What are assets?
More organized discussions on the definition of asset have already been made in the Conceptual Framework for Financial Statement under para 4.3 to para 4.18 of the Standard. It defines an asset as a present economic resource controlled by the entity as a result of past events. A balanced and well thought out definition and discussion have been made in the framework regarding the meaning of “right” and the “economic benefits” of the owner of the asset. Link here:
Here in this post, we will discuss about some forms of asset whose recognition as an asset has been tested through the decision made by the Revenue Tribunal and the Supreme Court.
Right of Use Assets
The big change brought by IFRS 16: Leases in comparison with the previous IAS 17 is that the lessee of the arrangement does not classify the leases into finance and operating anymore. So, at the commencement of the lease the lessee recognizes the “right of use asset” and corresponding “lease liability”. Under previous standard the operating lease payments used to be charged directly to the income statement whereas the asset arising under finance lease used to be recognized as asset and depreciation charged.
On the lessor’s side, there aren’t much changes in the recognition of lease asset compared to the previous standard. The lessor will have to classify the lease as either operating or finance lease at the inception of the lease. The income arising under the operating lease is recognized and depreciation charged in the income statement over the period of the lease. Similarly, in the finance lease the asset is derecognized and an asset in the form of lease receivable is recognized in the books. More detailed and thorough discussion has been made in the IFRS 16: Leases. Link here:
However, for tax purposes, the recognition of a lease arrangement for both lessor and lessee follows the same previous principle of the IAS 17. Regarding operating lease the income/expense is recognized as a period cost/income. In the context of the finance lease, Income Tax Act actually re-characterizes payments under finance leases as interest and a repayment of capital paid on a blended loan. This is to ensure similar treatment between these substitutable forms of financing. Without this recharacterization rule, payments under finance lease may be considered to have purely an income character, i.e. involve no repayment of capital. Payments under finance leases would be treated as the payment of rent or royalties with no part being treated as a capital payment despite substantial equivalence between a finance lease and an instalment sale. The definition of “finance lease” requires some further comment. Finance leases are treated as sales under the Income Tax Act. Therefore, the definition of “finance lease” is intended to provide a list of tests where a lease may be considered essentially equivalent to a sale and, therefore, justify the treatment as a sale. As this equivalence is a grey area and one that is often utilised by tax planners as the definition is somewhat arbitrary.
Despite the categorization of the operating lease and finance lease both under the financial reporting standard and the income tax laws, there are some key differences in identifying the finance lease:
For IFRS 16: Lease
For Income Tax Laws
Para 63: Examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease are:
Section 32(5): Any of the following conditions shall be required to be satisfied while conducting finance lease under this section:
(a) the lease transfers ownership of the underlying asset to the lessee by the end of the lease term;
(a) Arrangement is made in the lease agreement provides for transfer of ownership following the end of the lease term where, the lessee has an option to purchase the asset after expiry of the lease term for a fixed or presupposed price;
(b) the lessee has the option to purchase the underlying asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception date, that the option will be exercised;
(c) The estimated market value of the asset after expiry of the lease term is less than 20% of its market value at the commencement of the lease;
(c) the lease term is for the major part of the economic life of the underlying asset even if title is not transferred;
(b) The lease term exceeds 75% of the useful life of the asset;
(d) at the inception date, the present value of the lease payments amounts to at least substantially all of the fair value of the underlying asset; and
(d) In the case of a lease that commences before the last 25% of the useful life of the asset, the present value of the minimum lease payments equals or exceeds 90% of the market value of the asset at the commencement of the lease term; or
(e) the underlying asset is of such a specialized nature that only the lessee can use it without major modifications.
(e) The asset is custom-made for the lessee and after expiry of the lease term the asset will not be of practical use to anyone other than the lessee.
Another key distinction is that the recognition of the finance lease asset under the Financial Reporting Standards is based on the implicit interest rate prevalent in the lease payments and lease investment. However, for the purpose of Income Tax Laws, under Section 32(8) of the Income Tax Act 2058, present value of lease payments is calculated using a discount rate equal to the standard interest rate. Under Section 2(KaBa) of the Act, standard interest rate means 15% interest per annum.
Own Your Vehicle Scheme
The issue of the Own Your Vehicle Scheme is a famous asset recognition issue, at least in the context of Nepal. The scope of the IAS 19: Employee Benefits and the definition of “asset” provided under the Conceptual Framework for the Financial Statement should be viewed to actually rationalize how the vehicles under the Own Your Vehicle Scheme should be accounted for.
The definition for the term asset provides: An asset is a present economic resource controlled by the entity as a result of past events. An economic resource is a right that has the potential to produce economic benefits. Thus, an item of economic significance can only be recognized when (i) the entity has the right over the asset, (ii) the asset has the potential to produce the economic benefit and lastly, (iii) the entity controls the asset.
This is quite a tricky issue to deal with. Who would have thought something mundane like a company’s car would bring so much accounting and legal troubles? Who would have thought that such a huge debate would ensue over something as seemingly simple as using company car? But, using company’s car: how does employee use company’s car?
This debate touches three accounting standards in total. Let’s discuss them one by one:
IAS 19 Employee Benefits
These proponents cite IAS 19, which covers employee benefits and more specifically the treatment of short-term employee benefits, or essentially all forms of consideration given by an entity in exchange for service rendered by employees or for the termination of employment. It may seem obvious, then, that cars given as part of the employment package as a fringe benefit would fall into the category of “all forms”. And if one were still in doubt, IAS 19 is nice enough to list cars as an example of other short-term employee benefits. However, there may be some vesting period provisions, which will make difference in the accounting approach:
- Where an employee should have been engaged with the company for a certain period after which he receives the car: Under such condition, the cost of the car at the time of grant is directly expensed off to the income statement as employee benefits as the vesting period has already been satisfied before or at the time of grant. Another famously asked question is, does the company have to recognize the provision for the cost of the car before the grant date based on the vesting period? The answer is no. IAS 37 Provisions, Contingent Liabilities and Contingent Assets doesn’t apply on the expenses to be recognized under the IAS 19 Employee Benefits.
- Where an employee receives the car but should be engaged with the company for a certain period after the grant: Such contract with employee allows the company to recognize the employee receivable under the IFRS 9 Financial Instrument in form of financial asset. And the residual cost is charged to the income statement over its vesting period as a employee cost under IAS 19 Employee Benefits.
Let’s see how the courts have interpreted this matter. These are the decisions made by the revenue tribunal regarding the recognition issue of the assets under Own Your Vehicle Scheme:
- Mega Bank Limited v/s Large Taxpayer’s Office
- Nabil Bank Limited v/s Large Taxpayer’s Office
- Sunrise Bank Limited v/s Large Taxpayer’s Office
- Prime Commercial Bank Limited v/s Large Taxpayer’s Office
- Prime Commercial Bank Limited v/s Large Taxpayer’s Office
- National Insurance Company Limited v/s Large Taxpayer’s Office
- Lumbini General Insurance Company Limited v/s Large Taxpayer’s Office
- Everest Insurance Company Limited v/s Large Taxpayer’s Office
- Siddhartha Bank Limited v/s Large Taxpayer’s Office
In these decisions, the tribunal has taken a view that the company’s car provided to employee should be accounted as cost of employee benefits rather than as the depreciating asset of the company. This conclusion has been reached due to the following inherent characteristics of the Own Your Own Vehicle Scheme:
- बैंकको हित वा सेवा शर्त विपरीत कार्य गरेमा सुविधाबाट वञ्चित गर्न मात्र बैंकको स्वामित्व कायम राख्न सवारी साधन बैंकको नाममा राखिएको, The title has been retained by the company only to ensure the withdraw the facility if the employee actually doesn’t complete the vesting period or does any harm or damage to the bank
- उपलब्ध गराईएको सवारी साधन निर्वाध रुपमा उपयोग गर्ने अधिकार Possession Right सम्बन्धित कर्मचारीमा नै रहने, The employee assumes the risks, rewards and possession of the car
- ब्यबसायिक काममा समेत अन्यले प्रयोग गर्न नपाउने, The car cannot be utilized for the company’s purpose other than by the particular employee
- ईन्धन र मर्मतको खर्च निश्चित सीमा भन्दा माथिको सम्बन्धित कर्मचारीले नै ब्यहोर्ने, Only a certain capped fuel and repair expenses are borne by the company, other than those, they are borne by the employee himself
- कर्मचारी को रोजाईमा रकम थप गरेर सवारी साधन खरिद गर्न सकिने, The vehicle can be purchased at the option of the employee and employee can also contribute to purchase the vehicle of the choice of the employee
- सवारी साधनको प्रयोग बैंकको आय आर्जन सँग सम्बन्धित कामका लागि मात्र नहुने, व्यक्तिगत प्रयोजनमा बढी उपयोग हुने, The vehicle can be utilized for the personal purpose of the employee and the vehicle is not required to be substantially be used for the company’s purpose (say =, some metric like, 4:3 ratio, business to domestic use ratio based on 7 days of the week etc. is not required by the contract)
- पछि तोकिएको समयमा कर्मचारीलाई नै हस्तान्तरण भै सम्पतिको निसर्गबाट बैंकलाई कुनै प्रतिफल प्राप्त नहुने भएकाले, The vehicle is transferred at the end of the vesting period to the employee for no consideration
These conditions present in the Own Your Vehicle Scheme led to the decision from the Revenue Tribunal to conclude that the company actually doesn’t own the assets and do not fulfill the recognition criteria under IAS 16 Property, Plant and Equipment. Thus, the recognition of expense should have been made as employee cost under the IAS 19 Employee Benefits rather than depreciation cost under IAS 16 Property, Plant and Equipment. Due to this differing opinion from the Revenue Tribunal, the entities were faced the following consequences for tax purposes:
- Derecognition of the cars as assets of the company (citing Para 65 of IAS 16: Property, Plant and Equipment)
- Disallowance of the depreciation charged on the cars
- Disallowance of the Insurance Expense, Vehicle Tax Expense, Fuel Expense and Repair/Maintenance Expense incurred on the vehicles
Drawing corollary from the decision of the Revenue Tribunal, regarding the Insurance Expense, Vehicle Tax Expense, Fuel Expense and Repair/Maintenance Expense incurred on the vehicles, these costs should have been charged in the form of the employee benefits and subject to inclusion as employment income of the employees.
As it can be inferred from the above, given the revenue tribunal has somehow preferred the more dominant approach of accounting the asset under IAS 19 and IFRS 9, this view on lease accounting of the company car, may not be that relevant in that context. In addition to that when the costs are accounted as employee benefit expenses, this also arguably holds some sentimental basis for adverse assessment, as tax allowance of the employee benefit expenses are also usually protected by other laws like Labor Laws, Industrial Enterprise Laws and is counted as a significant value addition within the company. So, this method is the most preferable method of accounting for the company’s car and benefits, at least in the context of Nepal.
IFRS 16 Leases
If we look at the company cars that are provided to the employees, where an employee receives the car but should be engaged with the company for a certain period after the grant, it can very well be accounted under the principles of IFRS 9 Financial Instrument and IAS 19 Employee Benefits, as discussed above. But some accounting practitioners advocate for ownership of company cars based on the scope of IFRS 16, which says that the standard applies to all leases (with limited exceptions). They would go further to say that behind the arrangement of a company car for employee use is the lessee-lessor relationship established by the employer, who is in fact leasing the car from a provider in order to be able to provide said car to the employee. IFRS 16 does require the additional step of considering whether this contract is, or contains, a lease. This aspect alone may warrant a separate blog post but, in short, the focus of the assessment should be on whether the company has the right to direct “how and for what purpose the asset is used” and whether it is getting, substantially, all the economic benefit from the asset.
The accounting treatment under the two standards differs greatly. If you apply IAS 19, you would recognize an expense and a liability based on a simple fringe benefit calculation. Applying IFRS 16, however, would entail bringing the car onto the books in the form of a right-of-use asset with a corresponding lease liability, the calculations of which are significantly more complex than the calculations that would be necessary under IAS 19.
But what is the point? It’s just that a careful consideration should be given to both standards until more conclusive guidance has been issued. But in the context of Nepal, given the revenue tribunal has somehow preferred the more dominant approach of accounting the asset under IAS 19 and IFRS 9, this view on lease accounting of the company car, may not be that relevant in that context.
IAS 16 Property, Plant and Equipment
There is not much to discuss on the recognition of company car under IAS 16. The car is recognized as an asset of the company. The same old principle of the asset recognition should be satisfied for the company’s car to be recognized as asset of the company. The definition for the term asset provides: An asset is a present economic resource controlled by the entity as a result of past events. An economic resource is a right that has the potential to produce economic benefits. Thus, an item of economic significance can only be recognized when (i) the entity has the right over the asset, (ii) the asset has the potential to produce the economic benefit and lastly, (iii) the entity controls the asset.
Under this approach, the entity retains the full ownership of the assets and the employee cannot possess the asset significantly for their personal use. Similarly, the title is also retained by the company and the company can at anytime direct the use of the company car for other purposes of the company’s objectives. So, also referring to the basis for the revenue tribunal’s decision, as indicated above, it is extremely necessary to determine if the asset is in fact in the ownership of the company or the employee for deciding the accounting approach.
Assets at the place of Customer/Distributor
Some entities operating in specific industries have to sell / display the products in bottles, cylinders or devices that are significant in cost and subject to refund later after the actual sales of the product has taken place. Examples:
- An LPG bottling plant bottles LPG gas in gas cylinders
- A beverage bottling plant bottles beverages in bottles
- A propane/oxygen bottling plant bottles propane/oxygen in gas cylinders
- A paint manufacture installs a proprietary paint mixer/dispenser machine at the place of their distributor
Let’s take an example of LPG bottling plant. LPG bottling plant draws a contract with the customer containing terms that essentially enables them to recognize the cylinders as assets. These typically include that the:
- Company purchases cylinders fills them with gas and then sells only the gas to the customers.
- The customer is charged a returnable deposit on the cylinder not as a revenue charge.
- The customer either
- Returns with the empty cylinder and it is refilled so the customer is only charged for the gas, or
- Returns with the empty cylinder and receives a refund on the deposit, or
- Sometimes the customer will never return the cylinder and the company effectively forfeits the deposit.
- The cylinders can only be exclusively filled up by the same bottling plant but not with other vendors by the customers.
- The customers are not allowed to make the alternative use of the gas cylinders, exchange with cylinders from other companies or cause any damage to the cylinder.
- The customers only do have the possessory right of the cylinders until the use of the LPG gas. They are required by the contract to return the cylinders to the bottling plant after the use.
- The company is bound to maintain the standard for the quality of the cylinders in the market as per the prevalent laws regulating the LPG gas bottling industries. In case of any loss or damage is caused to the customers by the reason of fault in the cylinders, the industry is responsible to compensate the customer for the damages.
- The cylinders typically do not have any alternative use to the customers.
- The deposit is taken due to the fact that entity entertains many public customers and the cost of cylinder recovery without the deposit being taken would not be effective, being a purely commercial decision to enable the maximum returns of the cylinders.
- Since the average consumption time period of a cylinder of LPG gas is lower than a year, company arguably not required to compensate the customer for providing the interest on the deposit.
- Since the company refunds a deposit for all cylinders (unless they are damaged by the reason of dent, breakages), the cost of the repairs, checking valves and safe, of the cylinders should also be reasonably allowed for recognition as tax expense.
Such bottles or cylinders are typically recorded as a part of fixed asset under IAS 16 Property, Plant and Equipment and not as stock because obviously they are not intended to be consumed in the normal stock cycle. Depreciation expenses and repair and maintenance expenses are recognized based on the applicable Financial Reporting Framework and Tax Laws respective, as applicable.
Some decisions from the Supreme Court and Revenue Tribunal backing up our analysis above are: