THROUGHPUT ACCOUNTING AND THE THEORY OF CONSTRAINTS, PART 2

In the previous article, a member of the Paper F5 examining team revealed all aboutThe Goal, the book in which the theory of constraints and throughput accounting were introduced in the context of a novel. In this second article, she sets out the five focusing steps of the theory of constraints, briefly explaining each one

Then, I will go through two examples showing you how these steps might be applied in practice or in exam questions. It’s worth noting at this stage that, while the theory of constraints and throughput accounting were introduced in The Goal, they were further developed by Goldratt later.

THE FIVE FOCUSING STEPS

The theory of constraints is applied within an organisation by following what are called ‘the five focusing steps.’ These are a tool that Goldratt developed to help organisations deal with constraints, otherwise known as bottlenecks, within the system as a whole (rather than any discrete unit within the organisation.) The steps are as follows:

Step 1: Identify the system’s bottlenecks
In my first article, I discussed how Alex Rogo and his team set out to identify the bottlenecks within the factory. They talked to factory workers and physically saw the machines in front of which were stacked up piles of inventory. Consequently, they were able to identify the bottlenecks, or constraints on production as being one of the new robotic machines (NCX 10) and the furnaces.

Often, in exam questions, you will be told what the bottleneck resource is. If not, it is usually quite simple to work out. For example, let’s say that an organisation has market demand of 50,000 units for a product that goes through three processes: cutting, heating and assembly. The total time required in each process for each product and the total hours available are:

ProcessCuttingHeatingAssemblyHrs per unit234Total hours available100,000120,000220,000

The total time required to make 50,000 units of the product can be calculated and compared to the time available in order to identify the bottleneck.

ProcessCuttingHeatingAssemblyHrs per unit234Total hours required for 50,000 units100,000150,000200,000Total hours available100,000120,000220,000Shortfall in hours030,0000

It is clear that the heating process is the bottleneck. The organisation will in fact only be able to produce 40,000 units (120,000/3) as things stand.

Step 2: Decide how to exploit the system’s bottlenecks This involves making sure that the bottleneck resource is actively being used as much as possible and is producing as many units as possible. So, ‘productivity’ and ‘utilisation’ are the key words here. In ‘The Goal’, Alex noticed that the NCX 10 was sometimes dormant and immediately changed this by making sure that set ups took place before workers went on breaks, so that the machines were always left running. Similarly, the furnaces were sometimes left idle for extended periods before the completed parts were unloaded and new parts were put in. This was because workers were being called away to work on non-bottleneck machines, rather than being left standing idle while waiting for the furnaces to heat the parts. This was addressed by making sure that there were always workers at the furnaces, even if they had nothing to do for a while.

Step 3: Subordinate everything else to the decisions made in Step 2
The main point here is that the production capacity of the bottleneck resource should determine the production schedule for the organisation as a whole. Remember how, in the previous article, I talked about how new bottlenecks seemed to be appearing at the UniCo plant, because non-bottleneck machines were producing more parts than the bottleneck resources could absorb? Idle time is unavoidable and needs to be accepted if the theory of constraints is to be successfully applied. To push more work into the system than the constraint can deal with results in excess work-in-progress, extended lead times, and the appearance of what looks like new bottlenecks, as the whole system becomes clogged up. By definition, the system does not require the non-bottleneck resources to be used to their full capacity and therefore they must sit idle for some of the time.

Step 4: Elevate the system’s bottlenecks
In The Goal, Alex was initially convinced that there was no way to elevate the capacities of the NCX 10 machine and the furnace without investing in new machinery, which was not an option. Jonah made him and his team think about the fact that, while the NCX 10 alone performed the job of three of the old machines, and was very efficient at doing that job, the old machines had still been capable of producing parts. Admittedly, the old machines were slower but, if used alongside the NCX 10, they were still capable of elevating production levels. Thus, one of Alex’s staff managed to source some of these old machines from one of UniCo’s sister plants; they were sitting idle there, taking up factory space, so the manager was happy not to charge Alex’s plant for the machines. In this way, one of the system’s bottlenecks was elevated without requiring any capital investment.

This example of elevating a bottleneck without cost is probably unusual. Normally, elevation will require capital expenditure. However, it is important that an organisation does not ignore Step 2 and jumps straight to Step 4, and this is what often happens. There is often untapped production capacity that can be found if you look closely enough. Elevation should only be considered once exploitation has taken place.

Step 5: If a new constraint is broken in Step 4, go back to Step 1, but do not let inertia become the system’s new bottleneck
When a bottleneck has been elevated, a new bottleneck will eventually appear. This could be in the form of another machine that can now process less units than the elevated bottleneck. Eventually, however, the ultimate constraint on the system is likely to be market demand. Whatever the new bottleneck is, the message of the theory of constraints is: never get complacent. The system should be one of ongoing improvement because nothing ever stands still for long.

I am now going to have a look at an example of how a business can go about exploiting the system’s bottlenecks – ie using them in a way so as to maximise throughput. In practice, there may be lots of options open to the organisation such as the ones outlined in The Goal. In the context of an exam question, however, you are more likely to be asked to show how a bottleneck can be exploited by maximising throughput via the production of an optimum production plan. This requires an application of the simple principles of key factor analysis, otherwise known as limiting factor analysis or principal budget factor.

LIMITING FACTOR ANALYSIS AND THROUGHPUT ACCOUNTING

Once an organisation has identified its bottleneck resource, as demonstrated in Step 1 above, it then has to decide how to get the most out of that resource. Given that most businesses are producing more than one type of product (or supplying more than one type of service), this means that part of the exploitation step involves working out what the optimum production plan is, based on maximising throughput per unit of bottleneck resource.

In key factor analysis, the contribution per unit is first calculated for each product, then a contribution per unit of scarce resource is calculated by working out how much of the scarce resource each unit requires in its production. In a throughput accounting context, a very similar calculation is performed, but this time it is not contribution per unit of scarce resource which is calculated, but throughput return per unit of bottleneck resource.

Throughput is calculated as ‘selling price less direct material cost.’ This is different from the calculation of ‘contribution’, in which both labour costs and variable overheads are also deducted from selling price. It is an important distinction because the fundamental belief in throughput accounting is that all costs except direct materials costs are largely fixed – therefore, to work on the basis of maximising contribution is flawed because to do so is to take into account costs that cannot be controlled in the short term anyway. One cannot help but agree with this belief really since, in most businesses, it is simply not possible, for example, to hire workers on a daily basis and lay workers off if they are not busy. A workforce has to be employed within the business and available for work if there is work to do. You cannot refuse to pay a worker if he is forced to sit idle by a machine for a while.

Example 1
Beta Co produces 3 products, E, F and G, details of which are shown below:

 EFG $$$Selling price per unit120110130Direct material cost per unit607085Maximum demand (units)30,00025,00040,000Time required on the bottleneck resource (hours per unit)543

There are 320,000 bottleneck hours available each month.

Required:
Calculate the optimum product mix each month.

Answer
A few simple steps can be followed:
1. Calculate the throughput per unit for each product.
2. Calculate the throughput return per hour of bottleneck resource.
3. Rank the products in order of the priority in which they should be produced, starting with the product that generates the highest return per hour first.
4. Calculate the optimum production plan, allocating the bottleneck resource to each one in order, being sure not to exceed the maximum demand for any of the products.

It is worth noting here that you often see another step carried out between Steps 2 and 3 above. This is the calculation of the throughput accounting ratio for each product. Thus far, ratios have not been discussed, and while I am planning on mentioning them later, I have never seen the point of inserting this extra step in when working out the optimum production plan. The ranking of the products using the return per factory hour will always produce the same ranking as that produced using the throughput accounting ratio, so it doesn’t really matter whether you use the return or the ratio.

 EFG $$$Selling price per unit120110130Direct material cost per unit607085Throughput per unit604045Time required on the bottleneck resource (hours per unit)543Return per factory hour$12$10$15Ranking231

It is worth noting that, before the time taken on the bottleneck resource was taken into account, product E appeared to be the most profitable because it generated the highest throughput per unit. However, applying the theory of constraints, the system’s bottleneck must be exploited by using it to produce the products that maximise throughput per hour first (Step 2 of the five focusing steps). This means that product G should be produced in priority to E.

In practice, Step 3 will be followed by making sure that the optimum production plan is adhered to throughout the whole system, with no machine making more units than can be absorbed by the bottleneck, and sticking to the priorities decided.

When answering a question like this in an exam it is useful to draw up a small table, like the one shown below. This means that the marker can follow your logic and award all possible marks, even if you have made an error along the way.

ProductNo. of unitsHrs per unitTotal hrsT/put per hrTotal t/putG40,0003120,000$15$1,800,000E30,0005150,000$12$1,800,000F12,500450,000$10$5000,000     $4,100,00

Each time you allocate time on the bottleneck resource to a product, you have to ask yourself how many hours you still have available. In this example, there were enough hours to produce the full quota for G and E. However, when you got to F, you could see that out of the 320,000 hours available, 270,000 had been used up (120,000 + 150,000), leaving only 50,000 hours spare.

Therefore, the number of units of F that could be produced was a balancing figure – 50,000 hours divided by the four hours each unit requires – ie 12,500 units.

The above example concentrates on Steps 2 and 3 of the five focusing steps. I now want to look at an example of the application of Steps 4 and 5. I have kept it simple by assuming that the organisation only makes one product, as it is the principle that is important here, rather than the numbers. The example also demonstrates once again how to identify the bottleneck resource (Step 1) and then shows how a bottleneck may be elevated, but will then be replaced by another. It also shows that it may not always be financially viable to elevate a bottleneck.

Example 2
Cat Co makes a product using three machines – X, Y and Z. The capacity of each machine is as follows:

MachineXYZCapacity per week800600500

The demand for the product is 1,000 units per week. For every additional unit sold per week, net present value increases by $50,000. Cat Co is considering the following possible purchases (they are not mutually exclusive):

Purchase 1 Replace machine X with a newer model. This will increase capacity to 1,100 units per week and costs $6m.

Purchase 2 Invest in a second machine Y, increasing capacity by 550 units per week. The cost of this machine would be $6.8m.

Purchase 3 Upgrade machine Z at a cost of $7.5m, thereby increasing capacity to 1,050 units.

Required:
Which is Cat Co’s best course of action?

Answer
First, it is necessary to identify the system’s bottleneck resource. Clearly, this is machine Z, which only has the capacity to produce 500 units per week. Purchase 3 is therefore the starting point when considering the logical choices that face Cat Co. It would never be logical to consider either Purchase 1 or 2 in isolation because of the fact that neither machines X nor machine Y is the starting bottleneck. Let’s have a look at how the capacity of the business increases with the choices that are available to it.

 XYZDemandCurrent capacity per week800600500*1,000Buy Z800600*1,0501,000Buy Z & Y800*1,1501,0501,000Buy Z, Y & X1,1001,1501,0501,000*

* = bottleneck resource

From the table above, it can be seen that once a bottleneck is elevated, it is then replaced by another bottleneck until ultimately market demand constrains production. At this point, it would be necessary to look beyond production and consider how to increase market demand by, for example, increasing advertising of the product.

In order to make a decision as to which of the machines should be purchased, if any, the financial viability of the three options should be calculated.

Buy Z Additional sales = 600 - 500 = 100 units$'000Benefit: 100 x $50,0005,000Cost(7,500)Net cost(2,500)

Buy Z & Y Additional sales = 800 - 500 = 300 units Benefit : 300 x $50,00015,000Cost ($7.5m + $6.8m)(20,300)Net benefit700

Buy Z, Y & X Additional sales = 1,000 - 500 = 500 units Benefit: 500 x $50,00025,000Cost ($7.5m = $6.8m + $6m)(20,300)Net benefit4,700

The company should therefore invest in all three machines if it has enough cash to do so.

The example of Cat Co demonstrates the fact that, as one bottleneck is elevated, another one appears. It also shows that elevating a bottleneck is not always financially viable. If Cat Co was only able to afford machine Z, it would be better off making no investment at all because if Z alone is invested in, another bottleneck appears too quickly for the initial investment cost to be recouped.

RATIOS

I want to finish off by briefly mentioning throughput ratios. There are three main ratios that are calculated: (1) return per factory hour, (2) cost per factory hour and (3) the throughput accounting ratio.

(1) Return per factory hour
Throughput per unit/product time on bottleneck resource. As we saw in Example 1, the return per factory hour needs to be calculated for each product.

(2) Total factory costs/total time available on bottleneck resource.
The ‘total factory cost’ is simply the ‘operational expense’ of the organisation referred to in the previous article. If the organisation was a service organisation, we would simply call it ‘total operational expense’ or something similar. The cost per factory hour is across the whole factory and therefore only needs to be calculated once.

(3) Return per factory hour/cost per factory hour.
In any organisation, you would expect the throughput accounting ratio to be greater than 1. This means that the rate at which the organisation is generating cash from sales of this product is greater than the rate at which it is incurring costs. It follows on, then, that if the ratio is less than 1, this is not the case, and changes need to be made quickly.

CONCLUSION

At this point, I’m hopeful that you are now looking forward to reading The Goal as soon as possible and that you have a better understanding of the theory of constraints and throughput accounting, which you can put into practice by tackling some questions.

Written by a member of the Paper F5 examining team

THROUGHPUT ACCOUNTING AND THE THEORY OF CONSTRAINTS, PART 1

A member of the Paper F5 examining team shares her latest read and how it changed her views on throughput accounting and the theory of constraints

I’ve just finished reading a book. It was the type of book that you pick up and you cannot put down (other than to perform the mandatory tasks that running a house and looking after a family entail!) Even the much-awaited new series of one of my favourite television programmes couldn’t tempt me away from my book.

Now obviously I’m telling you this for a reason. I love reading and it’s not unusual to find me glued to a book for several days, if it’s a good one. But you’ve gathered by now that the book I’ve been reading was not the usual Man Booker or Orange prize fiction novel that you might ordinarily find tucked away in my handbag. It was in fact The Goal: A Process of Ongoing Improvement by Eli Goldratt and Jeff Cox. If by now you’ve settled quickly into the belief that I must conform to society’s expectations of your typical ‘number crunching’ accountant of which – by the way – I’ve met few in reality, you are wrong. So what then, you may ask, makes this book so different from the image that the title conjures up? Let me tell you all about it.

The Goal, originally published back in 1984, presents the theory of constraints and throughput accounting within the context of a novel. It tells the story of Alex Rogo, a plant manager at a fictional manufacturing company called UniCo, which is facing imminent closure unless Alex can turn the loss-making plant into a profitable one within three months. In his attempt to do so, Alex is forced to question the whole belief in the US at the time that success in manufacturing is represented by a 100% efficient factory (ie everyone and every machine is busy 100% of the time), which keeps cost per unit as low as possible.

To be honest, before I read the book, I wasn’t really convinced about throughput accounting – although the theory of constraints has always made perfect sense to me. But, having read about both in the context of a very believable plant that was representative of many at the time, my views have changed. It’s easy to stand in a classroom and lecture about throughput accounting and criticise it for being ‘nothing new’, but what we have to remember is, back in 1984, this was new, and for those companies that adopted it, it made a huge difference.

I’m aware that, if I want you to share my renewed interest in throughput accounting, I need to tell you more about the story that gripped me. If I don’t do this, you’ll just go away having read yet another article about throughput accounting, and any doubts that you have about its relevance today will remain the same. On the other hand, I’m also aware that, when sitting professional exams, you need to have a working knowledge of throughput accounting that you can apply in the exam hall. Consequently, I’ve decided that, in this first article, I’ll summarise the story contained in The Goal, bringing out some of the basic principles of the theory of constraints and throughput accounting. Then, in the second article, I’ll talk you through a practical approach to questions on throughput accounting.

THE IMPORTANCE OF CONSIDERING AN ORGANISATION’S GOAL

Alex Rogo’s journey begins with a chance meeting with his old physics teacher, Jonah, at an airport, after attending a conference about robotics. This is just before Alex finds out about the threat of closure at the plant. The UniCo factory has been using robotic machines for some time now and Alex is proudly telling Jonah about the improvements in efficiency at the factory. Jonah is quick to question whether these improvements in efficiency have actually led to an improvement in profits. Alex is confused by the way the conversation is going. This confusion is reflective of the US thinking at the time. There is so much focus on efficiency and reducing labour costs with increased automation, but without consideration of whether either of these things are having any impact on profit. In the case of UniCo – and indeed many other real factories at the time – the so-called improvements in efficiency are not leading to increased profits. In fact, they seem to be leading to losses.

Jonah leads Alex to consider what the goal of UniCo really is. Until this point, he – like his superiors at Head Office – has just assumed that if the factory is producing increasingly more parts at a lower unit cost, it is increasingly efficient and therefore must be doing well. All the performance criteria that the business is using support this view; all Alex’s bosses are concerned about seems to be cost efficiencies.

After some reflection, Alex realises that the overriding goal of an organisation is to make money. Just because a factory is making more parts does not mean to say that it is making more money. In fact, UniCo shows that just the opposite is happening. The plant has become seemingly more efficient, thanks to the use of the robots, but the fact is that inventory levels are huge and the plant is constantly failing to meet order deadlines. It is standard practice for orders to be five or six months late. An order at the plant only ever seems to go out when one of the customers loses patience and complains loudly, resulting in the order being expedited – ie all other work is put on hold in order to get the one order out. Customers are becoming increasingly dissatisfied, losses are growing, and crisis point is reached.

Clearly, the ‘goal’ that the objective of the plant is to make money needs to be more clearly defined, in order to generate improvements, and Jonah helps Alex do this by explaining that it will be achieved by ‘increasing throughput whilst simultaneously reducing inventory and operational expense’. Some definitions are given at this point:

‘throughput’ is the rate at which the system generates money through sales‘inventory’ is all the money that the system has invested in purchasing things that it intends to sell‘operational expense’ is all the money that the system spends in order to turn inventory into throughput

WORKING OUT HOW TO ACHIEVE THE GOAL

Having worked out what the goal is, Alex is then left with the difficult task of working out how that goal can be achieved. The answer begins to present itself to Alex when he takes his son and some other boys on a 10-mile hike. Given that the average boy walks at two miles an hour, Alex expects to reach the halfway point on the hike after about two and a half hours of walking. When this doesn’t happen, and Alex finds that the group is behind schedule and big gaps are appearing between them, he begins to question what is going on. He soon realises that the problem is arising because one of the boys is much slower than the others. This boy is preventing the other boys from going faster and Alex realises that, if everyone is to stay in one group as they must, the group can only go as fast as their slowest walker. The slow walker is effectively a bottleneck: the factor that prevents the group from going faster. It doesn’t matter how fast the quickest walker is; he cannot make up for the fact that the slowest walker is really slow. While the average speed may be two miles per hour, the boys can all only really walk at the speed of the slowest boy.

However, Alex also realises that they can increase the boy’s speed by sharing out the heavy load he is carrying in his bag, enabling him to walk faster. In this way, they can ‘elevate the bottleneck’ – ie increase the capacity of the critical resource. Alex cannot wait to get back and identify where the bottlenecks are happening in his factory and find out if they can be elevated in any way, without laying out any capital expenditure.

STATISTICAL FLUCTUATIONS AND DEPENDENT EVENTS

The other thing that Alex gains a better understanding of on the hike is the relationship between dependent events and statistical fluctuations. Jonah has already explained to Alex that the belief that a balanced plant is an efficient plant is a flawed belief. In a balanced plant, the capacity of each and every resource is balanced exactly with the demand from the market. In the 1980s, it was deemed to be ideal because, at the time, manufacturing managers in the Western world believed that, if they had spare capacity, they were wasting money. Therefore, they tried to trim capacity wherever they could, so that no resource was idle and everybody always had something to work on. However, as Jonah explains, when capacity is trimmed exactly to marketing demand, throughput goes down and inventory goes up. Since inventory goes up, the cost of carrying it – ie operational expense also goes up. These things happen because of the combination of two phenomena: dependent events and statistical fluctuations.

The fact that one boy walks at three miles an hour and one boy walks at one mile an hour on the hike is evidence of statistical fluctuations. But the actual opportunity for the higher fluctuation of three miles an hour to occur is limited by the constraint of the one mile per hour walker. The fast boy at the front of the group can only keep on walking ahead if the other boys are also with him – ie he is dependent on them catching up if he is to reach his three mile per hour speed. Where there are dependent events, such as this, the opportunity for higher fluctuations is limited. Alex takes this knowledge back to the factory with him and sets about rescuing his plant.

IDENTIFYING BOTTLENECKS

Back at the plant, Alex and his team set out to identify which machines at the plant are the bottleneck resources. After talking to staff and walking around the factory, where there are big piles of inventory sitting in front of two main machines, the bottlenecks become obvious. Eighty per cent of parts have to go through these machines, and the team make sure that all such parts are processed on the non-bottleneck machines in priority to the other 20% of parts, by marking them up with a red label. The parts that don’t go through the bottlenecks are marked with a green label. The result? Throughput increases. But the problem? Unfortunately, it doesn’t increase enough to save the factory.

ELEVATING BOTTLENECKS

The next step is therefore to try and elevate the capacity of the bottlenecks. This is not easy without spending money, but observation shows that, at times, the bottleneck machines are sometimes still idle, despite the labelling system giving priority to the parts that have to be ready to go through the bottleneck machines. This is partly because workers are taking their breaks before getting the machines running again, and partly because they have left the machines unmanned because they have been called away to work on another (non-bottleneck) machine. Both of these absences result in the machines becoming idle. At this point, Alex learns an important lesson: an hour lost on a bottleneck machine is an hour lost for the entire system. This hour can never be recouped. It is pointless to leave a bottleneck machine unmanned in order to go and load up a non-bottleneck machine because there is spare capacity on the non-bottleneck machine anyway. It doesn’t matter if it’s not running for a bit. But it does matter in the case of the bottleneck. From this point onwards, the two bottlenecks are permanently manned and permanently running. Their capacity is elevated this way, along with another few changes that are implemented.

THE NEED TO ACCEPT IDLE TIME

At this point, Alex and his team think they have saved the factory, and then suddenly they find that new bottlenecks seem to be appearing. Parts with green labels on are not being completed in sufficient quantities, meaning that final assembly of the company’s products is again not taking place, and orders are being delayed again (because final assembly of products requires both bottleneck and non-bottleneck parts). Alex calls Jonah in a panic and asks for help. Jonah soon identifies the problem. Factory workers are still trying to be as efficient as possible, all of the time. This means that they are getting their machines to produce as many parts as possible, irrespective of the number of parts that can actually be processed by the bottleneck.

Jonah begins to explain, labelling a bottleneck machine as X and a non-bottleneck machine as Y. Some products may not need to go through X, he says, but that doesn’t mean that workers should make as many parts as the machines can produce, just to keep the machine’s efficiency rate looking good. Y parts should only be produced to the extent that they can be used in the assembly of finished goods, and the production of these is constrained by their need for bottleneck parts too. Any excess Y parts will simply go to the warehouse and be stored as finished goods, ultimately becoming obsolete and having to be written off at a substantial cost.

As for those products that do need to go through X, they may, for example, go from Y to Y to X to Y (as there are numerous steps involved in the production process). But if the capacity of the first Y machine is far higher than the capacity of the next Y machine, and it processes excessive X parts, another bottleneck may look like it has appeared on the second Y machine because so many red labelled parts are being fed through that it never gets to process the green ones, which are also necessary for final assembly. Suddenly Alex realises that all machines must work at the pace set by the bottleneck machines, just like the boys on the hike that had to walk at the pace of the slowest walker.

Consequently, Alex realises that it is really important to let Y machines and workers sit idle when they have produced to the capacity of the bottleneck machines. By definition, they have spare capacity. It’s not only wasteful to produce parts that are not needed or cannot be processed; it also clogs up the whole system and makes it seem as if new bottlenecks are appearing. This idea of idle time not only being acceptable but also being essential flies in the face of everything that is believed at the time and, yet, when you understand the theory of constraints, it makes perfect sense. A balanced factory is not efficient at all; it is very inefficient because different machines and processes have different capacities, and if machines that have spare capacity are working 100% of the time, they are producing parts that are not needed. This is wasteful, not efficient. As evidenced in the novel, inventory goes up and throughput goes down. Alex is quick to resolve the problem and get things running smoothly again.

THROUGHPUT AND JUST-IN-TIME

Given that producing excess inventories both pushes costs up and prevents throughput, it becomes obvious that throughput accounting and just in time operate very well together. This becomes clear towards the end of the novel when UniCo secures even more orders by reducing its delivery time dramatically. It is able to do this by adopting some of the principles of just-in-time.

First, Alex reduces batch sizes substantially. For those unfamiliar with throughput accounting and just-in-time, it can be hard to get past the idea that if batch sizes are halved, financial results may still improve. The novice believes that if batch sizes are halved, costs must go up, because more orders are needed, more set ups are needed, more deliveries are needed, and so on... and surely these costs must be high? But the fact is – as proved in the novel – inventory costs are also halved and, even more importantly, lead time is halved, which in this case gives UniCo a competitive advantage. Throughput increases dramatically because of increased sales volumes. These increased sales volumes also led to a significantly lower operating cost per unit, which, along with the reduced inventory costs, more than makes up for increase in the other costs. Given that there is spare capacity for all of the non-bottleneck machines anyway, if the number of set ups for these is increased, no real additional cost arises because there is idle time. As Jonah says: ‘An hour saved on a non-bottleneck resource is a mirage.’

CONCLUSION

It is not possible, within the space of a few pages, to convey everything that The Goal has to say. To think that I could do so would be an insult to the authors of this 273-page novel. Nor is the theory contained within the novel beyond questioning and criticism; but this article was not meant as a critique.

Hopefully, however, I have told you enough to convince you that this book is worth reading should you have a couple of days to spare sometime. I haven’t, after all, told you the ending... Also, you should now have an understanding of the background to my second article, which you will find in the next issue of Student Accountant.

Written by a member of the Paper F5 examining team

Revenue Revisited

On 28 May 2014, the International Accounting Standards Board (IASB), as a result of the joint project with the US Financial Accounting Standards Board (FASB), issued IFRS 15, Revenue from Contracts with Customers. Application of the standard is mandatory for annual reporting periods starting from 1 January 2017 onward (though there is currently a proposal to defer this date to 1 January 2018) and earlier application is permitted.

In line with ACCA’s established rule, accounting standards issued by 1 September in a given year are examinable from 1 September in the following year, so IFRS 15 will be examinable in F7 from the September 2015 session.

This article considers the application of IFRS 15, Revenue from Contracts with Customersusing the five-step model. The new standard introduces some significant changes so you should ensure that you have the latest editions of all study materials.

Historically, there has been a significant divergence in practice over the recognition of revenue, mainly because International Financial Reporting Standards (IFRS) have contained limited guidance in certain areas. The original standard, IAS 18, Revenue, was issued in 1982 with a significant revision in 1993, however, IAS 18 was not fit for purpose in today’s corporate world as the guidance available was difficult to apply to many transactions. The result was that some companies applied US GAAP when it suited their needs.

Users often found it difficult to understand the judgments and estimates made by an entity in recognising revenue, partly because of the ‘boilerplate’ nature of the disclosures. As a result of the varying recognition practices, the nature and extent of the impact of the new standard will vary between entities and industries. For many transactions, such as those in retail, the new standard will have little effect but there could be significant change to current practice in accounting for long-term and multiple-element contracts.

IFRS 15 replaces the following standards and interpretations:

IAS 11, Construction ContractsIAS 18, RevenueIFRIC 13, Customer Loyalty ProgrammesIFRIC 15, Agreements for the Construction of Real EstateIFRIC 18, Transfer of Assets from CustomersSIC-31, Revenue – Barter Transactions Involving Advertising Services

One effect of this for the ACCA exams is that construction contracts are no longer an excluded topic in P2.

The core principle of IFRS 15 is that an entity shall recognise revenue from the transfer of promised good or services to customers at an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services. The standard introduces a five-step model for the recognition of revenue.

The five-step model applies to revenue earned from a contract with a customer with limited exceptions, regardless of the type of revenue transaction or the industry. 

Step one in the five-step model requires the identification of the contract with the customer. Contracts may be in different forms (written, verbal or implied), but must be enforceable, have commercial substance and be approved by the parties to the contract. The model applies once the payment terms for the goods or services are identified and it is probable that the entity will collect the consideration. Each party’s rights in relation to the goods or services have to be capable of identification. If a contract with a customer does not meet these criteria, the entity can continually reassess the contract to determine whether it subsequently meets the criteria.

Two or more contracts that are entered into around the same time with the same customer may be combined and accounted for as a single contract, if they meet the specified criteria. The standard provides detailed requirements for contract modifications. A modification may be accounted for as a separate contract or as a modification of the original contract, depending upon the circumstances of the case.

Step two requires the identification of the separate performance obligations in the contract. This is often referred to as ‘unbundling’, and is done at the beginning of a contract. The key factor in identifying a separate performance obligation is the distinctiveness of the good or service, or a bundle of goods or services. A good or service is distinct if the customer can benefit from the good or service on its own or together with other readily available resources and it is separately identifiable from other elements of the contract.

IFRS 15 requires that a series of distinct goods or services that are substantially the same with the same pattern of transfer, to be regarded as a single performance obligation. A good or service which has been delivered may not be distinct if it cannot be used without another good or service that has not yet been delivered. Similarly, goods or services that are not distinct should be combined with other goods or services until the entity identifies a bundle of goods or services that is distinct. IFRS 15 provides indicators rather than criteria to determine when a good or service is distinct within the context of the contract. This allows management to apply judgment to determine the separate performance obligations that best reflect the economic substance of a transaction.

Step three requires the entity to determine the transaction price, which is the amount of consideration that an entity expects to be entitled to in exchange for the promised goods or services. This amount excludes amounts collected on behalf of a third party – for example, government taxes. An entity must determine the amount of consideration to which it expects to be entitled in order to recognise revenue.

Additionally, an entity should estimate the transaction price, taking into account non-cash consideration, consideration payable to the customer and the time value of money if a significant financing component is present. The latter is not required if the time period between the transfer of goods or services and payment is less than one year. In some cases, it will be clear that a significant financing component exists due to the terms of the arrangement.

In other cases, it could be difficult to determine whether a significant financing component exists. This is likely to be the case where there are long-term arrangements with multiple performance obligations such that goods or services are delivered and cash payments received throughout the arrangement. For example, if an advance payment is required for business purposes to obtain a longer-term contract, then the entity may conclude that a significant financing obligation does not exist.

If an entity anticipates that it may ultimately accept an amount lower than that initially promised in the contract due to, for example, past experience of discounts given, then revenue would be estimated at the lower amount with the collectability of that lower amount being assessed. Subsequently, if revenue already recognised is not collectable, impairment losses should be taken to profit or loss.

Step four requires the allocation of the transaction price to the separate performance obligations. The allocation is based on the relative standalone selling prices of the goods or services promised and is made at the inception of the contract. It is not adjusted to reflect subsequent changes in the standalone selling prices of those goods or services.

The best evidence of standalone selling price is the observable price of a good or service when the entity sells that good or service separately. If that is not available, an estimate is made by using an approach that maximises the use of observable inputs – for example, expected cost plus an appropriate margin or the assessment of market prices for similar goods or services adjusted for entity-specific costs and margins or in limited circumstances a residual approach. The residual approach is different from the residual method that is used currently by some entities, such as software companies.

When a contract contains more than one distinct performance obligation, an entity should allocate the transaction price to each distinct performance obligation on the basis of the standalone selling price.

This will be a major practical issue as it may require a separate calculation and allocation exercise to be performed for each contract. For example, a mobile telephone contract typically bundles together the handset and network connection and IFRS 15 will require their separation.

Step five requires revenue to be recognised as each performance obligation is satisfied. This differs from IAS 18 where, for example, revenue in respect of goods is recognised when the significant risks and rewards of ownership of the goods are transferred to the customer. An entity satisfies a performance obligation by transferring control of a promised good or service to the customer, which could occur over time or at a point in time. The definition of control includes the ability to prevent others from directing the use of and obtaining the benefits from the asset. A performance obligation is satisfied at a point in time unless it meets one of the following criteria, in which case, it is deemed to be satisfied over time:

The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.The entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced.The entity’s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date.

Revenue is recognised in line with the pattern of transfer. Whether an entity recognises revenue over the period during which it manufactures a product or on delivery to the customer will depend on the specific terms of the contract.

If an entity does not satisfy its performance obligation over time, it satisfies it at a point in time and revenue will be recognised when control is passed at that point in time. Factors that may indicate the passing of control include the present right to payment for the asset or the customer has legal title to the asset or the entity has transferred physical possession of the asset.

As a consequence of the above, the timing of revenue recognition may change for some point-in-time transactions when the new standard is adopted.

In addition to the five-step model, IFRS 15 sets out how to account for the incremental costs of obtaining a contract and the costs directly related to fulfilling a contract and provides guidance to assist entities in applying the model to licences, warranties, rights of return, principal-versus-agent considerations, options for additional goods or services and breakage.

IFRS 15 is a significant change from IAS 18 and even though it provides more detailed application guidance, judgment will be required in applying it because the use of estimates is more prevalent.

For exam purposes, you should focus on understanding the principles of the five-step model so that you can apply them to practical questions.

Written by a member of the P2 examining team

Last updated: 21 Sep 2015

Computing cash flows

COMPUTING CASH FLOWS

Cash flows are either receipts (ie cash inflows and so are represented as a positive number in a statement of cash flows) or  payments (ie cash out flows and so are represented as a negative number using brackets in a statement of cash flows).

Cash flows are usually calculated as a missing figure. For example, when the opening balance of an asset, liability or equity item is reconciled to its closing balance using information from the statement of profit or loss and/or additional notes, the balancing figure is usually the cash flow.

Common cash flow calculations include the tax paid, which is an operating activity cash out flow, the payment to buy property plant and equipment (PPE) which is an investing activity cash out flow and dividends paid, which is a financing activity cash out flow. The following examples illustrate all three of these examples.

EXERCISE CALCULATING THE TAX PAID

At the start of the accounting period the company has a tax liability of $50 and at the reporting date a tax liability of $90. During the year the tax charged in the statement of profit or loss was $100.

Required: Calculate the tax paid.

Solution

It is necessary to reconcile the opening tax liability to the closing tax liability to reveal the cash flow – the tax paid - as the balancing figure. A vertical presentation of the numbers lends itself to noting the source of the numbers.

Tax liability

$

Explanation

Opening balance

50

Credit balance

Tax charge

100

The tax charged in the profit or loss means that the entity now owes more tax. The debit charged as the expense in profit or loss is posted and a credit to the tax liability account reflects the effect of increase in the tax liability

 

_____

 

Sub-total

150

This sub-total represents the amount of the tax liability that there would have been at the reporting date in the event that no tax had been paid

Cash flow – the payment of tax

60

This is the last figure written in the reconciliation. It is the balancing figure and explains why the actual year-end tax liability is smaller than the sub-total

 

_____

 

Closing balance

90

This is the closing balance of the tax liability

 

_____  

This simple technique of taking the opening balance of an item (in this case the tax liability) and adding (or subtracting) the non-cash transactions that have caused it to change, to then reveal the actual cash flow as the balancing figure, has wide application.

EXERCISE CALCULATING THE PAYMENTS TO BUY PPE

At the start of the accounting period the company has PPE with a carrying amount of $100. At the reporting date the carrying amount of the PPE is $300. During the year depreciation charged was $20, a revaluation surplus of $60 was recorded and PPE with a carrying amount of $15 was sold.

Required: Calculate the cash paid to buy new PPE.

Solution

Here we can take the opening balance of PPE and reconcile it to the closing balance by adjusting it for the changes that have arisen in period that are not cash flows. The balancing figure is the cash spent to buy new PPE.

PPE

$

Explanation

Opening balance

100

Debit balance

Deprecation

(20)

Deprecation reduces the carrying amount of the PPE without being a cash flow. The double entry for depreciation is a debit to statement of profit or loss to reflect the expense and to credit the asset to reflect its consumption.

Revaluation surplus

60

The revaluation gain increases PPE without being a cash flow. The double entry is a credit to the revaluation surplus to reflect the gain and to debit the asset to reflect its increase

Disposal

(15)

The carrying amount of the PPE that has been disposed of reduces the PPE thus a credit to the asset account which is then posted as a debit in the disposals account

 

_____

 

Sub-total

125

This sub-total represents the balance of the PPE if no PPE had been bought for cash

Cash flow – the payment to buy PPE

175

This is the last figure written in the reconciliation This balancing figure explains why the actual PPE at the reporting date is greater than the sub-total

 

_____

 

Closing balance

300

 

 

_____

 

EXERCISE CALCULATING THE DIVIDEND PAID

At the start of the accounting period the company has retained earnings of $500 and at the reporting date retained earnings are $700. During the reporting period a profit for the year of $450 was reported.

Required: Calculate the dividend paid.

Solution

As before, to ascertain the cash flow – in this case dividends paid - we can reconcile an opening to closing balance – in this case retained earnings. This working is in effect an extract from the statement of changes in equity.

Retained earnings

$

Explanation

Opening balance

500

Credit balance

Profit for the year

450

The profit for the year is a credit and increases the retained earnings

 

_____

 

 

950

This sub-total represents the balance on retained earnings in the event that no dividends have been paid

Cash flow – the dividends paid

250

This is the last figure written in the reconciliation. This balancing figure of dividends paid explains why the actual year-end retained earnings is less

 

_____

 

Closing balance

700

 

 

_____

 

CLASSIFICATION OF CASH FLOWS

IAS 7, Statement of Cash Flows requires an entity to present a statement of cash flows as an integral part of its primary financial statements. A statement of cash flow classifies and presents cash flows under three headings:

(i) Operating activities

(ii) Investing activities and

(iii) Financing activities

Operating activities can be presented in two different ways. The first is the direct method which shows the actual cash flows from operating activities – for example, the receipts from customers and the payments to suppliers and staff. The second is the indirect method which reconciles profit before tax to cash generated from operating profit. Under both of these methods the interest paid and taxation paid are presented as cash outflows.

Investing activity cash flows are those that relate to non-current assets. Examples of investing cash flows include the cash outflow on buying property plant and equipment, the sale proceeds on the disposal of non-current assets and any cash returns received arising from investments.

Financing activity cash flows relate to cash flows arising from the way the entity is financed. Entities are financed by a mixture of cash from borrowings from third parties (debt) and by the shareholders (equity). Examples of financing cash flows include the cash received from new borrowings or the cash repayment of debt as well as the cash flows with shareholders in the form of cash receipts following a new share issue or the cash paid to them in the form of dividends.

This topic is examined in much more depth in the F7 examination than it is at F3. For example, in F3, an extract, or the whole statement of cash flow might be required. F7, however, is more likely to ask for an extract from the statement of cash flows using more complex transactions (for example, the purchase of PPE using finance leases).  However, that does not mean that F7 will never require the preparation of a complete statement of cash flows so be prepared.

OPERATING ACTIVITIES – THE INDIRECT METHOD AND DIRECT METHOD

There are two different ways of starting the cash flow statement, as IAS 7, Statement of Cash Flows permits using either the 'direct' or 'indirect' method for operating activities.

The direct method is intuitive as it means the statement of cash flow starts with the source of operating cash flows. This is the cash receipts from customers. The operating cash out flows are payments for wages, to suppliers and for other operating expenses are then deducted. Finally the payments for interest and tax are deducted.

Alternatively, the indirect method starts with profit before tax rather than a cash receipt. The profit before tax is then reconciled to the cash that it has generated. This means that the figures at the start of the cash flow statement are not cash flows at all.  In that initial reconciliation, expenses that have been charged against profit that are not cash out flows; for example depreciation and losses, have to be added back, and non-cash income; for example investment income and profits are deducted. The changes in inventory, trade receivables and trade payables (working capital) do not impact on the measurement profit but these changes will have impacted on cash and so further adjustments are made. For example, an increase in the levels of inventory and receivables will have not impacted on profit but will have had an adverse impact on the cash flow of the business. Thus in the reconciliation process the increases in inventory and trade receivables are deducted. Conversely decreases in inventory and trade receivables are deducted. The opposite is applicable for trade payables. Finally the payments for interest and tax are presented.

The following exercise illustrates both the direct and indirect methods operating activities section.

EXERCISE: THE DIRECT AND INDIRECT METHOD

Extracts from the financial statements are as follows

  $  

Operating profit

80,000

 

Investment income

12,000

 

Finance costs

(10,000)

 

Profit before tax

82,000

 

Tax

(32,000)

 

Profit for the year

50,000

 

Other comprehensive income

 

 

Revaluation gain

40,000

 

Total comprehensive income

90,000

 

  Closing balance

$ Opening balance

$

Current assets

 

 

Inventory

30,000

25,000

Receivables

20,000

26,000

Current liabilities

 

 

Trade payables

14,000

11,000

Additional information

During the year depreciation of $50,000 and amortisation of $40,000 was charged to profit.  

Receipts from customers, combined with cash sales, were $800,000, payments to suppliers of raw materials $400,000, other operating cash payments were $100,000 and cash paid on behalf and to employees was $126,000.

Interest paid is $12,000 and taxation paid is $13,000.

Required:

(a) Using the direct method prepare the operating activities section of the statement of cash flows.

(b) Using the indirect method determine the operating activities section of the statement of cash flows.

Answer (a) direct method

The direct method is relatively straightforward in that all the data are cash flows so it is really just a case of listing the receipts as positive and the payments as negative.

Operating activities – 

Direct method

$

$

Cash received from customers

800,000

 

Cash paid to suppliers

(400,000)

 

Cash paid to staff

(100,000)

 

Other operating payments

(126,000)

 

Cash generated

174,000

 

Interest paid

(12,000)

 

Taxation paid

(13,000)

149,000

Answer (b) indirect method

The indirect method is more commonly examined. Here as we start with profit before tax we have to add back all the non-cash expenses charged, deduct the non-cash income and adjust for the changes in working capital. Only then are the two actual cash flows of interest paid and tax paid presented. Having a good understanding of the format of the statement of cash flows is key to a successful attempt at these questions.

Operating activities – Indirect method

$

$

Operating activities

 

 

Profit before tax

82,000

 

Investment income

(12,000)

 

Finance cost

10,000

 

Depreciation

50,000

 

Amortisation

40,000

 

Increase in inventory

(30,000 – 25,000)

(5,000)

 

Decrease in receivables 

(20,000 – 26,000)

6,000

 

Increase in payables

(14,000 – 11,000)

3,000

 

Cash generated

174,000

 

Interest paid

(12,000)

 

Taxation paid

(13,000)

 

149,000

Note how whichever method is used that the same cash is generated from operating activities.

FORMAT OF THE CASH FLOW STATEMENT – 

INDIRECT METHOD

You may be asked to prepare a statement of cash flows. The following is a pro forma showing the indirect method.

1. Operating activities

   

Profit before tax

X

 

Investment income

(X)

 

Finance cost

X

 

Depreciation

X

 

Less capital government grant released

(X)

 

Amortisation of intangible assets

X

 

Impairment loss charged in profit or loss

X

 

Loss on disposal of assets (profit)

X / (X)

 

Increase in provisions (decrease)

X / (X)

 

Changes in working capital

 

 

Increase / decrease in inventory

(X) / X

 

Increase / decrease in receivables and prepayments

(X) / X

 

Increase / decrease in trade payables and accruals

X / (X)

 

Cash generated

X

 

Interest paid

(X)

 

Taxation paid

(X)

X

 

2. Investing activities

 

 

Payments to buy PPE / Intangibles / Investments

(X)

 

Proceeds from sale of PPE / Intangibles / Investments

X

 

Dividends received from investments

X

 

Capital government grants received

X

(X)

 

3. Financing activities

 

 

Proceeds from an equity share issue

X

 

Dividends paid

(X)

 

Proceeds from the issue of new debt

X

 

Repayment of debt

(X)

 

Capital repayment of finance lease obligations

(X)

X/(X)

Change in cash and cash equivalents

 

X/(X)

Opening cash and cash equivalents

 

X/(X)

Closing cash and cash equivalents

 

X/(X)

Cash and cash equivalents comprise cash on hand and demand deposits, together with short-term, highly liquid investments that are readily convertible to a known amount of cash, and that are subject to an insignificant risk of changes in value.

Tom Clendon FCCA is a senior lecturer based in Singapore and he lectures for FTMS Global in their South East Asia colleges

part 2 : Measurement and depreciation

This is the second of two articles, and considers revaluation of property, plant and equipment (PPE) and its derecognition. The first part of the article (see 'Related links') considered the initial measurement and depreciation of PPE.
There are rather more differences between IAS 16, Property, Plant and Equipment (the international standard) and FRS 15, Tangible Fixed Assets (the UK standard) in relation to revaluation and derecognition compared to initial measurement and depreciation. For both topics addressed in this article, the international position is outlined first, and then compared to the UK position.

REVALUATION OF PPE – IAS 16 POSITION

General principles
IAS 16 allows entities the choice of two valuation models for PPE – the cost model or the revaluation model. Each model needs to be applied consistently to all PPE of the same ‘class’. A class of assets is a grouping of assets that have a similar nature or function within the business. For example, properties would typically be one class of assets, and plant and equipment another. Additionally, if the revaluation model is chosen, the revaluations need to be kept up to date, although IAS 16 is not specific as to how often assets need to be revalued.
When the revaluation model is used, assets are carried at their fair value, defined as ‘the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction’.
Revaluation gains
Revaluation gains are recognised in equity unless they reverse revaluation losses on the same asset that were previously recognised in the income statement. In these circumstances, the revaluation gain is recognised in the income statement. Revaluation changes the depreciable amount of an asset so subsequent depreciation charges are affected.
EXAMPLE 1
A property was purchased on 1 January 20X0 for $2m (estimated depreciable amount $1m – useful economic life 50 years). Annual depreciation of $20,000 was charged from 20X0 to 20X4 inclusive and on 1 January 20X5 the carrying value of the property was $1.9m. The property was revalued to $2.8m on 1 January 20X5 (estimated depreciable amount $1.35m – the estimated useful economic life was unchanged). Show the treatment of the revaluation surplus and compute the revised annual depreciation charge.
Solution
The revaluation surplus of $900,000 ($2.8m – $1.9m) is recognised in the statement of changes in equity by crediting a revaluation reserve. The depreciable amount of the property is now $1.35m and the remaining estimated useful economic life 45 years (50 years from 1 January 20X0). Therefore, the depreciation charge from 20X5 onwards would be $30,000 ($1.35m x 1/45).
A revaluation usually increases the annual depreciation charge in the income statement. In the above example, the annual increase is $10,000 ($30,000 – $20,000). IAS 16 allows (but does not require) entities to make a transfer of this ‘excess depreciation’ from the revaluation reserve directly to retained earnings.
Revaluation losses
Revaluation losses are recognised in the income statement. The only exception to this rule is where a revaluation surplus exists relating to a previous revaluation of that asset. To that extent, a revaluation loss can be recognised in equity.
EXAMPLE 2
The property referred to in Example 1 was revalued on 31 December 20X6. Its fair value had fallen to $1.5m. Compute the revaluation loss and state how it should be treated in the financial statements.
Solution
The carrying value of the property at 31 December 20X6 would have been $2.74m ($2.8m – 2 x $30,000). This means that the revaluation deficit is $1.24m ($2.74m – $1.5m).
If the transfer of excess depreciation (see above) is not made, then the balance in the revaluation reserve relating to this asset is $900,000 (see Example 1). Therefore $900,000 is deducted from equity and $340,000 ($1.24m – $900,000) is charged to the income statement.
If the transfer of excess depreciation is made, then the balance on the revaluation reserve at 31 December 20X6 is $880,000 ($900,000 – 2 x $10,000). Therefore $880,000 is deducted from equity and $360,000 ($1.24m – $880,000) charged to the income statement.

REVALUATION OF PPE – FRS 15 POSITION

Although the basic position in FRS 15 is similar to that of IAS 16, there are differences:

• FRS 15 is more specific than IAS 16 regarding the frequency of valuations. FRS 15 states that, as a minimum, assets should be revalued every five years.
• Under FRS 15 the amount to which a fixed asset is revalued is different than under IAS 16. As far as properties are concerned (these probably being the class of fixed asset most likely to be carried at valuation) the basic valuation principle is value for existing use – not reflecting any development potential. Notional, directly attributable acquisition costs should also be included where material. However, specialised properties may need to be valued on the basis of depreciated replacement cost, since there may be no data on which to base an ‘existing use’ valuation. If properties are surplus to the entity’s requirements, then they should be valued at open market value net of expected directly attributable selling costs. 
• Revaluation losses that are caused by a clear consumption of economic benefits, for example physical damage to an asset, should be recognised in the profit and loss account. Such losses are recognised as an operating cost similar to depreciation. 
• Other revaluation losses, for example the effect of a general fall in market values on a portfolio of properties, should be partly recognised in the statement of total recognised gains and losses. However, if the loss is such that the carrying amount of the asset falls below depreciated historical cost, then any further losses need to be recognised in the profit and loss account. 

EXAMPLE 3
State how the answers to Examples 1 and 2 would change if FRS 15 were applied rather than IAS 16.
Solution
The answer to Example 1 would not change at all. For Example 2, if the revaluation loss was caused by a consumption of economic benefits, then the whole loss would be recognised in the profit and loss account. If the revaluation loss was caused by general factors, then it would be necessary to compute the depreciated historical cost of the property. This is the carrying value of the property at 31 December 20X6 if the first revaluation on 1 January 20X5 had not been carried out and would be $1.86m ($2m – 7 x $20,000). The actual carrying value of the property at 31 December 20X6 was $2.74m (see Example 2). Therefore, of the revaluation loss of $1.24m (see Example 2), $880,000 ($2.74m – $1.86m) is charged to the statement of total recognised gains and losses, and the balance of $360,000 ($1.24m – $880,000) charged to the profit and loss account.

DERECOGNITION OF PPE – THE IAS 16 POSITION

PPE should be derecognised (removed from PPE) either on disposal or when no future economic benefits are expected from the asset (in other words, it is effectively scrapped). A gain or loss on disposal is recognised as the difference between the disposal proceeds and the carrying value of the asset (using the cost or revaluation model) at the date of disposal. This net gain is included in the income statement – the sales proceeds should not be recognised as revenue.
Where assets are measured using the revaluation model, any remaining balance in the revaluation reserve relating to the asset disposed of is transferred directly to retained earnings. No recycling of this balance into the income statement is permitted.

DISPOSAL OF ASSETS – IFRS 5 POSITION

IFRS 5, Non-current assets held for sale and discontinued operations is another standard that deals with the disposal of non-current assets and discontinued operations. An item of PPE becomes subject to the provisions of IFRS 5 (rather than IAS 16) if it is classified as held for sale. This classification can either be made for a single asset (where the planned disposal of an individual and fairly substantial asset takes place) or for a group of assets (where the disposal of a business component takes place). This article considers the implications of disposing of a single asset.
IFRS 5 is only applied if the held for sale criteria are satisfied, and an asset is classified as held for sale if its carrying amount will be recovered principally through a sale transaction rather than through continued use. For this to be the case, the asset must be available for immediate sale in its present condition and its sale must be highly probable. Therefore, an appropriate level of management must be committed to a plan to sell the asset, and an active programme to locate a buyer and complete the plan must have been initiated. The asset needs to be actively marketed at a reasonable price, and a successful sale should normally be expected within one year of the date of classification.
The types of asset that would typically satisfy the above criteria would be property, and very substantial items of plant and equipment. The normal disposal or scrapping of plant and equipment towards the end of its useful life would be subject to the provisions of IAS 16. When an asset is classified as held for sale, IFRS 5 requires that it be moved from its existing balance sheet presentation (non-current assets) to a new category of the balance sheet – ‘non-current assets held for sale’. No further depreciation is charged as its carrying value will be recovered principally through sale rather than continuing use.
The existing carrying value of the asset is compared with its ‘fair value less costs to sell’ (effectively the selling price less selling costs). If fair value less costs to sell is below the current carrying value, then the asset is written down to fair value less costs to sell and an impairment loss recognised. When the asset is sold, any difference between the new carrying value and the net selling price is shown as a profit or loss on sale.
EXAMPLE 4
An asset has a carrying value of $600,000. It is classified as held for sale on 30 September 20X6. At that date its fair value less costs to sell is estimated at $550,000. The asset was sold for $555,000 on 30 November 20X6. The year end of the entity is 31 December 20X6.

1. How would the classification as held for sale, and subsequent disposal, be treated in the 20X6 financial statements?
2. How would the answer differ if the carrying value of the asset at 30 September 20X6 was $500,000, with all other figures remaining the same?

Solution 1

1. On 30 September 20X6, the asset would be written down to its fair value less costs to sell of $550,000 and an impairment loss of $50,000 recognised. It would be removed from non-current assets and presented in ‘non-current assets held for sale’. On 30 November 20X6 a profit on sale of $5,000 would be recognised.
2. On 30 September 20X6 the asset would be transferred to non-current assets held for sale at its existing carrying value of $500,000. When the asset is sold on 30 November 20X6, a profit on sale of $55,000 would be recognised.

Where an asset is measured under the revaluation model then IFRS 5 requires that its revaluation must be updated immediately prior to being classified as held for sale. The effect of this treatment is that the selling costs will always be charged to the income statement at the date the asset is classified as held for sale.
EXAMPLE 5
An asset being classified as held for sale is currently carried under the revaluation model at $600,000. Its latest fair value is $700,000 and the estimated costs of selling the asset are $10,000. Show how this transaction would be recorded in the financial statements.
Solution
Immediately prior to being classified as held for sale, the asset would be revalued to its latest fair value of $700,000, with a credit of $100,000 to equity. The fair value less costs to sell of the asset is $690,000 ($700,000 – $10,000). On reclassification, the asset would be written down to this value (being lower than the updated revalued amount) and $10,000 charged to the income statement.

DERECOGNITION OF PPE – FRS 15 POSITION

The FRS 15 position is effectively identical to that of IAS 16 in as far as derecognition of PPE is covered by IAS 16. However, there is no UK standard equivalent to IFRS 5, although the UK Accounting Standards Board has issued an exposure draft that is very similar to IFRS 5.
Paul Robins is a lecturer at Kaplan

Part 1 : Measurement and depreciation

This is the first of two articles which consider the main features of IAS 16, Property, Plant and Equipment (PPE). Both articles are relevant to students studying the International or UK stream. The series will primarily focus on the requirements of IAS 16, but will also compare IAS 16 with the equivalent UK standard, FRS 15, Tangible Fixed Assets. These standards deal with the four main aspects of financial reporting of PPE that are likely to be of major relevance in the exams, namely:

• initial measurement and depreciation – covered in this article
• revaluation and derecognition – covered in the second article.
  

Note: There are no significant differences between IAS 16 and FRS 15 as far as either initial measurement or depreciation of PPE are concerned.

IAS 16 defines PPE as tangible items that are:

• held for use in the production or supply of goods or services, for rental to others, or for administrative purposes and
• expected to be used during more than one accounting period.
  
  

THE INITIAL MEASUREMENT OF PPE

IAS 16 requires that PPE should initially be measured at ‘cost’. The cost of an item of PPE comprises:

• the cost of purchase, net of any trade discounts plus any import duties and non-refundable sales taxes
• 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 management.
  

These are costs that would have been avoided if the asset had not been purchased or constructed. General overhead costs cannot be allocated to the cost of PPE. Directly attributable costs include:

• employee benefits payable to staff installing, constructing, or initially testing the asset
• site preparation
• professional fees directly associated with the installation, construction, or initial testing of the asset
• any other overhead costs directly associated with the installation, construction, or initial testing of the asset.
  

Where these costs are incurred over a period of time (such as employee benefits), the period for which the costs can be included in the cost of PPE ends when the asset is ready for use, even if the asset is not brought into use until a later date. As soon as an asset is capable of operating it is ready for use. The fact that it may not operate at normal levels immediately, because demand has not yet built up, does not justify further capitalisation of costs in this period. Any abnormal costs (for example, wasted material) cannot be included in the cost of PPE.

IAS 16 does not specifically address the issue of whether borrowing costs associated with the financing of a constructed asset can be regarded as a directly attributable cost of construction. This issue is addressed in IAS 23, Borrowing Costs. IAS 23 requires the inclusion of borrowing costs as part of the cost of constructing the asset. In order to be consistent with the treatment of ‘other costs’, only those finance costs that would have been avoided if the asset had not been constructed are eligible for inclusion. If the entity has borrowed funds specifically to finance the construction of an asset, then the amount to be capitalised is the actual finance costs incurred. Where the borrowings form part of the general borrowing of the entity, then a capitalisation rate that represents the weighted average borrowing rate of the entity should be used.

The cost of the asset will include the best available estimate of the costs of dismantling and removing the item and restoring the site on which it is located, where the entity has incurred an obligation to incur such costs by the date on which the cost is initially established. This is a component of cost to the extent that it is recognised as a provision under IAS 37, Provisions, Contingent Liabilities and Contingent Assets. In accordance with the principles of IAS 37, the amount to be capitalised in such circumstances would be the amount of foreseeable expenditure appropriately discounted where the effect is material.

EXAMPLE 1
On 1 October 20X6, Omega began the construction of a new factory. Costs relating to the factory, incurred in the year ended 30 September 20X7, are as follows:

	$000
Purchase of the land	10,000
Costs of dismantling existing structures on the site	500
Purchase of materials to construct the factory	6,000
Employment costs (Note 1)	1,800
Production overheads directly related to the construction (Note 2)	1,200
Allocated general administrative overheads	600
Architects’ and consultants’ fees directly related to the construction	400
Costs of relocating staff who are to work at the new factory	300
Costs relating to the formal opening of the factory	200
Interest on loan to partly finance the construction of the factory (Note 3)	1,200

Note 1
The factory was constructed in the eight months ended 31 May 20X7. It was brought into use on 30 June 20X7. The employment costs are for the nine months to 30 June 20X7.

Note 2
The production overheads were incurred in the eight months ended 31 May 20X7. They included an abnormal cost of $200,000, caused by the need to rectify damage resulting from a gas leak.

Note 3
Omega received the loan of $12m on 1 October 20X6. The loan carries a rate of interest of 10% per annum.

Note 4
The factory has an expected useful economic life of 20 years. At that time the factory will be demolished and the site returned to its original condition. This is a legal obligation that arose on signing the contract to purchase the land. The expected costs of fulfilling this obligation are $2m. An appropriate annual discount rate is 8%.

Requirement
Compute the initial carrying value of the factory (see solution).

DEPRECIATION OF PPE

IAS 16 defines depreciation as ‘the systematic allocation of the depreciable amount of an asset over its useful life’. ‘Depreciable amount’ is the cost of an asset, cost less residual value, or other amount (for more on the revaluation of the asset, see the second article in the August 2007 issue of student accountant). Depreciation is not providing for loss of value of an asset, but is an accrual technique that allocates the depreciable amount to the periods expected to benefit from the asset. Therefore assets that are increasing in value still need to be depreciated.

IAS 16 requires that depreciation should be recognised as an expense in the income statement, unless it is permitted to be included in the carrying amount of another asset. An example of this practice would be the possible inclusion of depreciation in the costs incurred on a construction contract that are carried forward and matched against future income from the contract, under the provisions of IAS 11.

A number of methods can be used to allocate depreciation to specific accounting periods. Two of the more common methods, specifically mentioned in IAS 16, are the straight line method, and the reducing (or diminishing) balance method.

The assessments of the useful life (UL) and residual value (RV) of an asset are extremely subjective. They will only be known for certain after the asset is sold or scrapped, and this is too late for the purpose of computing annual depreciation. Therefore, IAS 16 requires that the estimates should be reviewed at the end of each reporting period. If either changes significantly, then that change should be accounted for over the remaining estimated useful economic life.

EXAMPLE 2
An item of plant was acquired for $220,000 on 1 January 20X6. The estimated UL of the plant was five years and the estimated RV was $20,000. The asset is depreciated on a straight line basis. On 31 December 20X6 the future estimate of the UL of the plant was changed to three years, with an estimated RV of $12,000.

At the date of purchase, the plant’s depreciable amount would have been $200,000 ($220,000 – $20,000). Therefore, depreciation of $40,000 would have been charged in 20X6, and the carrying value would have been $180,000 at the end of 20X6. Given the reassessment of the UL and RV, the depreciable amount at the end of 20X6 is $168,000 ($180,000 – $12,000) over three years. Therefore, the depreciation charges in 20X7, 20X8 and 20X9 will be $56,000 ($168,000/3) unless there are future changes in estimates. Where an asset comprises two or more major components with substantially different economic lives, each component should be accounted for separately for depreciation purposes, and each depreciated over its UL.

EXAMPLE 3
On 1 January 20X2, an entity purchased a furnace for $200,000. The estimated UL of the furnace was 10 years, but its lining needed replacing after five years. On 1 January 20X2 the entity estimated that the cost of relining the furnace (at 1 January 20X2 prices) was $50,000. The lining was replaced on 1 January 20X7 at a cost of $70,000.

Requirement
Compute the annual depreciation charges on the furnace for each year of its life.

Solution

20X2–20X6 inclusive
The asset has two depreciable components: the lining element (allocated cost $50,000 – UL five years); and the balance of the cost (allocated cost $150,000 – UL 10 years). Therefore, the annual depreciation is $25,000 ($50,000 x 1/5 + $150,000 x 1/10). At 31 December 20X6, the ‘lining component’ has a written down value of zero.

20X7–20Y1 inclusive
The $70,000 spent on the new lining is treated as the replacement of a separate component of an asset and added to PPE. The annual depreciation is now $29,000 ($70,000 x 1/5 + $150,000 x 1/10).

Paul Robins is a lecturer at Kaplan

How to account for property

Relevant to Papers F7 and P2
With very few exceptions, all land in Hong Kong is owned by the Government and leased out for a limited period. It does not matter if the properties are high-rise buildings, residential, offices or factories, they are built on land under a government lease.

Developers of these properties lease lots of land from the Government and develop the land according to the lease conditions, such as to construct buildings on the land according to the specifications within a specified period.

Individual units of these lots of land and buildings are usually sold as undivided shares in the lots. Interests of all parties, including future buyers of the units, are governed by the deeds of mutual covenant.

In substance and in form, ‘owners' of these units are a lessee of a lease of land and buildings. According to IFRS, the land and buildings elements of these leases should be considered separately for the purposes of lease classification under IAS 17.

Allocation of the interests in leases of land and building

IAS 17
When a lease includes both land and buildings elements, we should assess the classification of each element as a finance or an operating lease separately. (Except, if the amount that would initially be recognised for the land element is immaterial, the land and buildings ma y be treated as a single unit for the purpose of lease classification. In such a case, the economic life of the buildings is regarded as the economic life of the entire leased asset.)

In determining whether the land element is an operating or a finance lease, an important consideration is that land normally has an indefinite economic life, which makes most of the land elements operating leases.

However, this is not always the case. Land elements can be classified as a finance lease if significant risks and re wards associated with the land during the lease period would have been transferred from the lessor to the lessee despite there being no transfer of title. For example, consider a 999-year lease of land and buildings. In this situation, significant risks and rewards associated with the land during the lease term would have been transferred to the lessee despite there being no transfer of title.

Separate measurement of the land and buildings elements is not required when the lessee’s interest in both land and buildings is classified as an investment property in accordance with IAS 40 and the fair value model is adopted.

Classification as property, plant and equipment or as an investment property

The issue is complicated when the separate elements of the land and buildings are further classified in accordance with IAS 16, Property, Plant and Equipment and IAS 40, Investment Properties.

IAS 16
According to IAS 16, land and buildings are separable assets and are accounted for separately, even when they are acquired together. Land has an unlimited useful life and, therefore, is not depreciated. Buildings have a limited useful life and, therefore, are depreciable assets. An increase in the value of the land on which a building stands does not affect the determination of the depreciable amount of the building.

IAS 40
A property interest that is held by a lessee under an operating lease may be classified and accounted for as investment property provided that:

• the rest of the definition of investment property is met
• the operating lease is accounted for as if it were a finance lease in accordance with IAS 17, Leases, and
• the lessee uses the fair value model for investment property
  

The choice between the cost and fair value models is not available to a lessee accounting for a property interest held under an operating lease that it has elected to classify and account for as investment property. The standard requires such investment property to be measured using the fair value model.

IAS 40 depends on IAS 17 for requirements for the classification of leases, the accounting for finance and operating leases and for some of the disclosures relevant to leased investment properties. When a property interest held under an operating lease is classified and accounted for as an investment property, IAS 40 overrides IAS 17 by requiring that the lease is accounted for as if it were a finance lease.

Scenario summaries

Scenario 1: Long-term lease of land

Element	Option 1	Option 2	Option 3	Option 4
Land	IAS 16 (Cost model)	IAS 16 (Revaluation model)	IAS 40 (Cost model)	IAS 40 (Fair model)
Buildings	IAS 16 (Cost model)	IAS 16 (Revaluation model)	IAS 40 (Cost model)	IAS 40 (Fair model)

Land element is classified as a finance lease under IAS 17 as significant risks and rewards associated with the land during the lease period would have been transferred to the lease despite there being no transfer of title.
The land should be recognised under IAS 16 (option 1 and 2) if it is owner-occupied or under IAS 40 (option 3 and 4) if it is used for rental earned.

• Option 1: Both land and buildings elements are measured at cost and presented under Property, Plant and Equipment in the statement of financial position. No depreciation is required for the land element but it is required for the buildings element.
• Option 2: Both land and buildings elements are measured at fair value with changes being posted to equity and presented under Property, Plant and Equipment in the statement of financial position. No depreciation is required for the land element but it is required for the buildings element.
• Option 3: Both land and buildings elements are measured at cost and presented under investment property in the statement of financial position. No depreciation is required for the land element but is required for the buildings element.
• Option 4: Both land and buildings elements are measured at fair value and presented under investment property in the statement of financial position. No depreciation is required for either the land element or buildings element.

Scenario 2: Short-term lease of land

Element	Option 1	Option 2	Option 3	Option 4
Land	IAS 17	IAS 17	IAS 17	IAS 40 (Fair value model) – for both land and building
Buildings	IAS 16 (Cost model)	IAS 16 (Revaluation model)	IAS 40 (Cost model)

Land element is classified as an operating lease under IAS 17 because it has indefinite economic life.
The land element should be recognised under IAS 17, as prepaid lease payments that are amortised over the lease term. Except for, it can be classified as investment property and the fair value model is used (option 4).
The buildings element should be recognised under IAS 16 (option 1 and 2) if it is owner occupied or under IAS 40 (option 3 and 4) if it is used for rental earned.

• Option 1: Land element is measured as prepaid lease payments that are amortised over the lease term. While the buildings element is measured at cost and presented under Property, Plant and Equipment in the statement of financial position. Depreciation is required for the building element.
• Option 2: Land element is measured as prepaid lease payments that are amortised over the lease term. While the buildings element is measured at fair value with changes being posted to equity and presented under Property, Plant and Equipment in the statement of financial position. Depreciation is required for the building element.
• Option 3: Land element is measured as prepaid lease payments that are amortised over the lease term. While the buildings element is measured at cost and presented under Investment property in the statement of financial position. Depreciation is required for buildings element.
• Option 4: Both land and buildings elements are measured at fair value and presented under Investment property in the statement of financial position. No depreciation is required for the land element and buildings element.

Scenario 3: Land element is immaterial

Element	Option 1	Option 2	Option 3	Option 4
Land	All the purchase price will be treated as buildings element
Buildings	IAS 16 (Cost model)	IAS 16 (Revaluation model)	IAS 40 (Cost model)	IAS 40 (Fair model)

As the land element is immaterial, the land and buildings elements are treated as a single unit for the purpose of lease classification. The economic life of the buildings is regarded as the economic life of the entire leased property.

• Option 1: Property is measured at cost and presented under Property, Plant and Equipment in the statement of financial position. Depreciation is required.
• Option 2: Property is measured at fair value with change being posted to equity and presented under Property, Plant and Equipment in the statement of financial position. Depreciation is required.
• Option 3: Property is measured at cost and presented under Investment property in the statement of financial position. Depreciation is required.
• Option 4: Property is measured at fair value and presented under Investment property in the statement of financial position. No depreciation is required.

Impairment review under IAS 36 is required to all assets at the reporting date except for those where the fair value model is adopted.
Linda Ng, HKCA Learning Media