Whilst much of the technical accounting world has been focussed on the reporting challenges of Covid-19 this year, the IASB issued in May an amendment to IAS 16 that will impact on many organisations. The amendments to IAS 16 prohibit a company deducting from the cost of an item of PPE any proceeds from selling items produced while making that item of PPE available for its intended use, for example during a necessary testing or commissioning period. Consequently, a company would recognise such sales proceeds directly in profit or loss.
The prior treatment required that any costs incurred, and revenue recognised up to the point that the asset is ready for use, be capitalised, or in the case of revenue, offset against the cost of an asset. The amendments will mainly affect extractive and petrochemical industries.
Summary: What do you need to know
- Sale of proceeds no longer deducted from the cost of property, plant and equipment (PPE) before its intended use
- Increase in the costs of assets reflected in a company’s financial statements
- Change in the recognition and presentation of profit with potential tax implications
What does this mean for your company’s financial statements?
Under the amendments, proceeds from selling items before the related item of PPE is available for use should be recognised in profit or loss together with the costs associated with that item of PPE in accordance with IFRS 15 Revenue from Contracts with Customers and IAS 2 Inventories respectively.
In applying the amendments companies will need to distinguish between:
- Costs associated with producing and selling items before the item of PPE is available for use; and
- costs associated with making the item of PPE available for its intended use.
Making this allocation of costs may require significant estimation and judgement. Companies will need to determine what is normal capacity in order to allocate costs to the items produced and sold. Because the asset is still being constructed, company’s may not be able to readily determine the asset’s normal capacity or a relevant production measure in order to cost the output produced.
Companies will also be required to analyse direct and indirect costs incurred during the testing period. For example, a company would need to determine how much materials and labour to allocate between items sold and the PPE under construction. This would be a new judgement not previously required.
Furthermore, companies may not have a reliable or comprehensive costing system available before an item of PPE is available for use.
How should you recognise and present any profit?
Under the amendments, profit made from sales of items before the related item of PPE is available for use will be recognised earlier than previously. Companies will also have to determine whether the sales are within ‘ordinary activities’ which may not be clear.
If a company concludes that the sales are within ordinary activities the disclosure requirements of IFRS 15 Revenue from Contracts with Customers and IAS 2 will apply.
For the sale of items that are not part of a company’s ordinary activities, the amendments require the company to:
- disclose separately the sales proceeds and related production cost recognised in profit or loss; and
- specify the line items in which such proceeds and costs are included in the statement of comprehensive income.
This disclosure is not required if such proceeds and cost are presented separately in the statement of comprehensive income.
When do the amendments come into effect?
The amendments are effective for annual periods beginning on or after 1 January 2022, however early application is permitted.
The amendments apply retrospectively, but only to items of PPE made available for use on or after the beginning of the earliest period presented in the financial statements in which the company first applies the amendments.
What are the tax considerations?
The changes to accounting could potentially affect the timing of companies’ taxation.
Historically if an asset was tested before full operation commenced, and income received in this phase was offset against the cost of deploying the asset, the company could simply capitalise the net amount. The tax treatment would be to follow the GAAP accounting (s46 CTA 2009), which will in effect mean taxing the income over time through a reduction in capital allowances qualifying expenditure.
Following the revised accounting standard, such offset income has to be recognised as such and therefore the gross costs would be capitalised. This potentially gives a tax cashflow disadvantage compared with the previous approach. This is because: the income will be taxable up front: higher capital allowances will be available, but in most cases only over time and on a reducing balance basis. If the company is pre-trading when the income is received, capital allowances qualifying expenditure may be treated as incurred in a later period than the period in which the income is taxable.
What can you do now?
The practical challenges of implementing the amendments can be complex. A big change for some sectors – for example the Energy and Petrochemical sectors – will be the cost allocation process. Making the allocation of costs can be a difficult process which requires significant estimation and judgement. You should start planning for this challenge now.
You need to understand how your systems currently look like and how you can monitor these costs at a more granular level to allocate costs. And make sure you have clarity on exactly which data is needed – this can only come from a deep understanding of the relevant accounting standards.