Corporate Reporting

With reference to the measurement of tangible non-current assets, critically

evaluate whether financial statements prepared using IFRS’s provide useful

information. Use specific examples from the annual reports of FTSE 100

companies to illustrate your points.

Written by

Jason Cates

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© Jason Cates, 2012

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Hans Hoogervorst, chairman of the IASB, said at the International Association for Accounting

Education and Research conference in Amsterdam on 20 June 2012 that he “was struck by

the multitude of measurement techniques that both IFRSs and US GAAP prescribe”.

With reference to the measurement of tangible non-current assets, critically evaluate

whether financial statements prepared using IFRS’s provide useful information. Use specific

examples from the annual reports of FTSE 100 companies to illustrate your points.

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Contents Aim .......................................................................................................................................................... 4

Structure and Introduction ................................................................................................................. 4

Comparison ............................................................................................................................................. 6

Fair Value vs. Historic Cost .................................................................................................................. 6

PPE (Valuation and Lifespan) .............................................................................................................. 6

Aircraft ................................................................................................................................................ 7

Conclusions ......................................................................................................................................... 8

Implications ........................................................................................................................................... 10

Comparability .................................................................................................................................... 10

Relevance .......................................................................................................................................... 10

Reliability ........................................................................................................................................... 11

Understandability ............................................................................................................................. 11

Conclusions ........................................................................................................................................... 12

Formalities ............................................................................................................................................ 13

Signatories......................................................................................................................................... 13

References ........................................................................................................................................ 14

Appendix ........................................................................................................................................... 15

Note 1 – Depreciation and Impairment for year ended 31st December 2011 .............................. 15

Note 2 –Percentage Calculations for Depreciation ....................................................................... 15

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Part I

Aim

The aim of this paper is to evaluate the usefulness of financial statements prepared in line with the

IFRS standards with a focus on the measurement of tangible non-current assets. This is in light of a

recent statement made by Hans Hoogervorst, chairman of the IASB, stating that he “was struck by

the multitude of measurement techniques that both IFRSs and US GAAP prescribe”. (Hoogervorst,

H., 2012)

Structure and Introduction

The above aim will be carried out by comparing the valuation techniques utilised by both

BAE Systems and Rolls-Royce in terms of their implementation of IAS 16 and IAS 36.

At this point, it is appropriate that we define the term “useful” in the context of this paper.

In this case, there are 4 key characteristics of usefulness. These are comparability, relevance,

reliability and understandability. (Elliot & Elliot, 2012) The implications on these key characteristics

due to differing interpretations of the IFRS standards will be evaluated later on in this paper.

As stated, the companies utilised in this paper are BAE Systems and Rolls-Royce. This is due

to their comparability in terms of industry and types of asset held. This comparability will help

facilitate the evaluation of their measurement of tangible non-current assets with a focus on how

they differ, why they differ and its effect on “usefulness”. (Bloomberg, 2012)

BAE has total assets worth £23.101bn, £16.720bn in non-current assets and PPE worth £2.496bn

(11% of total assets). (BAE, 2012) This is while Rolls-Royce has total assets worth £16.423bn,

£8.108bn in non-current assets and PPE worth £2.338bn (14% of total assets). (Rolls-Royce, 2012) All

as at 31st December 2011. This shows BAE is the larger of the two companies in terms of total assets,

but with both companies having relatively similar PPE figures. These figures and their treatment will

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be evaluated with a focus on their implications concerning “usefulness” under the 4 key aspects

mentioned earlier. This paper will then conclude by answering the question; do “financial

statements prepared using IFRS’s provide useful information?”

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Part II

Comparison

Fair Value vs. Historic Cost

In relation to fair value vs. using historic value, the valuation method utilised depends on the

nature of the business and the relevance each method has to the business. As stated above, PPE

makes up 11-14% of total assets. Therefore, the difference fair value accounting will have on

tangible non-current assets is relatively immaterial. Thus, whichever method they utilise will have

little impact on the key accounting ratios such as gearing and/or return on capital employed.

Additionally, the benefits of using fair value may be outweighed by the costs involved, both

financially and in terms of being time consuming. This issue relates specifically to aircraft where

there may be significant difficulty determining fair value during the “course of construction”. As

such, the matters of cost and materiality are key issues when weighting the use fair value against

that of historic cost.

PPE (Valuation and Lifespan)

As stated in BAE’s Annual Report 2011, “all fixed asset investments are stated at cost less

provisions for impairments.” and “Depreciation is provided, normally on a straight-line basis, to

write off the cost or valuation of tangible fixed assets over their estimated useful economic lives”. It

also states that BAE considers its buildings to have an estimated life of “up to 50 years” and other

equipment to having estimated lives of “10 to 15 years”. Simply speaking, BAE values its “tangible

assets” at historic cost minus accumulated depreciation and impairment. (BAE, 2012)

Additionally, Rolls-Royce’s annual report states that “Depreciation is provided on a straight-

line basis to write off the cost, less the estimated residual value, of property, plant and equipment

over their estimated useful lives. No depreciation is provided on assets in the course of

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construction”. This is in line with BAE’s valuation policy, but the difference lies in the assigned

lifespans of these non-current assets. (Rolls-Royce, 2012)

In terms of property, BAE depreciates its buildings for “up to 50 years” with an average of 22

years; Rolls-Royce on the other hand uses the life span of “five to 45 years” with an average of 21

years. This apparently minor difference saw BAE’s depreciation charge £4M lower in 2011 than if it

had used the average lifespans utilised by Rolls-Royce. (Rolls-Royce, 2012)

In terms of plant and equipment, Rolls-Royce’s policy is to depreciate these over “five to 25

years” and at an average of 12.9 years in 2011. This is while the average for BAE in 2011 was 12.7

years. This difference saw BAE’s depreciation charge £3M higher in 2011 than if it had used the

average lifespans utilised by Rolls-Royce. (BAE, 2012) (Rolls-Royce, 2012)

Aircraft

Although inventory is generally considered a current asset, companies such as Rolls-Royce

and BAE produce inventory that often takes more than a year to manufacture. In addition, Rolls-

Royce leases out much of its inventory rather than selling it. As such, some inventory may be

categorised as PPE. Therefore, how this inventory is valued is relevant when considering the

measurement of tangible non-current assets. (BAE, 2012)

Both BAE and Rolls-Royce have included a separate category for “aircraft” in their PPE, but

with Rolls-Royce separating out completed aircraft and those “In Course of Construction” with both

categories being treated differently. Both companies show their aircraft “In Course of Construction”

simply at cost. Then once completed, these aircraft are then depreciated over their assigned lives.

For BAE, this life is “up to 15 years” and Rolls-Royce, “five to 20 years” with an average of 16 years.

Due to this difference in inventory lifespans, BAE’s depreciation charge was £8m higher in 2011 as

compared to the average lifespans used Rolls-Royce. (BAE, 2012) (Rolls-Royce, 2012)

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In addition, Rolls-Royce’s separation of complete and incomplete inventory allows users to

determine the effects this may have on the company’s short-to-medium term profitability. This

relates to the rate of depreciation being charged as well as the level of long-term inventory open to

being leased out. (Rolls-Royce, 2012) However, in their 2011 annual report, BAE states that they

treat these two categories of inventory differently, but they fail to state how much inventory is

assigned to each category. (BAE, 2012) This lack of transparency by BAE has a negative impact on

their information’s usefulness.

Conclusions In 2011, BAE depreciated its tangible non-current assets at a rate of 6.1% per year as

compared to 6.6% per year by Rolls-Royce. Therefore, in proportion to the total value of tangible

non-current assets, it is Rolls-Royce who pays the higher level of depreciation. However in 2011, BAE

charged 14 times more impairment in proportion to its tangible non-current assets. (BAE, 2012)

(Rolls-Royce, 2012)

This difference in treatment comes down to the nature in which these companies operate.

In the case of Roll-Royce, it tends of lease out long-term inventory to a greater extent than BAE.

Thus, its future cash flows and inventory lifespans can be estimated more accurately. Due to this

increase in accuracy, there may be less need for Rolls-Royce to impair its assets. (Rolls-Royce, 2012)

This is unlike BAE who has to account for greater uncertainty while estimating future cash

flows. This includes, among other things, uncertainty relating to the long-term value of it’s aircraft.

Furthermore, BAE’s future cash flows may also be partially dependant on performance targets such

as delivery dates. This includes budget overruns and/or penalties for late delivery. Therefore, aircraft

value and expected future cash flows may be lower than accounted for, thus leading to a greater

need for BAE to impair such assets. However, these penalties can be measured relatively accurately,

therefore leading to an accurate level of impairment being charged. (BAE, 2012)

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To conclude, in stable economic conditions, Rolls-Royce will see its profits impaired when

compared to BAE due to their higher rate of depreciation. However, in downward economic

conditions, BAE may have to impair the value of its assets to a greater extent than Rolls-Royce due to

its higher book value of its assets. This will make BAE appear to be fairing comparably worse off in

such economic downturns, but “better off” in more stable economic conditions. This is in spite of the

fact that in reality, both companies may be facing very similar trading conditions, but have simply

recognised this differently in the accounts.

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Part III

Implications

This paper will now consider how the above treatment of tangible non-current assets affects

the usefulness of information provided by companies such as BAE Systems and Rolls-Royce.

Comparability

This issue of comparability, or lack of, has been a continuing theme throughout this paper.

As stated, the difference in the way the two companies discussed operate has brought about a

difference in their accounting policies. As stated, although both companies’ value assets using

historic cost, difference arises in relation to the lifespans they assign these assets as well as the level

of impairment each asset then incurs throughout its life. This reduces the comparability of their

accounts and thus hinders their usefulness to users. (BAE, 2012) (Rolls-Royce, 2012)

Relevance

It can be argued that in order to be relevant, accounts should be tailored to the company in

which they represent, sometimes at the expense of comparability. Again, this has been a continuing

theme throughout this paper. By allowing the companies the flexibility to tailor the standards, the

information provided by these companies then becomes more relevant, but less comparable.

Therefore, a balance has to be struck between these two sometimes conflicting issues in order for

the information provided to be considered “useful”.

An example of this is aircraft valuation. Rolls-Royce depreciates its aircraft over 25 years and

in 2011; saw impairments of £2m (0.46% of cost). In comparison, BAE depreciates its aircraft over 15

years and saw impairments of £14m (1.44% of cost) in the same year. This lower rate of depreciation

and impairment seen at Rolls-Royce reflects the nature of their operations in terms of leasing out

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aircraft to a far greater extent than BAE. This increases relevance, but hinders comparability. (BAE,

2012) (Rolls-Royce, 2012)

Reliability

Due to the difference in treatment of similar assets by both companies discussed in this

paper, this leads to the question as to whether their treatment of such assets is reliable. In terms of

BAE, the fact that they are having to impair their assets, namely their aircraft, much more so that

Rolls-Royce shows that their depreciation policy may not be as reliable as that of Rolls-Royces. (BAE,

2012) (Rolls-Royce, 2012) This may be due to greater certainty as to Rolls-Royces future cash flows

due to leasing out aircraft rather than selling them on.

Thus, reliability depends on the nature of the company and to what extent they can

accurately value such tangible non-current assets.

Understandability

In terms of understandability, although minor differences do exist between these two

companies, their implementation of IFRS standards does remain relativity similar. This will help

facilitate understandability for those who are accustomed to analysing such information. However, if

companies do diverge in their implementation of the IFRS standards, a lack of transparency will

hinder the information’s understandability to readers, thus hindering the information’s usefulness to

stakeholders.

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Part IV

Conclusions

To conclude, in regards to tangible non-current assets, information provided in line with the

IFRS standards can provide useful information. However, the degree of this usefulness depends on

which qualitative characteristic is more relevant to the given situation.

This is due to different qualitative characteristics applying in varying degrees in different

situations. These differences increase the risk of potential conflict arising between these qualitative

characteristics and in such cases, which qualitative characteristic should take precedence?

These potential conflicts continue to hinder the usefulness of information. Further guidance

is therefore required for companies on how to overcome these conflicts. This may require adapting

or adding to the current IFRS standards in order to better facilitate this “conflict resolution”. This

may include, but not exclusively, ranking the qualitative characters in order of precedence. This will

allow companies to focus on the characteristics that best promote “usefulness” as outlined in this

paper.

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Part V

Formalities

Signatories I commend this paper to the University of Hertfordshire to be delivered on or by 26 November 2012.

Jason Cates

___________

Mail: AdrJasonCates@GoogleMail.com

Portfolio: SlideShare.net/AdrJasonCates

LinkedIn: LinkedIn.com/in/AdrJasonCates

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References (In line with Harvard Referencing)

BAE Systems (2011) Annual Report 2011. [Online] Available at: http://www.baesystems.com/cs/groups/public/documents/document/mdaw/mdu2/~edisp/baes_045566.pdf [Accessed: 14th October 2012]

Bloomberg (2012) Aerospace/Defence Companies. [Online] Available at: http://www.bloomberg.com/markets/companies/aerospace-defense/ [Accessed: 16th October 2012]

Elliot, B. & Elliot, J. (2012) Financial Accounting and Reporting. 15th edn. Malaysia: Pearson.

Rolls Royce (2011) Annual Report 2011. [Online] Available at: http://www.rolls-royce.com/Images/RR_full_AR_2011_tcm92-34435.pdf [Accessed: 14th October 2012]

Hoogervorst, H. (2012) The imprecise world of accounting. [Online] Available at: http://www.ifrs.org/Alerts/Conference/Documents/HHoogervorstJune2012theimpreciseworldofaccounting.pdf [Accessed: 2nd October 2012]

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Appendix

Note 1 – Depreciation and Impairment for year ended 31st December 2011

BAE Systems £Millions Land &

Buildings Plant &

Machinery Aircraft Total

Cost 2195 2551 759 5505

Depreciation 101 201 34 336

Impairment 29 - 14 43

(BAE, 2012)

Rolls Royce £Millions Land &

Buildings Plant &

Machinery Aircraft Total

Cost 806 2387 439 3632

Depreciation 39 185 15 239

Impairment - - 2 2

(Rolls-Royce, 2012)

Note 2 –Percentage Calculations for Depreciation

BAE - Depreciation as a Percentage of Cost for 2011 (£Millions)

Land & Buildings 101/2195 4.6%

Plant & Machinery 201/2551 7.9%

Aircraft 34/759 4.5%

Total 336/5505 6.1%

(BAE, 2012)

Rolls Royce - Depreciation as a Percentage of Cost for 2011 (£Millions)

Land & Buildings 39/806 4.8%

Plant & Machinery 185/2387 7.8%

Aircraft 15/439 3.4%

Total 239/3632 6.6%

(Rolls-Royce, 2012)