Information × Standard #1
#InsightByStandard
A series of articles in which we explore a specific point from a particular accounting standard.
We seek success and guidance from God.
IAS 16: Property, Plant and Equipment
As we all know, if a company purchases a new production line, any costs incurred to bring the asset to a condition ready for its intended use are capitalized (added to the cost of the asset).
Part of this preparation process often involves conducting operational tests on the production line.
But what if the samples produced during these tests are sold? How should that value be recorded?
Consider this scenario, which frequently occurs in businesses: Your company decides to expand and purchases a new production line for 1 million SAR. To ensure the line operates efficiently and meets the required specifications, you spend 50,000 SAR on trial raw materials, labor, and inspection engineers. During these trials, some samples are produced, which the company then sells for 10,000 SAR.
**The question is: How should the 50,000 SAR in expenses and the 10,000 SAR in revenue be treated in the accounting records? 🤔💡**
Many accountants might handle this in one of two ways: either by recording the net amount (40,000 SAR) as an operating expense in the income statement, or by offsetting the 10,000 SAR in revenue against the cost of the asset to reduce it.
However, IAS 16 (Property, Plant and Equipment) takes a different approach:
– First: The 10,000 SAR generated from the sale of the samples must be recorded as revenue; under no circumstances should it be deducted from the cost of the asset! – Second: Regarding the trial run costs (the 50,000), you should break them down and separate the costs associated with the samples sold—covering both raw materials and labor—in accordance with the inventory standard, IAS 2. Let’s assume the breakdown is as follows:
* 35,000 for costs related to the inspection, calibration, and testing of the production line.
* 15,000 for raw materials, labor, and operational costs attributable to the products manufactured during the testing phase.
– The 35,000 spent on inspection, calibration, and line testing should be capitalized (added to the value of the asset), as the asset would not be technically ready for use without these inspections and trials.
– The 15,000 spent on raw materials and labor for the samples should be recorded as the “cost of revenue” (cost of goods sold) to match the revenue generated from their sale.
Consequently, you would have the following:
– 35,000 SAR (Property, Plant, and Equipment)
– 15,000 SAR (Cost of Revenue)
– 10,000 SAR (Revenue)
—
So, what is the basis for this in the accounting standards? 📌 Paragraph 20A 📌
“Items may be produced while bringing an item of property, plant, and equipment to the location and condition necessary for it to be capable of operating in the manner intended by management (for example, samples produced when testing whether the asset is functioning properly). An entity recognizes the proceeds from selling any such items, and the cost of those items, in profit or loss in accordance with the applicable standards. The entity measures the cost of those items by applying the measurement requirements set out in IAS 2, ‘Inventories’.”
**📌 The crucial question: When do we stop capitalizing costs and begin recording them as operating expenses?**
Capitalization ceases the moment the asset is ready for use in the manner intended by management.
What is the basis for this in the standard?
📌 Paragraph 20 📌
“Recognition of costs in the carrying amount of an item of property, plant, and equipment ceases when the item is at the location and in the condition necessary for it to be capable of operating in the manner intended by management.”
In other words, if a production line becomes ready to operate at full capacity today, but company management decides to postpone the start of actual production until next month—for marketing or logistical reasons—any costs incurred from today onwards (such as routine maintenance or labor wages) must be charged directly to the income statement; they are no longer added to the cost of the asset! —
**💡 A Quick Tip for Your Interview:**
The standard stipulates that tests must be “technical and necessary” to achieve the required operational readiness—they cannot simply be classified as marketing expenses or market research!
If this post provided you with something new, save it for future reference and share it with your colleagues in accounting groups so everyone can benefit! 🚀✨
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Information × Standard #2
#Insight×Standard (Post #02)
IAS 2: Inventories
*A very common interview question: If the market price of the goods you hold in inventory drops below the price you originally paid for them, how would you account for this decline in your books? 🤔💡*
Imagine your company purchased a shipment of electronic devices for 100,000 SAR. After holding them in inventory for some time, a newer model is released on the market, causing the value of your shipment to drop suddenly!
Should you keep the goods on the balance sheet at their original cost until they are sold, or should you adjust the figure?
IAS 2 (Inventories) addresses this by stating: “At the end of the financial period, inventory must be valued at the lower of cost or Net Realizable Value (NRV)!”
📌 Excerpt from the standard (Paragraph 9):
“Inventories shall be measured at the lower of cost and net realizable value.”
Let’s clarify the concepts mentioned in the standard to ensure you understand them correctly:
1. Cost: This is not just the purchase price! It includes all expenses incurred until the goods reach your warehouse and are ready for sale.
📌 Excerpt from the standard (Paragraph 10):
“The cost of inventories shall comprise all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition.”
2. Net Realizable Value (NRV): This is the net amount you expect to receive upon the sale of the goods. 📌 Excerpt from the Standard (Paragraph 6)
“Net realizable value is the estimated selling price in the ordinary course of business, less the estimated costs of completion and the estimated costs necessary to make the sale.”
🔢 A quick practical example:
An inventory item costs you 10,000 SAR.
Its expected market selling price is currently 9,000 SAR, and to sell it, you would incur 500 SAR in commissions and transportation costs.
– Net Realizable Value (NRV) = 9,000 SAR – 500 SAR = 8,500 SAR.
– Comparison: The cost (10,000 SAR) is higher than the NRV (8,500 SAR).
– Accounting Treatment: You must write down the value of the inventory on the balance sheet by 1,500 SAR and immediately recognize it as an “inventory write-down expense” in the income statement for the same period!
💡 A golden tip for interviews (Paragraph 29):
Valuing inventory at NRV is generally applied to each inventory item separately (item-by-item), rather than to the total inventory as a single aggregate!
📌 Excerpt from the Standard (Paragraph 29)
“Inventories are usually written down to net realizable value on an item-by-item basis.”
If this post broadened your understanding, hit **Save** so you can refer back to it, and share it with your colleagues in accounting groups so everyone can benefit! 🚀✨
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Information × Standard #3
#Insight×Standard (Post #03)
Post 03 | IAS 37: Provisions, Contingent Liabilities and Contingent Assets
Why does the value of a provision increase in the accounting records every year—even if the company hasn’t paid a single additional riyal? 🤔💡
Imagine your company builds a power plant or a factory, and it is under a legal obligation to dismantle the equipment and restore the site to its original condition after 10 years.
The expected cost for this operation in 10 years is 1,000,000 riyals.
The question is:
Do you record the provision today at the full 1,000,000 riyals?
Or do you record it at its present value?
The answer is clearly stated in IAS 37: 👇
If the effect of the “time value of money” is material, the provision must be measured at the “present value” of the expenditures expected to be required to settle the obligation.
📌 Excerpt from IAS 37 – Paragraph (45):
“Where the effect of the time value of money is material, the amount of a provision shall be the present value of the expenditures expected to be required to settle the obligation.” 🔢 Let’s look at the numbers:
Assume that:
• The expected cost in 10 years = 1,000,000 SAR
• The discount rate = 6%
• The present value is approximately = 558,395 SAR
Therefore, the company will not record a provision of 1,000,000 SAR today; instead, it will record it at its present value, which is approximately:
558,395 SAR
But this raises a very important question:
Why would the value of the provision increase year after year, even though the company hasn’t paid anything yet? 🤔
Because as we get closer to the date the 1,000,000 SAR is due, the effect of discounting diminishes, and consequently, the present value of the liability increases.
At the end of the first year: 558,395 × 6% ≈ 33,504 SAR
As a result, the provision becomes approximately: 591,899 SAR
This 33,504 SAR is known as the “unwinding of the discount.”
📌 Excerpt from IAS 37, paragraph 60:
“Where discounting is used, the carrying amount of a provision increases in each period to reflect the passage of time. This increase is recognized as a borrowing cost.”
In other words, the increase resulting solely from the passage of time is not considered an increase in the original expected cost of the transaction; rather, it reflects the fact that we are drawing closer to the date the liability must be settled. It is recognized as a “borrowing cost” in accordance with paragraph 60.
📒 Simplified journal entry at the end of the first year:
Debit: Borrowing Cost – Unwinding of Discount: 33,504
Credit: Provision for Asset Dismantling and Site Restoration: 33,504
Consequently, the provision balance increases:
From 558,395 to approximately 591,899 (in the relevant currency).
The unwinding of the discount continues over the years until the provision approaches the amount expected to be paid at the settlement date, assuming no further changes in estimates occur.
⚠️ However, take note of a very important point:
In the example of dismantling a plant and restoring the site, the matter is not governed solely by IAS 37.
Upon initial recognition, if the criteria of IAS 16 are met, the initial estimate of the costs for dismantling and removing the asset and restoring the site is included in the cost of the asset, with a corresponding provision recognized.
In simple terms:
Debit: Property, Plant, and Equipment (PPE) – Decommissioning Cost
Credit: Decommissioning Provision
(Recorded at the present value of the obligation.)
Thereafter, two distinct paths emerge:
1️⃣ The Asset:
The amount added to the cost of the asset is depreciated over the asset’s useful life.
2️⃣ The Provision:
It increases over time due to the “unwinding of the discount,” and this increase is recognized as a “borrowing cost” in accordance with IAS 37.60.
This means that:
Depreciation ≠ Unwinding of Discount
Both are expenses, but each has a different underlying cause and a completely distinct accounting treatment. 🔥
💡 A golden tip for your interview – IAS 37, paragraph 47:
The discount rate used to measure a provision must be a **pre-tax rate**.
It should reflect:
✔️ Current market assessments of the time value of money.
✔️ Risks specific to the liability.
However, it should *not* reflect risks for which the future cash flow estimates have already been adjusted—this ensures we don’t account for the same risks twice.
🎯 In short:
A long-term provision is not necessarily recorded at its expected future value.
If the effect of the time value of money is material:
Future value of the liability
⬇️ Discounting
Present value of the provision
Then, each year:
Opening Provision × Discount Rate
⬇️
Unwinding of the discount
⬇️
Borrowing cost + an increase in the provision
This continues until the value of the provision approaches the amount required for settlement at the due date.
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Information × Standard #4