I am convinced that the classic British TV series Yes, Minister was a documentary, not a comedy. In one episode, permanent secretary Sir Humphrey Appleby complains to the minister Jim Hacker: ‘If local authorities don’t send us the statistics that we ask for, then government figures will be a nonsense… they will be incomplete.’ Hacker replies, ‘But government figures are a nonsense anyway’. To which civil servant Bernard Woolley interjects, ‘I think Sir Humphrey wants to ensure they are a complete nonsense.’
I doubt that any standard setter has ever had a goal of creating a complete nonsense, but in IAS 16, Property Plant and Equipment, they have knocked it out of the park. The numbers and disclosure look superficially fine, but it all falls apart when you dig into the details.
This is not the place to revisit the relative merits of fair value versus historic cost accounting. Personally, I am in the historic camp. I have always found the idea that accountants can calculate the fair value of non-traded assets as questionable; at least historic cost removes the element of judgment.
The worst possible outcome is an opaque blend of both approaches
Whichever side of the debate you support, I hope we can all agree on one thing: the worst possible outcome is an opaque blend of both approaches. And that is exactly what we have with tangible fixed assets.
In a tangle
Let’s start with gross tangible assets. Consider a factory that cost £100m to build and equip, ignoring the cost of the land. The cash cost appears on the balance sheet and is then depreciated down to an expected residual value. Even fully depreciated assets stay on the balance sheet if they are still delivering ‘economic benefits’.
I like this approach. I can see what has been spent and what the assets are now carried at. I can compare the annual depreciation with the gross and net asset values. This lets me derive estimates of average asset age and expected life. For asset-intensive business, this sort of analysis can be very insightful. I used to do this all the time when I was an industrial analyst. It also works well for companies that lease out assets to customers. The only downside is that the historic cost becomes less meaningful during periods of prolonged high inflation.
Using historic cost data for tangible fixed assets helps investors derive a meaningful return on capital employed (ROCE) metric. The choice of metrics is a personal one, but I usually found that ROCE was a reliable measure of stewardship. Persistently high ROCE is a sign of good management focused on delivering value for shareholders; the converse is also true.
Companies rarely revalue fixed assets unless there has been an obvious impairment
Unfortunately, this is where it starts to go wrong. Companies can opt to revalue fixed assets when there has been a material change. If they do this, the gross value gets restated to a new fictitious amount to make sure that the other numbers align mathematically. The gross value is no longer a measure of what was spent. More worryingly, the net value ceases to be useful as an ROCE input.
In my experience companies rarely revalue fixed assets unless there has been an obvious impairment. The unspoken rationale here is to reduce the depreciation charge and boost reported profitability.
Companies are in effect penalised for buying businesses with attractive assets
The real problem is with acquisitive companies. Revaluation is mandatory for assets acquired in an acquisition, which often results in notionally higher invested capital (revaluations tend to be upwards) and lower profitability (the depreciation charge goes up). Neither change makes any sense to an investor who wants to look at stewardship.
Companies are in effect penalised for buying businesses with attractive assets. This makes no sense to me. And you can’t disaggregate the note into ‘organic’ and ‘acquired’ assets; it becomes an impenetrable mess of historic cost and fair value.
I suspect that one of the team who wrote IAS 16 was called Bernard.
