Occasional Education Notes

                                            
Depreciation and IFRS Excepting rare instances where productive processes do not interact, and very high levels of input aggregation, financial accounting’s allocation assertions are ambiguous and incorrigible. They may be employed to code the accountant’s communication of estimates about the firm (as in estimation theory), but allocation assertions do not reflect anything that exists in the external world, and do not correspond to any aspects of the firm’s economic state or activities. (Arthur Thomas)1 Before leaving this subject, we should issue an important warning: Investors are often led astray by CEOs and Wall Street analysts who equate depreciation charges with the amortization charges [of goodwill] we have just discussed. In no way are the two the same: With rare exceptions, depreciation is an economic cost every bit as real as wages, materials, or taxes. Certainly that is true at Berkshire and at virtually all the other businesses we have studied. Furthermore, we do not think so-called EBITDA (earnings before interest, taxes, depreciation and amortization) is a meaningful measure of performance. Managements that dismiss the importance of depreciation - and emphasize "cash flow" or EBITDA - are apt to make faulty decisions, and you should keep that in mind as you make your own investment decisions. (Warren Buffett)2 Introduction In recent years, standard-setters have paid little attention to fixed asset accounting and depreciation. The quotes from Arthur Thomas and Warren Buffett perhaps capture the dilemma. Depreciation is an inexact measure derived from a past transaction. It has none of the apparent science and precision found in estimates of fair value used for financial instruments. But as Buffett says, it is a real economic cost. For manufacturing and trading companies, fixed assets and depreciation are far more significant to measuring economic success or failure than financial instruments. As jurisdictions implement International Financial Reporting Standards (IFRSs), many find that the accounting for fixed assets is a special challenge. Their previous accounting was often influenced or governed by tax, rather than financial, reporting rules. They wonder how much their previous practices must change to conform to the guidance in IAS 16, Property, Plant and 1 Arthur L. Thomas, The Allocation Problem in Financial Accounting Theory, Studies in Accounting Research, no. 3, and The Allocation Problem: Part Two, Studies in Accounting Research, no. 9. (Evanston, Ill.: American Accounting Association, 1969 and 1974, respectively). 2 Buffett, Warren E., BERKSHIRE HATHAWAY INC. AN OWNER'S MANUAL, A Message from Warren E. Buffett, Chairman and CEO, January 1999. This article represents the views of the author and is not an official pronouncement of the IASB.
icle represents the views of the author and is not an official pronouncement of the IASB. Depreciation and IFRS This article represents the views of the author and is not an official pronouncement of the IASB. Equipment. This short article attempts to assist in answering those questions by examining some of the principles in IAS 16. IAS 16 requires accounting for components of fixed assets Component accounting is the first challenge in IAS 16. Many companies are accustomed to aggregating fixed assets into large units of account—perhaps accounting for a building, an aircraft, or an oil production facility as a single asset. Paragraph 9 of IAS 16 reads: This Standard does not prescribe the unit of measure for recognition, ie what constitutes an item of property, plant and equipment. Thus, judgement is required in applying the recognition criteria to an entity’s specific circumstances. It may be appropriate to aggregate individually insignificant items, such as moulds, tools and dies, and to apply the criteria to the aggregate value. However, and this is more significant to fixed-asset record-keeping systems, paragraphs 43 and 44 read: Each part of an item of property, plant and equipment with a cost that is significant in relation to the total cost of the item shall be depreciated separately3 . An entity allocates the amount initially recognised in respect of an item of property, plant and equipment to its significant parts and depreciates separately each such part. For example, it may be appropriate to depreciate separately the airframe and engines of an aircraft, whether owned or subject to a finance lease. Some express concern that those paragraphs require an entity to subdivide its fixed assets into dozens of component parts. As with everything in IFRS, the key words are ‘judgement is required’. There is little point in allocating the cost of an asset to components if the effect of doing so is not material. Still, some assets have components with useful lives that are significantly different from one another, and some jurisdictions already separate assets into components. For example, a building’s, elevators, and heating/air conditioning plant may have lives that are shorter than that of the building shell. In a manufacturing facility, custom-built assembly lines may have lives that are shorter than that of the rest of the facility. IFRSs require allocation among those component parts for purposes of computing depreciation.