FINA NCIAL STATEME NT RELIABILITY UNDER IFRS: … · 10/3/2016 · Financial Statement Reliability...

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:

[email protected]

0

: Problems with Expense Recognition

ENT

FRS:

PROBLEMS WITH

RECOGNITION

Dr Jacek Welc:

[email protected]

RECOGNIZING EXPENSES

RELATED TO INVENTORY AND

RECEIVABLE ACCOUNTS


PART 1:



RECEIVABLE ACCOUNTS

1




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.


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


finished goods, materials and services.

2


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


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.



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


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


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


are directly related to the units of

allocation of indirect


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


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


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






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


4




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


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




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



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)


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).



-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


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


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


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.


SELECTED PRACTICAL PROBLEMS WITH ACCOUNTING FOR



allocation of indirect costs of conversion, based on

if the production volume is unusually low (significantly

), the increased unit manufacturing costs, resulting from


in a carrying amount of inventory). If, in such periods, the company


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 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


n such periods, the company capitalizes


The problem is that normal production levels are not

directly observable and must be determined, which may be problematic for




�� PROBLEM 2: estimation of

values of inventories fall below their carrying amounts

must be written down to net realizable values

an income statement).


illustrated in Example 2

future selling prices are not directly observable

multiple subjective inputs) and are difficult to verify





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




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




�� 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.





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




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



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





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,




reflect increased (new) market prices, while cost of goods sold may still

be based on lower (old) prices from purchases made long ago.


when “fresher” layers of inventories become the costs of goods sold).

10



directly from IFRS regulations:

average cost on reported

when the purchase prices of inventories grow

are reflected in rising sales prices, the




market prices, while cost of goods sold may still

be based on lower (old) prices from purchases made long ago. The resulting


f goods sold).



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.





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


physical inventory count detects the non

11



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


the non-existent but




�� 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




her problems related to inventory (not resulting directly from IFRS)

recording cost of goods sold – when products are sold




(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



her problems related to inventory (not resulting directly from IFRS):

hen products are sold, the




to record costs of goods sold, while

results in overstating inventory, understating

physical inventory count detects

d in Example 3.




�� 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.





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



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


EXAMPLES OF IMPACT OF MIS-REPORTED INVENTORIES ON


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


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


Cash (BS) -100.000

Net sales (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


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

-


-

Cost of goods sold (IS) 100.000

0


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


Period t+2

Inventory (BS)**** -50.000

Cash (BS) 60.000




Period t+2

Inventory (BS) -75.000

Cash (BS) 60.000



Pre-tax profit (IS) -15.000

period t+1, including costs of unused capacity)

The reversal of prior




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.




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.





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



Company X is a distributor of mobile phones (products that are generally characterized by

mobile phones for 100 EUR each.





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)


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



Overstatement of earnings, caused by

overstated net realizable value

17




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.



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




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



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)


Pre-tax profit (IS)

Incorrect booking entries :

Period t

Inventory (BS) 10

Cash / receivables(BS) -10.000

Net sales (IS)


Pre-tax profit (IS)

* 1.000 units x 10 EUR ** 500 units x 12 EUR *** 500 units x 10 EUR


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


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


** 500 units x 12 EUR *** 500 units x 10 EUR

Overstatement of earnings, caused by non

recognition of cost of goods sold.

19


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).



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%




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


not listed on any stock exchange. These relationships look as follows.

company, owned by

John

PC (public company)

30%

70% 100%

John

20



private person, John, who holds

remaining 30% is free floating on the stock market). John has


OC

(a “friendly”

company, owned by

John or his relatives

or his friends)



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




John serves also as CEO at PC. All this means that OC is related-party to PC. However, from



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


a loss for PC in the following periods.

21



party to PC. However, from



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




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




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,


in period t+1 or later:

sale of inventory by PC to a third party,

.000 EUR for 2.000 EUR

22



OC

(private company,

fully-owned by John)


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) /


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


Inventory (BS) 0

Profit before taxes (IS) 0

Impact on inventory 0

Artificial sale of inventory

results in

overstatement by 7.000


party transaction of PC’s results:

Period t+1

12.000

Inventory (IS) /

Payables (BS) 12.000

5.000


Inventory (BS) -


7.000


Profit before taxes (IS)

5.000

Impact on inventory 12.000

party transaction:

Period t+1

Inventory (IS) /

Payables (BS) 0


Inventory (BS) -



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


Period t+2

Net sales (IS) /




Profit before taxes (IS) -10.000


Period t+2

Net sales (IS) /




Profit before taxes (IS) -3.000


Reversal of prior


(by 7.000)



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.


PLES OF IMPACT OF MIS-REPORTED INVENTORIES ON


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


24



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


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:


– 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



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.


recorded.”

related numerical data, disclosed in the annual reports of Renault Group

following analysis of company’s revenues, earnings and inventories:

25


INVENTORY IMPAIRMENT ALLOWANCES

of Renault for 2009:

“Inventories are stated at the lower of cost or net realizable value. Cost corresponds to



re of fixed costs to be


of Renault Group, enable the



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)



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



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)



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:



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



for sale, their cost does not include any borrowing costs.


estimated based on market conditions and any relevant external information

imated costs necessary to complete the sale (such as variable direct


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



of Peugeot for 2009:

at the lower of cost and net realizable value, in accordance with

out (FIFO) method and includes all direct and




estimated based on market conditions and any relevant external information

imated costs necessary to complete the sale (such as variable direct


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



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.




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


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



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


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



(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


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



(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


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


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.





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


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


debts and gross credit sales. 30





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


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


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.


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


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)



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


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


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


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



VOLKSWAGEN GROUP


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


DEBT ALLOWANCES OF


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



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


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



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


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:


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


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



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


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



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


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.



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


despite all these facts, the management apparently was becoming

compared to 2007) in terms of the estimated credit quality of the Group’s receivables,


39


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


despite all these facts, the management apparently was becoming more optimistic (as

ality of the Group’s receivables,



RELATED TO

AND EQUIPMENT


PART 2:


RELATED TO PROPERTY, PLANT

AND EQUIPMENT

40



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.



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.


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


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


Initial estimate of the costs of dismantling and removing the item or restoring the site


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).



directly attributable costs are costs incurred to bring the asset to the locatio


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


are costs incurred to bring the asset to the location and


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)


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).


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


(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).


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.



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


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


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


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)


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




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


estimated fair value of the asset given up, (with some exceptions, e.g.



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



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


given up, (with some exceptions, e.g.



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.


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



If a company acquires a bundle of assets (e.g. an organized and integrated business


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


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


If a company acquires a bundle of assets (e.g. an organized and integrated business line), it


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”.


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



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).



cate the total cost of the asset into its components, if they are



According to par. 29 of IAS 16, after an initial recognition of an asset it may be accounted for


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


Both models are vulnerable to multiple subjective

judgments (the revaluation model to a larger extent).

47


cate the total cost of the asset into its components, if they are separable



itial recognition of an asset it may be accounted for


, 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



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).



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


available market prices of similar assets).

48


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



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.



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


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)


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



subject to depreciation charges since it is at the location and in the working

capable of operating in the manner intended by management


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.



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


since it is at the location and in the working

capable of operating in the manner intended by management.


(resulting from e.g. the expected intensity of its

(resulting from e.g. the technological progress or



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


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



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.


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



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


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


rrying amount is decreased as a



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.



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.


This is related to PROBLEM 9

particularly routine maintenance, should be expensed as

incurred instead of cap

they overstate reported earnings and assets)

52


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.


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)


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




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


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



intention of earning rentals

may be reported at either fair value


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.




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



, 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.


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



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.


assets, at the lower of the following values:

The asset’s carrying amount before it was classified as “held-for


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


sale and discontinued operations), where

for-sale” and should be

less cost to sell. After such


for-sale”, adjusted for


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.


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



An entity classifies an item of PPE as “held-for-sale”, if it expects to recover the asset’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


”, if it expects to recover the asset’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).


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


EXAMPLES OF IMPACT OF MIS-REPORTED PROPERTY, PLANT


TREATING ROUTINE MAINTENANCE COSTS AS INVESTMENTS IN



all those assets were estimated to be 10 years and for simplicity let’s assume that the



years). The company’s annual net sales (from charter flights) are 3.000 thousands EUR.

57


REPORTED PROPERTY, PLANT


TREATING ROUTINE MAINTENANCE COSTS AS INVESTMENTS IN FIXED



simplicity let’s assume that the



flights) are 3.000 thousands EUR.



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.





In order to ensure reproduction of fixed-assets the company incurs in each year the capital



ve permission for flights within the European Aviation Area). These are



the current benefits). Therefore, those expenditures should be expensed (in operating


into fixed assets) and are depreciated or

58





assets the company incurs in each year the capital



ve permission for flights within the European Aviation Area). These are



the current benefits). Therefore, those expenditures should be expensed (in operating


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




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


Computation of depreciation and balance-sheet carrying values of the initial fixed 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




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)


*****net value of fixed assets at the end of the previous year + reproduction expenditures

59


sheet carrying values of the initial fixed 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)


*****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*





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


Computation of depreciation and balance-sheet carrying values of the


2009 2010

Routine safety control expenditures 0 1.000 1.000

Depreciation of safety control expenditures* 0 0

incurred in 2010 0 0




sheet) value of

capitalized safety control expenditures** 0 1.000 1.800

depreciation starting at the beginning of the next year


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


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


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


total carrying (net) amount of fixed assets, including the “true” assets as well


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


total carrying (net) amount of fixed assets, including the “true” assets as well


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



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



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



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



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.



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



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


STS), THE RESULT WOULD BE REPORTED SEEMINGLY ONE-OFF (!!!) OPERATING LOSS OF 1.731 (1.069

63



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



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


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.


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


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


in all the years between

artificial boost to earnings by creating fictitious and non-existent


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



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).




TREATING OPERATING COSTS, WHICH SHOULD BE EXPENSED AS INCURRED

ALLOCATED TO INVENTORIES, AS INVESTMENTS IN FIXED ASSETS



workers) as being incurred on development of company’s own fixed assets,

while actually those expenditures are direct costs of inventory.


uction facilities, can allocate part of the salaries of workers

ordered projects (those salaries should be allocated to work


ose salaries are capitalized in fixed assets and then depreciated).



inventory occur while they are depreciated through longer periods).

65




TREATING OPERATING COSTS, WHICH SHOULD BE EXPENSED AS INCURRED

ALLOCATED TO INVENTORIES, AS INVESTMENTS IN FIXED ASSETS



workers) as being incurred on development of company’s own fixed assets,


uction facilities, can allocate part of the salaries of workers

ordered projects (those salaries should be allocated to work-in-


ose salaries are capitalized in fixed assets and then depreciated).



inventory occur while they are depreciated through longer periods).



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.




DELAYS IN DEPRECIATING FIXED ASSETS

depreciation since when they are ready to be used in operations.


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


66




when they are ready to be used in operations.


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




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.



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


The total expenditures incurred (in 2009) on developing the factory equaled 10 million EUR

and its useful life was estimated to be 10 years.


7% and the repayment is postponed to 2012.

67



ON RELIABILITY OF FINANCIAL STATEMENTS

new factory in the period between 1st

January

January 2010 the company started manufacturing operations in this newly-developed


ctory equaled 10 million EUR


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)


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


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.


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


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


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.”


– ACCOUNTING FOR PP&E BY 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

70


ACCOUNTING FOR PP&E BY 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


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






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






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)


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




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


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



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


PART 3:



73


EXPENSES


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


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



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


identifiable non-monetary

”. An intangible assets is identifiable if it either:

capable of being separated or divided from the entity and sold,



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)


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.



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


, 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.


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.



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



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)


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.



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


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


(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


. Goodwill will be discussed with

These are very subjective areas and may

significantly distort the quality of

financial statements.


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.



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



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


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



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.


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.




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


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



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


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.


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.



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


asset to be capable of operating in a manner intended by management.



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,



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


expenditures must be

67 of IAS 38, the development costs that qualify for


d by management.



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,



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


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)



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


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


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


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



they must be amortized

. The principles of amortization are similar to depreciation of PP&E

line or accelerated or


, 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


PROBLEM 22 (cont.): The estimates of useful lifes of intangibles may

be very subjective, unverifiable and prone to manipulations (and


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).


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.



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


e useful life.

Such circumstances are very rare. Thus,

intangibles are usually assumed to have zero

residual values.

82


may be assumed only when either of the

to acquire the asset at the end of its useful life,

, and residual value can be


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



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


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


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



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


useful lifes for many intangibles (e.g.

between the carrying amount of the capitalized


significantly reduce the reliability and

comparability of financial statements of those companies

which invest intensively into R&D.


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


– ACCOUNTING FOR DEVELOPMENT COSTS


information, related to capitalization of development expenditures,


In accordance with IAS 38, research costs are recognized as expenses when incurred.




ts are not met, the expenses are recognized in the income

statement in the year in which they are incurred. Capitalized development costs


. 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


ACCOUNTING FOR DEVELOPMENT COSTS

, related to capitalization of development expenditures, may


In accordance with IAS 38, research costs are recognized as expenses when incurred.




ts are not met, the expenses are recognized in the income

Capitalized development costs


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.



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.”


– ACCOUNTING FOR DEVELOPMENT CO


Research costs and development costs which are not capitalized are recognized as



technical feasibility and successful marketing are assured. It must also be



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



Research costs and development costs which are not capitalized are recognized as



technical feasibility and successful marketing are assured. It must also be



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”.



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.




Development expenditure on vehicles and mechanical assemblies (engines and


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


. 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




86



on vehicles and mechanical assemblies (engines and


series production is recognized in

production date over the asset’s


. 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






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




Development costs are recognized if the conditions for capitalization according to


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).”


development costs. However, it applies much wider range of amortization periods


to apply a single period of seven years).

.

87



Development costs are recognized if the conditions for capitalization according to


accumulated amortization and accumulated impairment losses. Capitalized

s include all direct costs and allocable overheads and are amortized


der range of amortization periods




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).




Development expenses incurred between the approval of the decision to begin



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


(except for PEUGEOT, which capitalizes only direct costs). However, RENAULT sets



.

88



Development expenses incurred between the approval of the decision to begin



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.”


(except for PEUGEOT, which capitalizes only direct costs). However, RENAULT sets



IMPAIRMENT TESTING OF


PART 4:

IMPAIRMENT TESTING OF

89


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.


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


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


check if the asset’s carrying amount may be

occurs when the asset’s recoverable amount falls below its current carrying


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).


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.




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


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


91



, e.g. when market prices of similar assets declined significantly in the

, e.g. when significant adverse changes occurred or are


ates grew significantly in the recent past,

, e.g. when the observed market value of a company (for




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.



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


92


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 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.



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


93


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


PROBLEM 25: Value in use calls for forecasts

of future cash flows, obtainable from an

asset. Such forecasts are usually very



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.



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


Level 2 Inputs (Indirectly Observable) – Directly or indirectly observable prices in active

, quoted prices for identical or similar items in markets that are not


volatilities) or “market corroborated inputs”,

Level 3 Inputs (Unobservable) – Inputs that are unobservable and that reflect

about the assumptions market participants would make.


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.

94


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


Directly or indirectly observable prices in active

in markets that are not


nobservable and that reflect management’s

about the assumptions market participants would make.


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.


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



present value of future cash flows relating to the asset being measured.


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


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


relating to the asset being measured.


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.


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


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


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


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


recoverable amount. Although it cannot be claimed that the discount rate used



reported for 2007, but boosted earnings reported for 2008).

96


IMPAIRMENT TESTING OF ASSETS BY

may be found in the

As a result of improved earnings prospects, impairment losses amounting to €106


recognized in previous years were reversed in the past fiscal year. Value in use was

significantly reduced the discount rate used in discounting forecasted


Although it cannot be claimed that the discount rate used



d for 2008).

REAL-LIFE EXAMPLE

ASSECO GROUP


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:”



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


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.


percentage growth of sales revenues,

as factors with influence on the recoverable value of a cash-

assuming other factors remain unchanged.


97



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


could be changed so that the estimated value in use

generating units equaled the net book value of operating assets.


-generating unit,


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



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%



estimated recoverable amounts were only marginally higher that th

amounts. Small change of subjective assumptions would result in impairment.

98



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%)



estimated recoverable amounts were only marginally higher that the tested carrying

amounts. Small change of subjective assumptions would result in impairment.

FOR YOUR ATTENTION


THANK YOU

FOR YOUR ATTENTION

Dr Jacek Welc:

[email protected]

99


FOR YOUR ATTENTION

Dr Jacek Welc:

[email protected]

FINA NCIAL STATEME NT RELIABILITY UNDER IFRS: … · 10/3/2016 · Financial Statement Reliability...

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