IFRS Gaining Momentum
The business world has become increasingly flat with less geographic hurdles for people and companies to trade and invest. Since many companies here in the U.S. operate and invest globally, a need for standard accounting and performance measurement between national general accepted accounting principles (“GAAP”) has become essential.
The International Accounting Standards Board (“IASB”) has published its standards in a series of pronouncements called International Financial Reporting Standards (“IFRS”) in an attempt to establish global GAAPs. The acceptance of IFRS has been gaining momentum across the globe. According to the American Institute of Certified Public Accountants, approximately 120 nations and reporting jurisdictions permit or require IFRS for domestic listed companies.1 See map below.
The Security and Exchange Commission (“SEC”) continues to move forward with a work plan to consider specific areas and factors relevant to a determination as to whether, when, and, how the current financial reporting system for U.S. companies should be transitioned to a system incorporating IFRS.2 In the event the SEC determines a convergence of IFRS is needed, the Financial Accounting Standards Board (”FASB”) would be the standard-setting body responsible for promulgating U.S. GAAP under the framework.
Some sort of convergence of IFRS into the U.S. financial reporting system appears to be inevitable. The transition will affect many areas of accounting including accounting for fixed assets.
IAS 16 and Componentization
The International Accounting Standards section 16 (“IAS 16”) within IFRS outlines the requirements and concepts related to the accounting for property, plant, and equipment (“PP&E”). This article focuses on one of the most significant aspects of implementing IAS 16, componentization. Componentization is the requirement that each part of an item of property, plant, and equipment with a cost that is significant in relation to the total cost of the item shall be depreciated separately.3 It is similar to a cost segregation study performed for tax purposes, where different components of a building are separated into different tax lives to take advantage of accelerated depreciation.
Componentization, which is allowed but not required under U.S. GAAP, will require an entity to allocate the amount initially recognized as an item of PP&E to its significant parts and separately depreciate each such part. For example, most U.S. companies would account for a new building on a composite basis, with one asset entry on the fixed asset register with a typical life of 40 years. However, the theory behind componentization is that a major asset such as a building, or some manufacturing equipment, will have significant parts; and these significant parts may or may not have different useful lives.
In the example of the building, the building’s protective roofing and the HVAC system might be considered major components, and both would have lives shorter than 40 years. The values and lives of these components would be identified and booked separately under the componentization requirement.
Componentizing assets could result in an impact to the income statement. To continue the building example, while the depreciation expense for the shorter lived components (protective roofing and HVAC system) would be accelerated, the useful life of the building structure would increase to something greater than 40 years and as a result the depreciation expense of this larger component would be decelerated.
Two Key Areas for Concern
The difference between financial and tax accounting for fixed assets and how fixed asset software accommodates those differences are two key concerns.
Tax vs. Book Accounting. In Fedex Corp. v. United States, 291 F. Supp.2d 699 (W.D. Tenn. 2003), aff’d, 412 F.3d617 (6th Cir. 2005) the taxpayer performed repairs on jet engines by removing them from the airplane and then having parts replaced. The taxpayer argued that these expenses were deductible, but the Internal Revenue Service (”IRS”) stated that the costs should be capitalized. The court held that the inspection and replacement costs could be deducted because the improvements did not add to the value and did not prolong the life of the airplanes as a whole.
In an attempt to clarify when a component may be capitalized, U.S. taxing authorities now provide guidance on capitalization and deduction of costs related to tangible property. IRS Prop. Reg. § 1.263(a)-3(d)(2)(v) sets forth nine factors to use when determining whether an item should be treated as an individual piece of property or as part of a whole.
Because the tax law may define the relevant unit of property more broadly than the unit of property used for financial reporting purposes under IFRS, it is likely the unit of property used for tax purposes will differ substantially from that used for financial reporting purposes. Tracking fixed asset additions and disposals, as well as analyzing repairs to identify capital improvements based on different units of property, will be complex and burdensome.
Fixed Asset Accounting Software. Convergence would also have a significant impact on IT applications.4 A company must make sure their fixed asset accounting system has the functionality to accommodate the componentization requirement. Many accounting and financial ERP software providers have been addressing the IFRS convergence issues as part of the IASB System Company Discussion Group.5 The Fixed Asset component of Oracle’s E-Business Suite provides a ‘parent-child’ asset feature to group assets after componentization. This feature allows the child assets to be linked to the parent asset, yet depreciates the child assets individually according to their respective useful lives and booked costs. This feature also allows for additions and retirements of child assets.
Making sure your fixed asset accounting system has the functionality to support IFRS requirements is only half the battle. Your transition strategy must incorporate and implement a standard set of guidelines for componentizing capital expenditures to support an ongoing process. Since large IT system changes typically take from two to four years to go live, a well-crafted, forward-looking IT strategy requires significant forethought around the impact of IFRS.6
Implementing the componentization requirement of IAS 16 would require an extensive transition strategy.
Developing a “Componentization Policy” for Your Company. Currently, neither the SEC nor IFRS provides any clear guidance as to the level of componentization required when capitalizing PP&E. Each company will need to outline an approach to facilitate a consistent accounting treatment for all of its assets. Consultation with the company’s facilities, plant engineering and maintenance personnel, or with outside professionals in the tangible asset valuation industry may be necessary.
The following steps should be considered to assist in developing a company policy on the identification of asset components.
- Review major assets to determine whether there are any definable components with significant cost or different useful lives with respect to the overall asset
- Review plant maintenance programs. If the replacement of a component is significant enough to be listed on a maintenance schedule, it may have a cost that is significant in comparison to the total cost of the asset. Also, significant overhauls may qualify as components. This includes non-physical costs such as labor, consulting fees, and engineering
- Review historical retirement patterns to evaluate what is a component
- Analyze major capital expenditures, with costs detailed at a more granular level
It is important to recognize that the fixed asset accountant will be an integral part of the ongoing componentization process and should be involved in the policy development. In addition to establishing a componentization policy it will also be important to develop a plan to recognize asset / component retirements in accordance with IAS 16, as this would be completed at a more detailed level.
Retrospective or Prospective Application. In May 2011 the SEC released a Staff Paper, “Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for U.S. Issuers.” The focus of this paper was to outline a possible approach for incorporation of IFRS into the U.S. financial reporting system, if the SEC was to decide that incorporation of IFRS is in the best interest of U.S. investors.
Among other things, the paper addresses the implementation of IAS 16 and the componentization requirement. The paper notes that retrospective application of the componentization requirement could require U.S. companies to expend significant efforts to analyze significant numbers of recorded assets. In order to minimize the implementation effort, the FASB may determine that the componentization aspects of IAS 16, if not the entire standard, would be best incorporated on a prospective basis. That is, all PP&E acquired subsequent to the effective date of IAS 16 as incorporated into the relevant Accounting Standards Codification (“ASC”) would need to be componentized.
The Staff Paper requests comments on the possible incorporation approaches. Incorporation on a prospective basis would
certainly be preferable to most U.S. companies, but it would not come without complications. For instance, using our previous building example, if a company was to install new protective roofing onto a building subsequent to the effective date, how would it account for the removal of any carrying value attributable to the old protective roofing?
Application of the componentization requirement might also complicate accounting for fixed assets at the time of a merger or acquisition. An acquiring company may need to identify asset components and value them in compliance with its own componentization policy. The magnitude of such an exercise should not be underestimated and will be at least partially dependent on the quality of the acquired company’s fixed asset record keeping.
Timing. The Staff Paper does not provide an extensive discussion of a potential timeline of incorporation but does suggest a transitional period during which existing differences between IFRS and U.S. GAAP would be eliminated through ongoing FASB standard-setting efforts over some defined period (e.g., five to seven years). At the end of this period, the objective would be for U.S. companies to be compliant with U.S. GAAP and also be in position to assert that they are compliant with IFRS as issued by the IASB.
This article touches on just one of the many PP&E related issues to be addressed if and when convergence happens. If your company is among the 86% of U.S. public companies or 98% of U.S. private companies that are not actively preparing or ready to adopt IFRS,7 working through the issues of componentization may be a good starting point in the convergence process.
Due to the time and resources needed to comply with the componentization requirement, consulting valuation professionals will be critical to insure compliance. For some companies, it may be advantageous to request their assets be componentized as part of any future appraisals.
1 “International Financial Reporting Standards (IFRS) – An AICPA Backgrounder,” American Institute of CPAs 1 Jan. 2011:3.
2 Staff of the U.S. Securities and Exchange Commission, Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for U.S. Issuers (Washington, SEC, 2011) 18.
3 International Accounting Standards Board, 2011 IFRS - Consolidation without early application (London: IFRS, 2010) 1226.
4 Pravin Sekhani and Giriraj Somani, “IFRS Transition Strategy for E-Business Suite,” Infosys, 3, Apr. 2010, Feb. 2011.
5 “Oracle’s Financial Management Solutions: Transition to IFRS with Oracle E-Business Suite,” Oracle Corporation, 11, Jun. 2010, Feb 2011 < http://www.oracle.com/us/products/applications/057039.pdf>.
6 “IFRS on the horizon – are your systems ready?” PriceWaterhouseCoopers, Nov. 2009, Apr. 2011 <http://www.pwc.com/en_US/us/issues/ifrs-reporting/assets/oracle-ifrs.pdf>.
7 “IFRS Readiness Survey,” American Institute of Certified Public Accountants, May 2011, June 2011 <http://www.aicpa.org/Research/StudiesandPapers/DownloadableDocuments/IFRS%20Readiness%20Survey%20--Spring%202011%20--%20public.pdf>.