The IFRS (International Financial Reporting Standards) include a set of accounting standards. Usually, they apply in many jurisdictions and dictate how companies account for financial transactions. Some companies may also use GAAP (Generally Accept Accounting Principles). These standards may have some similarities. However, they differ in various critical areas. Each has a set of rules and regulations that companies must follow during accounting.
The IFRS provides crucial guidance on various areas in accounting. It applies to more jurisdictions compared to GAAP. However, that does not imply the latter is less significant. Both cover several accounting rules that determine how companies account for financial transactions. On top of that, they also cover other areas, such as reporting and presentation. Nonetheless, they may follow the same accounting principles and conventions.
Generally, the primary differences between the IFRS and GAAP come from their accounting standards. These standards apply to particular areas and cover specific items. One of these includes the costs that companies can capitalize. While some of these may be similar under both accounting rules, they differ in several aspects. Before understanding what costs companies can capitalize under the IFRS, it is crucial to discuss capital expenditure.
What is Capital Expenditure?
Capital expenditure refers to expenses that companies use for specific purposes. In accounting, these expenses become a part of balance sheet items. Usually, expenditures classify under the income statement. However, the particular purpose for capital expenditure requires companies to capitalize them. This treatment entails putting specific costs in the balance sheet. Usually, these include expenses on inventory, fixed assets, etc.
Capital expenditures cover various costs. These include expenses to acquire, upgrade and maintain physical assets. Usually, these resources consist of property, plants, buildings, equipment, inventory. As mentioned, these requirements may differ based on the set of accounting rules a company follows. Therefore, a cost capitalizable under the IFRS may not get the same treatment in GAAP standards.
Capital expenditure is the opposite of revenue expenditure. The treatment for both of these items differs due to their fundamental differences. However, the IFRS and GAAP have similar definitions for what may fall under each category. On top of that, both standards treat them similarly in the financial statements. Usually, capital expenditure is a part of the balance sheet. However, it may go into the income statement through accounting methods such as depreciation.
Revenue expenditures, in contrast, do not go to the balance sheet. They become a part of the income statement as an expense. At each year-end, these expenses reduce the profits a company makes. Consequently, it also impacts the retained earnings for that company. These earnings become a part of the balance sheet. However, revenue expenditures never become a part of this statement directly.
Overall, capital expenditure includes funds used by companies to purchase, improve or maintain fixed assets. When companies make these costs a part of the balance sheet, it falls under capitalization. Some accounting standards may require companies to capitalize expenses that meet a specific definition. On the other hand, if they don’t meet that definition, they will become a revenue expenditure.
What Costs Can be Capitalized Under the IFRS?
The process to capitalize specific costs does not fall under a specific principle. Instead, the IFRS specifies what expenses companies must consider for capitalization when applicable. It implies that companies should consider specific IFRS standards to determine whether they should capitalize a cost. As mentioned above, this process usually applies to assets, specifically fixed assets. However, it can also cover various other areas.
Generally, if a cost meets the definition of capital expenditure, companies must capitalize it. However, the distinction may not be as straightforward in some cases. On top of that, the situations may differ, requiring companies to classify the same cost as an expense. Therefore, companies must consider the capitalization process based on various factors. Once they meet the definition for capital expenditure, companies can capitalize those costs.
Apart from the definition for capital expenditures, companies must also consider specific standards. These IFRS standards dictate the particular costs that companies must capitalize. Some of these standards are as follows.
IAS 16 Property, Plant and Equipment
IAS 16 Property, Plant and Equipment cover fixed, tangible assets. It requires companies to recognize an item when it meets the definition of an asset set by the contextual framework. Similarly, it dictates that companies must ensure the asset’s cost is measurable reliably. However, these definitions do not provide details on which costs companies should recognize.
IFRS 16 provides specific items that companies must include as a part of the initial measurement for a fixed asset. These items are the costs that companies should capitalize under IAS 16. On top of that, it also includes items that companies cannot capitalize. The specific requirements from this standard are as follows.
- Include all costs involved in bringing the asset into working condition.
- Include costs such as site preparation, delivery costs, installation costs, borrowing costs, etc.
- Revenue costs should not be a part of the asset’s capitalized cost.
- Include dismantling costs as a part of the asset’s initial measurement value. However, companies must calculate the present value for these costs first.
The above items provide details on the costs that companies must capitalize for fixed assets. One of the areas within these also includes borrowing costs. While IAS 16 mentions these costs, the specific items that companies can capitalize within them come from IAS 23.
IAS 23 Borrowing Costs
IAS 23 Borrowing Costs require companies to capitalize these costs as a part of an asset. This standard defines the qualifying assets for this process as one which “necessarily takes a substantial period of time to get ready for its intended use or sale”. On top of that, it provides details on the commencement and cessation periods for the capitalization.
IAS 23 requires companies to capitalize all borrowing costs from the time the following conditions are available:
- Expenditure for the asset is being incurred.
- Borrowing costs are being incurred.
- Activities necessary to prepare the asset for its intended use or sale are in progress.
Once any of these conditions are not available, companies must cease capitalizing borrowing costs.
IAS 2 Inventory
IAS 2 covers the inventory companies keep as a part of their operations. This standard dictates that companies value inventories at lower cost and net realizable value. Furthermore, it provides the criteria for the cost that companies can capitalize for the latter value. Usually, it includes the cost of bringing inventory items to their present location and condition.
The primary costs that companies can capitalize under IAS 2 include purchase and conversion costs. The former category consists of the following costs:
- Purchase price of the inventory items, including import duties, transport and handling costs.
- Any other costs that are directly attributable to those items, minus trade discounts, rebates and subsidies.
On the other hand, conversion costs include the following:
- Costs specifically attributable to production units, such as direct labour, direct expenses, etc.
- Production overheads, based on the normal activity level.
- Other overheads that are attributable in specific circumstances.
Furthermore, it dictates companies cannot capitalize the following costs.
- Abnormal wastage.
- Storage costs.
- Administrative overheads that do not contribute to bringing the inventory items to their present location and condition.
- Selling costs.
Companies must differentiate between capital and revenue expenditure when accounting for expenses. Apart from these, companies must also meet the specific requirements for capitalizing costs under IFRS. These requirements come from standards that cover particular areas. Some examples include IAS 16, IAS 23 and IAS 2. Apart from these, other standards may also dictate the costs to capitalize under IFRS.