Capitalize or charge out

[Ahmadraza]

Asalamu alaikum

I want to know that the cost incurred for building a prototype or model of a housing scheme to be displayed at their sales center would be capitalized or this should be charge out.

please guide in light of IASs,

if this cost needs to be charge out, can we deferr this cost as
pre-commencement expenditures as defined under section 25 to the Income Tax ordinance, 2001

Regards

[kamranACA]

Dear,

I at the outset say that this cost cannot either be capitalized or deferred.

For capitalization, an item should meet the criteria given by IAS 16, which in my view such prototypes dont meet.

There is no concept of deferral of any cost even for un-listed or private companies, as the fifth schedule has been revised recently.

However, for capitalization, some basis could be made provided that the prototype is considered to be bringing some economic benefits flowing towards your organization. Strictly as per my view, prototypes dont have such accompanying benefits. Still, this has to be seen in specific circumstances.

But there is no concept of deferral.


Regards,


Kamran.

[Schuaeb]

Kamran Sb, I would like to know whether the cost incurred for the construction of prototype before production is to be dealt with in accordance with IAS 38 or not. I guess the above case qualifies for being recognized as an intangible asset being a development expenditure

[kamranACA]

Dear Shoaib,

I, before posting my views, thought about the implication of IAS 38. However, IAS 38 has laid down certain criterion parameters which must be met, if some expenditure has to be recognised as development cost.

Para 18 of IAS 38 states that the recognition of of an intangible asset requires an entity to demonstrate that the itme meets

(a) the definition of an intangible asset given in paragraph 8 to 17; and

(b) the recognition criteria given in paragraph 21 to 23.

I think a prototype is not an intangible

- in its definition as it is not an asset without physical substance; and

- in the nature of development as strictly speaking it is not an application of research findings at all for the production of new or substantially improved materials, devices, products, processes, systems or services before the start of commercial production or use.

Further to above, as per paragraph 57, the intangible asset arising from development shall be recognised only if it meets the criteria given in its sub cluases (a) to (f), which, in my view the prototype does not meet.

Still, there could be a difference of opinion on this issue.

Hope to find some inputs from you as well.


Regards,


Kamran.

[noman]

my understanding is......as its to be displayed at sales centre....and only purpose is adverstisement.....it should be expensed out..

as mentioned by kamran..

its not an intangible
it doesn't involve research or improvement of any kind...
also...as i remember.....benchmark is to expense out everything....only under certain conditions it can be capitalised.....

[Ahmadraza]

Asalamu alaikum

thanks for your help, now i got a more clear picture, just want to confirm my second point, that as per defination given under section 25 of The Income Tax Ordinance,2001

further the audit period is june 30, 2006 so we have to follow the old schedule and not the new one.

thanks once again for your guidance

Regards

[Schuaeb]

As in the question it is mentioned that the prototype is meant for advertisement, then in my opinion its not a capital expense. However, I can't recall where but I have read protypes as an example of development expenditures, and most probably that meet the criteria for capitalization. I try to find out the source.

[Schuaeb]

Its PAC's book on IFRS (Vol 1). It includes among the examples of development expenditures "the design, construction, and testing of pre-production or pre-use prototypeand models". And for recognition cost could be measured reliably and future economic benefits are probable.

Still I didn't find anything very conclusive in the standards regarding recognition of prototypes as intangibles.

[kamranACA]

Dear Ahmed and Shoaib,


Prototype should be analysed in view of the criterion given in paragraph 57 in its sub-paras (a) to (f) as it is an internally generated/created design. PAC's book cannot be considered the bible for this purpose. However, there could be materially different professional views on the subject matter.

As far as Income Tax Ordinance, 2001 is concerned, it was promulgated when no development / improvement work was done on Companies ordinance and its schedules, as it was baiscally promulgated in 2001 although implemented in 2003. The companies amendment ordinance 2002 was issued during the month of October 2002 which was promulgated after the Income tax ordinance 2001 and was also a confused development on so many areas which were gradually amended and corrected afterwards. And this process is still going on.

There had been a very critical debate on the applicability of section 234 of the companies ordinace and its severe conflict with fifth scedule to the companies ordinance (before its current revisions). This prompted ICAP and SECP to take a corrective action which has resulted in current revision of fifth schedule and development of accounting standard on medium and small size entities.

As a matter of fact, professional opinion has since been evolved to amend and resemble the disclosures, methodologies and presentation with IFRSs. So manys started doing it well before the current change in fifth schdule and development of local standards.

The accounting and financial reporting standard for MSEs can be analysed to conclude that almost all the IFRSs have been used as a guideline to reach the conclusions and infact is only a Précis writing effort.

It is also our habit not to amend various laws to bring similarity and agreement among them. This cud be seen in so many cases. Thats why section 25 of ITO 2001 has not so far been amended even the revision of fifth schedule in August 2007.

In my view fifth schedule was basically purposed only for specifying disclosure requirements while for recognition and measurement we were always dependent upon Legal Generally Accepted Accounting Principles (Legal GAAP). And in Pakistan Legal GAAP (approved set of accounting standards) was only the IFRSs and other guidances as per CO84. After the amendment in CO 84 in 2002, in my view, it was quite sensible to follow as a general guideline what was being followed by listed companies for recognition and measurement purposes. Since the recognition and measurement as per legal GAAP was not allowing to defer the costs and expenditures, therefore, what was stipulated in disclosures list provided by the then Fifth schedule was almost redundant and irrelevant. This has been proved by the subsequent events.

Therefore, in my view, even in 2006 accounts, it is not sensible to follow the previous fifth schedule as it will lead to a change in accounting policy in the year 2007 and again the balance of any such outstanding deferal will have to be written off.

Further to above, as per standard for MSEs, an entity must observe the date of approval and authorization for issue of financial statements. Any thing or event before the date of authorization (normally Board meeting) of accounts is not considered as non adjusting event. The effective date of standard and revised schedule is not given in the notification which means that these are applicable from the date of issuance that almost falls in August 2007.

If the authorization of financial statements is made after this date, then in my view, it would not be justified and sensible to follow the omitted legislation and framework.

I hope this can help to understand.


Regards,

Kamran.

[Ahmadraza]

Asalamu alaikum

thanks for the contributions from all of you guys, espacially Kamran sb. this helps me a lot in analysing the situation and making decision, thanks once again

May Allah swt helps us all in helping others


Allah nigahbaan

[Schuaeb]

Dear Kamran,

Some clarifications are required regarding capitalization of expenses. I mean previously various companies were deferring their expenses before the start of normal profit and loss activities. The present revisions you say do not allow this. I am talking in the context of private companies. Which provisions of IFRS or companies ordinance allowed deferring of expenses? I am not very sure but I think I have seen expenses deferred in current year accounts of a company. (I will try to confirm things).

I thing this revision will require restatement of previous year. I actually want to know how all this will take place. I mean how would the accounts of a company look like which previously had not prepared its profit and loss account and is continuing the practice of deferring its expenses after netting off with income if any?

[kamranACA]

Dear,

The concept of differentiating among recognition, measurement, subsequent recognition, de-recognition and disclosure etc has been given by IFRSs and much emphasis has been made in the recent past.

CO 84, when developed, it was the era of very limited knowledge, research and importance for the financial statements and accountancy. Therefore, it included what could have been deemed fit in those earlier days and so much was influenced by Companies ACt 1913.

Section 234 had been dealing with IASs and IFRSs since the promulgation of CO 84 specifying for notified standards and their relevance for various companies. Even then, there was no particular guidelines regarding other accounting issues and criterion except the disclosure and presentation requirements given in the (before amendment) Fourth and Fifth schedules. There was no particular mention of recognition and measurement principles and even for dercognition in crystal clear words. A mixture of such instructions was available which was supposed to provide only a raw guideline.

Then came the amendments in 2002 to CO 84 where IASs were made compulsory for all companies including private limited or unlisted ones. Still, there had been real conflict in this section 234 as it in its ownself exepmted certain companies from cash flow statement and statement of changes in equity that was really against the IASs. Moreover, the disclosure requirements of 4th and 5th schedules included so many such things which did not at all agree to IFRSs and had real conflicts with them. These may be seen in case of segment information and segment selection/identification, government grants and relevant recognition of assets, capitalization of exchange differences, deferring certain costs and so many others.

This had ever been in the eyes of ICAP and other stakeholders and regulators, so, amendment in law was always desired. Still, being a governmental issue, it took so much of time to bring 4th schedule of CO 84 in line with IFRSs providing only certain additional disclosures. For example IAS 24 does not accept the chief executive, directors or executives remuneration as a related party transaction. Even it is not described by CO 84 as such. Still its detailed disclosure has beend demanded by 4 the schedule as in pakistan the service contracts of CEO and directors are typically carrying related parties issues and have to be kept under the eye of regulators. You will appreciate that a Matric pass/fail CEO can get salary in millions in Pakistan thus making it a related party issue by all means. So it is only for explaining that additional disclosures prescribed by 4th schedule after amendment are not in conflict with IFRSs and now it is almost in agreement with IFRSs.

Further to it, since IFRSs were applicable on all companies but disclosures required under 5th schedule were different than IFRSs and its revision was also desired. Meanwhile, ICAP developed standard for MSEs and SSEs under TR 5. Therefore, fifth schedule was revised keping in view practical issues and categorization for following IFRSs or MSE standard or SSE standard was laid down.

Now, about ur question, yes, there was no where mentioned for deferring such costs in CO 84 except fourth schedule and Fifth schedule, before their current revision. Even these were given as a disclosure items, still, this caused the reason for their existence and provided a mild way out to account for such transactions in this way.

After the revision of schedules and elimination of such options, companies had to change their accounting policies wherever necessary and the companies in fact did this all applying IAS 8 in case of listed companies and other relevant standards in case of other companies.

The company which had not been preparing its profit and loss account, has to prepare it, adjusting /writing off the deferred cost to loss in the earliest period presented and then adjusting remaining figures in comparative and current profit and loss account.

Only some transition provision ould be helpful to avoid such on spot adjustments as were specified for capitalization of exchange differences and deferred cost already recognized etc.

However, after such pronouncements, it was mandatory to do what has been prescribed.

Hope you would be benefited.


Regards,


Kamran.

[Schuaeb]

Dear Kamran,

I am really thankful for this detailed reply. However, I would like a bit more clarification regarding your following lines.

<blockquote id="quote"><font size="1" face="Verdana, Tahoma, Arial" id="quote">quote<hr height="1" noshade id="quote"><i>Originally posted by kamranACA</i>
<br />Only some transition provision ould be helpful to avoid such on spot adjustments as were specified for capitalization of exchange differences and deferred cost already recognized etc.
<hr height="1" noshade id="quote"></font id="quote"></blockquote id="quote">

What are these transition provisions for already recognized deferred cost? And I think application of IAS 8 is required in this case for listed as well as unlisted companies. I am not very sure what do standards for MSEs say in this regard.

Thanks once again for your kind consideration


Regards
Shoaib

[kamranACA]

Dear Shoaib,

When 4th schedule was revised SECP issued a circular (I think it was issued in October 2005) that the already recognized deferred cost may not be totally reversed as per IAS 8 by adjusting opening balances of deferred cost and retained earnings. Rather, it prescribed that the already recognized deferred cost would be allowed to carry in the balance sheet and amortize within the period specified as per already adopted and disclosed accounting policy. However, it strictly abstained from deferring any more costs after revision of 4th schedule. This rqeuired modification to such extent in the accounting policy of deferred costs.

So, companies carried the deferred cost and amortized it at the rate (within the years) stated in the accounting policy, but never deferred any cost after revision of 4th schedule.

So such transitional provisions are provided through notifications, circulars or other legislative pronouncements.

Now, after revision of 5th schedule no such transitional provision has been specifically annoounced so far (as per my info). But it would be logical to follow what listed companies had followed in this situation some two years earlier.

This could be understood as a general guideline.


Regards,

Kamran.

[Schuaeb]

Thanks Kamran, so IAS 8 is not needed to be applied, however, further costs whether pre operation expenses can't be deferred by a listed or un listed company.

IAS 18 lays down the guidance relating revenue recognition. In many cases revenue can't be recognized as it doesn't fulfill the specified recognition crieteria. So it was also used as a plea for deferring pre operating expenses.