Ever since the adoption of International Financial Reporting Standards (IFRS) in South Africa in 2005, and even more so with the impending adoption of Generally Recognised Accounting Practice (GRAP) in the public sector, many entities in both the private and the public sectors have been finding the need to reconstruct their fixed asset registers. This has been mainly due to the fact that the requirements in IAS 16 (and now also in GRAP 17): Property, Plant and Equipment (PPE)** to revise the useful lives and residual values of all PPE annually, and the requirement to split assets into their significant components, have resulted in a major upheaval in the way fixed assets were previously accounted for locally.
Previously, most entities would simply select a useful life that was convenient for tax purposes, or that seemed reasonable at initial recognition, and then never gave any further thought to adjusting that useful life estimate in future periods, regardless of changes in intention or circumstances. Similarly, residual values were not frequently, if ever, updated. But perhaps worst of all, at least from the perspective of this article, was the nasty habit that entities had of recognising groups of assets as single line-items in their asset registers (hereafter referred to as “grouped assets”). Despite the fact that entities have been exposed to the new/correct way of doing things for some time now, many auditors will testify that fixed assets continue to be a major and ongoing problem at many of their audit clients. To make matters worse, fixed assets are more often than not one of the more material items on the statement of financial position, and often lead to audit qualifications. The focus of this article is on how to reconstruct the asset register as a result of inappropriately grouped items (with differing useful lives), a lack of sufficient supporting documentation, or unrecorded assets.
In terms of both SA GAAP/IFRS and GRAP, assets must be broken down into their significant components, mainly to allow for the varying useful lives and residual values of assets within a similar class. In essence, this means that no two assets (or parts thereof), even if identical, need have precisely the same useful life and residual value. This is an interesting perspective that is supported directly by accounting standards, but is unfortunately not very well understood in practice – that the useful life of an asset is to a large extent determined by management’s intentions in respect of that individual asset, and not necessarily by the nature or condition of the asset directly. IAS 16.57 states: “The useful life of an asset is defined in terms of the asset’s expected utility to the entity. The asset management policy of the entity may involve the disposal of assets after a specified time or after consumption of a specified proportion of the future economic benefits embodied in the asset. Therefore, the useful life of an asset may be shorter than the economic life. The estimation of the useful life of the asset is a matter of judgement based on the experience of the entity with similar assets.”
Therefore, the best evidence of management’s intentions is an approved asset policy that is supported by practice. This does not prohibit the grouping of similar assets as long as the intended useful life of those assets is the same. Auditors sometimes get this wrong and usually assess the validity of an asset’s useful life and residual value by reference to (for example) the condition of the asset, expert advice, past trends, etc. However, sometimes this is the only option available to an auditor when management does not have adequate written policy documentation to support its accounting estimates and expectations. In such cases, resorting to this type of information for audit purposes may be a suitable proxy for determining management’s true intentions. This means that, where there is a lack of evidence supporting the similar useful lives of grouped assets, auditors would be forced to qualify their opinions on the basis of non-compliance with IAS 16.
Overhaul vs. Repair
Most would agree that it would be preferable to avoid a situation such as that described in the preceding paragraph by proactively tackling the fixed asset register well in advance of the next audit. In doing so, one of the first things that an entity must determine is the extent of the “damage” in the asset register. Just like a car that is driven for too long without oil or water, the longer a fixed asset register has been run without adhering to accounting standards, the worse will be the damage. Depending on the significance and complexity of the PPE, some entities might be in the fortunate position of only needing a bit of repair work, while others will have to face up to the reality of performing a complete overhaul. So what are the signs to look out for that might signify the need for a major reconstruction of the asset register? Here are some clues:
• There are a large number of fully depreciated/zero-value assets that are still in use.
• There are vague asset descriptions that are likely to be groups of individually significant assets (for example: “factory; workshop; power station, network, etc).
• There are a number of assets that are under the control of the entity but are not included in the fixed asset register (completeness problem).
• There are assets that are still on the asset register, being depreciated, that are no longer in use (validity problem).
Sticking with the car analogy, any one or more of the above, depending on the extent of the problem, could be like finding oil in your water tank – and you don’t need to be a mechanic to know what that means.
How to fix it
So you’ve identified the problem, and you’ve realised that this requires more than a minor repair or a quick fix. You need an overhaul – a complete asset register reconstruction. But where does one begin?
Firstly, you need to determine whether there are any assets under the control/ownership of the entity that were not recorded in the fixed asset register. If there are such assets, it implies that you have some serious prior period errors (dealt with in more detail later). It is important to understand that, apart from a revaluation under the revaluation model accounting policy option allowed by IAS 16, such prior period errors are the only other possible valid cause of an increase in the cost of recorded PPE.
People often confuse a re-assessment of the useful lives and residual values of PPE with a “revaluation”, thereby mixing two different accounting bases. Perhaps even more concerning is that many entities consciously make the mistake of performing a “revaluation” of their PPE in an attempt to correct their asset register problems. This is usually a bad idea, since IAS 8: Accounting Policies, Changes in Accounting Estimates, and Errors, par 16 requires an accounting policy to be applied consistently from year to year, and any voluntary changes in a policy must demonstrably improve the reliability and relevance of information presented. Although it may be fairly easy to argue that the revaluation model would achieve this, people often don’t realise the problems that this creates in the future. Under the revaluation model, the entity must revalue all items of PPE in that class of assets on a regular basis. There is therefore no such thing as a “one-off revaluation” in IAS 16. Taking into account the nature of the assets normally contributing to the problem in the first place, the cost and work involved in maintaining a revaluation policy as envisaged in the Standards would be prohibitive and extremely undesirable for most entities in this predicament, which unfortunately would not meet the definition of impracticability. What this effectively means is that entities that voluntarily change to a revaluation model for certain classes of PPE (for the wrong reasons) are opening themselves up to unnecessary costs and effort, and probably more audit qualifications in future periods when they cannot maintain that policy properly.
We have therefore eliminated revaluations as a feasible option for solving the historical errors in an asset register. The more realistic, practical, and technically correct option is to determine appropriate historical costs for the recorded and unrecorded PPE, at an appropriate level of componentisation. This would involve the following steps:
1. Decide, at a documented policy level, precisely what classes of PPE are relevant to the entity. This is based on management’s judgement and experience, and guidance is also provided in IAS 16. It is important not to skip this step, as it will inform the personnel involved in the remaining steps as to how to classify and componentise the assets, eventually leading into the financial statements disclosure. It also extremely important to ensure that the policies adopted are not contrary to the relevant accounting standards, and that all assumptions are reasonably supported.
2. Perform a complete asset count/walkthrough, documenting all assets that are under the control of the entity, and also recording their descriptions, location, condition, identifying information such as asset numbers and serial numbers, and any other useful information that might be available. Pre-printed count sheets/specialised software can assist in this regard. It is especially important to educate the personnel involved in the count about how to identify and record significant components of the assets separately. This requires proper policy decisions and planning on management’s part, whilst bearing in mind the ultimate aim of allocating different useful lives to the different components. Where useful lives are not expected to differ, there may be no need to componentise a single asset into its parts.
3. Populate the “new” asset register with all the information obtained in step 2 above.
4. Perform a review of the captured information to sort out any inconsistencies, duplications or errors, and to ensure compliance with the original instructions and the fixed asset policies.
5. Attempt to tie-up assets in the existing “old” asset register to the new asset register. It is useful to try and make this link as the most accurate source of historical information (most importantly cost and acquisition dates) for the assets in the new register would be any source documentation relating to the original acquisition thereof. It is likely that source documentation, where available, would have been referenced in some way to the old register, and it makes sense to take advantage of any such links if they exist. It is at this stage, assuming that the componentisation and location information was captured correctly in step 2 above, that inappropriate grouping of assets can be addressed.
As explained earlier, entities often captured groups of assets under a single line item, which is a practice that is no longer acceptable under IFRS/SA GAAP and GRAP. Some refer to the corrections in this regard as “unbundling” their assets. This is also often the stage in which entities incorrectly venture into the realm of “revaluing their assets”; the result usually being that the new combined carrying value of the unbundled assets far exceeds the original cost of the group. It is again emphasised that this result is not appropriate unless other previously unrecorded assets were introduced into the group. Assuming there are no additional assets, an arbitrary allocation of the original group’s cost to the underlying unbundled assets is more appropriate, with no change in the overall cost were the individual assets to be added back together. A suitable basis for that allocation should be used and in practice determining the depreciated replacement cost of the individual assets as a percentage of the total depreciated replacement cost (DRC) of the group would usually be an acceptable method (more on DRC later). This approach incidentally is also supported by the Companies Act, no 61 of 1973, which states as one of the required registers to be kept by a company, in section 284(1)(b):
“a register of fixed assets showing the respective dates of acquisition and the cost thereof, depreciation, if any, the date of any revaluation and the revalued amount, the respective dates of any disposals and the consideration received in respect thereof: Provided that in respect of fixed assets acquired before the commencement of this Act, a company may, as at the end of its first financial year after the said commencement, take an inventory of all fixed assets and make a realistic allocation of the total value of fixed assets as shown in the financial statements as at that date over the inventory of assets;”
6. Once all options of tracing the assets to source documentation have been exhausted, the remaining assets need to be assigned values in some way. As explained in step 5, some of the assets would already have been allocated an estimated historical cost simply by splitting up the total cost of the grouped items in the old asset register. However, there will very often be instances where historical cost information is completely unavailable and the only realistic option, short of falling back on impracticability, is to determine a suitable proxy for the historical cost price of each remaining asset. IAS 16 does not provide explicit guidance on this situation, (the Standard Setters probably never envisaged that entities would find themselves in this situation, and in any event accounting standards are usually based on the presumption of sound underlying financial controls). It is therefore necessary to formulate a reasonable approach based on best practice. Although not in the same context, IAS 16 does provide us with some clues as to the types of valuation methods that the IASB seems to find acceptable where there is no better alternative. IAS 16. 33 deals with the situation where an entity has adopted the revaluation model for PPE, but subsequently finds it impossible to determine the fair value due to the specialised nature of the item and the fact that there is no market. In such an instance, IAS 16.33 allows an entity to estimate fair value using either an income or a depreciated replacement cost approach (DRC). It is, in the author’s opinion, reasonable to consider applying these methods to the reconstruction of the asset register in lieu of any better solutions.
DRC basically means the current cost that an entity would incur to replace an asset with a new asset that would perform a similar function and provide a similar output, depreciated for the number of years that the old asset has already been held by the entity (more on this later). In most cases, an entity will find it fairly easy to determine a replacement cost for its PPE, despite significant technological changes over the past few years. It is also likely that an entity will have ready access to replacement cost information in the form of quotations from suppliers and capital expenditure budgets. A key assumption in this regard is the fact that the old asset is still being used and that it allows the entity to avoid purchasing a new, perhaps more modern replacement, which implies that the output of the existing asset is similar in value to the brand new asset, were it already of a similar age and condition.
However, another obstacle would be where the entity does not know how long some of the old assets have been in use. This would especially be the case where, for example, machinery has been used for such a long time that no one in the entity has any recollection of when it was acquired, and all records of its acquisition have been lost. This phenomenon is more often encountered in public sector entities such as municipalities and is due to a variety of factors that are beyond the scope of this article.
The only way around this obstacle is to define appropriate assumptions about the age of different types of assets, based on relevant indicators such as physical appearance, output, down-time and expert opinion. If all else fails, it may be more appropriate to attempt to place a value on the asset based on future income-earning potential (the other alternative in IAS 16.33). However, this should be a last resort since this doesn’t take into account the age of the asset and might distort even further the historical cost basis of the PPE.
Therefore, as a proxy for historical cost, DRC is a practical and reasonable estimation method to apply in the absence of any better historical information.
7. Reconcile/reperform the depreciation calculations, impairments, etc. using the new updated asset register and process the differences via correcting journals.
8. As a final consideration, one should bear in mind the requirements of IAS 8. The fact that certain items of PPE were never recorded, or that useful lives were previously incorrect, means that a prior period error has occurred. IAS 8 requires that material errors be corrected retrospectively in the financial statements, by restating all comparatives and opening balances. In other words, the new asset register should be reflected as if it had always been in place as far back as the opening balance of the earliest comparatives presented (assuming the errors occurred prior to that date). IAS 8 prescribes certain important disclosures in this regard.
A well-organised, up-to-date and IFRS compliant fixed asset register is well worth the effort and cost. Apart from the obvious accounting advantages, this doubles as a tool that assists with keeping track of and safeguarding an entity’s assets, budgeting, and resource planning. If faced with a large-scale reconstruction of the asset register, it is strongly recommended that the auditors of the entity be proactively engaged and informed on the process being followed, especially where significant costs are going to be incurred in an attempt to make the corrections. Disagreements regarding the approach and assumptions could then be dealt with in good time. Very often, entities do not have the skills or capacity to facilitate an asset register reconstruction and need to make use of specialist service providers. In such cases, it is even more important to agree in advance on the methodology and approach to be followed, since interpretations and understanding may differ between the entity, the service provider, and the auditors.
** References to the terms IAS 16, GRAP 17, IFRS, SA GAAP, and GRAP have been used interchangeably since the matters dealt with in this article apply equally across all three of these frameworks.
Alexi Colyvas CA(SA), heads up Altimax’s Technical Unit.