Affiliate Hench Apparel in Financial Distress
Warren Company’s CEO, Mr. James Stevens, reads the final report of Janerey Avella, the firm’s consultant for special projects. The report highlights the reasons for the recommended closure of Hench Apparel, a fashion store for men and women acquired by Warren five years ago. The store is situated in a nearby town with establishments sprawling within the area but many miles away in high-crime areas that are hot in the news lately. Although Hench’s fashion designer has a name in fashion, designs of the different clothes are not really that attractive to its current clients. Its sales have dropped from an exciting $1,500,000 five years ago to a guarded $400,000 this year. Competitors also are rising in the area. Neighborhood crime contributes to the pulling-out of some investors in the once lively town.
Stevens encircles the figure $4,000,000, which represents the building purchased five years ago. After a long silence, in a low tone, he asks Mr. Avella, “What are we going to do with this? I don’t think the members of the Board of Directors will agree to the idea of investing in another fashion apparel business nor open any other business in this risky area.” Avella answers, “Then I cannot give any suggestion except that Warren has to dispose of the fixed assets right away.”
What are Fixed Assets–Their Classifications and Exclusions
Fixed Assets are commonly identified as property, plant and equipment under IAS 16 rules or simply classified as non-operating assets or tangible assets that are held by an enterprise for use in the production or supply of goods and services, for rental to others, or for administrative purposes. These assets are expected to be used more than one fiscal period.
They are classified as:
- Property ordinarily not subject to depreciation or depletion, such as land;
- Property subject to depreciation or amortization, such as land improvements, buildings, machinery, equipment, furniture, improvements to leased facilities and bookplates.
- Property subject to depletion, such as timber tracts and mineral and oil deposits
Some items that are sometimes mistaken to be part of this category are:
- Spare parts and servicing equipment that are usually carried as inventory and recognized in profit or loss as consumed. However, major spare parts and stand-by equipment qualify as property, plant, and equipment when an entity expects to use them more than one period.
Land tracts held by real-estate development companies that are intended to be sold in the normal course of business are classified as inventory rather than property, plant, or equipment because they are the units that will bring in revenue for the business. Land held as a future plant site is qualified to be reported as part of the property, plant, and equipment; but land that is acquired for long-term capital appreciation as well as land held for a currently undetermined future use is reported as investment property.
How are Fixed Assets Measured?
IFRS accounting for fixed assets requires that an item of property, plant, and equipment shall be initially measured at its cost, including any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by the management.
- The cost of an item of property, plant, and equipment is the cash price equivalent at the recognition date
- If payment is deferred beyond normal credit terms, the difference between the cash price equivalent and the total payment is recognized as the finance cost over the credit period.
- If the asset is acquired by issuing equity securities of the enterprise, cost is the fair value of the asset received or the fair value of the securities issued, whichever is more reliably measurable.
- The cost of an item that is acquired by exchanging a non-monetary asset (or combination of monetary and non-monetary asset) is measured at fair value, unless the transaction lacks commercial substance or the fair value of neither the asset received nor the asset given up is reliably measurable. If the acquired item is not measured at fair value, its cost is measured at the carrying amount of the asset given up.
- An item of property, plant and equipment acquired through donation is initially recorded at fair market value at the time of donation.
The computer package acquired for Hench Apparel was made in cash, while the building was acquired through financing, which was 30 percent higher than its spot cash price.
Please continue to page 2 for more on IFRS Accounting for Fixed Assets
What is Depreciation? How is It Computed?
Are there expenses inolved in the use of fixed assets? Yes, there are. Repairs and maintenance is one category of expense, and it is unavoidable. The wearing-out of the asset or its used portion is also regarded as expense, which we call depreciation.
Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life. It is considered as a part of the operating expense every benefited year and it is a non-cash outplay expense. How is depreciation computed?
Consider the following data that is supposed to be done with the Hench Apparel building, one of Warren Company’s fixed assets:
Cost of the building $4,000,000
Salvage value $200,000
Estimated life 5 years
Every end of the year for five years, the company will include $760,000 in its operating expenses as depreciation expense for its associate’s building, computed as follows:
Cost of equipment ($120,000) minus salvage value ($20,000) divided by 5 years equals to $20,000
Applying the New IFRS Standard to Hench’s Asset Disposal
What has management come up with for Hench Apparel?
The Warren CEO, together with management, agrees on the winding-up of all the affairs of Hench Apparel. As to the fixed assets, this is what the accountant says:
This is a timely application for the new standard, International Financial Reporting Standard No. 5, specifically on Non-Current Assets Held for Sale and Discontinued Operations. If Hench will be closed, there is a need to sell its non-current assets because the assets will be not of use anymore to the company.
IFRS 5 was issued to converge the accounting treatment under International Financial Reporting Standard, United States and United Kingdom, Return On Investment, Generally Accepted Accounting Principle, in the specific area of assets held for sale and discontinued operations.
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The accountant further discusses the information below:
Features of a Held-for-Sale asset in order to qualify under this ruling:
- In the balance sheet classification within the current assets, the asset is categorized under a section called ‘held for resale.’
- The ‘held for resale’ classification could contain both fixed assets and whole trading operations with both assets and liabilities, although assets and liabilities held for resale will be disclosed separately in current assets and liabilities.
- ‘Held for resale’ items will be valued at the lower of carrying value or fair value less selling costs.
- Assets included in ‘held for resale’ will not be depreciated (even though they may continue to be used).
- ‘Held for resale’ items are shown separately on the balance sheet.
Features of a Discontinued Operation in order to qualify under this ruling:
- The operation becomes ‘discontinued’ when it meets the criteria for being ‘held for resale’ (IFRS 3 has more stringent criteria).
- The results for discontinued operations are to be shown separately on the profit and loss account (similar to the requirement under IFRS 3).
- IFRS 5 prohibits retroactive classification of an operation as discontinuing.
Furthermore, to be included in the category of ‘held for resale’ the asset must:
- Be available for immediate sale in its present condition.
- A sale is highly probable.
- There must be active marketing.
- A reasonable price has been set.
- The sale is expected to be completed within a year.
Assets to be abandoned may be classified as discontinued in the profit and loss account but may not be disclosed as held for resale in the balance sheet. Any impairment loss on assets transferred to ‘held for resale’ should be recognized in the profit and loss account. Gains on assets ‘held for resale’ can also be recognized but only to the extent that they reverse a previous impairment. Assets ceasing to meet the criteria for ‘held for resale’ should be reclassified back to fixed assets at the lower of: its original carrying value adjusted for depreciation that was not charged because the asset was ‘held for resale’; or its recoverable amount.
The Hench Apparel case’s above-enumerated provisions qualify under IFRS accounting for fixed assets.
Conclusion: How Will Warren Company Properly Manage Its Fixed Assets?
Because a significant amount of enterprise resources is tied up to investment in non-current operating assets, management has to carefully evaluate alternatives in choosing what non-current operating assets to acquire. The use of capital budgeting and discounted cash flow analysis will help management make the best choice. After acquisition, the economic benefits dervied from property, plant, and equipment and the condition of the assets must be constantly monitored to evaluate if the assets will contribute to the productivity of the company. Otherwise, the assets must be considered for disposal.
Unfortunately, Warren Company has to be firm in its decision to dispose of its associate company’s fixed assets, because at the moment it will be too costly for the company to pursue its fashion apparel operations. Good thing–a friendly competitor offers to buy the equipment for a total package equipment at a price equivalent to its book value!
Book, Webpage, and Image Credits:
Accounting for Fixed Assets, Raymund H. Peterson, 2002