We shall continue our discussion from where we ended in this column published on August 18. But let us digress a little.
Voluntary change in accounting policy by an entity is rare. Usually, an entity changes accounting policy only if it is required by law or by a new accounting standard. Transition to IFRS gives one- time opportunity to change the accounting policy voluntarily.
IFRS-1 does not require that an entity should be bound by the accounting policy, which it followed under the local GAAP, which is the Indian GAAP for entities domiciled in India. Companies should take advantage of this opportunity.
Each company should form a team to evaluate alternative accounting methods available under IFRS. The CEO and CFO should formulate the accounting policy based on that evaluation.
It is the responsibility of the audit committee to formulate the appropriate accounting policy. Therefore, the proposed accounting policy should be discussed in detail by the audit committee and the board of directors before according approval to the same.
Finance literature observes that the choice of the accounting policy has no bearing on the valuation of a company in the capital market. Therefore, the primary considerations in selecting the accounting policy are the appropriateness of the accounting method in the particular industry in which the company operates and the estimated cost of implementing the accounting policy.
Accounting method that is simplest to implement should get preference over other accounting methods. For example, IFRS provides a choice between ‘cost model’ and ‘revaluation model’ for accounting for fixed assets. An entity can use the cost model for some classes of assets and the revaluation model for others.
Of course, in absence of an active market, revaluation model cannot be used for intangible assets. Therefore, for all practical purpose only the cost model is available for the accounting of intangible assets.
Should an entity adopt the revaluation model for the accounting for PPE? The answer will depend on assessment of the benefits (in terms of increase in the informative value of financial statements) of using the revaluation model and the cost of determining fair value frequently.
It is quite possible that an entity may decide to use the revaluation model for land and building while cost model for other classes of PPE because it is quite onerous to estimate the fair value of items other than land and building. An entity should weigh the cost and benefits carefully before deciding the accounting policy.
Let us now come back to the topic of accounting for fixed assets. IFRS requires that entities which have adopted the ‘cost model’ for accounting for PPE should estimate the residual value and the useful life at least at each financial year-end.
IFRS stipulates that the residual value should not take into account expected future inflation or any other variable that might increase or decrease the residual value in future. If the residual value is immaterial, the entity may consider it as zero. If, the residual value is higher than the carrying amount, no depreciation is charged.
Entities will be required to estimate the residual value and useful life of all the items of PPE, which are not classified as ‘held for sale’ at the transition date and at the end of each subsequent fiscal year.
However, practically, there will be no need to review the useful life and residual value for assets which are carried in the balance sheet at a nominal amount (say at Re. 1) because the acquisition cost is written off fully, even though the asset is in use. IFRS-1, which stipulates the rules for the first time adoption of IFRS, provides an option to entities to use the fair value of PPE at the transition date as deemed cost.
Transition date is the date of the opening balance sheet. For example, if the first financial statements under IFRS are those for the year 2011-12 (that is, the period from April 1, 2011 to March 31, 2012) and the company provides comparative figures for the previous year (that is 2010-2011), the transition date is April 1, 2010, that is the first day of the period 2010-2011.
In case of intangible assets, the transition requirement is little different from that for PPE. IAS-38, which deals with accounting for intangible assets, requires that intangible assets, which have indefinite useful life should not be amortised. Those should be tested for impairment at least annually. An intangible asset is regarded as having an indefinite useful life when, based on an analysis of all the relevant factors, there is no foreseeable limit to the period over which the asset is expected to generate net cash inflows for the enterprise. Product brand is an example of intangible asset with indefinite useful life.
Indian GAAP does not recognise the concept of ‘intangible asset with indefinite useful life’. Rather, there is a rebuttable presumption that the useful life of an intangible asset cannot exceed ten years from the date it is available for use. Therefore, entities amortise assets with indefinite useful life (like brand) over a period not exceeding ten years.
Entities will be required to look back to all the intangible assets (other than goodwill) acquired individually or in a business combination and classify then in two categories: intangible assets with finite useful life and intangible assets with indefinite useful life.
As regards intangible assets with indefinite useful life transition to IFRS from the Indian GAAP is a change in accounting policy. Therefore, even if the cost of an asset is written off fully before the transition date, it should be restated and should be tested for impairment at the transition date.
However, as regards goodwill, IFRS-1 stipulates that the carrying amount under the previous GAAP will be the carrying amount in the opening balance sheet, subject to some adjustments, if necessary.
As regards intangible assets with finite useful life, the adjustments required for transition to IFRS, such as review of residual value and useful life, are the same as those applicable to PPE. However, except in rare situations, the residual value of intangible assets is taken as zero.
It is advisable that the companies start collating information about assets acquired in past well in time for smooth transition to IFRS.