Query relating to Capitalization policy

[SNIPER]

Hello all.

I would like to seek your comments on the following situation.

Suppose Company X has a capitalization policy of Rs 5,000 (i.e expenditure of capital nature above Rs. 5,000 be capitalized while that falling below this threshold be expensed out). Now the company purchases the following from a supplier in a single transaction.

> 5 Chairs (Rs 2,000 each) - Rs. 10,000
> 4 Tables (Rs 1,000 each) - Rs. 4,000
> 1 Conference table - Rs. 10,000

Total Amount Paid - Rs. 24,000


The question thus is, how will the above transaction be treated in light of the company's capitalization policy?

> Should we compare the value of the transaction (Rs. 24,000) against the threshold (Rs. 5,000)?
> Should the value of each furniture type (i.e Rs. 10,000 for 5 chairs) be compared with the threshold (Rs. 5,000)?, or
> Should the value of a single item (One chair - Rs. 2,000) be matched against the threshold?


Regards,

[kamranACA]

Dear,

In my view the above accounting policy is a bit arbitrary and does not strictly coincide the recognition criteria given in paragraph 7 of IAS 16 i.e. it is probable that economic benefits will flow to the entity (during holding period) and cost could be measured reliably.

Now saying that economic benefits will flow to the entity only in case of additions exceeding Rs 5000 in value appears to be vague. Therefore, this policy requires a debate and professional input. Specially auditors should satisfy theirselves that the accounting estimate regarding matching the threshhold with recognition criteria is suitable or not.

Chairs, tables etc are distinct assets and do not make part of an isolated asset. IAS 16 allows separately capitalizing the parts of an asset where such parts have separate importance, economic jusitification and useful life from the main asset. However, grossing up of seprately identified assets, in this case, does not appear to be justifiable as each chair or table has seprately identified useful life and cost.

Despite the question on fairness of accounting policy under discussion, in my view, the threshhold decided in the accounting policy would be applied on each chair and table seprately. Thus meeting the last option given in your question.

The reason is becoz the policy cannot focuss the transaction value or contract value. Rather, it has to place its focuss on establishing the criteria about an asset i.e. capital expenditure on a particular asset. IAS 16 has no where discussed the transaction level or contract value levels for establishing the recognition critera.

For example what would be the decision for capitalization where such an entity has purchased 10 calculators having Rs.3000 value per calculator and where such caculators are expected to be used for number of years, say 7 years. In my view the threshhold would be applied on one calculator of Rs 3000 rather than on all calculators simultaneously for Rs 30000. If this has to happen then very tiny items (having useful life of more than one year) would be capitalized making part of a whole transaction.

However, wording of policy is not specific and clear and management can mold it in either way to decide what they like.

Therefore, question still remains about the fairness and validity of the policy.

Hope you would find this reply beneficial for you.

Regards,

Kamran.

[SNIPER]

Kamran,

Thank you for the detailed answer.

Defining a threshold for capitalization is a normal practice in Pakistan. However, it should be noted that the threshold alone is not the criteria for capitalization, the said expenditure has to meet the definition of IAS 16 (i.e control, future ecnonomic benifits, more than a single period).

Taking your example of calculator, the economic benifits are consumed over a number of year and therefore it meets the criteria set by IAS 16. But most companies will not capitalize these calculators on the basis that the amount is not material. No company will want to capitalize a calculator purchased for a nominal value say Rs 300 thus the threshold.

This threshold thus acts as a filter for materiliaty.

Regards,

[kamranACA]

Dear,

IAS 16 does not provide for any materiality criteria for recording the property, plant and equipment. The stipulation laid down by IAS is the probability of future economic benefits by virtue of holding such asset and the reliable measurement of its cost.

I know this practice is prevelant in many companies to settle some threshhold for this purpose. However, I cannot understand that how flowing of future economic benefits could be ascertained by deciding a threshhold. There is no such stipulation or guidance in IFRSs. Simply saying that, IFRSs are not meant for immaterial items, will not lead us to conclude that some thresh-hold is likely to be settled for differentiation between capital and revenue expenditure.

In my view, if any item (asset) has a life for more than one year and its utility remains for the entity then it should be capitalized. This is the best tool to place the physical control on misplacements / movements of such assets. Because, if capitalized, it will also appear in the fixed assets register with all location and custodian information. Any entity normally does not maintain same registers for revenue items. Safegaurding of assets is main responsibility of the management. TR-06 issued by ICAP has stipulated certain minimum requirements of fixed assets register and also stipulates the physcal verification of fixed assets after specified intervals. So that the balances appearing in fixed assets register could be verified with physical balances and adjustements be made for the shortages found during physical verification.

I cannot understand how an entity will ensure safegaurding of all its asset of whatever value if it will not maintain the fixed asset register. Further, if items below the threshhold are not capitalized, how their physical existence and control on their misplacements can be ensured. In my view, recording the assets as capital expenditure has direct linkage with careful custodianship of such items. If these items will be charged to revenue, the management, in my view, will hardly be able to safe gaurd them even if these are calculators of Rupees 500 each. What requires to be decided is, does it has useful life of more than one year. If this condition is met, in my view, IAS 16 does not allow to expense it out. A company cannot affoard losing such items solely with the reason that these fall short of thresh-hold decided by it.


I understand that so many accounting policies adopted traditionally by various companies need to be evaluated. For example, besides above, IAS 16 (para 8) requires capitalizing all major spares and stand by equipments when an entity expects to use them during more than one period. Only minor spares and servicing items are to be kept as inventory. All major spare parts and supporting equipments qualify for capitalization along with the property, plant and equipment. I rarely see this accounting treatment by companies although wherever new plants are errected, so many of such major spares and stand by equipments are accompanied by the main machinery. These are normally kept by entities as inventories. I want to clear that these qualify for capitalization, even if these are not issued for installations and are kept in stores. Huge expansion is seen in cement sector. But I expect Companies will rarely follow this stipulation of IAS 16.

Further to above, para 16 of IAS 16 explains the components of cost of an item of property, plant and equipment. I recommend you to see its sub para/clause (C). It stipulates the following to be recognised as part of cost of an item to be capitalized

"........the initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located, the obligation for which an entity incurs either when the item is acquired or as a consequence of having used the item during a particular period for purposes other than to produce inventories during that period........."

This mainly happens in sugar manufacturing and oil extraction and refining business. However, it can happen in even other businesses. If such an estimated expense is to be capitalized at the time of initial recognition of the asset, the relevant provision will also be required under IAS 37 to complete the double entry.

Except for OGDCL, I rarely see this accounting treatment by companies.

I know I am talking on more complex issues than the simple issue raised by you. In fact I just endeavor to point out that so much happening as traditional acounting practice in Pakistan needs to be re-considered and evaluated.

I have full regard and respect for the opinion of any other professional and I know that I cannot alter any conclusion that may be drawn by any one else on this forum. However, in my view, this accounting policy needs to be properly evaluated specially where even the thresh-hold decided cannot be implemented with a clarified difference. I mean the situation pointed out by you. I may be wrong as I am not one of those who make the pronouncements. I just shared my views on this matter raised by your goodself.

Best regards,

Kamran.

[SNIPER]

Kamran,

The capitalization policy of most Companies that I've seen almost always specificy a threshold. Whilst this threshold does not form the part of IAS-16, it is mostly endorsed by their auditors.

For a company having a balance sheet footing of say Rs. 10 million, a calculator worth Rs 500 is of little, if any, value. It would waste precios management time to seperately calculate the depreciation, gain/loss on disposal on a monthly basis, updating schedule for these nominal items, when this time could add greater value by tackling other more important tasks. Implenting controls over safeguarding of assets is vital for entities, but, it will be useless if the cost of implementing these controls exceed the benifits they serve. Further in the said case, the management of the entity was keeping a seperate record for such inventory for the purpose of safeguarding these assets.

I highly value your input on these professional issues, to be honest, I was also not satisfied with this prevailing practice by different entities initially, but after a careful thought and discussions with other professionals, I dont have any objections left on entities using such capitalization criteria.

Regards

[kamranACA]

Dear,

Thank you for your response.

I know cost benefit analysis helps in deciding what to capitalize or not. This makes a part of management's accounting estimates. However, it is a matter of judgment from case to case basis. This should not result in settling down a subjective thresh-hold. By the way, none of my clients has adopted this accounting policy. They may not be capitalizing each and every item but it is the matter of case to case analysis based upon cost-benefit estimation. Yes, off course calculators and other such nominal value items are not capitalized.

If an entity estimates that the future benefit of an item is so meager that categorizing it as a capital item would lead to excessive cost than its benefits, then off course, such item needs not to be capitalized. But again closed eye thresh-hold will some time make the things adverse.

However, in my view, specifying a thresh-hold is not a measure of cost and benefit.

Just for example, if some component of a plant (that falls under the recognition criteria of IAS 16)is not available in local market and is of immense importance to the operating capability of the plant, should be capitalized irrespective of its value. Becoz, its benefits are off course enormous that may have to be analysed on qualitative grounds. In such cases, a fixed thresh-hold would not be a good measure for making an acounting estimate.

However, as you said, that inventory record of such items is also being maintained by the entity discussed by you, then it will create a sufficient control for safe gaurding such lower value assets.

Thank you very much for your comments for me. I am off course a humble creature of God and do not have any claim for perfection.

Best regards,

Kamran.