Accounting in Practice - Tangible Assets
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Transcript of Accounting in Practice - Tangible Assets
Corporate Reporting
With reference to the measurement of tangible non-current assets, critically
evaluate whether financial statements prepared using IFRS’s provide useful
information. Use specific examples from the annual reports of FTSE 100
companies to illustrate your points.
Written by
Jason Cates
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© Jason Cates, 2012
Reproduction for the following uses is authorised provided the source is acknowledged in
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This paper has referenced appropriate sources in line with Harvard Referencing.
Any queries regarding this publication should be sent to:
LinkedIn.com/in/AdrJasonCates
To be delivered to the University of Hertfordshire on or by
3 December 2012
Ordered by Jason Cates to be printed
26 November 2012
Printed in the United Kingdom
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Hans Hoogervorst, chairman of the IASB, said at the International Association for Accounting
Education and Research conference in Amsterdam on 20 June 2012 that he “was struck by
the multitude of measurement techniques that both IFRSs and US GAAP prescribe”.
With reference to the measurement of tangible non-current assets, critically evaluate
whether financial statements prepared using IFRS’s provide useful information. Use specific
examples from the annual reports of FTSE 100 companies to illustrate your points.
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Contents Aim .......................................................................................................................................................... 4
Structure and Introduction ................................................................................................................. 4
Comparison ............................................................................................................................................. 6
Fair Value vs. Historic Cost .................................................................................................................. 6
PPE (Valuation and Lifespan) .............................................................................................................. 6
Aircraft ................................................................................................................................................ 7
Conclusions ......................................................................................................................................... 8
Implications ........................................................................................................................................... 10
Comparability .................................................................................................................................... 10
Relevance .......................................................................................................................................... 10
Reliability ........................................................................................................................................... 11
Understandability ............................................................................................................................. 11
Conclusions ........................................................................................................................................... 12
Formalities ............................................................................................................................................ 13
Signatories......................................................................................................................................... 13
References ........................................................................................................................................ 14
Appendix ........................................................................................................................................... 15
Note 1 – Depreciation and Impairment for year ended 31st December 2011 .............................. 15
Note 2 –Percentage Calculations for Depreciation ....................................................................... 15
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Part I
Aim
The aim of this paper is to evaluate the usefulness of financial statements prepared in line with the
IFRS standards with a focus on the measurement of tangible non-current assets. This is in light of a
recent statement made by Hans Hoogervorst, chairman of the IASB, stating that he “was struck by
the multitude of measurement techniques that both IFRSs and US GAAP prescribe”. (Hoogervorst,
H., 2012)
Structure and Introduction
The above aim will be carried out by comparing the valuation techniques utilised by both
BAE Systems and Rolls-Royce in terms of their implementation of IAS 16 and IAS 36.
At this point, it is appropriate that we define the term “useful” in the context of this paper.
In this case, there are 4 key characteristics of usefulness. These are comparability, relevance,
reliability and understandability. (Elliot & Elliot, 2012) The implications on these key characteristics
due to differing interpretations of the IFRS standards will be evaluated later on in this paper.
As stated, the companies utilised in this paper are BAE Systems and Rolls-Royce. This is due
to their comparability in terms of industry and types of asset held. This comparability will help
facilitate the evaluation of their measurement of tangible non-current assets with a focus on how
they differ, why they differ and its effect on “usefulness”. (Bloomberg, 2012)
BAE has total assets worth £23.101bn, £16.720bn in non-current assets and PPE worth £2.496bn
(11% of total assets). (BAE, 2012) This is while Rolls-Royce has total assets worth £16.423bn,
£8.108bn in non-current assets and PPE worth £2.338bn (14% of total assets). (Rolls-Royce, 2012) All
as at 31st December 2011. This shows BAE is the larger of the two companies in terms of total assets,
but with both companies having relatively similar PPE figures. These figures and their treatment will
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be evaluated with a focus on their implications concerning “usefulness” under the 4 key aspects
mentioned earlier. This paper will then conclude by answering the question; do “financial
statements prepared using IFRS’s provide useful information?”
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Part II
Comparison
Fair Value vs. Historic Cost
In relation to fair value vs. using historic value, the valuation method utilised depends on the
nature of the business and the relevance each method has to the business. As stated above, PPE
makes up 11-14% of total assets. Therefore, the difference fair value accounting will have on
tangible non-current assets is relatively immaterial. Thus, whichever method they utilise will have
little impact on the key accounting ratios such as gearing and/or return on capital employed.
Additionally, the benefits of using fair value may be outweighed by the costs involved, both
financially and in terms of being time consuming. This issue relates specifically to aircraft where
there may be significant difficulty determining fair value during the “course of construction”. As
such, the matters of cost and materiality are key issues when weighting the use fair value against
that of historic cost.
PPE (Valuation and Lifespan)
As stated in BAE’s Annual Report 2011, “all fixed asset investments are stated at cost less
provisions for impairments.” and “Depreciation is provided, normally on a straight-line basis, to
write off the cost or valuation of tangible fixed assets over their estimated useful economic lives”. It
also states that BAE considers its buildings to have an estimated life of “up to 50 years” and other
equipment to having estimated lives of “10 to 15 years”. Simply speaking, BAE values its “tangible
assets” at historic cost minus accumulated depreciation and impairment. (BAE, 2012)
Additionally, Rolls-Royce’s annual report states that “Depreciation is provided on a straight-
line basis to write off the cost, less the estimated residual value, of property, plant and equipment
over their estimated useful lives. No depreciation is provided on assets in the course of
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construction”. This is in line with BAE’s valuation policy, but the difference lies in the assigned
lifespans of these non-current assets. (Rolls-Royce, 2012)
In terms of property, BAE depreciates its buildings for “up to 50 years” with an average of 22
years; Rolls-Royce on the other hand uses the life span of “five to 45 years” with an average of 21
years. This apparently minor difference saw BAE’s depreciation charge £4M lower in 2011 than if it
had used the average lifespans utilised by Rolls-Royce. (Rolls-Royce, 2012)
In terms of plant and equipment, Rolls-Royce’s policy is to depreciate these over “five to 25
years” and at an average of 12.9 years in 2011. This is while the average for BAE in 2011 was 12.7
years. This difference saw BAE’s depreciation charge £3M higher in 2011 than if it had used the
average lifespans utilised by Rolls-Royce. (BAE, 2012) (Rolls-Royce, 2012)
Aircraft
Although inventory is generally considered a current asset, companies such as Rolls-Royce
and BAE produce inventory that often takes more than a year to manufacture. In addition, Rolls-
Royce leases out much of its inventory rather than selling it. As such, some inventory may be
categorised as PPE. Therefore, how this inventory is valued is relevant when considering the
measurement of tangible non-current assets. (BAE, 2012)
Both BAE and Rolls-Royce have included a separate category for “aircraft” in their PPE, but
with Rolls-Royce separating out completed aircraft and those “In Course of Construction” with both
categories being treated differently. Both companies show their aircraft “In Course of Construction”
simply at cost. Then once completed, these aircraft are then depreciated over their assigned lives.
For BAE, this life is “up to 15 years” and Rolls-Royce, “five to 20 years” with an average of 16 years.
Due to this difference in inventory lifespans, BAE’s depreciation charge was £8m higher in 2011 as
compared to the average lifespans used Rolls-Royce. (BAE, 2012) (Rolls-Royce, 2012)
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In addition, Rolls-Royce’s separation of complete and incomplete inventory allows users to
determine the effects this may have on the company’s short-to-medium term profitability. This
relates to the rate of depreciation being charged as well as the level of long-term inventory open to
being leased out. (Rolls-Royce, 2012) However, in their 2011 annual report, BAE states that they
treat these two categories of inventory differently, but they fail to state how much inventory is
assigned to each category. (BAE, 2012) This lack of transparency by BAE has a negative impact on
their information’s usefulness.
Conclusions In 2011, BAE depreciated its tangible non-current assets at a rate of 6.1% per year as
compared to 6.6% per year by Rolls-Royce. Therefore, in proportion to the total value of tangible
non-current assets, it is Rolls-Royce who pays the higher level of depreciation. However in 2011, BAE
charged 14 times more impairment in proportion to its tangible non-current assets. (BAE, 2012)
(Rolls-Royce, 2012)
This difference in treatment comes down to the nature in which these companies operate.
In the case of Roll-Royce, it tends of lease out long-term inventory to a greater extent than BAE.
Thus, its future cash flows and inventory lifespans can be estimated more accurately. Due to this
increase in accuracy, there may be less need for Rolls-Royce to impair its assets. (Rolls-Royce, 2012)
This is unlike BAE who has to account for greater uncertainty while estimating future cash
flows. This includes, among other things, uncertainty relating to the long-term value of it’s aircraft.
Furthermore, BAE’s future cash flows may also be partially dependant on performance targets such
as delivery dates. This includes budget overruns and/or penalties for late delivery. Therefore, aircraft
value and expected future cash flows may be lower than accounted for, thus leading to a greater
need for BAE to impair such assets. However, these penalties can be measured relatively accurately,
therefore leading to an accurate level of impairment being charged. (BAE, 2012)
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To conclude, in stable economic conditions, Rolls-Royce will see its profits impaired when
compared to BAE due to their higher rate of depreciation. However, in downward economic
conditions, BAE may have to impair the value of its assets to a greater extent than Rolls-Royce due to
its higher book value of its assets. This will make BAE appear to be fairing comparably worse off in
such economic downturns, but “better off” in more stable economic conditions. This is in spite of the
fact that in reality, both companies may be facing very similar trading conditions, but have simply
recognised this differently in the accounts.
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Part III
Implications
This paper will now consider how the above treatment of tangible non-current assets affects
the usefulness of information provided by companies such as BAE Systems and Rolls-Royce.
Comparability
This issue of comparability, or lack of, has been a continuing theme throughout this paper.
As stated, the difference in the way the two companies discussed operate has brought about a
difference in their accounting policies. As stated, although both companies’ value assets using
historic cost, difference arises in relation to the lifespans they assign these assets as well as the level
of impairment each asset then incurs throughout its life. This reduces the comparability of their
accounts and thus hinders their usefulness to users. (BAE, 2012) (Rolls-Royce, 2012)
Relevance
It can be argued that in order to be relevant, accounts should be tailored to the company in
which they represent, sometimes at the expense of comparability. Again, this has been a continuing
theme throughout this paper. By allowing the companies the flexibility to tailor the standards, the
information provided by these companies then becomes more relevant, but less comparable.
Therefore, a balance has to be struck between these two sometimes conflicting issues in order for
the information provided to be considered “useful”.
An example of this is aircraft valuation. Rolls-Royce depreciates its aircraft over 25 years and
in 2011; saw impairments of £2m (0.46% of cost). In comparison, BAE depreciates its aircraft over 15
years and saw impairments of £14m (1.44% of cost) in the same year. This lower rate of depreciation
and impairment seen at Rolls-Royce reflects the nature of their operations in terms of leasing out
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aircraft to a far greater extent than BAE. This increases relevance, but hinders comparability. (BAE,
2012) (Rolls-Royce, 2012)
Reliability
Due to the difference in treatment of similar assets by both companies discussed in this
paper, this leads to the question as to whether their treatment of such assets is reliable. In terms of
BAE, the fact that they are having to impair their assets, namely their aircraft, much more so that
Rolls-Royce shows that their depreciation policy may not be as reliable as that of Rolls-Royces. (BAE,
2012) (Rolls-Royce, 2012) This may be due to greater certainty as to Rolls-Royces future cash flows
due to leasing out aircraft rather than selling them on.
Thus, reliability depends on the nature of the company and to what extent they can
accurately value such tangible non-current assets.
Understandability
In terms of understandability, although minor differences do exist between these two
companies, their implementation of IFRS standards does remain relativity similar. This will help
facilitate understandability for those who are accustomed to analysing such information. However, if
companies do diverge in their implementation of the IFRS standards, a lack of transparency will
hinder the information’s understandability to readers, thus hindering the information’s usefulness to
stakeholders.
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Part IV
Conclusions
To conclude, in regards to tangible non-current assets, information provided in line with the
IFRS standards can provide useful information. However, the degree of this usefulness depends on
which qualitative characteristic is more relevant to the given situation.
This is due to different qualitative characteristics applying in varying degrees in different
situations. These differences increase the risk of potential conflict arising between these qualitative
characteristics and in such cases, which qualitative characteristic should take precedence?
These potential conflicts continue to hinder the usefulness of information. Further guidance
is therefore required for companies on how to overcome these conflicts. This may require adapting
or adding to the current IFRS standards in order to better facilitate this “conflict resolution”. This
may include, but not exclusively, ranking the qualitative characters in order of precedence. This will
allow companies to focus on the characteristics that best promote “usefulness” as outlined in this
paper.
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Part V
Formalities
Signatories I commend this paper to the University of Hertfordshire to be delivered on or by 26 November 2012.
Jason Cates
___________
Mail: [email protected]
Portfolio: SlideShare.net/AdrJasonCates
LinkedIn: LinkedIn.com/in/AdrJasonCates
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References (In line with Harvard Referencing)
BAE Systems (2011) Annual Report 2011. [Online] Available at: http://www.baesystems.com/cs/groups/public/documents/document/mdaw/mdu2/~edisp/baes_045566.pdf [Accessed: 14th October 2012]
Bloomberg (2012) Aerospace/Defence Companies. [Online] Available at: http://www.bloomberg.com/markets/companies/aerospace-defense/ [Accessed: 16th October 2012]
Elliot, B. & Elliot, J. (2012) Financial Accounting and Reporting. 15th edn. Malaysia: Pearson.
Rolls Royce (2011) Annual Report 2011. [Online] Available at: http://www.rolls-royce.com/Images/RR_full_AR_2011_tcm92-34435.pdf [Accessed: 14th October 2012]
Hoogervorst, H. (2012) The imprecise world of accounting. [Online] Available at: http://www.ifrs.org/Alerts/Conference/Documents/HHoogervorstJune2012theimpreciseworldofaccounting.pdf [Accessed: 2nd October 2012]
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Appendix
Note 1 – Depreciation and Impairment for year ended 31st December 2011
BAE Systems £Millions Land &
Buildings Plant &
Machinery Aircraft Total
Cost 2195 2551 759 5505
Depreciation 101 201 34 336
Impairment 29 - 14 43
(BAE, 2012)
Rolls Royce £Millions Land &
Buildings Plant &
Machinery Aircraft Total
Cost 806 2387 439 3632
Depreciation 39 185 15 239
Impairment - - 2 2
(Rolls-Royce, 2012)
Note 2 –Percentage Calculations for Depreciation
BAE - Depreciation as a Percentage of Cost for 2011 (£Millions)
Land & Buildings 101/2195 4.6%
Plant & Machinery 201/2551 7.9%
Aircraft 34/759 4.5%
Total 336/5505 6.1%
(BAE, 2012)
Rolls Royce - Depreciation as a Percentage of Cost for 2011 (£Millions)
Land & Buildings 39/806 4.8%
Plant & Machinery 185/2387 7.8%
Aircraft 15/439 3.4%
Total 239/3632 6.6%
(Rolls-Royce, 2012)