Since the publication, in the June 2009 Accountancy SA, of the article on Overhauling Your Fixed Assets Register I have seen some confusion as to how to proceed once the fixed assets register has been updated, even though the article does briefly mention the recommended course of action. 

Accounting for the overhauling of your fixed assets register (45min)


Accounting for the overhauling of your fixed assets register

Problem statement
It was common practice for smaller entities to adopt the Practice Note 19 wear and tear or similar rates as the basis for determining the annual depreciation without taking into account the residual value or useful lives of the underlying assets. This led to depreciation disproportionate to the value and use of the asset and left companies with fixed assets registers reflecting various assets with R1 carrying amounts. This practice was widely accepted, as a systematic basis of allocating the cost of the assets to the statement of comprehensive income, for its ease and uniformity.

Now, as those who followed the above methodology are waking up to the reality of the requirements of IAS16 (AC123) (Overhauling Your Fixed Assets Register, Accountancy SA – June 2009), they are reworking their fixed assets registers to be more in line with the economic reality of the underlying assets and the requirements of accounting standards. This invariably leads to large adjustments of the accounting records as a result of the cumulative effect of non-compliance. The purpose of this article is to highlight the accounting treatment of these adjustments as there appears to be inconsistencies in the interpretations of the accounting standards.

The Theory Behind The Confusion
Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life. The depreciable amount is the cost of the asset less the amount the management expects to obtain for the asset today if the asset were in the state it would be at the end of its useful life, known as the residual value. The useful life is the time period that management intends to use the asset. From the above it should be clear that the depreciable amount of an asset does not equate to the cost of the asset and the useful life of the asset is not the same as the actual or economic life of the asset.

The residual value and useful life of an asset are regarded as accounting estimates and intrinsically have an element of uncertainty associated with them. As such they are based on information available at the time that they are estimated. It is therefore expected that these figures can, and most likely will, differ at various stages of an assets life depending on economic times and management's intentions. It is with this in mind that IAS16 (AC123) requires that these estimates be assessed and revised, if necessary, at each statement of financial position date.

Current Accounting Practice
Due to the fact that the accounting standards regard a change in either the residual value or the useful life of an asset as a change in accounting estimate [IAS16 (AC123).51] some accountants believe that the adjustment, resulting from a rework of the fixed assets register to take account of the residual value and useful life of an asset, should be treated as a change in accounting estimate with changes being made prospectively.

Another option that is being adopted is to change the basis of accounting from the cost model to the revaluation model and to revalue the assets to the amounts reflected in the reworked fixed assets register. As the initial change from the cost model to the revaluation model is outside the scope of retrospective restatement [IAS8 (AC103).17-18] the adjustment to the accounting records would only affect the current and future financial information in accordance with IAS16 (AC123).

The last option that is available is to account for the adjustments as a prior period error, in accordance with IAS8 (AC103), where the accounting records are corrected from as far back as is practically possible. This used to be the opening balances of the comparative period however IAS1 (AC100) (Revised 2007) now requires, that where the figures are restated retrospectively, that the company present a statement of financial position as at the beginning of the beginning of the earliest comparative period [IAS1 (AC100).10(f)]. Essentially what this means is that the company will have to present three statements of financial position in the year in which the error is corrected.

It would appear that there is uncertainty as to which of the above options is the correct way of treating the adjustment to the accounting records.

Recommended Accounting Practice
Before we jump into the recommended accounting practice it is necessary to define some of the concepts underlying the arguments.

change in accounting estimate is an adjustment of the carrying amount of an asset or a liability, or the amount of the periodic consumption of an asset, that results from the assessment of the present status of, and expected future benefits and obligations associated with, assets and liabilities. Changes in accounting estimates result from new information or new developments and, accordingly, are not corrections of errors. [IAS8 (AC103).5]
Revaluation model
After recognition as an asset, an item of property, plant and equipment whose fair value can be measured reliably shall be carried at a revalued amount, being its fair value at the date of the revaluation less any subsequent accumulated depreciation and subsequent accumulated impairment losses. Revaluations shall be made with sufficient regularity to ensure that the carrying amount does not differ materially from that which would be determined using fair value at the end of the reporting period. [IAS16 (AC123).31]
Prior period errors are omissions from, and misstatements in, the entity's financial statements for one or more prior periods arising from a failure to use, or misuse of, reliable information that:
(a) was available when financial statements for those periods were authorized for issue; and
(b) could reasonably be expected to have been obtained and taken into account in the preparation and presentation of those financial statements.
Such errors include the effects of mathematical mistakes, mistakes in applying accounting policies, oversights or misinterpretations of facts, and fraud. [IAS8 (AC103).5]

IAS16 (AC123).51 states that changes in the useful life or residual value of an asset shall be accounted for as a change in accounting estimate and at first glance this also appears to be in line with the definition of a change in accounting estimate. Treating the adjustment as a change in accounting estimate would most likely result in negative depreciation being put to the statement of comprehensive income as the excessive depreciation of prior periods are recovered in the current year. Although this treatment would reflect the correct closing balances of assets, I do not believe that this is correct course of action as part of the definition of a change in accounting estimate requires that the change results from new information or developments. The requirement to estimate useful lives and residual values have always been there. Also the company has always known what the asset is worth, how long they intend to use it and if they will be able to sell it. I do not believe that the fact that they chose not to apply this knowledge entitles them to claim that they are acting on new information. I further also do not believe that you can change something that, in some cases, never existed in the first place.

On the other hand if accountants insist on treating the adjustment as a change in accounting estimate in accordance with IAS16 (AC123) then regard should be had for the provisions of paragraph 54 of that statement which states that when the residual value of an asset increases above its carrying amount then no further depreciation should be charged until the situation has reversed. As the effect of incorrectly depreciating the assets were to write them off too quickly, thus leaving an assets register with a whole lot of R1 assets, any estimate of a residual value would exceed the current carrying amount. This would mean that no further depreciation must be raised and the practice of putting through negative depreciation is unacceptable. The effect of this is that the accounting records remain unchanged and misstated and the whole exercise of reworking the fixed assets register is nullified. This cannot be the correct way to proceed.

Revaluing the assets concerned to be in line with the reworked fixed assets register would have the effect of correcting year end balances and, if the revaluation is effective from the beginning of the year, current year depreciation as well. This is however not the correct course of action as retained earnings is still misstated and the cumulative effect of the incorrect depreciation is now mistakenly disguised as a revaluation reserve. My opinion is that this option will create a misrepresentation in the financial statements by creating the impression that there is more value in the assets than there actually is. The revaluation model was introduced to take account of the fact that certain assets would increase in value over time and to provide for a means for a company to account for that increase in value. The rework of the fixed assets register could identify assets that have increased in value however in most cases the increase would be as a result of incorrect depreciation. Another problem with adopting this approach is that the fair value of assets should be readily determinable which will not be the case for all assets. Furthermore the statement requires that assets under the revaluation model must be revalued on a continual basis which might prove too onerous an exercise for smaller entities.

The only option that is left is to account for the adjustment as a prior period error which appears to be the only option that is theoretically sound and gives a fair reflection of the financial figures. The adjustment to the accounting records fits within the definition of a prior period error as follows:

  • Not taking into account the useful life and residual value of an asset in determining the depreciation results in a misstatement of current and prior period financial statements.
  • The misstatement results from a failure to use reliable information that was available when the AFS were authorized and which management could reasonably have been expected to be able to obtain.
  • Although fraud is an unlikely cause, the error is:
    - a mathematical mistake,
    - a mistake in applying accounting policies,
    - an oversight and
    - a misrepresentation of facts.

This treatment is also more in line with the requirements of financial information, as stated in the Framework, to be reliable, relevant, understandable and comparable [FW.24]. Restating retrospectively also gives adherence to the accrual concept as the depreciation is now matched to the period in which the related income was generated.

Furthermore auditors should be inclined to favour this option as their opinion in any year is implicitly expressed on the comparative figures as well. International Statement on Auditing 710 – Comparatives require that, where it is discovered that the corresponding figures are incorrect and those figures have not been reissued or restated, the auditor issue a modified audit opinion [ISA710.14-16]. Therefore accepting an adjustment, by the accountant, to the current year figures, based on previous non-compliance with accounting standards, without a corresponding adjustment to the comparative figures would mean that they will be expressing an inappropriate audit opinion.

In cases where the wear and tear rates were religiously applied there is one more adjustment to bear in mind.  When the values of the assets are adjusted it would give rise to temporary differences as the accounting base is no longer equal to the tax base. Retrospective restatement would apply equally to this adjustment and other errors that could be identified during the rework of the fixed assets register such as unrecorded assets or assets that should have been removed from the register. 

IFRS for SME's
Those who resist change believe that the new statement will be the answer to their prayers and that if they adopt IFRS for SME's they will not have to update their fixed assets registers or account for the changes. This is unfortunately not the case as IFRS for SME's still require that management estimate the residual values and useful lives of assets but now only when there are indications that they may have changed from previous estimates [IFRS for SME's 17.18-19]. Another difference is that they will no longer have the option of revaluing their fixed assets to fix the problem as IFRS for SME's eliminates the revaluation model as an option of accounting for property, plant and equipment [IFRS for SME's 17.15].

However when one initially changes to IFRS for SME's you are obliged to follow the transitional provisions in the statement. These provisions require retrospective restatement of the financial statements on first time adoption of the statement, barring some exceptions. One of these exceptions is the option not to restate the financial statements for changes in the estimates between the previous reporting framework and IFRS for SME's [IFRS for SME's 35.9(c)]. Could this be the loophole that everyone is looking for? Unfortunately not! When you look at the reasoning behind the exemption, contained in the Basis for Conclusions to IFRS for SME's, the standard setters state that they aimed to include those exemptions that were granted in terms of IFRS 1 [IFRS for SME's BC34(gg)]. One therefore needs to read IFRS 1 to fully understand the conditions of the exemption. The statement requires that the estimates to be used, on first time adoption, shall be consistent with those under the previous reporting framework unless there is objective evidence that those estimates were in error [IFRS 1.31]. As illustrated above there is objective evidence that the original estimates, or the absence thereof, were in error which brings us back to the retrospective restatement for a prior period error as the only feasible way to correct the financial figures [IFRS for SME's 10.21].

The correction of the accounting records following the initial rework of the fixed assets register, to be in compliance with the accounting standards, must be treated as a prior period error with retrospective restatement of the financial figures. Where the rework also identifies assets that qualify for revaluation those assets should only be revalued, in line with IAS16 (AC123), after the correction of the prior period error. Only once the fixed assets register have been reworked and the accounting records correctly updated should subsequent changes in the residual value or the useful life of assets be treated as a change in accounting estimate. Lastly, the decision to adopt IFRS for SME's as the reporting framework should not be based solely on the perceived relief offered by the statement.

Author: Werner Phillip Botha, BCom, is an Audit Supervisor.