ACCOUNTING & AUDITING

Financial Accounting

Property, Plant, and Equipment
New Accounting Rules Introduced by AcSEC

By Michael D. Oleson

In September 2003, the Accounting Standards Executive Committee (AcSEC) of the AICPA finalized the statement of position (SOP) Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment. FASB will consider approving the sop at its April 2004 meeting. In the statement, which would be in effect for fiscal years beginning after December 15, 2004, AcSEC replaces the loose set of traditions and conventions that make up current U.S. generally accepted accounting principles for property, plant, and equipment (PPE) with one consistent set of rules on the costs that can be capitalized either as part of the initial acquisition or construction of an asset or during the asset’s useful life. AcSEC bases its conclusions on the following principles:

Although the three principles do not seem controversial, in fleshing them out AcSEC consistently chose procedures that would eliminate many costs companies routinely capitalize as PPE.

New Approaches to Capitalization

Only costs incurred after acquisition or construction is likely to occur can be capitalized. In expounding on the principle of which expenditures can be capitalized as part of the cost of PPE, AcSEC concluded that it depends upon both when the expenditure occurs and what the expenditure is for. Traditionally, “when” is broken into two stages: initial acquisition or construction, and subsequent activities. When the PPE is ready for its intended use was previously used to separate the two stages. Now, AcSEC identifies four stages in which the subsequent activities stage becomes the in-service stage and the initial acquisition or construction stage breaks into the following three stages (in chronological order):

In the new rule, AcSEC still considers the entrance of PPE to the in-service stage as when the asset is “substantially complete and ready for its intended use,” which conforms with SFAS 34, Capitalization of Interest Cost.

AcSEC uses SFAS 67, Accounting for Costs and Initial Rental Operations of Real Estate Projects, as the basis for dividing the initial acquisition or construction into three stages. While SFAS 67 does not explicitly define stages, the types of capitalizable costs depend upon whether the property has been acquired (preacquisition versus postacquisition). In addition, SFAS 67 requires that, except for purchase options, no costs can be capitalized that are incurred before the acquisition of the property becomes “probable.” AcSEC separates the before-acquisition/construction stage from the acquisition/construction stage. Next, using the cutoff that it is “probable” that the company will acquire or construct the specific PPE, AcSEC further subdivides the before-acquisition/construction stage into the preliminary and preacquisition stages.

In choosing “probable” as a cutoff, AcSEC had to choose between definitions. In SOP 98-1, Accounting for Costs of Computer Software Developed or Obtained for Internal Use, AcSEC defines probable as something that is reasonably expected to happen, based on the definition of an asset in FASB’s Concept Statement 6, Elements of Financial Statements. SFAS 67 uses the more restrictive meaning in SFAS 5, Accounting for Contingencies, where probable is defined as “likely to occur.” While AcSEC uses the definition of an asset to justify separating the preliminary stage from the preacquisition stage, it believes using the more restrictive definition of “likely to occur” is more appropriate. AcSEC requires expensing of virtually all costs incurred during the preliminary stage. The more restrictive definition disallows many costs that the more lenient definition of Concept Statement 6 would have allowed to be capitalized.

Even using the well-established definition of “likely to occur,” companies could still have difficulty in deciding when a project has moved from the preliminary stage to the preacquisition stage. Different parts of the project can enter the preacquisition stage at different times. For example, the preacquisition stage for a purchase of land begins when the company believes it is likely that a specific piece of land will be used in the construction, while the preacquisition stage for the architectural costs begins when the company believes it is likely that a specific building design will be used.

Only directly related costs can be capitalized. AcSEC limits the types of PPE costs that can be capitalized to those that are directly related. AcSEC intentionally chose the more restrictive “directly related” requirement of SFAS 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases, over the less restrictive “clearly associated” requirement of SFAS 67. AcSEC had previously used SFAS 91 in establishing the cost capitalization rules for internally used computer software in SOP 98-1, and considered it more reflective of current thinking than SFAS 67. By not choosing “clearly associated,” AcSEC eliminated the capitalization of indirect and overhead costs. Exhibit 1 lists the general categories of costs that can be included as part of the original cost of the PPE; Exhibit 2 lists examples of costs AcSEC considers to be incremental direct costs. The only cost reduction listed is for liquidating damages the company receives because a third party did not deliver or complete the construction by a contractually specified date. If the liquidating damages are more than the rest of the asset’s capitalized cost, the excess is recognized as income.

AcSEC allowed two exceptions to the no-indirect-cost requirement:

Certain types of PPE costs can never be capitalized (Exhibit 3). AcSEC does not permit the cost of any support function in PPE, even if another company provides that support function. For departments that directly work on the purchase or construction of PPE, only wages and benefits paid to the employees for time worked on the purchase or acquisition of the specific asset can be capitalized. No nonemployee costs of that department can be included. The only capitalizable overhead costs are those that an outside company implicitly covers when setting the price it charges for directly related work.

Companies must use these new rules for costs that are incurred after they first apply the SOP. For costs capitalized before the SOP is first applied, companies have two choices: They can elect either to write off the previously capitalized costs that do not meet the new rules as a cumulative-effect adjustment, or to let these costs remain capitalized. In either case, any accruals for future maintenance must be reversed and any related maintenance liability eliminated.

By excluding indirect and overhead costs from PPE, AcSEC is setting the line of demarcation for the types of costs that can be capitalized between assets the company intends to use or rent and assets the company intends to sell. AcSEC does not allow the rules for capitalizing inventory costs for PPE because:

AcSEC believes that by expensing overhead for PPE, the timing of the expense more closely matches the timing of expensing inventory overhead costs as cost of goods sold, because inventory turns over so quickly that the amount of overhead costs expensed each period would not be materially different if overhead costs were expensed as they occur. To allow the SOP to cover more assets, FASB will issue a new standard that would exclude real estate under an operating lease from SFAS 67 so that it can be included within the scope of the SOP.

Comment letters to AcSEC from the Financial Accounting Policy Committee of the Association for Investment Management and Research (AIMR) and the Committee on Corporate Reporting of Financial Executives International (FEI) specifically address the inconsistency AcSEC creates in the cost rules for PPE and inventory. Both organizations agree that, as stated by AIMR, “Identical costs should not be valued differently based on management’s intended use” (emphasis in the original). The two bodies’ solutions to the inconsistency differ, however: FEI believes the “full-costing approach (which includes overhead cost in the cost of a fixed asset) is the appropriate valuation method for fixed assets.” AIMR, on the other hand, believes that capitalizing only directly related costs should apply to both PPE and inventory.

Depreciation by component is better matching than composite depreciation. Component accounting is AcSEC’s answer to the problems of PPE’s depreciation period and the capitalization of in-service costs. Component accounting recognizes that a given asset comprises several smaller parts, called components, and that each part might have a different useful life. AcSEC’s original exposure draft required separate accounting for each component that had a different useful life from the whole asset. Because many companies would find fulfilling that requirement difficult and expensive, AcSEC revised the requirement to let companies set their own policy as to which parts would be accounted for separately, as long as the policy did not combine parts from different “functional units.” AcSEC defines a functional unit as the smallest combination of parts that are needed to enable the asset to perform its intended function. For example, a company would not be required to account for a building’s roof and elevators separately from the rest of the building because the roof and elevators are both needed for the building to fulfill its intended function. On the other hand, a company could not combine several buildings that are in the same complex if each building has its own intended function.

By requiring that different functional units not be depreciated as one asset, AcSEC eliminates the option of using composite depreciation. With composite depreciation, the average useful life of the different assets in a group is calculated and the group’s assets are depreciated over that average life. AcSEC allows the use of the mass-asset (group-life) method for determining depreciation because it does not combine different functional units. To use the mass-asset method, the assets combined must be homogenous in terms of their physical characteristics, use, and expected useful life, and the method must be consistently and rigorously applied.

To ease the transition to depreciating by component, a company is allowed to have two different component level policies—one for its preadoption assets and one for its postadoption assets—under which any PPE entering the in-service stage after the company adopts the SOP is a postadoption asset. AcSEC expects many companies to set policies such that preadoption assets have fewer components than similar postadoption assets. For postadoption assets, the total cost of PPE would be allocated over its components when the asset enters the in-service stage and the cost of each separate component would be depreciated over its useful life. AcSEC gives three methods for allocating total cost to the components:

A company must make two major decisions concerning its preadoption assets. First, it must decide the number of components for these assets. Second, it must decide whether to include all previously capitalized costs or only those costs that meet the new capitalization rules. If the company chooses to exclude the costs that are no longer allowed, it would recognize a cumulative-effect adjustment. If the company chooses not to exclude any previously capitalized costs, no cumulative-effect adjustment is needed.

A company would then use two steps in allocating the book value of the preadoption PPE over the chosen components:

The final book value for each component would be the sum of the book value computed in Step 1 plus the additional amount allocated to it in Step 2. This final book value would be depreciated over the component’s remaining useful life.

Cost capitalization ends when PPE is placed in service. By requiring component accounting, AcSEC eliminates the tradition that allows capitalization of a subsequent cost that increases either the useful life or the output quantity or quality. After an asset is placed in service, all costs associated with the existing components of that asset, as defined by the company’s policy, are expensed. Only costs associated with new components, either an addition to the asset or a replacement of an existing component, can be capitalized. This is because the components originally chosen for a given asset set the smallest asset level for accounting purposes. Any maintenance or repairs that involve only some pieces of a component must be expensed. AcSEC does not require that an existing component be physically removed to be considered a replacement, only removed from service. The replacement component need not be identical to the existing component, but it must perform the same function.

AcSEC provides guidance on the three possibilities that can occur when an existing part is completely replaced. First, if the company has been separately depreciating the existing part as a component, the remaining book value of the existing component is added to the depreciation expense for that year. The directly related cost of the replacement component is capitalized using the rules described earlier for the construction/acquisition of PPE.

Second, if the company’s policy was not to depreciate the part as a separate component and the company chooses not to change that policy, the entire cost of the replacement part would be expensed.

The third and most complicated possibility occurs when the company was not depreciating the existing part as a separate component, but chooses to change its component level policy for that asset beginning with this replacement. The change in the company’s policy must be applied to all PPE containing that part, not just to the specific asset whose part is being replaced. If the company has different component level policies for its preadoption and postadoption assets, only the policy for the similar assets in the same group (preadoption or postadoption) must be changed. The policy change must meet the preferability requirement of paragraph 16 of APBO 20, Accounting Changes, for a change in accounting policy, and the cumulative effect of the change must be calculated and recognized in the current year’s income statement. The company would then be allowed to capitalize the directly related cost of the replacement component. Whichever possibility applies, all costs to remove the existing part or relocate the asset must be expensed.

AcSEC rules for subsequent costs would also apply to planned major maintenance activities. AcSEC would not allow the cost of these activities to be accrued in advance, either as a liability or as additional depreciation expense. If the planned activity involves a replacement of an existing component, then the rules discussed earlier on replacements would apply. All other costs would be expensed as they occur.

Consistency with IASB Rules

One of AcSEC’s objectives is to have U.S. accounting rules for PPE consistent with the IASB requirements in the soon-to-be-revised IAS 16, Property, Plant, and Equipment. The rules of the SOP are very similar to those of the revised IAS 16, with three exceptions:

In general, the cost capitalization rules of the SOP are slightly more restrictive during the initial acquisition stages and significantly more restrictive during the in-service stage than the rules in IAS 16 (see Exhibit 4).

Conceptual Inconsistencies

The new SOP will increase the comparability across companies by standardizing the types of costs that can be capitalized both when the asset is being acquired or constructed and when the asset is being used. The directly related costs of PPE are capitalized beginning when the acquisition or construction becomes likely and ending when the asset is ready for its intended use. When the asset is ready for use, its total capitalized cost is allocated across its components and each component depreciated separately. No new costs are capitalized after the asset is in use, unless they are new assets, including replacements and additions. When a component is replaced, the existing component’s book value is expensed.

Clearly, AcSEC’s intent with these basic rules is to not permit capitalization of many costs that companies currently include as part of the cost of PPE. While precedents in earlier accounting standards support each of AcSEC’s decisions, other precedents, such as inventory cost capitalization rules, would have allowed more costs to be capitalized. As AIMR and FEI pointed out, this SOP also creates a conceptual inconsistency because the capitalized cost of an asset that the company intends to use or rent is lower than the capitalized cost of that same asset if the company intends to sell it. Some believe that component depreciation threatens comparability because of the discretion it would allow to each company’s management. Ultimately, FASB will need to resolve these issues.