To capitalize or not?

16.05.2009

Epigraph

First accountant: On the one hand, it is convenient, but, on the other hand, still annoying to be compelled to write off at once… The company has leased half a building in Kiev center from the city authorities for 5 years and has invested about UAH 1.5 million in renovation. We will be leasing the rooms out for presentations, workshop, etc. And though it looks like we will be getting profit during all these 5 years, we will have to write off the renovation expenses right away. At least in financial accounting.

Second accountant: Why should you write them off? This is a normal capital expenditure which will be even necessary to depreciate both in NAS and IFRS during the lease period.

FA: However, the building belongs to the city and we are not very hard on controlling this asset. I agree that the lease period accounts for 5 years but each year the price may be revised, which makes the problem even harder. There is no guarantee that we should not be bound to leave it, say, in three years.

SA: If we look at things like that, assets in the balance sheet will not be very big amount at all. A purchased machine may hopelessly go out of service, a building may burn down and a truck may be stolen. Yet our task as that of accountants’ lies in estimating the assets with due regard for the fact that we will keep moving smoothly and that the contract signed by the parties for 5 years will remain valid for the specified period.

FA: But how can we estimate that we will probably hold the lease for the entire contracted period when a year hardly ever passes without change of the authorities?

SA: What may I answer? Neither me, nor anybody else can give a guarantee. This is where all the complexity of our job comes from – a very significant portion of accounting data relies on assumptions of the future as seen from today. We may agree to the contract of lease and its five-year duration, we may assume there might be problems, we may seek the help of real property appraisers (especially as the contract stipulates a possible change of the price) – no option provides a guarantee and we are all the same confronted with a need to make a well-reasoned choice.

Body

Only in theory investments in purchased and created non-current assets (fixed and intangible) differ from current investments so easily that it evokes no complexity. In practice the problematic issue “to capitalize or not” can be very multifold. It may be solved differently in various accounts (US GAAP, IFRS, NAS, tax accounting, etc.), by various types of organizations (commercial, state-owned, non-profit), companies of various sectors and sizes, etc.

Specific trends of creating fixed and intangible assets may give rise to developing and putting into effect various rules for expenditure capitalization and grouping methodologies – “collecting” accounting entities, charts of accounts and subaccounts for capital investments and administrative itemizations.

Such differences in expenditure capitalization processes may lead to a tendency toward simplified detection of expenses subject to capitalization, their classification, grouping and recognition as depreciable assets. Simplification may often be justified from the point of view of materiality. But in many cases it may result in inadequate estimation and, ultimately, in two opposite tendencies:

Writing off capitalizable costs as operating expenses;
Capitalizing expenses which should be written off in a current period (as overhead, administrative costs) or in a period when income gets generated (as operational activity expenses).

In both cases this may lead to distorted financial statements, but supernormal capitalization is even a “heavier sin” which will more obviously cause overestimation of profitability in the current period and its underestimation in the periods that follow. This mistake may be made both unconsciously and purposefully. Anyway, the company should make every effort to bring its estimations as closer to the reality as possible.

What do the basic standards say?

All accounting environments, regardless of their internal nature, aim at distinguishing revenue and expenses type of transactions from investment type of transactions. In this case, capital investments are always understood as expenses leading to creation of accounting items which, when used, will bring certain economic benefits in the course of more than one operational period.

This wording, quite general and complex, has been differently reflected in different accounting standards, that is GAAP (US GAAP), IFRS (IAS, IFRS), NAS, tax accounting rules (Ukrainian companies basically use the last three sets of standards).

Among them the easiest to use are tax accounting rules in compliance with the Law “On Taxation of Enterprises’ Profits”, which says that the wording “fixed assets” implies tangible assets which may be used more than 365 days, with the value exceeding UAH 1.000 and gradually getting lower due to their physical or moral depreciation. This unambiguous interpretation is “spoilt” by a further definition of an intangible asset that has no valuation criteria but referring to assets only those intellectual property items that belong to the company under the right of ownership. Yet the tax accounting rules imply no considerable difficulty in differentiating between current operational and capital expenditures – the rules are as unambiguous as far from reality (that is traditionally required from the tax rules).

Companies keeping accounting according to US GAAP must be guided by much more complex criteria. The number of Financial Accounting Standards (FAS) alone, which to various extent raise the subject of capital expenses is more than five. To those may be referred, for example, Standards “Account of expenditure on research and developments”; “Capitalization of borrowing costs”; “Capitalization of borrowing costs in financial statements that include investments accountable according to the capital ownership method”, “Research and development”, etc.

Luckily, Ukrainian companies more often keep accounting records according to IFRS according to which an attempt has been made to incorporate fixed assets issues under one Standard 16 - “Property, Plant and Equipment”. Combined with the rules for capitalization of expenses on creation (purchase) of intangible assets, this Standard forms a basis for accounting of the company’s capital investments. The Standard puts forward the following criteria referring an asset to fixed assets: “used in production and supply of goods and services, let out to lease to other companies or for administrative purpose” and “is meant to be used for more than one operational period”. Fixed assets may be recognized as such only if they provide for future economic benefits and objective valuation of their initial costs can be derived at.

So, the Standard envisages neither availability of cost criteria of capitalization, nor presence of a basic unit of fixed assets.

Very much alike are rules of National Accounting Standards (NAS) which additionally distinguish a special account for accumulating information about ongoing capital investments - 15 "Capital investments" (in compliance with the Instruction for charts of accounts application), which is typically itemized down to subaccounts 151 (capital construction), 152 (purchase of fixed assets), 153 (purchase of other non-current tangible assets).

It becomes clear from the foregoing that, apart form the tax accounting rules, in remaining cases a company has in effect to develop internal additional expenditure capitalization criteria on its own and to work out charts of accounts and internal control procedures.

Correct process

First of all, accounting policy for each type of accounting should stipulate a special clause dedicated to investments, which would include, among other things, capitalization of expenses associated with investments. No doubt that accounting policy should declare here compliance and interconnection with respective standards. Then it is worth while outlining a chart of accounts related to accumulation of information about capital expenditure. If the upper itemization level should comply with an approved nation-wide chart of accounts in the Ukrainian accounting, tax accounting and IFRS provide for no restrictions for a chart of accounts. Nevertheless, in my opinion, a company may create in all types of accountings identical upper-level itemization adding to it only an account for accumulating information about investments in intangible assets. Lower levels of chart of accounts itemization will be substantially different with different companies – items will grow in number as a company creates fixed and intangible assets. Mandatory items in the accounting policy should also include:

Rules of grouping expenses to form one identifiable item (of fixed or intangible assets).
Rules of allocating general expenses for investment projects. Those, for example, may cover staff salaries, electricity fees, etc. It should be noted that more often companies decide to allocate such expenses according to the total costs of projects. However, in this case, cost of a facility is just being formed, which may cause essential allocation distortions. Therefore, if expenses for allocation are significant, you may use a simpler option for an allocation base, which is a estimated cost of a project or, which is more difficult, apply an ABC methodology (activity-based costing) to develop adequate allocation bases. Anyway, it is in accounting policy where an allocation system should be established to provide an unambiguous interpretation by all subdivisions.

Logical description of investment-related processes stands apart from accounting policy. Such description may also help to determine a structure of internal source documents pertaining to investments. An emphasis should be put here on distinguishing between source documents in interpretation of financial accounting and tax accounting. Interpreting capital expenses, transition between investment stages, finished fixed and intangible assets according to source documents in terms of tax accounting (that is signed acceptance acts, invoices, official construction documents) is a very common mistake. Then it occurs that, for example, a fixed asset has been in operation for a long time without being depreciated since mutual claims prevent the parties from signing acts with suppliers and assemblers. Internal documents (valuation acts, registers, internal invoices, etc.) which will bring accounting estimates as close to reality as possible ought to be actively used.

Description of processes, responsibilities of managers, source documents will be unique for each company. This is not a closing stage for creating a system intended to help a company to detect, estimate and account for capital expenditure because operation of this system presents an isolated problematic area.

Control, even “post-mortem”

Description of the rules for capitalization of expenditures applicable to a particular company based on general standards, implementation of procedures and source documents pertaining to these expenditures form only a part of an expenditure-related problem. Expenditure capitalization may be accompanied by manipulations, both unconscious and intentional, aiming at both increasing and decreasing the profit. These manipulations mean that if specific expenses incurred in a particular period are capitalized, then later they should be subject to depreciation for a period typically ranging between 36 and 120 months. As a result, during all this period they negatively affect company’s profit (for a majority of items). In other words, if these expenditures are related to generated profits only in one period or are to be written off as part of administrative expenses, they reduce only profit of the specified period. The scope of this problem may be small but it may lead even to the collapse of some companies. Generally, the more open a company is and the more actively it creates the items of non-current assets, this problem gets more critical. What are the most widespread variants of mistakes and manipulations?

Firstly, this is capitalization of operating expenses that gives rise to profit overestimation. A simple example: a company established the capitalization limit at the level of USD 500. In this case a company purchases a set of furniture consisting of 20 chairs at UAH 450 and 10 desks at UAH 930. The accounting reflects it as a single item – “a set of furniture for the conference room” acquired at the purchase price of UAH 18,300. Here is another example: a company carries out a certification project for all IT-employees in accordance with an international certification program that requires availability of a certificate as a condition of further employment. Expenses related to this process may be capitalized, however, since they are considerably scattered in time and written off at once in tax accounting, their writing-off happens in the recognition period.

Companies have to impose stringent regulations upon investment-related projects. In most companies this will be facilitated by the budget process that should, apart from technical details, contain well-grounded data about necessity and objects of investment. Preliminary consideration of a future investment issue will noticeably narrow a space for the above-mentioned mistakes. In some cases, especially when investing in the core business, a company may also strictly bind capital expenditure to future income (e.g. a drinkable water production line is bound to specific products it will be producing in future). However, post-mortem (the word of Latin origin) control, that is an inspection conducted by an internal audit service or accounting staff, is also important. In this case it is referred to detection and depreciation of non-current assets that are in use but do not bring economic benefits any longer. This, in small scopes, resembles a “small bath” practice, when a company massively writes off considerable amounts of earlier capitalized costs. Yet such “small bath” should be permanent and related to every-day routine rather than to global strategy revision, business sales, etc. Then it makes it possible to carry out an analysis, say, of the following nature: the Odessa-based branch keeps writing off the items of non-current assets twice as often as it is average with the company, and the branch keeps balancing on edge of zero profitability all the time. This information will help to remedy the situation and to prevent similar problems from happening in the future.

Secondly, writing off capitalizable amounts as operating expenses. This is a situation opposite to the previous one. To begin with, the earliest possible write-offs may be supported by both the company top management and accountants. This, in effect, is encouraged by all accounting standards. In addition, these expenses are rather difficult to track by services in control for similar transactions. However, the typology of expenses subject to inspection may at leased be monitored. This will help auditors to focus on weak points that are likely to be associated with:

Expenses on repairs and maintenance of fixed assets. Capitalization of such expenses is possible if they significantly increase the term of useful life of a particular item or its efficiency. If these expenses just allow to support the asset on initially planned level of usage, they should not be capitalized;
IT-expenses. Expenses on constant update of software have lately grown rather frequent, which requires a close attention to their capitalizable part;
R&D expenses, traditionally split up into research (non-capitalizable) and development (capitalizable) expenses. Because the difference may be vague between these two notions, they deserve a closer consideration. Issues of capitalizing or writing off geological prospecting expenses are, to some extent, also alike in substance. Here we are dealing with preliminary exploration (various types of survey, soil probing, projects, etc.) prior to receiving data on economically recoverable reserves, and development proper, which is based on “successful efforts” accounting method. Consequently, similar activities on distinguishing between non-capitalizable and capitalizable expenses will be expected from a company.

A large unanimity of standards with regard to investment and expenditure capitalization issues can hardly be expected. As a result, each company in its accounting policy should clearly provide for relevant “investment” chart of accounts, management and processes, as well as organize real opposition to significant mistakes and manipulations in this area. Then a bigger trust would favor a more reasonable attitude to company’s own accounting and its submission to external users.

This is a nice mistake!

WorldCom (telecommunication company) is considered to have made the biggest “mistake” in treating expenses capitalizable rather than to recognize it in the period when they occur. Still in 1999, this company reached capitalization at $185 billion, and in 2002, confronting with the pressure of collected evidence, it acknowledged it had made a great deal of financial manipulations and declared itself bankrupt. In 2006, the company was sold (already named MCI) for $6.7 billion. According to open sources of information, huge manipulations, which helped the company, for example, with real loss at $48.9 billion in 2000, to declare a $4.6 billion profit, contained those with expenses which should have been written off in the current period but were capitalized instead. The decision confirming lack of necessity to regularly revalue initial estimates of investments, including those on acquisitions of subsidiary companies has also been recognized as manipulative. The total amount of similar infringements involving capital expenditure exceeded $10 billion. This is much more than those of Enron Corporation’s detected manipulations, with the profit that was overestimated approximately by $1 billion, or Xerox, who declared profits exceeding the real ones by more than $6 billion.

Russia obeys orders

In Russian Federation the general procedure for accounting of long-term investments, such as expenses to create (purchase) non-current assets of long-term use (more than one year) is governed by Regulation of Finance Ministry No. 160 of 30/12/1993.

It stipulates a standard for accounting investments (prior to their completion) based on their actual costs. An exception is made only to construction developers who also have to keep records based on contracted price. Taking into consideration the fact that financial accounting in Russian Federation forms the basis for accrual of tax on property and corporate tax, this procedure prevails over adequate recognition of investments in accounting.

The procedure also advises companies to group long-term investment expenses as follows:

expenses on civil engineering;
expenses on equipment assemblage;
expenses on purchase of equipment in assemblage;
expenses on purchase of ready-to-operate equipment; tools and fittings; equipment demanding assemblage but meant for perpetual inventory;
other capital costs;
expenses that do not add value to fixed assets.

These recommendations only show companies an advisable direction to organize their detailed accounts to support the capital investments information and cannot be used in practice with no adjustment to specific company’s conditions. A company may require, for instance, much more details for work-in-progress in construction; or it may need an additional set of accounts for record intangible assets in progress.

Back Comments on forum (0)