual assets). In such cases, the total amount paid must be allocated
identifiable assets acquired (which must then be accounted for separately in an acquirer’s
In such business transactions the par. 2 of IFRS 3 (Business combinations
according to which the total cost “should be allocated to the individual identifiable assets
and liabilities on the basis of their relative fair values at the date of purchase
As a result, a total purchase cost paid for a bundle of assets must be allocated into the
individual assets in proportion to their relative estimated fair values.
PROBLEM 13: When a bundle of assets is acquired, a single
price must be allocated to individual assets, on the ground of
their relative estimated fair values (which are subjective and
difficult to verify). The distorted allocation may result in
distorted future reported earnings.
46
: Problems with Expense Recognition
If a company acquires a bundle of assets (e.g. an organized and integrated business line), it
often pays a single total amount for all the assets acquired (without determining the values
allocated to the individual
ed for separately in an acquirer’s
Business combinations) is applicable,
should be allocated to the individual identifiable assets
at the date of purchase”.
As a result, a total purchase cost paid for a bundle of assets must be allocated into the
When a bundle of assets is acquired, a single
individual assets, on the ground of
their relative estimated fair values (which are subjective and
difficult to verify). The distorted allocation may result in
distorted future reported earnings.
ACCOUNTING FOR PP&E UNDER IFRS
An entity should allocate the total cost of the asset into its components, if they are
(e.g. they have varying useful lifes). However, the standard does not clarify how to separate
components, so an identification of what constitutes a separate item or component requires
the exercise of judgment.
According to par. 29 of IAS 16, after an in
under two possible measurement approaches (however, a single policy must be applied to
an entire class of similar assets, instead of individual assets):
���� The cost model, where the asset is depreciated (on the ground of its
and residual value) from its initial (gross) carrying amount,
���� The revaluation model, where the asset is
depreciated from that fair
value).
Both models are vulnerable to multiple subjective
judgments (the revaluation model to a larger extent).
Financial Statement Reliability under IFRS: Problems with Expense Recognition
ACCOUNTING FOR PP&E UNDER IFRS
cate the total cost of the asset into its components, if they are
(e.g. they have varying useful lifes). However, the standard does not clarify how to separate
components, so an identification of what constitutes a separate item or component requires
According to par. 29 of IAS 16, after an initial recognition of an asset it may be accounted for
under two possible measurement approaches (however, a single policy must be applied to
an entire class of similar assets, instead of individual assets):
, where the asset is depreciated (on the ground of its
) from its initial (gross) carrying amount,
, where the asset is periodically revalued to fair value
depreciated from that fair value (on the ground of its expected useful life
PROBLEM 14: If an asset consists of significant sepa
components, its initial value should be allocated to
individual components (which is subjective and difficult
to verify). The distorted allocation may result in
distorted future reported earnings.
Both models are vulnerable to multiple subjective
judgments (the revaluation model to a larger extent).
47
: Problems with Expense Recognition
cate the total cost of the asset into its components, if they are separable
(e.g. they have varying useful lifes). However, the standard does not clarify how to separate
components, so an identification of what constitutes a separate item or component requires
itial recognition of an asset it may be accounted for
under two possible measurement approaches (however, a single policy must be applied to
, where the asset is depreciated (on the ground of its expected useful life
periodically revalued to fair value and then
expected useful life and residual
If an asset consists of significant separable
components, its initial value should be allocated to
individual components (which is subjective and difficult
to verify). The distorted allocation may result in
distorted future reported earnings.
ACCOUNTING FOR PP&E UNDER IFRS
The choice of the measurement basis (cost
relevance vs. reliability trade-off
The cost model is considered more reliable and verifiable (because it is free from
revaluation-related problems with valuation assump
may result in irrelevant information (where cost
far from their market values).
In contrast, the revaluation model
(because they are “updated” to follow the market changes), but is prone to valuation
problems (particularly for specialized assets for which no any liquid markets exist, with easily
available market prices of similar assets).
Financial Statement Reliability under IFRS: Problems with Expense Recognition
ACCOUNTING FOR PP&E UNDER IFRS
The choice of the measurement basis (cost-based vs. revaluation
off.
is considered more reliable and verifiable (because it is free from
related problems with valuation assumptions, judgments and estimates), but
may result in irrelevant information (where cost-based carrying amounts of assets deviate
the revaluation model is expected to bring more relevant and useful asset values
ecause they are “updated” to follow the market changes), but is prone to valuation
problems (particularly for specialized assets for which no any liquid markets exist, with easily
available market prices of similar assets).
48
: Problems with Expense Recognition
based vs. revaluation-based) reflects the
is considered more reliable and verifiable (because it is free from
tions, judgments and estimates), but
based carrying amounts of assets deviate
is expected to bring more relevant and useful asset values
ecause they are “updated” to follow the market changes), but is prone to valuation
problems (particularly for specialized assets for which no any liquid markets exist, with easily
ACCOUNTING FOR PP&E UNDER IFRS
According to par. 6 of IAS 16:
���� Depreciation is the systematic allocation of the
useful life,
���� Depreciable amount is the cost of an asset, or other amount substituted for cost, less its
residual value,
���� Residual value of an asset is the
from disposal of the asset, after deducting the estimated costs of disposal,
were already of the age and in the condition expected
���� Useful life is:
(a) The period over which an asset is
(b) The number of production or similar units
by an entity.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
ACCOUNTING FOR PP&E UNDER IFRS
is the systematic allocation of the depreciable amount
is the cost of an asset, or other amount substituted for cost, less its
of an asset is the estimated amount that an entity would currently obtain
from disposal of the asset, after deducting the estimated costs of disposal,
were already of the age and in the condition expected at the end of its
The period over which an asset is expected to be available for use
The number of production or similar units expected to be obtained from the asset
PROBLEM 15
estimates of a
expected residu
are heavily su
(and financial statement distortions)
49
: Problems with Expense Recognition
depreciable amount of an asset over its
is the cost of an asset, or other amount substituted for cost, less its
that an entity would currently obtain
from disposal of the asset, after deducting the estimated costs of disposal, if the asset
at the end of its useful life,
to be available for use by en entity, or
to be obtained from the asset
PROBLEM 15: Depreciation of PP&E calls for
s of an asset’s expected useful life and its
esidual value (if any). Both these estimates
ily subjective and prone to manipulations
(and financial statement distortions)
ACCOUNTING FOR PP&E UNDER IFRS
An item of PPE is subject to depreciation charges
condition to be capable of operating in the manner intended by management
According to par. 56 of IAS 16, the following factors should be taken into consideration in
determining the useful life:
���� The expected usage of the asset by the entity,
���� The expected physical wear and tear
use and its operational conditions),
���� Technical or commercial obsolescence
probable changes in demand),
���� Legal or similar limits on the use of the as
Thus, the expected useful life (which constitutes the crucial input in calculating depreciation
charges) may have nothing to do with the economic or physical duration of the asset.
According to par. 58 of IAS 16,
have an unlimited life and therefore
This may cause significant distortions if a bundle of assets is purchased (because
a company may over-allocate the total price into non
Financial Statement Reliability under IFRS: Problems with Expense Recognition
ACCOUNTING FOR PP&E UNDER IFRS
subject to depreciation charges since it is at the location and in the working
capable of operating in the manner intended by management
According to par. 56 of IAS 16, the following factors should be taken into consideration in
of the asset by the entity,
expected physical wear and tear (resulting from e.g. the expected intensity of it
use and its operational conditions),
Technical or commercial obsolescence (resulting from e.g. the technological progress or
probable changes in demand),
on the use of the asset.
Thus, the expected useful life (which constitutes the crucial input in calculating depreciation
charges) may have nothing to do with the economic or physical duration of the asset.
According to par. 58 of IAS 16, land is a special type of asset, which normally is assumed to
and therefore is not subject for depreciation.
PROBLEM 16: An item of PP&
since it is ready to be used as intended my
management. Setting this point in time is subjective
and delays of depreciation may significantly distort
the reported earnings and assets.
This may cause significant distortions if a bundle of assets is purchased (because
allocate the total price into non-depreciable assets)
All these estimates are very
“soft” and subjective
50
: Problems with Expense Recognition
since it is at the location and in the working
capable of operating in the manner intended by management.
According to par. 56 of IAS 16, the following factors should be taken into consideration in
(resulting from e.g. the expected intensity of its
(resulting from e.g. the technological progress or
Thus, the expected useful life (which constitutes the crucial input in calculating depreciation
charges) may have nothing to do with the economic or physical duration of the asset.
is a special type of asset, which normally is assumed to
An item of PP&E is to be depreciated
since it is ready to be used as intended my
management. Setting this point in time is subjective
and delays of depreciation may significantly distort
the reported earnings and assets.
All these estimates are very
“soft” and subjective
ACCOUNTING FOR PP&E UNDER IFRS
Under the revaluation model, the fair values should be determined by professional
appraisers, using market-based evidence
are unavailable (which is usually the case for specialized assets), the
estimated at depreciated replacement cost
Par. 39 of IAS 16 states that if an asset’s carrying amount is increased as a result of a
revaluation, the increase shall be credited directly to equity […].
In contrast, according to par. 40 of IAS 16, if an asset’s ca
result of a revaluation, the decrease shall be recognized in profit or loss (however, the
decrease shall be debited directly to equity […] to the extent of any credit balance existing in
the revaluation reserve in respect of
Financial Statement Reliability under IFRS: Problems with Expense Recognition
ACCOUNTING FOR PP&E UNDER IFRS
uation model, the fair values should be determined by professional
based evidence. However, if relevant data on market transactions
are unavailable (which is usually the case for specialized assets), the
at depreciated replacement cost.
Par. 39 of IAS 16 states that if an asset’s carrying amount is increased as a result of a
revaluation, the increase shall be credited directly to equity […].
In contrast, according to par. 40 of IAS 16, if an asset’s carrying amount is decreased as a
result of a revaluation, the decrease shall be recognized in profit or loss (however, the
decrease shall be debited directly to equity […] to the extent of any credit balance existing in
the revaluation reserve in respect of that asset.
PROBLEM 17
additional problem (as compared to a cost
model) arises: the PP&E must be periodically
revalued to fair values (with all the problems of
subjectivity of estimated fair values)
51
: Problems with Expense Recognition
uation model, the fair values should be determined by professional
. However, if relevant data on market transactions
are unavailable (which is usually the case for specialized assets), the fair value may be
Par. 39 of IAS 16 states that if an asset’s carrying amount is increased as a result of a
rrying amount is decreased as a
result of a revaluation, the decrease shall be recognized in profit or loss (however, the
decrease shall be debited directly to equity […] to the extent of any credit balance existing in
PROBLEM 17: Under the revaluation model the
additional problem (as compared to a cost
model) arises: the PP&E must be periodically
revalued to fair values (with all the problems of
subjectivity of estimated fair values)
ACCOUNTING FOR PP&E
The costs related to an asset, incurred after its initial recognition, should be
increase the carrying value of that asset)
benefits obtainable from that asset (e.g. expenditures aimed at improving output quality,
boosting capacity or lowering costs of operations).
In contrast, expenditures incurred only to
routine maintenance and repair) should be
Thus, to qualify for capitalization (as asset), such expenditures must meet the recognition
criteria for assets.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
ACCOUNTING FOR PP&E UNDER IFRS
The costs related to an asset, incurred after its initial recognition, should be
increase the carrying value of that asset) only if they increase future probable economic
obtainable from that asset (e.g. expenditures aimed at improving output quality,
boosting capacity or lowering costs of operations).
In contrast, expenditures incurred only to maintain the asset in its current condition
air) should be expensed as incurred.
Thus, to qualify for capitalization (as asset), such expenditures must meet the recognition
This is related to PROBLEM 9
particularly routine maintenance, should be expensed as
incurred instead of cap
they overstate reported earnings and assets)
52
: Problems with Expense Recognition
The costs related to an asset, incurred after its initial recognition, should be capitalized (i.e.
only if they increase future probable economic
obtainable from that asset (e.g. expenditures aimed at improving output quality,
maintain the asset in its current condition (e.g.
Thus, to qualify for capitalization (as asset), such expenditures must meet the recognition
This is related to PROBLEM 9: some expenditures,
particularly routine maintenance, should be expensed as
f capitalized (and if they are capitalized,
they overstate reported earnings and assets)
ACCOUNTING FOR PP&E UNDER IFRS
Some items of PPE, which are not used in company’s operations or are intended to be
disposed of, may be reported as:
���� Investment property – defined as real estate held with the
or for capital appreciation (or both),
���� Assets “held-for-sale” – defined as assets to be disposed of.
Under IAS 40 (Investment property
or at depreciated cost less accumulated impairment. When investment property is carried at
fair value, at each subsequent period its carrying amount must be
the adjustment being reported as
encourages (but does not require)
valuation done by an independent
Financial Statement Reliability under IFRS: Problems with Expense Recognition
ACCOUNTING FOR PP&E UNDER IFRS
Some items of PPE, which are not used in company’s operations or are intended to be
as:
defined as real estate held with the intention
or for capital appreciation (or both),
defined as assets to be disposed of.
Investment property) investment property may be reported at either
or at depreciated cost less accumulated impairment. When investment property is carried at
fair value, at each subsequent period its carrying amount must be revalued to fair value, with
the adjustment being reported as either profit or loss in that period. The
encourages (but does not require) an entity to determine the fair value on the basis of the
valuation done by an independent appraiser.
PROBLEM 18
reported at fair values (with all the problems
of subjectivity of estimated fair values), with
period-to-
reported as gains and losses.
PROBLEM 18 (cont.): There is no requirement
for fair value estimates to be done by
professional and independent appraisers
(instead, a company may do them on its own).53
: Problems with Expense Recognition
Some items of PPE, which are not used in company’s operations or are intended to be
intention of earning rentals
may be reported at either fair value
or at depreciated cost less accumulated impairment. When investment property is carried at
revalued to fair value, with
in that period. The standard
an entity to determine the fair value on the basis of the
PROBLEM 18: Investment property may be
reported at fair values (with all the problems
ectivity of estimated fair values), with
-period changes of fair value
reported as gains and losses.
There is no requirement
estimates to be done by
professional and independent appraisers
(instead, a company may do them on its own).
ACCOUNTING FOR PP&E
If, when revaluing investment property, an entity lacks observable data on current prices of
similar properties on an active market
sources, including:
���� Current prices on an active market of
the differences, recent prices on less active markets, with
���� Discounted cash flow projections
an appropriate discount rate
If there exists a clear evidence
estimated reliably (on a continuous basis), the entity should report that investment property
at cost.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
ACCOUNTING FOR PP&E UNDER IFRS
If, when revaluing investment property, an entity lacks observable data on current prices of
similar properties on an active market, it should use information from variety of other
Current prices on an active market of dissimilar properties with suitable adjustments for
, recent prices on less active markets, with necessary adjustments
Discounted cash flow projections based on reliable estimates of future cash flows
appropriate discount rate.
clear evidence that the fair value of the investment property cannot be
(on a continuous basis), the entity should report that investment property
PROBLEM 18 (cont.)
inputs are heavily prone to subjective
judgments and are difficult to verify.
PROBLEM 19: If a fair value of an investment
property cannot be reliably estimated, the asset may
be reported at cost. This may result in significant
overstatements of earnings and assets, when
property’s market values decline deeply.
54
: Problems with Expense Recognition
If, when revaluing investment property, an entity lacks observable data on current prices of
, it should use information from variety of other
suitable adjustments for
necessary adjustments, and
reliable estimates of future cash flows using
that the fair value of the investment property cannot be
(on a continuous basis), the entity should report that investment property
PROBLEM 18 (cont.): All these valuation
inputs are heavily prone to subjective
judgments and are difficult to verify.
If a fair value of an investment
cannot be reliably estimated, the asset may
be reported at cost. This may result in significant
overstatements of earnings and assets, when
property’s market values decline deeply.
ACCOUNTING FOR PP&E UNDER IFRS
According to IFRS 5 (Noncurrent assets held for
management decided to sell an asset, it should be classified as “
measured at the lower of carrying amount or
reclassification, the asset is no lo
If the asset held for sale is not later disposed of, it is to be reclassified to the operating
assets, at the lower of the following values:
(1) The asset’s carrying amount before it was classified as “held
any depreciation that would have been recognized during the time when it was
classified as “held-for-sale”,
(2) The recoverable amount
Financial Statement Reliability under IFRS: Problems with Expense Recognition
ACCOUNTING FOR PP&E UNDER IFRS
Noncurrent assets held for sale and discontinued operations
to sell an asset, it should be classified as “held-for
measured at the lower of carrying amount or fair value less cost to sell. After such
the asset is no longer subject to depreciation charges.
If the asset held for sale is not later disposed of, it is to be reclassified to the operating
assets, at the lower of the following values:
The asset’s carrying amount before it was classified as “held-for
any depreciation that would have been recognized during the time when it was
sale”,
recoverable amount at the date of the subsequent decision not to sell.
PROBLEM 20: If an item of PP&E is reclassified to
“held-for-sale” category, it is no longer depreciated.
Thus, if a company deliberately treats some
operating assets as “held
significantly overstate the reported earnings.
55
: Problems with Expense Recognition
sale and discontinued operations), where
for-sale” and should be
less cost to sell. After such
If the asset held for sale is not later disposed of, it is to be reclassified to the operating
for-sale”, adjusted for
any depreciation that would have been recognized during the time when it was
at the date of the subsequent decision not to sell.
If an item of PP&E is reclassified to
category, it is no longer depreciated.
Thus, if a company deliberately treats some
operating assets as “held-for-sale”, it may
significantly overstate the reported earnings.
ACCOUNTING FOR PP&E UNDER IFRS
An entity classifies an item of PPE as “
carrying amount through a sale transaction rather than the asset’s use in the company’s
operations. An asset may be reported as “
���� The asset must be available for immediate sale in its present condition an
be highly probable,
���� The asset must be currently being
relation to its current fair value
���� The sale should be completed, or
classification (with some limited exceptions),
���� The actions required to complete the planned sale have been made, and it is
that the plan will be significantly changed or withdrawn,
���� For the sale to be highly probable, management must be
and must be actively looking for
���� In the case that the sale may not be completed within one year, the asset could still be
classified as “held-for-sale” if the delay is caused by
and the entity remains committed
Financial Statement Reliability under IFRS: Problems with Expense Recognition
ACCOUNTING FOR PP&E UNDER IFRS
An entity classifies an item of PPE as “held-for-sale”, if it expects to recover the asset’s
carrying amount through a sale transaction rather than the asset’s use in the company’s
operations. An asset may be reported as “held-for-sale” if the following conditions are met:
The asset must be available for immediate sale in its present condition an
The asset must be currently being marketed actively at a price that is
fair value,
The sale should be completed, or expected to be so, within a year from the date of the
classification (with some limited exceptions),
The actions required to complete the planned sale have been made, and it is
that the plan will be significantly changed or withdrawn,
ighly probable, management must be committed
actively looking for a buyer,
In the case that the sale may not be completed within one year, the asset could still be
sale” if the delay is caused by events beyond the entity’s control
committed to selling the asset.
PROBLEM 20 (cont.)
and enable manipulated argumentation (aimed
at deliberate reclassification of some assets to
“held
56
: Problems with Expense Recognition
”, if it expects to recover the asset’s
carrying amount through a sale transaction rather than the asset’s use in the company’s
” if the following conditions are met:
The asset must be available for immediate sale in its present condition and its sale must
at a price that is reasonable in
to be so, within a year from the date of the
The actions required to complete the planned sale have been made, and it is unlikely
committed to sell the asset
In the case that the sale may not be completed within one year, the asset could still be
beyond the entity’s control
PROBLEM 20 (cont.): All these factors are “soft”
and enable manipulated argumentation (aimed
at deliberate reclassification of some assets to
“held-for-sale” category).
EXAMPLES OF IMPACT OF MIS
AND EQUIPMENT ON RELIABILITY OF FINANCIAL STATEMENTS
EXAMPLE 5: TREATING ROUTINE MAINTENANCE COSTS AS INVESTMENTS IN
ASSETS
At the end of 2009 the small airline purchased several new airplanes for 10.000 thousands
EUR. The operations (charter flights) were started at the beginning of 2010. The useful lifes of
all those assets were estimated to be 10 years and for
residual values are zero. The company assumed linear depreciation, so the annual
depreciation (reflected in income statement) is 1.000 thousands EUR (10.000.000 EUR / 10
years). The company’s annual net sales (from charter
Financial Statement Reliability under IFRS: Problems with Expense Recognition
EXAMPLES OF IMPACT OF MIS-REPORTED PROPERTY, PLANT
AND EQUIPMENT ON RELIABILITY OF FINANCIAL STATEMENTS
TREATING ROUTINE MAINTENANCE COSTS AS INVESTMENTS IN
At the end of 2009 the small airline purchased several new airplanes for 10.000 thousands
EUR. The operations (charter flights) were started at the beginning of 2010. The useful lifes of
all those assets were estimated to be 10 years and for simplicity let’s assume that the
residual values are zero. The company assumed linear depreciation, so the annual
depreciation (reflected in income statement) is 1.000 thousands EUR (10.000.000 EUR / 10
years). The company’s annual net sales (from charter flights) are 3.000 thousands EUR.
57
: Problems with Expense Recognition
REPORTED PROPERTY, PLANT
AND EQUIPMENT ON RELIABILITY OF FINANCIAL STATEMENTS
TREATING ROUTINE MAINTENANCE COSTS AS INVESTMENTS IN FIXED
At the end of 2009 the small airline purchased several new airplanes for 10.000 thousands
EUR. The operations (charter flights) were started at the beginning of 2010. The useful lifes of
simplicity let’s assume that the
residual values are zero. The company assumed linear depreciation, so the annual
depreciation (reflected in income statement) is 1.000 thousands EUR (10.000.000 EUR / 10
flights) are 3.000 thousands EUR.
EXAMPLES OF IMPACT OF MIS
AND EQUIPMENT ON RELIABILITY OF FINANCIAL STATEMENTS
EXAMPLE 5: TREATING ROUTINE MAINTENANCE COSTS AS INVESTMENTS IN FIXED
ASSETS
In order to ensure reproduction of
expenditures equaling annual depreciation of those assets. However, each year the company
must spend another 1.000 thousands EUR associated with the obligatory safety control (this
is necessary to have permission for flights within the European Aviation Area). These are
typical current expenditures that should be classified as necessary for maintaining the
current state of the asset (and not extending the future benefits from the asset, as compared
to the current benefits). Therefore, those expenditures should be expensed (in operating
costs) as incurred. However, the company’s accounting policy states that those expenditures
are separate investments (into fixed
years.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
EXAMPLES OF IMPACT OF MIS-REPORTED PROPERTY, PLANT
AND EQUIPMENT ON RELIABILITY OF FINANCIAL STATEMENTS
TREATING ROUTINE MAINTENANCE COSTS AS INVESTMENTS IN FIXED
In order to ensure reproduction of fixed-assets the company incurs in each year the capital
expenditures equaling annual depreciation of those assets. However, each year the company
must spend another 1.000 thousands EUR associated with the obligatory safety control (this
ve permission for flights within the European Aviation Area). These are
typical current expenditures that should be classified as necessary for maintaining the
current state of the asset (and not extending the future benefits from the asset, as compared
the current benefits). Therefore, those expenditures should be expensed (in operating
costs) as incurred. However, the company’s accounting policy states that those expenditures
into fixed assets) and are depreciated or
58
: Problems with Expense Recognition
REPORTED PROPERTY, PLANT
AND EQUIPMENT ON RELIABILITY OF FINANCIAL STATEMENTS
TREATING ROUTINE MAINTENANCE COSTS AS INVESTMENTS IN FIXED
assets the company incurs in each year the capital
expenditures equaling annual depreciation of those assets. However, each year the company
must spend another 1.000 thousands EUR associated with the obligatory safety control (this
ve permission for flights within the European Aviation Area). These are
typical current expenditures that should be classified as necessary for maintaining the
current state of the asset (and not extending the future benefits from the asset, as compared
the current benefits). Therefore, those expenditures should be expensed (in operating
costs) as incurred. However, the company’s accounting policy states that those expenditures
depreciated or amortized through 5
Computation of depreciation and balance
(airplanes) and following true capital expenditures related to reproduction of those assets.
1) Gross value of fixed
2) Depreciation of initial fixed assets**
3) Reproduction expenditures***
4) Depreciation of reproduction expenditures****
expenditures incurred in 2010
expenditures incurred in 2011
expenditures incurred in 2012
expenditures incurred in 2013
5) Total depreciation (2 + 4)
6) Net (balance-sheet) value of fixed assets****** initial 10.000 + cumulative reproduction expenditures
***equaling annual depreciation (in order to ensure full
****assuming linearity, 10 years and depreciation starting at the beginning of the next year
*****net value of fixed assets at the end of the previous year + reproduction expenditures
Financial Statement Reliability under IFRS: Problems with Expense Recognition
Computation of depreciation and balance-sheet carrying values of the initial fixed assets
(airplanes) and following true capital expenditures related to reproduction of those assets.
2009 2010
Gross value of fixed assets* 0 11.000 12.100
Depreciation of initial fixed assets** 0 1.000 1.000
Reproduction expenditures*** 0 1.000 1.100
Depreciation of reproduction expenditures**** 0 0
expenditures incurred in 2010 0 0
expenditures incurred in 2011 0 0
expenditures incurred in 2012 0 0
expenditures incurred in 2013 0 0
Total depreciation (2 + 4) 0 1.000 1.100
sheet) value of fixed assets***** 10.000 10.000 10.000* initial 10.000 + cumulative reproduction expenditures **10% from the initial value of fixed assets (airplanes)
***equaling annual depreciation (in order to ensure full reproduction of the assets’ usage)
****assuming linearity, 10 years and depreciation starting at the beginning of the next year
*****net value of fixed assets at the end of the previous year + reproduction expenditures
59
: Problems with Expense Recognition
sheet carrying values of the initial fixed assets
(airplanes) and following true capital expenditures related to reproduction of those assets.
2011 2012 2013
12.100 13.310 14.641
1.000 1.000 1.000
1.100 1.210 1.331
100 210 331
100 100 100
0 110 110
0 0 121
0 0 0
1.100 1.210 1.331
10.000 10.000 10.000 **10% from the initial value of fixed assets (airplanes)
reproduction of the assets’ usage)
****assuming linearity, 10 years and depreciation starting at the beginning of the next year
*****net value of fixed assets at the end of the previous year + reproduction expenditures – total depreciation
Computation of depreciation and balance
assets) expenditures on obligatory safety control
1) Routine safety control expenditures
2) Depreciation of safety control expenditures*
expenditures incurred in 2010
expenditures incurred in 2011
expenditures incurred in 2012
expenditures incurred in 2013
3) Net (balance-sheet) value of
capitalized safety control expenditures**
* assuming linearity, 5 years and depreciation
**net value of capitalized safety control expenditures at the end of the previous year + routine safety
control expenditures in a given year
The
Financial Statement Reliability under IFRS: Problems with Expense Recognition
Computation of depreciation and balance-sheet carrying values of the
assets) expenditures on obligatory safety control
2009 2010
Routine safety control expenditures 0 1.000 1.000
Depreciation of safety control expenditures* 0 0
incurred in 2010 0 0
expenditures incurred in 2011 0 0
expenditures incurred in 2012 0 0
expenditures incurred in 2013 0 0
sheet) value of
capitalized safety control expenditures** 0 1.000 1.800
depreciation starting at the beginning of the next year
**net value of capitalized safety control expenditures at the end of the previous year + routine safety
control expenditures in a given year – depreciation of safety control expenditures
The carrying amount of these “assets” grows steadily, because in each
period the routine safety control expenditures exceed the annual
depreciation of the expenditures capitalized in the past
60
: Problems with Expense Recognition
sheet carrying values of the capitalized (as fixed
2011 2012 2013
1.000 1.000 1.000
200 400 600
200 200 200
0 200 200
0 0 200
0 0 0
1.800 2.400 2.800
starting at the beginning of the next year
**net value of capitalized safety control expenditures at the end of the previous year + routine safety
of safety control expenditures
carrying amount of these “assets” grows steadily, because in each
period the routine safety control expenditures exceed the annual
depreciation of the expenditures capitalized in the past
Computation of total carrying (net) amount of fixed assets, including the “true” assets as well
as the capitalized (as fixed assets) expenditures on obligatory safety control
Net value of „true” fixed assets
Capitalized routine safety control expenditures
Total net (balance-sheet) value of fixed assets
The carrying
Financial Statement Reliability under IFRS: Problems with Expense Recognition
total carrying (net) amount of fixed assets, including the “true” assets as well
assets) expenditures on obligatory safety control
2009 2010
of „true” fixed assets 10.000 10.000 10.000
safety control expenditures 0 1.000 1.800
sheet) value of fixed assets 10.000 11.000 11.800
The carrying amount of total fixed assets grows steadily
because of the unjustified repeated capitalization of
routine safety control expenditures. The longer it is
continued, the higher is the resulting “asset bubble”
61
: Problems with Expense Recognition
total carrying (net) amount of fixed assets, including the “true” assets as well
assets) expenditures on obligatory safety control
2011 2012 2013
10.000 10.000 10.000
1.800 2.400 2.800
11.800 12.400 12.800
Selected income statement data with and without the capitalization (as intangible assets) of
routine safety control expenditures
Incorrect income statement
Net sales
Depreciation and amortization
Costs of routine safety control
Profit before income taxes
Correct income statement
Net sales
Depreciation and amortization
Costs of routine safety control
Profit before income taxes
NOTE THAT IN EACH YEAR THE DIFFERENCE BETWEEN PROFIT WITH CAPITALIZATION AND PROFIT WITHOUT
CAPITALIZATION EQUALS THE DIFFERENCE BETWEEN THE SAFETY CONTROL EXPENDITURES INCURRED IN A GIVEN YEAR
AND DEPRECIATION OF THE PREVIOUSLY CAPITALIZED SAFETY CONTROL EXPENDITURES. FOR EXAMPLE, IN 2013 THIS
DIFFERENCE EQUALS 400 (1.069 – 669) AND EQUALS THE DIFFERENCE BETWEEN SAFETY CONTROL EXPENDITURES
INCURRED IN 2013 (1.000) AND DEPRECIATION
Financial Statement Reliability under IFRS: Problems with Expense Recognition
Selected income statement data with and without the capitalization (as intangible assets) of
routine safety control expenditures
Incorrect income statement 2009 2010 2011 2012
Net sales 0 3.000 3.000 3.000
Depreciation and amortization 0 1.000 1.300 1.610
Costs of routine safety control 0 0 0 0
Profit before income taxes 0 2.000 1.700 1.390
Correct income statement 2009 2010 2011 2012
Net sales 0 3.000 3.000 3.000
Depreciation and amortization 0 1.000 1.100 1.210
Costs of routine safety control 0 1.000 1.000 1.000
Profit before income taxes 0 1.000 900 790
NOTE THAT IN EACH YEAR THE DIFFERENCE BETWEEN PROFIT WITH CAPITALIZATION AND PROFIT WITHOUT
CAPITALIZATION EQUALS THE DIFFERENCE BETWEEN THE SAFETY CONTROL EXPENDITURES INCURRED IN A GIVEN YEAR
OF THE PREVIOUSLY CAPITALIZED SAFETY CONTROL EXPENDITURES. FOR EXAMPLE, IN 2013 THIS
669) AND EQUALS THE DIFFERENCE BETWEEN SAFETY CONTROL EXPENDITURES
DEPRECIATION OF PRIOR SAFETY CONTROL EXPENDITURES (600)
Capitalization of the routine safety
expenditures brings about the repeated
overstatements of reported earnings
62
: Problems with Expense Recognition
Selected income statement data with and without the capitalization (as intangible assets) of
2012 2013
3.000 3.000
1.610 1.931
0
1.390 1.069
2012 2013
3.000 3.000
1.210 1.331
1.000 1.000
790 669
NOTE THAT IN EACH YEAR THE DIFFERENCE BETWEEN PROFIT WITH CAPITALIZATION AND PROFIT WITHOUT
CAPITALIZATION EQUALS THE DIFFERENCE BETWEEN THE SAFETY CONTROL EXPENDITURES INCURRED IN A GIVEN YEAR
OF THE PREVIOUSLY CAPITALIZED SAFETY CONTROL EXPENDITURES. FOR EXAMPLE, IN 2013 THIS
669) AND EQUALS THE DIFFERENCE BETWEEN SAFETY CONTROL EXPENDITURES
ITURES (600)
Capitalization of the routine safety control
expenditures brings about the repeated
overstatements of reported earnings
Carrying (balance sheet) value of fixed assets with and without the capitalization (as
intangible assets) of routine safety control expenditures
Incorrect balance sheet
"True" fixed assets
Capitalized safety control expenditures
Total fixed assets
Correct balance sheet
"True" fixed assets
Capitalized safety control expenditures
Total fixed assets
NOTE THAT THE CARRYING VALUE OF CAPITALIZED SAFETY CONTROL EXPENDITURES AT THE END OF 2013 (2.800)
EQUALS THE DIFFERENCE BETWEEN THE CUMULATIVE EXPENDITURES (4.000) AND CUMULATIVE AMORTIZATION OF
THOSE “ASSETS” (1.200 = 200 IN 2011 + 400 IN 2012 + 600 IN
OCCUR SOONER OR LATER (USUALLY AFTER THE AUDITOR’S INTERVENTION). IF THE COMPANY WRITES
IMPROPERLY CAPITALIZED “ASSETS” AT THE END OF 2013 (EXPENSING THEIR CARRYING VALUE AS OTHER OPERATING
COSTS), THE RESULT WOULD BE REPORTED
2013.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
Carrying (balance sheet) value of fixed assets with and without the capitalization (as
intangible assets) of routine safety control expenditures
Incorrect balance sheet 2009 2010 2011
"True" fixed assets 10.000 10.000 10.000
Capitalized safety control expenditures 0 1.000 1.800
Total fixed assets 10.000 11.000 11.800
Correct balance sheet 2009 2010 2011
"True" fixed assets 10.000 10.000 10.000
Capitalized safety control expenditures 0 0 0
Total fixed assets 10.000 10.000 10.000
NOTE THAT THE CARRYING VALUE OF CAPITALIZED SAFETY CONTROL EXPENDITURES AT THE END OF 2013 (2.800)
EQUALS THE DIFFERENCE BETWEEN THE CUMULATIVE EXPENDITURES (4.000) AND CUMULATIVE AMORTIZATION OF
THOSE “ASSETS” (1.200 = 200 IN 2011 + 400 IN 2012 + 600 IN 2013). IF THIS IS FICTITIOUS ASSET, THE REVERSAL MUST
OCCUR SOONER OR LATER (USUALLY AFTER THE AUDITOR’S INTERVENTION). IF THE COMPANY WRITES
IMPROPERLY CAPITALIZED “ASSETS” AT THE END OF 2013 (EXPENSING THEIR CARRYING VALUE AS OTHER OPERATING
STS), THE RESULT WOULD BE REPORTED SEEMINGLY ONE-OFF (!!!) OPERATING LOSS OF 1.731 (1.069
63
: Problems with Expense Recognition
Carrying (balance sheet) value of fixed assets with and without the capitalization (as
2012 2013
10.000 10.000
2.400 2.800
12.400 12.800
2012 2013
10.000 10.000
0 0
10.000 10.000
NOTE THAT THE CARRYING VALUE OF CAPITALIZED SAFETY CONTROL EXPENDITURES AT THE END OF 2013 (2.800)
EQUALS THE DIFFERENCE BETWEEN THE CUMULATIVE EXPENDITURES (4.000) AND CUMULATIVE AMORTIZATION OF
2013). IF THIS IS FICTITIOUS ASSET, THE REVERSAL MUST
OCCUR SOONER OR LATER (USUALLY AFTER THE AUDITOR’S INTERVENTION). IF THE COMPANY WRITES-OFF THOSE
IMPROPERLY CAPITALIZED “ASSETS” AT THE END OF 2013 (EXPENSING THEIR CARRYING VALUE AS OTHER OPERATING
OPERATING LOSS OF 1.731 (1.069 – 2.800) IN
CONCLUSIONS:
� the result of this improper capitalization of costs is inflating earnings
2010 and 2013 and corresponding
� however, because this is an artificial boost to earnings by creating fictitious and non
assets (could these capitalized safety control expenditures be sold, licensed or used as debt
guarantee?), it is unsustainable in the long
one-off write-down,
� all this means that this mechanism enables boosting e
stop it) at the cost of future earnings (the future one
write-down must equal the sum of the cumu
� unfortunately, given the substantial dose of subjectivity
expenditures, it is often difficult to make a clear
should be expensed as incurred
capital-intensive companies with very specialized, sophisticated and high
� this is a typical gimmick that creates an “asset bubble”, which usually ends up with
and unexpected (for analysts and investors) collapse of future earnings.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
the result of this improper capitalization of costs is inflating earnings in all the years between
and corresponding overstatement of fixed-assets,
artificial boost to earnings by creating fictitious and non
assets (could these capitalized safety control expenditures be sold, licensed or used as debt
guarantee?), it is unsustainable in the long-run and sooner or later must be followed by
all this means that this mechanism enables boosting earnings (as long as the auditor does not
) at the cost of future earnings (the future one-off charge stemming from these “assets”
sum of the cumulative prior year earnings overstatements);
unfortunately, given the substantial dose of subjectivity in classifying PP&E
s often difficult to make a clear-cut distinction between expenditures that
should be expensed as incurred and those that could be capitalized (especially in the case of
intensive companies with very specialized, sophisticated and high
this is a typical gimmick that creates an “asset bubble”, which usually ends up with
nd unexpected (for analysts and investors) collapse of future earnings.
64
: Problems with Expense Recognition
in all the years between
artificial boost to earnings by creating fictitious and non-existent
assets (could these capitalized safety control expenditures be sold, licensed or used as debt
run and sooner or later must be followed by a large
arnings (as long as the auditor does not
ng from these “assets”
earnings overstatements);
in classifying PP&E-related
cut distinction between expenditures that
and those that could be capitalized (especially in the case of
intensive companies with very specialized, sophisticated and high-tech fixed assets),
this is a typical gimmick that creates an “asset bubble”, which usually ends up with a dramatic
EXAMPLES OF IMPACT OF MIS
AND EQUIPMENT ON RELIABILITY OF FINANCIAL STATEMENTS
EXAMPLE 6: TREATING OPERATING COSTS, WHICH SHOULD BE EXPENSED AS INCURRED
OR ALLOCATED TO INVENTORIES, AS INVESTMENTS IN FIXED ASSETS
Frequently used gimmick in some industries (especially in construction and in manufacturing
of specialized industrial equipment) is false allocation of some operating expenditures (e.g.
construction workers) as being incurred on development of company’s own fixed assets,
while actually those expenditures are direct costs of inventory.
For example, a construction company that builds commercial real estate for its customers,
but also owns its own production facilities, can allocate part of the salaries of workers
working on customer-ordered projects (those salaries should be allocated to work
progress inventories) to the development and investment projects related to company’s fixed
assets (thus, those salaries are capitalized in fixed assets and then depreciated).
The impact on earnings is similar to the preceding example: overstatement of current
earnings at the expense of future earnings (those salaries should decrease income when the
sale of inventory occur while they are depreciated through longer periods).
Financial Statement Reliability under IFRS: Problems with Expense Recognition
EXAMPLES OF IMPACT OF MIS-REPORTED PROPERTY, PLANT
AND EQUIPMENT ON RELIABILITY OF FINANCIAL STATEMENTS
TREATING OPERATING COSTS, WHICH SHOULD BE EXPENSED AS INCURRED
ALLOCATED TO INVENTORIES, AS INVESTMENTS IN FIXED ASSETS
Frequently used gimmick in some industries (especially in construction and in manufacturing
of specialized industrial equipment) is false allocation of some operating expenditures (e.g.
workers) as being incurred on development of company’s own fixed assets,
while actually those expenditures are direct costs of inventory.
For example, a construction company that builds commercial real estate for its customers,
uction facilities, can allocate part of the salaries of workers
ordered projects (those salaries should be allocated to work
progress inventories) to the development and investment projects related to company’s fixed
ose salaries are capitalized in fixed assets and then depreciated).
The impact on earnings is similar to the preceding example: overstatement of current
earnings at the expense of future earnings (those salaries should decrease income when the
inventory occur while they are depreciated through longer periods).
65
: Problems with Expense Recognition
REPORTED PROPERTY, PLANT
AND EQUIPMENT ON RELIABILITY OF FINANCIAL STATEMENTS
TREATING OPERATING COSTS, WHICH SHOULD BE EXPENSED AS INCURRED
ALLOCATED TO INVENTORIES, AS INVESTMENTS IN FIXED ASSETS
Frequently used gimmick in some industries (especially in construction and in manufacturing
of specialized industrial equipment) is false allocation of some operating expenditures (e.g.
workers) as being incurred on development of company’s own fixed assets,
For example, a construction company that builds commercial real estate for its customers,
uction facilities, can allocate part of the salaries of workers
ordered projects (those salaries should be allocated to work-in-
progress inventories) to the development and investment projects related to company’s fixed
ose salaries are capitalized in fixed assets and then depreciated).
The impact on earnings is similar to the preceding example: overstatement of current
earnings at the expense of future earnings (those salaries should decrease income when the
inventory occur while they are depreciated through longer periods).
EXAMPLES OF IMPACT OF MIS
AND EQUIPMENT ON RELIABILITY OF FINANCIAL STATEMENTS
EXAMPLE 7: DELAYS IN DEPRECIATING FIXED ASSETS
Items of PP&E are subject to depreciation since
Before this moment these assets are treated as assets under construction and no
depreciation is charged.
This creates a temptation to artificially lengthen the period
classified as being under construction
company’s operations. This overstates reported earnings because no depreciation is charged
during this “construction” period.
However, this is not the end of the story, because delays in depreciating fixed assets can
overstate earnings through two related channels:
interest expenses. This is so because
associated with those particular
the book value of fixed assets) only when these assets are still under construction.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
EXAMPLES OF IMPACT OF MIS-REPORTED PROPERTY, PLANT
AND EQUIPMENT ON RELIABILITY OF FINANCIAL STATEMENTS
DELAYS IN DEPRECIATING FIXED ASSETS
depreciation since when they are ready to be used in operations.
Before this moment these assets are treated as assets under construction and no
temptation to artificially lengthen the period, during which
classified as being under construction, even though actually they may be already
. This overstates reported earnings because no depreciation is charged
during this “construction” period.
d of the story, because delays in depreciating fixed assets can
overstate earnings through two related channels: understated depreciation and
expenses. This is so because IFRS require a capitalization of
particular assets. But these interest costs can be capitalized (increasing
the book value of fixed assets) only when these assets are still under construction.
66
: Problems with Expense Recognition
REPORTED PROPERTY, PLANT
AND EQUIPMENT ON RELIABILITY OF FINANCIAL STATEMENTS
when they are ready to be used in operations.
Before this moment these assets are treated as assets under construction and no
during which the fixed assets are
even though actually they may be already used in
. This overstates reported earnings because no depreciation is charged
d of the story, because delays in depreciating fixed assets can
depreciation and understated
capitalization of borrowing costs
assets. But these interest costs can be capitalized (increasing
the book value of fixed assets) only when these assets are still under construction.
EXAMPLES OF IMPACT OF MIS
AND EQUIPMENT ON RELIABILITY OF FINANCIAL STATEMENTS
EXAMPLE 7: DELAYS IN DEPRECIATING FIXED ASSETS
Suppose that a company was developing
2009 and 31st
December 2009.
On 1st
January 2010 the company started manufacturing operations in this newly
factory. However, the factory was artificially held as still being under construction until the
end of 2010.
The total expenditures incurred (in 2009) on developing the fa
and its useful life was estimated to be 10 years.
The construction was fully financed by debt of 10 million EUR. The interest rate on this debt is
7% and the repayment is postponed to 2012.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
EXAMPLES OF IMPACT OF MIS-REPORTED PROPERTY, PLANT
ON RELIABILITY OF FINANCIAL STATEMENTS
DELAYS IN DEPRECIATING FIXED ASSETS
company was developing a new factory in the period between 1
January 2010 the company started manufacturing operations in this newly
factory. However, the factory was artificially held as still being under construction until the
The total expenditures incurred (in 2009) on developing the factory equaled 10 million EUR
and its useful life was estimated to be 10 years.
The construction was fully financed by debt of 10 million EUR. The interest rate on this debt is
7% and the repayment is postponed to 2012.
67
: Problems with Expense Recognition
REPORTED PROPERTY, PLANT
ON RELIABILITY OF FINANCIAL STATEMENTS
new factory in the period between 1st
January
January 2010 the company started manufacturing operations in this newly-developed
factory. However, the factory was artificially held as still being under construction until the
ctory equaled 10 million EUR
The construction was fully financed by debt of 10 million EUR. The interest rate on this debt is
Incorrect booking entries
Depreciation (IS)
Interest expenses (IS)
Factory (BS) +
capitalized borrowing costs (BS)
Profit before taxes
Correct booking entries
Depreciation (IS)
Interest expenses (IS)
Factory (BS) +
capitalized borrowing costs (BS)
Profit before taxes
construction” to “ready to be used” boosts earnings
reported for 2010 (through two related channels)
Financial Statement Reliability under IFRS: Problems with Expense Recognition
2009 2010
0 0
0 0
10.700 11.400
capitalized borrowing costs (BS) (10.000 + 700) (10.700 + 700)
0 0
2009 2010
0 1.070
(10.700 / 10 years)
0 700
10.700 9.630
capitalized borrowing costs (BS) (10.000 + 700) (10.700 – 1.070)
0 -1.770 (1.070 + 700)
Delay in reclassifying an asset from “under
construction” to “ready to be used” boosts earnings
reported for 2010 (through two related channels)
68
: Problems with Expense Recognition
2011
1.140
(11.400 / 10 years)
700
10.260
(11.400 – 1.140)
-1.840 (1.140 + 700)
2011
1.070
700
8.560
(9.630 – 1.070)
-1.770 (1.070 + 700)
Reversal of prior overstatement of
earnings follows the asset’s
reclassification (when it is
depreciated)
CONCLUSIONS:
� the result of this improper delay in depreciating the factory is
earnings by 1.770 (which is the sum of understated depreciation of 1.070 and capitalized
costs of 700),
� in the following periods (from 2011
1.770) reverses gradually, and profits in those future years are lower than in the correct
scenario (this is so because the depreciation is higher),
� again, all this means that this
(the future higher depreciation gradually reverses the initial overstatement of earnings),
� the capital-intensive companies can
periods (not just a one year), if the asset
many assets simultaneously),
� thus, this gimmick is particularly dangerous
asset-development periods (e.g. power plants, hotels, pharmaceuticals),
� this is a typical gimmick that cre
future earnings.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
improper delay in depreciating the factory is an overstatement of 2010 pre
earnings by 1.770 (which is the sum of understated depreciation of 1.070 and capitalized
in the following periods (from 2011 onwards) that initial overstatement of reported earnings (by
and profits in those future years are lower than in the correct
scenario (this is so because the depreciation is higher),
this means that this mechanism enables boosting earnings at the cost of future earnings
higher depreciation gradually reverses the initial overstatement of earnings),
intensive companies can repeatedly overstate earnings through several consecutive
if the asset-development periods are long enough
gimmick is particularly dangerous in the case of capital-intensive companies with long
development periods (e.g. power plants, hotels, pharmaceuticals),
this is a typical gimmick that creates an “asset bubble”, which usually ends up with the depression of
69
: Problems with Expense Recognition
overstatement of 2010 pre-tax
earnings by 1.770 (which is the sum of understated depreciation of 1.070 and capitalized borrowing
initial overstatement of reported earnings (by
and profits in those future years are lower than in the correct-booking
at the cost of future earnings
higher depreciation gradually reverses the initial overstatement of earnings),
overstate earnings through several consecutive
development periods are long enough (or if they invest in
intensive companies with long
ates an “asset bubble”, which usually ends up with the depression of
REAL-LIFE EXAMPLE –
MANUFACTURERS
The following descriptive information may be found in the annual reports of selected global car
manufacturers for 2008 (before the capitalization of borrowing costs became required under IFRS
VOLKSWAGEN GROUP:
“Property, plant and equipment is carried at cost less depreciation and
necessary – write-downs for impairment. […] Borrowing costs are recorded as current
expenses. […] Property, plant and equipment is
method over its estimated useful life.
HONDA MOTOR COMPANY:
“Depreciation of property, plant and equipment is calculated principally by
declining-balance method based on estimated useful lives and salvage values of the
respective assets.”
Financial Statement Reliability under IFRS: Problems with Expense Recognition
– ACCOUNTING FOR PP&E BY GLOBAL CAR
The following descriptive information may be found in the annual reports of selected global car
before the capitalization of borrowing costs became required under IFRS
Property, plant and equipment is carried at cost less depreciation and
downs for impairment. […] Borrowing costs are recorded as current
expenses. […] Property, plant and equipment is depreciated using the straight
r its estimated useful life.”
Depreciation of property, plant and equipment is calculated principally by
based on estimated useful lives and salvage values of the
VW applies straight-line depreciation of
PP&E, while Honda chose to use an
accelerated depreciation scheme
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: Problems with Expense Recognition
ACCOUNTING FOR PP&E BY GLOBAL CAR
The following descriptive information may be found in the annual reports of selected global car
before the capitalization of borrowing costs became required under IFRS):
Property, plant and equipment is carried at cost less depreciation and – where
downs for impairment. […] Borrowing costs are recorded as current
depreciated using the straight-line
Depreciation of property, plant and equipment is calculated principally by the
based on estimated useful lives and salvage values of the
line depreciation of
PP&E, while Honda chose to use an
accelerated depreciation scheme
REAL-LIFE EXAMPLE –
MANUFACTURERS
RENAULT:
“The gross value of property, plant and equipment corresponds to historical
acquisition or production cost. Borrowing costs borne during the final preparation of
the assets for use are charged to expenses for the period they are incurred, and are
not included in the value of the asset.
basis […].”
TOYOTA MOTOR CORPORATION
“Property, plant and equipment are stated at cost. […] Depreciation of property,
plant and equipment is mainly computed on the
parent company and Japanese subsidiaries and on the straight
foreign subsidiary companies
respective assets according to general class, type of construction an
Financial Statement Reliability under IFRS: Problems with Expense Recognition
– ACCOUNTING FOR PP&E BY GLOBAL CAR
“The gross value of property, plant and equipment corresponds to historical
acquisition or production cost. Borrowing costs borne during the final preparation of
the assets for use are charged to expenses for the period they are incurred, and are
ded in the value of the asset. Depreciation is calculated on a straight
CORPORATION:
Property, plant and equipment are stated at cost. […] Depreciation of property,
plant and equipment is mainly computed on the declining-balance method for the
parent company and Japanese subsidiaries and on the straight-
foreign subsidiary companies at rates based on estimated useful lives of the
respective assets according to general class, type of construction and use
Renault applies straight-line depreciation for all its
PP&E, while Toyota applies various methods for
various assets (depending on their location)
71
: Problems with Expense Recognition
ACCOUNTING FOR PP&E BY GLOBAL CAR
“The gross value of property, plant and equipment corresponds to historical
acquisition or production cost. Borrowing costs borne during the final preparation of
the assets for use are charged to expenses for the period they are incurred, and are
Depreciation is calculated on a straight-line
Property, plant and equipment are stated at cost. […] Depreciation of property,
balance method for the
-line method for
at rates based on estimated useful lives of the
d use.”
line depreciation for all its
PP&E, while Toyota applies various methods for
various assets (depending on their location)
REAL-LIFE EXAMPLE –
MANUFACTURERS
The following information about the useful lifes assumed
selected global car manufacturers for 2008
BMW GROUP:
Factory and office buildings, distribution facilities and residential
buildings
Plant and machinery
Other equipment, factory and office equipment
DAIMLER:
Buildings and site improvements
Technical equipment and machinery
Other equipment, factory and office equipment
Financial Statement Reliability under IFRS: Problems with Expense Recognition
– ACCOUNTING FOR PP&E BY GLOBAL CAR
about the useful lifes assumed may be found in the annual reports of
selected global car manufacturers for 2008:
Factory and office buildings, distribution facilities and residential
factory and office equipment
Buildings and site improvements
Technical equipment and machinery
Other equipment, factory and office equipment
BMW seems to be more conservative than Daimler in estimating useful
lifes (although differences may be fully justified if the assets of both
companies differ significantly (e.g. in their quality and durability)
72
: Problems with Expense Recognition
ACCOUNTING FOR PP&E BY GLOBAL CAR
be found in the annual reports of
Useful life
8 to 50 years
5 to 10 years
3 to 10 years
Useful life
10 to 50 years
6 to 26 years
2 to 30 years
BMW seems to be more conservative than Daimler in estimating useful
differences may be fully justified if the assets of both
companies differ significantly (e.g. in their quality and durability)
RECOGNIZING
RELATED TO INTANGIBLE ASSETS
Financial Statement Reliability under IFRS: Problems with Expense Recognition
PART 3:
RECOGNIZING EXPENSES
RELATED TO INTANGIBLE ASSETS
73
: Problems with Expense Recognition
EXPENSES
RELATED TO INTANGIBLE ASSETS
ACCOUNTING FOR INTANGIBLES
Par. 8 of IAS 38 (Intangible assets
asset without physical substance
(a) Is separable, i.e., is capable of being separated or divided from the entity
transferred, licensed, rented or exchanged, either individually or together with a
related contract, identifiable asset or liability, regardless of whether the entity
intends to do so; or
(b) Arises from contractual or other legal rights, regardle
transferable or separable
Financial Statement Reliability under IFRS: Problems with Expense Recognition
INTANGIBLES UNDER IFRS
Intangible assets) defines an intangible asset as “identifiable non
asset without physical substance”. An intangible assets is identifiable if it eit
capable of being separated or divided from the entity
transferred, licensed, rented or exchanged, either individually or together with a
related contract, identifiable asset or liability, regardless of whether the entity
contractual or other legal rights, regardless of whether those rights are
transferable or separable from the entity or from other rights and obligations.
Intangible asset exists if it is either “separable” from
a company as a whole (e.g. brand or copyright) or it
is contractually / legally confirmed, even if it is non
transferable (e.g. non-competition agreement)
74
: Problems with Expense Recognition
identifiable non-monetary
”. An intangible assets is identifiable if it either:
capable of being separated or divided from the entity and sold,
transferred, licensed, rented or exchanged, either individually or together with a
related contract, identifiable asset or liability, regardless of whether the entity
ss of whether those rights are
from the entity or from other rights and obligations.
Intangible asset exists if it is either “separable” from
a company as a whole (e.g. brand or copyright) or it
is contractually / legally confirmed, even if it is non-
competition agreement)
ACCOUNTING FOR INTANGIBLES
From the point of view of an origination of intangible assets
1) Intangible assets purchased from third parties
(a) Separately identifiable assets (e.g. trademarks, patents, software, other licenses),
(b) Goodwill.
2) Internally developed intangibles
(a) Development costs – they are capitalized as assets and then amortized,
(b) All other internally developed intangibles (e.g. trademarks, research projects,
reputation, staff skills), which are expensed as incurred.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
INTANGIBLES UNDER IFRS
origination of intangible assets, they may be classified as:
Intangible assets purchased from third parties:
Separately identifiable assets (e.g. trademarks, patents, software, other licenses),
Internally developed intangibles:
they are capitalized as assets and then amortized,
other internally developed intangibles (e.g. trademarks, research projects,
reputation, staff skills), which are expensed as incurred.
These three classes of intangib
may be reported as assets (and then either amortized or
tested periodically for impairment)
Expenditures related to this class of intangibles are
expensed as incurred (e.g. spending on a
marketing campaign to create or strengthen a
brand). Thus, they are never reported as assets.
75
: Problems with Expense Recognition
, they may be classified as:
Separately identifiable assets (e.g. trademarks, patents, software, other licenses),
they are capitalized as assets and then amortized,
other internally developed intangibles (e.g. trademarks, research projects,
These three classes of intangibles may be recognized and thus
may be reported as assets (and then either amortized or
tested periodically for impairment)
Expenditures related to this class of intangibles are
expensed as incurred (e.g. spending on a
create or strengthen a
brand). Thus, they are never reported as assets.
ACCOUNTING FOR INTANGIBLES
From the point of view of the control over intangible assets
1) Intangible assets which may be individually controlled by an entity
copyrights, software licenses, patents, secret
they are separately identifiable and may be reported as separate assets
additional criteria are met)
2) Intangibles which cannot be controlled, although may significantly affect the value of a
business as a whole: staff skills, managerial talents, reputation as employer, customer
and supplier relationships, etc.
not recognized as separate assets.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
INTANGIBLES UNDER IFRS
control over intangible assets, they may be classified as:
Intangible assets which may be individually controlled by an entity
copyrights, software licenses, patents, secret formulas, franchise agreements, etc.
they are separately identifiable and may be reported as separate assets
additional criteria are met).
Intangibles which cannot be controlled, although may significantly affect the value of a
staff skills, managerial talents, reputation as employer, customer
and supplier relationships, etc. – they are not separately identifiable and normally are
not recognized as separate assets.
All such intangible may be reported as separate assets, if
purchased from other entities. However, not all of them may
be recognized as assets if developed internally.
These intangibles are never recognized when developed i
related expenditures are expensed as incurred). If they are purchased from other
entities (e.g. as part of the merger with other company), they constitute part of
GOODWILL (which will be discussed with details in Module 4)
76
: Problems with Expense Recognition
, they may be classified as:
Intangible assets which may be individually controlled by an entity: trademarks,
formulas, franchise agreements, etc. –
they are separately identifiable and may be reported as separate assets (if some
Intangibles which cannot be controlled, although may significantly affect the value of a
staff skills, managerial talents, reputation as employer, customer
they are not separately identifiable and normally are
All such intangible may be reported as separate assets, if
purchased from other entities. However, not all of them may
be recognized as assets if developed internally.
These intangibles are never recognized when developed internally (instead, the
related expenditures are expensed as incurred). If they are purchased from other
entities (e.g. as part of the merger with other company), they constitute part of
GOODWILL (which will be discussed with details in Module 4)
ACCOUNTING FOR INTANGIBLES
When intangible assets are acquired as part of
nor recorded in the assets of a target company), they are initially recognized at
value in accordance with IFRS 3 (
combinations requires not only a revaluatio
in its balance sheet, but also an
off-balance-sheet assets. This issue will be discussed with more details in Module 4.
Goodwill is a special type of an intangible assets, which may be recorded in a balance sheet,
even though it is not separately identifiable. This is as
business combination (e.g. merger of two companies) over the sum of fair values of
individually identifiable net assets of the acquired entity
more detail in Module 4.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
INTANGIBLES UNDER IFRS
When intangible assets are acquired as part of business combination (also those, which were
nor recorded in the assets of a target company), they are initially recognized at
in accordance with IFRS 3 (Business combinations). Thus, the accounting for business
combinations requires not only a revaluation of intangibles recorded earlier
in its balance sheet, but also an identification and valuation of any separable and identifiable
. This issue will be discussed with more details in Module 4.
type of an intangible assets, which may be recorded in a balance sheet,
even though it is not separately identifiable. This is as excess of a purchase price in a
business combination (e.g. merger of two companies) over the sum of fair values of
y identifiable net assets of the acquired entity. Goodwill will be discussed with
These are very subjective areas and may
significantly distort the quality of
financial statements.
77
: Problems with Expense Recognition
(also those, which were
nor recorded in the assets of a target company), they are initially recognized at estimated fair
). Thus, the accounting for business
earlier by a subsidiary
identification and valuation of any separable and identifiable
. This issue will be discussed with more details in Module 4.
type of an intangible assets, which may be recorded in a balance sheet,
excess of a purchase price in a
business combination (e.g. merger of two companies) over the sum of fair values of
. Goodwill will be discussed with
These are very subjective areas and may
significantly distort the quality of
financial statements.
ACCOUNTING FOR INTANGIBLES
IAS 38 requires research and development (R&D) projects to be split into the
and development phase, where:
���� Research is original and planned investigation undertaken with the prospect of gaining
new scientific or technical knowledge and understanding,
���� Development is the application of research findings or other knowledge to a plan o
design for the production of new or substantially improved materials, devices, products,
processes, systems or services before the start of commercial production or use.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
INTANGIBLES UNDER IFRS
IAS 38 requires research and development (R&D) projects to be split into the
, where:
is original and planned investigation undertaken with the prospect of gaining
new scientific or technical knowledge and understanding,
is the application of research findings or other knowledge to a plan o
design for the production of new or substantially improved materials, devices, products,
processes, systems or services before the start of commercial production or use.
PROBLEM 21: In practice, the borderline between these two
phases may be very blurred. As a result, splitting the whole
project into its research and development phases may be very
subjective, unverifiable and prone to manipulations.
78
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IAS 38 requires research and development (R&D) projects to be split into the research phase
is original and planned investigation undertaken with the prospect of gaining
is the application of research findings or other knowledge to a plan or
design for the production of new or substantially improved materials, devices, products,
processes, systems or services before the start of commercial production or use.
PROBLEM 21: In practice, the borderline between these two
blurred. As a result, splitting the whole
project into its research and development phases may be very
subjective, unverifiable and prone to manipulations.
ACCOUNTING FOR INTANGIBLES
According to par. 57 of IAS 38, in order to classify an expenditure as a development
investment (and to capitalize it as asset, instead
must prove all of the following requirements:
(a) The technical feasibility
for use or sale;
(b) Its intention to complete the intangible asset and use or sell it;
(c) Its ability to use or sell the intangible asset;
(d) How the intangible asset will generate
other things, the entity can demonstrate the
the intangible asset or the intangible asset itself or, if it is to be used internally, the
usefulness of the intangible asset
(e) The availability of adequate technical, financial and other resources
development and to use or sell the intangible asset;
(f) Its ability to measure reliably
during its development.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
INTANGIBLES UNDER IFRS
According to par. 57 of IAS 38, in order to classify an expenditure as a development
investment (and to capitalize it as asset, instead of expensing when incurred) the company
must prove all of the following requirements:
of completing the intangible asset so that it will be available
to complete the intangible asset and use or sell it;
or sell the intangible asset;
How the intangible asset will generate probable future economic benefits
other things, the entity can demonstrate the existence of a market
the intangible asset or the intangible asset itself or, if it is to be used internally, the
usefulness of the intangible asset;
adequate technical, financial and other resources
development and to use or sell the intangible asset;
measure reliably the expenditure attributable to the intangible asset
PROBLEM 21 (cont.): All these factors are very “soft”
issues, making the research / develop
very subjective, unverifiable and prone to manipulations.
79
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According to par. 57 of IAS 38, in order to classify an expenditure as a development
of expensing when incurred) the company
of completing the intangible asset so that it will be available
probable future economic benefits. Among
existence of a market for the output of
the intangible asset or the intangible asset itself or, if it is to be used internally, the
adequate technical, financial and other resources to complete the
the expenditure attributable to the intangible asset
PROBLEM 21 (cont.): All these factors are very “soft”
issues, making the research / development distinction
very subjective, unverifiable and prone to manipulations.
ACCOUNTING FOR INTANGIBLES
After all the above criteria are met, the following development
capitalized. According to par. 66
capitalization are all directly attributable costs necessary to create, produce and prepare the
asset to be capable of operating in a manner intende
Until the end of the development process, the development asset’s carrying amount is a
cumulative development expenditure incurred on it (subject, however, to annual impairment
testing). After the development process is completed (i.e. a
a new model of a car, becomes ready to bring the economic benefits
development expenditures are amortized (throughout the
resulting assets).
According to par. 63-64 of IAS 38
customer lists and items similar in substance shall not be recognized as intangible assets
(because the costs associated with developing such assets cannot be distinguished from the
costs of developing a business as a whole). Thus, the development expenditures are the only
internally generated intangibles which may be capitalized.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
INTANGIBLES UNDER IFRS
After all the above criteria are met, the following development expenditures must be
. According to par. 66-67 of IAS 38, the development costs that qualify for
capitalization are all directly attributable costs necessary to create, produce and prepare the
asset to be capable of operating in a manner intended by management.
Until the end of the development process, the development asset’s carrying amount is a
cumulative development expenditure incurred on it (subject, however, to annual impairment
testing). After the development process is completed (i.e. after the asset, e.g. a new drug or
becomes ready to bring the economic benefits
development expenditures are amortized (throughout the expected useful life
64 of IAS 38, internally generated brands, mastheads, publishing titles,
customer lists and items similar in substance shall not be recognized as intangible assets
(because the costs associated with developing such assets cannot be distinguished from the
loping a business as a whole). Thus, the development expenditures are the only
internally generated intangibles which may be capitalized.
PROBLEM 22: Capitalized development expenditures call for estimating the
lifes, which may be very subjective, unverifiable and prone to manipulations (and
usually is much more difficult than in the case of PP&E).
80
: Problems with Expense Recognition
expenditures must be
67 of IAS 38, the development costs that qualify for
capitalization are all directly attributable costs necessary to create, produce and prepare the
d by management.
Until the end of the development process, the development asset’s carrying amount is a
cumulative development expenditure incurred on it (subject, however, to annual impairment
fter the asset, e.g. a new drug or
becomes ready to bring the economic benefits), the capitalized
expected useful life of the
, internally generated brands, mastheads, publishing titles,
customer lists and items similar in substance shall not be recognized as intangible assets
(because the costs associated with developing such assets cannot be distinguished from the
loping a business as a whole). Thus, the development expenditures are the only
PROBLEM 22: Capitalized development expenditures call for estimating their useful
lifes, which may be very subjective, unverifiable and prone to manipulations (and
usually is much more difficult than in the case of PP&E).
ACCOUNTING FOR INTANGIBLES UNDER IFRS
From the point of view of the intangible asset’s useful life
1) Intangible assets having finite useful life
over that useful life. The principles of amortization are similar to depreciation of PP&E
and the following two models are permitted:
- A cost model, where assets are amortized (with a straight
natural amortization) from their initial depreciable amount (i.e. the difference
between an initial cost and residual value),
- A revaluation model, where assets are periodically revalued to fair values and then
amortized (however, this model
market prices on active markets).
2) Intangible assets having indefinite useful life
possibility to determine the expected limit of the period during which the
expected to generate economic benefits. Such assets are not amortized, instead they
are regularly (at least annually)
Financial Statement Reliability under IFRS: Problems with Expense Recognition
ACCOUNTING FOR INTANGIBLES UNDER IFRS
intangible asset’s useful life, they may be classified as:
Intangible assets having finite useful life, e.g. a 20-year patent – they must be
. The principles of amortization are similar to depreciation of PP&E
and the following two models are permitted:
, where assets are amortized (with a straight-line or
natural amortization) from their initial depreciable amount (i.e. the difference
between an initial cost and residual value),
, where assets are periodically revalued to fair values and then
amortized (however, this model is permitted only for rare intangibles with observable
market prices on active markets).
Intangible assets having indefinite useful life, e.g. a brand – in their case there is no
possibility to determine the expected limit of the period during which the
expected to generate economic benefits. Such assets are not amortized, instead they
are regularly (at least annually) tested for impairment.
PROBLEM 22 (cont.): The estimates of useful lifes of intangibles may
be very subjective, unverifiable and prone to
usually is much more difficult than in the case of PP&E).
PROBLEM 23: Such intangibles are not amortized, so there is
no any expense related to them in an income
long as they are not impaired). 81
: Problems with Expense Recognition
, they may be classified as:
they must be amortized
. The principles of amortization are similar to depreciation of PP&E
line or accelerated or
natural amortization) from their initial depreciable amount (i.e. the difference
, where assets are periodically revalued to fair values and then
is permitted only for rare intangibles with observable
in their case there is no
possibility to determine the expected limit of the period during which the asset is
expected to generate economic benefits. Such assets are not amortized, instead they
PROBLEM 22 (cont.): The estimates of useful lifes of intangibles may
be very subjective, unverifiable and prone to manipulations (and
usually is much more difficult than in the case of PP&E).
PROBLEM 23: Such intangibles are not amortized, so there is
no any expense related to them in an income statement (as
long as they are not impaired).
ACCOUNTING FOR INTANGIBLES UNDER IFRS
The non-zero residual value of an intangible asset
following conditions is met:
���� There is a commitment by a third party
or
���� There is an active market for that type of intangible asset
measured reliably by reference to that market and it is probable that such a market will
exist at the end of the useful life.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
ACCOUNTING FOR INTANGIBLES UNDER IFRS
zero residual value of an intangible asset may be assumed only when either of the
commitment by a third party to acquire the asset at the end of its useful life,
active market for that type of intangible asset, and residual value can be
measured reliably by reference to that market and it is probable that such a market will
e useful life.
Such circumstances are very rare. Thus,
intangibles are usually assumed to have zero
residual values.
82
: Problems with Expense Recognition
may be assumed only when either of the
to acquire the asset at the end of its useful life,
, and residual value can be
measured reliably by reference to that market and it is probable that such a market will
Such circumstances are very rare. Thus,
intangibles are usually assumed to have zero
PROBLEMS WITH CAPITALIZATION OF DEVELOPMENT COSTS
The required capitalization of development expenditures brings the following problems
���� High subjectivity and limited v
already in its development phase
���� Large scope for manipulations in
laboratories, salaries of designers, etc.) between various R&D projects,
���� High subjectivity and limited verifiability of the
the new models of cars, mobile phones, etc.),
���� Lack of any economic relationship
development expenditures (which include only part of their historical expenditures) and
the actual fair value of the cr
Financial Statement Reliability under IFRS: Problems with Expense Recognition
PROBLEMS WITH CAPITALIZATION OF DEVELOPMENT COSTS
required capitalization of development expenditures brings the following problems
High subjectivity and limited verifiability of the criteria for stating if the project is
already in its development phase (or still in a research phase),
Large scope for manipulations in allocation of all R&D expenditures
laboratories, salaries of designers, etc.) between various R&D projects,
High subjectivity and limited verifiability of the useful lifes for many intangibles
the new models of cars, mobile phones, etc.),
Lack of any economic relationship between the carrying amount of the capitalized
development expenditures (which include only part of their historical expenditures) and
the actual fair value of the created intangible assets.
All these factors may significantly reduce the reliability and
comparability of financial statements of those companies
which invest intensively into R&D.
83
: Problems with Expense Recognition
PROBLEMS WITH CAPITALIZATION OF DEVELOPMENT COSTS
required capitalization of development expenditures brings the following problems:
criteria for stating if the project is
allocation of all R&D expenditures (e.g. costs of
laboratories, salaries of designers, etc.) between various R&D projects,
useful lifes for many intangibles (e.g.
between the carrying amount of the capitalized
development expenditures (which include only part of their historical expenditures) and
significantly reduce the reliability and
comparability of financial statements of those companies
which invest intensively into R&D.
REAL-LIFE EXAMPLE –
BY GLOBAL CAR MANUFACTURERS
The following descriptive information
be found in the annual reports of selected global car manufacturers for 2008:
VOLKSWAGEN GROUP:
“In accordance with IAS 38, research costs are recognized as expenses when incurred.
Development costs for future series products and other internally generated
intangible assets are capitalized at cost, provided manufacture of the products is
likely to bring the Volkswagen Group an economic benefit. If the criteria for
recognition as assets are not met, the expenses are recognized in the income
statement in the year in which they are incurred.
include all direct and indirect costs that are directly attributable to the development
process. Borrowing costs are n
straight-line method from the start of production over the expected life cycle of the
models or powertrains developed
Financial Statement Reliability under IFRS: Problems with Expense Recognition
– ACCOUNTING FOR DEVELOPMENT COSTS
BY GLOBAL CAR MANUFACTURERS
information, related to capitalization of development expenditures,
be found in the annual reports of selected global car manufacturers for 2008:
In accordance with IAS 38, research costs are recognized as expenses when incurred.
Development costs for future series products and other internally generated
intangible assets are capitalized at cost, provided manufacture of the products is
likely to bring the Volkswagen Group an economic benefit. If the criteria for
ts are not met, the expenses are recognized in the income
statement in the year in which they are incurred. Capitalized development costs
include all direct and indirect costs that are directly attributable to the development
. Borrowing costs are not capitalized. The costs are amortized
line method from the start of production over the expected life cycle of the
models or powertrains developed – generally between five and ten years
Company capitalizes both direct and indirect development
costs. Then, the capitalized development costs are
amortized through five to ten years.
84
: Problems with Expense Recognition
ACCOUNTING FOR DEVELOPMENT COSTS
, related to capitalization of development expenditures, may
be found in the annual reports of selected global car manufacturers for 2008:
In accordance with IAS 38, research costs are recognized as expenses when incurred.
Development costs for future series products and other internally generated
intangible assets are capitalized at cost, provided manufacture of the products is
likely to bring the Volkswagen Group an economic benefit. If the criteria for
ts are not met, the expenses are recognized in the income
Capitalized development costs
include all direct and indirect costs that are directly attributable to the development
The costs are amortized using the
line method from the start of production over the expected life cycle of the
generally between five and ten years.”
Company capitalizes both direct and indirect development
costs. Then, the capitalized development costs are
amortized through five to ten years.
REAL-LIFE EXAMPLE –
BY GLOBAL CAR MANUFACTURERS
BMW GROUP:
“Research costs and development costs which are not capitalized are recognized as
an expense when incurred. Development costs for vehicle and engine projects are
capitalized at manufacturing cost, to the extent that costs can be allocated reliably
and both technical feasibility and successful marketing are assured. It must also be
probable that the development expenditure will generate future economic benefits.
Capitalized development costs comprise all expenditure that can be attributed
directly to the development process, including development
Capitalized development costs are amortized
commencement of production, over the estimated product life
seven years.”
Financial Statement Reliability under IFRS: Problems with Expense Recognition
– ACCOUNTING FOR DEVELOPMENT CO
BY GLOBAL CAR MANUFACTURERS
Research costs and development costs which are not capitalized are recognized as
an expense when incurred. Development costs for vehicle and engine projects are
capitalized at manufacturing cost, to the extent that costs can be allocated reliably
technical feasibility and successful marketing are assured. It must also be
probable that the development expenditure will generate future economic benefits.
Capitalized development costs comprise all expenditure that can be attributed
lopment process, including development-related overheads
Capitalized development costs are amortized on a systematic basis, following the
commencement of production, over the estimated product life which is generally
Similarly as VW, BMW capitalizes both direct and indirect development
costs. However, it claims to apply less varying amortization periods
(“generally seven years”, instead of “between five and ten years”.
85
: Problems with Expense Recognition
ACCOUNTING FOR DEVELOPMENT COSTS
Research costs and development costs which are not capitalized are recognized as
an expense when incurred. Development costs for vehicle and engine projects are
capitalized at manufacturing cost, to the extent that costs can be allocated reliably
technical feasibility and successful marketing are assured. It must also be
probable that the development expenditure will generate future economic benefits.
Capitalized development costs comprise all expenditure that can be attributed
related overheads.
on a systematic basis, following the
which is generally
Similarly as VW, BMW capitalizes both direct and indirect development
costs. However, it claims to apply less varying amortization periods
(“generally seven years”, instead of “between five and ten years”.
REAL-LIFE EXAMPLE –
BY GLOBAL CAR MANUFACTURERS
PSA PEUGEOT / CITROEN:
“Development expenditure
gearboxes) incurred between the project launch (corresponding to the styling
decision for vehicles) and the start
intangible assets. It is amortized from the s
useful life, representing up to seven years for vehicles and ten years for mechanical
assemblies. The capitalized amount mainly comprises payroll costs of personnel
directly assigned to the project, the cost of prot
services related to the project.
rent, building depreciation and information system utilization costs
The company seems to apply amortization periods for capitalized
costs, which are comparable to VW and BMW (seven to ten years). However, in
contrast to its German competitors, it capitalizes only direct costs (payroll,
prototypes, etc.) and expensed the indirect development costs as they are incurred.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
– ACCOUNTING FOR DEVELOPMENT COSTS
BY GLOBAL CAR MANUFACTURERS
Development expenditure on vehicles and mechanical assemblies (engines and
gearboxes) incurred between the project launch (corresponding to the styling
decision for vehicles) and the start-up of pre-series production is recognized in
is amortized from the start-of-production date over the asset’s
useful life, representing up to seven years for vehicles and ten years for mechanical
. The capitalized amount mainly comprises payroll costs of personnel
directly assigned to the project, the cost of prototypes and the cost of external
services related to the project. No overheads or indirect costs are included, such as
rent, building depreciation and information system utilization costs.”
The company seems to apply amortization periods for capitalized
costs, which are comparable to VW and BMW (seven to ten years). However, in
contrast to its German competitors, it capitalizes only direct costs (payroll,
prototypes, etc.) and expensed the indirect development costs as they are incurred.
86
: Problems with Expense Recognition
ACCOUNTING FOR DEVELOPMENT COSTS
on vehicles and mechanical assemblies (engines and
gearboxes) incurred between the project launch (corresponding to the styling
series production is recognized in
production date over the asset’s
useful life, representing up to seven years for vehicles and ten years for mechanical
. The capitalized amount mainly comprises payroll costs of personnel
otypes and the cost of external
No overheads or indirect costs are included, such as
”
The company seems to apply amortization periods for capitalized development
costs, which are comparable to VW and BMW (seven to ten years). However, in
contrast to its German competitors, it capitalizes only direct costs (payroll,
prototypes, etc.) and expensed the indirect development costs as they are incurred.
REAL-LIFE EXAMPLE –
BY GLOBAL CAR MANUFACTURERS
DAIMLER:
“Development costs are recognized if the conditions for capitalization according to
IAS 38 are met. Subsequent to initial recognition, the asset is carried at cost less
accumulated amortization and accumulated impairment losses.
development costs include all direct costs and allocable overheads and are amortized
over the expected product life cycle (2 to 10 years)
Similarly as VW and BMW, DAIMLER capitalizes both direct and (allocable) indirect
development costs. However, it applies much wi
(two to ten years), as compared to VW (five to ten years) and BMW (which claims
Financial Statement Reliability under IFRS: Problems with Expense Recognition
– ACCOUNTING FOR DEVELOPMENT COSTS
BY GLOBAL CAR MANUFACTURERS
Development costs are recognized if the conditions for capitalization according to
IAS 38 are met. Subsequent to initial recognition, the asset is carried at cost less
accumulated amortization and accumulated impairment losses.
s include all direct costs and allocable overheads and are amortized
over the expected product life cycle (2 to 10 years).”
Similarly as VW and BMW, DAIMLER capitalizes both direct and (allocable) indirect
development costs. However, it applies much wider range of amortization periods
(two to ten years), as compared to VW (five to ten years) and BMW (which claims
to apply a single period of seven years).
.
87
: Problems with Expense Recognition
ACCOUNTING FOR DEVELOPMENT COSTS
Development costs are recognized if the conditions for capitalization according to
IAS 38 are met. Subsequent to initial recognition, the asset is carried at cost less
accumulated amortization and accumulated impairment losses. Capitalized
s include all direct costs and allocable overheads and are amortized
Similarly as VW and BMW, DAIMLER capitalizes both direct and (allocable) indirect
der range of amortization periods
(two to ten years), as compared to VW (five to ten years) and BMW (which claims
REAL-LIFE EXAMPLE –
BY GLOBAL CAR MANUFACTURERS
RENAULT:
“Development expenses incurred between the approval of the decision to begin
development and implement production facilities for a new vehicle or part (e.g.
engine or gearbox) and the subsequent approval of the design for mass production
are capitalized as intangible assets.
the date of approval for production,
part, up to a maximum period of seven years
mainly comprise the cost of prototypes, the cost of studies invoiced by external firms,
and a share of overheads dedicated exclusively to development activities
Company capitalizes both direct and indirect development expenditures, similarly as most of its
competitors (except for PEUGEOT, which capitalizes only direct costs). However, RENAULT sets
the maximum amortization period at seven years, which is shorter than in the case of some of
its competitors (e.g. VW or DAIMLER, where the maximum period is ten years).
Financial Statement Reliability under IFRS: Problems with Expense Recognition
– ACCOUNTING FOR DEVELOPMENT COSTS
BY GLOBAL CAR MANUFACTURERS
Development expenses incurred between the approval of the decision to begin
development and implement production facilities for a new vehicle or part (e.g.
engine or gearbox) and the subsequent approval of the design for mass production
intangible assets. They are amortized on a straight
the date of approval for production, over the expected market life of the vehicle or
part, up to a maximum period of seven years. Capitalized development expenses
of prototypes, the cost of studies invoiced by external firms,
share of overheads dedicated exclusively to development activities
Company capitalizes both direct and indirect development expenditures, similarly as most of its
(except for PEUGEOT, which capitalizes only direct costs). However, RENAULT sets
the maximum amortization period at seven years, which is shorter than in the case of some of
its competitors (e.g. VW or DAIMLER, where the maximum period is ten years).
.
88
: Problems with Expense Recognition
ACCOUNTING FOR DEVELOPMENT COSTS
Development expenses incurred between the approval of the decision to begin
development and implement production facilities for a new vehicle or part (e.g.
engine or gearbox) and the subsequent approval of the design for mass production
on a straight-line basis from
over the expected market life of the vehicle or
. Capitalized development expenses
of prototypes, the cost of studies invoiced by external firms,
share of overheads dedicated exclusively to development activities.”
Company capitalizes both direct and indirect development expenditures, similarly as most of its
(except for PEUGEOT, which capitalizes only direct costs). However, RENAULT sets
the maximum amortization period at seven years, which is shorter than in the case of some of
its competitors (e.g. VW or DAIMLER, where the maximum period is ten years).
IMPAIRMENT TESTING OF
Financial Statement Reliability under IFRS: Problems with Expense Recognition
PART 4:
IMPAIRMENT TESTING OF
89
: Problems with Expense Recognition
ASSETS
IMPAIRMENT TESTING
The purpose of impairment testing is to
recovered in the future, by either
Impairment occurs when the asset’s recoverable amount falls below its current carrying
amount.
According to IAS 36, the following assets must be tested for impairment:
(a) Assets in which case there exists some
when such indication occurs)
(b) Intangible assets which are not
- Intangibles with indefinite useful lifes (e.g. brands),
- Intangibles assets not yet available for use (i.e. development costs of projects in
progress),
- Goodwill recognized on business combinations.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
IMPAIRMENT TESTING UNDER IFRS
The purpose of impairment testing is to check if the asset’s carrying amount may be
, by either the use of an asset or its disposal.
occurs when the asset’s recoverable amount falls below its current carrying
According to IAS 36, the following assets must be tested for impairment:
Assets in which case there exists some indication of impairment
dication occurs)
Intangible assets which are not amortized (they must be tested annually):
Intangibles with indefinite useful lifes (e.g. brands),
Intangibles assets not yet available for use (i.e. development costs of projects in
nized on business combinations.
Thus, the impairment testing assumes that the
benefits from an asset may be recovered through
either its sale or its use (depending on which is
more beneficial for an asset’s owner).
90
: Problems with Expense Recognition
check if the asset’s carrying amount may be
occurs when the asset’s recoverable amount falls below its current carrying
According to IAS 36, the following assets must be tested for impairment:
indication of impairment (they must be tested
(they must be tested annually):
Intangibles assets not yet available for use (i.e. development costs of projects in
Thus, the impairment testing assumes that the
benefits from an asset may be recovered through
either its sale or its use (depending on which is
more beneficial for an asset’s owner).
IMPAIRMENT TESTING UNDER IFRS
IAS 36 provides two groups of basic (minimum) indications of impairment:
1) External sources of information:
- Market value, e.g. when market prices of similar assets declined significantly in
recent past,
- Entity’s environment / market
expected to occur in the technological, market, economic or legal environment in
which the entity operates,
- Interest rates, e.g. when market interest r
- Market capitalization, e.g. when the observed market value of a company (for
instance, on a stock market) falls below the book value of its net assets.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
IMPAIRMENT TESTING UNDER IFRS
IAS 36 provides two groups of basic (minimum) indications of impairment:
External sources of information:
, e.g. when market prices of similar assets declined significantly in
Entity’s environment / market, e.g. when significant adverse changes occurred or are
expected to occur in the technological, market, economic or legal environment in
which the entity operates,
e.g. when market interest rates grew significantly in the recent past,
, e.g. when the observed market value of a company (for
instance, on a stock market) falls below the book value of its net assets.
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IAS 36 provides two groups of basic (minimum) indications of impairment:
, e.g. when market prices of similar assets declined significantly in the
, e.g. when significant adverse changes occurred or are
expected to occur in the technological, market, economic or legal environment in
ates grew significantly in the recent past,
, e.g. when the observed market value of a company (for
instance, on a stock market) falls below the book value of its net assets.
IMPAIRMENT TESTING UNDER IFRS
IAS 36 provides two groups of basic (minimum) indications of impairment:
2) Internal sources of information:
- Obsolescence or physical damage of an asset
- Changes use within an entity
capacity,
- Economic performance of the
the asset are significantly higher than expected or actual cash inflows and profits are
lower than expected.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
IMPAIRMENT TESTING UNDER IFRS
groups of basic (minimum) indications of impairment:
sources of information:
Obsolescence or physical damage of an asset,
Changes use within an entity, e.g. when an asset becomes idle as a result of excess
Economic performance of the asset, e.g. when actual cash flows for maintenance of
the asset are significantly higher than expected or actual cash inflows and profits are
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groups of basic (minimum) indications of impairment:
, e.g. when an asset becomes idle as a result of excess
e.g. when actual cash flows for maintenance of
the asset are significantly higher than expected or actual cash inflows and profits are
IMPAIRMENT TESTING UNDER IFRS
The impairment test involves comparing the carrying amount of an asset with its
amount.
The recoverable amount of an asset or a cash
less costs to sell and its value in use
Fair value less costs to sell is the amount
generating unit in an arm’s length transaction between knowledgeable, willing parties, less
the costs of disposal.
Costs of disposal are incremental costs directly attributable to the disposal of an asset or
cash-generating unit, excluding finance costs and income tax expense.
Value in use is the present value of the future cash flows expected to be derived
asset or cash-generating unit.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
IMPAIRMENT TESTING UNDER IFRS
involves comparing the carrying amount of an asset with its
of an asset or a cash-generating unit is the higher of its
value in use.
is the amount obtainable from the sale
in an arm’s length transaction between knowledgeable, willing parties, less
are incremental costs directly attributable to the disposal of an asset or
generating unit, excluding finance costs and income tax expense.
present value of the future cash flows expected to be derived
PROBLEM 24: Fair value less costs to sale calls
for estimating the probable
from the sale of an asset. Such estimates call
for many assumptions, which are often
subjective and difficult to verify.
PROBLEM 25: Value in use calls for forecasts
of future cash flows, obtainable from an
asset. Such forecasts are usually very
subjective and difficult to verify.
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involves comparing the carrying amount of an asset with its recoverable
generating unit is the higher of its fair value
of an asset or cash-
in an arm’s length transaction between knowledgeable, willing parties, less
are incremental costs directly attributable to the disposal of an asset or
present value of the future cash flows expected to be derived from an
PROBLEM 24: Fair value less costs to sale calls
for estimating the probable amount, obtainable
from the sale of an asset. Such estimates call
for many assumptions, which are often
subjective and difficult to verify.
PROBLEM 25: Value in use calls for forecasts
of future cash flows, obtainable from an
asset. Such forecasts are usually very
subjective and difficult to verify.
IMPAIRMENT TESTING UNDER IFRS
IFRS 13 provides a fair value input hierarchy
inputs based on the extent to which they are based on observable data. According to this
hierarchy there are following three levels of inputs:
���� Level 1 Inputs (Directly Observable)
that the reporting entity has the ability to access at the measurement date,
���� Level 2 Inputs (Indirectly Observable)
markets for similar assets, q
active, inputs other than quoted prices (e.g. interest rates, yield curves, credit risks,
volatilities) or “market corroborated inputs”,
���� Level 3 Inputs (Unobservable)
own assumptions about the assumptions market participants would make.
If there is an active market for the asset tested for impairment, the fair value is the observed
market price (Level 1 Input). If Level 1 is no
determined by adjusting observable prices
Level 1 nor Level 2 is available, the estimate of fair value should be determined using
valuation techniques.
Financial Statement Reliability under IFRS: Problems with Expense Recognition
IMPAIRMENT TESTING UNDER IFRS
fair value input hierarchy to serve as a framework for classifying valuation
on the extent to which they are based on observable data. According to this
hierarchy there are following three levels of inputs:
Level 1 Inputs (Directly Observable) – Quoted prices in active markets for identical assets
that the reporting entity has the ability to access at the measurement date,
Level 2 Inputs (Indirectly Observable) – Directly or indirectly observable prices in active
, quoted prices for identical or similar items in markets that are not
active, inputs other than quoted prices (e.g. interest rates, yield curves, credit risks,
volatilities) or “market corroborated inputs”,
Level 3 Inputs (Unobservable) – Inputs that are unobservable and that reflect
about the assumptions market participants would make.
If there is an active market for the asset tested for impairment, the fair value is the observed
market price (Level 1 Input). If Level 1 is not available, the estimate of fair value
adjusting observable prices of market transactions for similar assets
Level 1 nor Level 2 is available, the estimate of fair value should be determined using
PROBLEM 24 (cont.): Level 1 inputs are rarely
available. Level 2 and
to find, but they are much more subjective,
difficult to verify and prone to manipulations.
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to serve as a framework for classifying valuation
on the extent to which they are based on observable data. According to this
Quoted prices in active markets for identical assets
that the reporting entity has the ability to access at the measurement date,
Directly or indirectly observable prices in active
in markets that are not
active, inputs other than quoted prices (e.g. interest rates, yield curves, credit risks,
nobservable and that reflect management’s
about the assumptions market participants would make.
If there is an active market for the asset tested for impairment, the fair value is the observed
the estimate of fair value should be
for similar assets. If neither
Level 1 nor Level 2 is available, the estimate of fair value should be determined using other
PROBLEM 24 (cont.): Level 1 inputs are rarely
available. Level 2 and Level 3 inputs are easier
to find, but they are much more subjective,
difficult to verify and prone to manipulations.
IMPAIRMENT TESTING UNDER IFRS
Value in use is the present value of future cash flows
According to par. 30 of IAS 36, the following five elements must be reflected in the
calculation of the value in use:
(a) An estimate of the future cash flows the entity expects to derive
(b) Expectations about possible variations
flows,
(c) The time value of money, represented by the
interest,
(d) The price for bearing the uncertainty inherent
premium),
(e) Other factors, such as illiquidity, that
future cash flows the entity expects to derive from the asset.
PROBLEM 25 (cont.): Value in use calls for estimates of discount rates, which take into account not
only a risk-free rate (which may be quite objective), but also adjustments for various risks specific for
a tested asset. Such estimates are almost
Financial Statement Reliability under IFRS: Problems with Expense Recognition
IMPAIRMENT TESTING UNDER IFRS
present value of future cash flows relating to the asset being measured.
According to par. 30 of IAS 36, the following five elements must be reflected in the
future cash flows the entity expects to derive
Expectations about possible variations in the amount or timing of those future cash
The time value of money, represented by the current market risk
The price for bearing the uncertainty inherent in the asset (i.e. an
, such as illiquidity, that market participants would reflect
future cash flows the entity expects to derive from the asset.
PROBLEM 25 (cont.): Value in use calls for forecasts
of future cash flows, but also for estimates of
variability (risks) related to those expected cash
flows. Such long-run predictions are always heavily
subjective and extremely difficult
PROBLEM 25 (cont.): Value in use calls for estimates of discount rates, which take into account not
free rate (which may be quite objective), but also adjustments for various risks specific for
a tested asset. Such estimates are almost always very subjective and difficult to verify.95
: Problems with Expense Recognition
relating to the asset being measured.
According to par. 30 of IAS 36, the following five elements must be reflected in the
future cash flows the entity expects to derive from the asset,
in the amount or timing of those future cash
current market risk-free rate of
in the asset (i.e. an expected risk
market participants would reflect in pricing the
PROBLEM 25 (cont.): Value in use calls for forecasts
of future cash flows, but also for estimates of
variability (risks) related to those expected cash
run predictions are always heavily
subjective and extremely difficult to verify.
PROBLEM 25 (cont.): Value in use calls for estimates of discount rates, which take into account not
free rate (which may be quite objective), but also adjustments for various risks specific for
always very subjective and difficult to verify.
REAL-LIFE EXAMPLE
VOLKSWAGEN GROUP
The following descriptive information
annual report of Volkswagen Group
“As a result of improved earnings prospects, impairment losses amounting to
million on several joint ventures attributable to the Automotive Division that were
recognized in previous years were reversed in the past fiscal year. Value in
estimated using a discount factor of 9.4% (previous year: 13%)
Company
cash flows. Reduction of the discount rate boosts the obtained estimate of the
recoverable amount.
in 2008 (9.4%) has been deliberately understated, the scope of its reduction
clearly helped in reversing previous impairment (which depressed earnings
Financial Statement Reliability under IFRS: Problems with Expense Recognition
LIFE EXAMPLE – IMPAIRMENT TESTING OF ASSETS BY
VOLKSWAGEN GROUP
The following descriptive information, related to value-in-use estimates,
Volkswagen Group for 2008 (page 229):
As a result of improved earnings prospects, impairment losses amounting to
million on several joint ventures attributable to the Automotive Division that were
recognized in previous years were reversed in the past fiscal year. Value in
discount factor of 9.4% (previous year: 13%).”
Company significantly reduced the discount rate used in discounting forecasted
cash flows. Reduction of the discount rate boosts the obtained estimate of the
recoverable amount. Although it cannot be claimed that the discount rate used
in 2008 (9.4%) has been deliberately understated, the scope of its reduction
clearly helped in reversing previous impairment (which depressed earnings
reported for 2007, but boosted earnings reported for 2008).
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IMPAIRMENT TESTING OF ASSETS BY
may be found in the
As a result of improved earnings prospects, impairment losses amounting to €106
million on several joint ventures attributable to the Automotive Division that were
recognized in previous years were reversed in the past fiscal year. Value in use was
significantly reduced the discount rate used in discounting forecasted
cash flows. Reduction of the discount rate boosts the obtained estimate of the
Although it cannot be claimed that the discount rate used
in 2008 (9.4%) has been deliberately understated, the scope of its reduction
clearly helped in reversing previous impairment (which depressed earnings
d for 2008).
REAL-LIFE EXAMPLE
ASSECO GROUP
The following descriptive information
annual report of Asseco Group (the sixth largest IT company in Europe) for 2011
“The Group carried out a sensitivity analysis […] in relation to […] impairment test
conducted as at 31 December 2011, in order to find out how much the selected
parameters applied in the model
of cash-generating units equaled the net book value of operating assets.
The sensitivity analysis examined the impact of changes in the applied:
a) discount rate, and
b) percentage growth of sales revenues,
as factors with influence on the recoverable value of a cash
assuming other factors remain unchanged.
The results of the conducted sensitivity analysis are presented in the table below:”
Financial Statement Reliability under IFRS: Problems with Expense Recognition
LIFE EXAMPLE – IMPAIRMENT TESTING OF ASSETS BY
The following descriptive information, related to value-in-use estimates,
(the sixth largest IT company in Europe) for 2011
The Group carried out a sensitivity analysis […] in relation to […] impairment test
conducted as at 31 December 2011, in order to find out how much the selected
parameters applied in the model could be changed so that the estimated value in use
generating units equaled the net book value of operating assets.
The sensitivity analysis examined the impact of changes in the applied:
percentage growth of sales revenues,
as factors with influence on the recoverable value of a cash-
assuming other factors remain unchanged.
The results of the conducted sensitivity analysis are presented in the table below:”
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IMPAIRMENT TESTING OF ASSETS BY
may be found in the
(the sixth largest IT company in Europe) for 2011 (page 96):
The Group carried out a sensitivity analysis […] in relation to […] impairment test
conducted as at 31 December 2011, in order to find out how much the selected
could be changed so that the estimated value in use
generating units equaled the net book value of operating assets.
The sensitivity analysis examined the impact of changes in the applied:
-generating unit,
The results of the conducted sensitivity analysis are presented in the table below:”
REAL-LIFE EXAMPLE
ASSECO GROUP
Asseco Central Europe Group
Asseco South Eastern Europe Group
Magic Software Enterprises Ltd.
Matrix IT Ltd.
Asseco Germany A.G.
Matrix42 A.G.
Asseco Spain S.A.
Necomplus S.L.
Combidata Poland Group
Asseco Denmark
Sintagma UAB
Gladstone Consulting Ltd
ADH-Soft Sp. z o.o.
ZUI OTAGO Sp. z o.o.
In impairment tests for those assets, the parameters applied in the test (estimate of value in
use) were close to their “frontiers” (labeled by Asseco as “terminal rates”). It means that the
Financial Statement Reliability under IFRS: Problems with Expense Recognition
LIFE EXAMPLE – IMPAIRMENT TESTING OF ASSETS BY
Discount rate Sales revenue growth rate
Applied in
the model
Terminal
rate
Applied in
the model
Asseco Central Europe Group 7.7% 10.5% 2.5%
Asseco South Eastern Europe Group 11.7% 15.9% 7.4%
Magic Software Enterprises Ltd. 5.4% 9.3% 8.4%
5.7% 11.3% 3.1%
7.0% 9.3% 6.1%
7.5% 8.9% 8.3%
9.8% 10.4% 20.0%
9.8% 12.4% 4.6%
8.2% 8.9% -
8.0% 18.7% 2.0%
11.7% 11.8% 5.9%
9.1% 12.4% -
10.0% 30.5% 4.5%
10.0% 14.6% 3.1%
In impairment tests for those assets, the parameters applied in the test (estimate of value in
use) were close to their “frontiers” (labeled by Asseco as “terminal rates”). It means that the
estimated recoverable amounts were only marginally higher that th
amounts. Small change of subjective assumptions would result in impairment.
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IMPAIRMENT TESTING OF ASSETS BY
Sales revenue growth rate
Applied in
model
Terminal
rate
(0.7%)
1.6%
(3.2%)
(6.6%)
4.5%
7.8%
18.3%
(0.5%)
(2.9%)
(15.5%)
3.8%
(4.2%)
(9.0%)
(6.0%)
In impairment tests for those assets, the parameters applied in the test (estimate of value in
use) were close to their “frontiers” (labeled by Asseco as “terminal rates”). It means that the
estimated recoverable amounts were only marginally higher that the tested carrying
amounts. Small change of subjective assumptions would result in impairment.
FOR YOUR ATTENTION
Financial Statement Reliability under IFRS: Problems with Expense Recognition
THANK YOU
FOR YOUR ATTENTION
Dr Jacek Welc:
99
: Problems with Expense Recognition
FOR YOUR ATTENTION
Dr Jacek Welc: