Componentization and related depreciation is an area where there can be significant differences between Canadian GAAP and IFRS.
Under IFRS (IAS 16), an item should be separated into parts (components) when the cost of those parts is significant in relation to the total cost of the item. There is a similar concept in Canadian GAAP, but it has been applied only when practical to do so, which essentially meant that it has very rarely been applied at all. In contrast to Canadian GAAP, componentization will be an expectation and requirement under IFRS.
The rationale behind componentization is quite simple and logical – not all components of a fixed asset that has been acquired, have the same useful life and furthermore, they may wear down or depreciate at different rates throughout their life. Therefore, it is appropriate under the accounting “matching principle”, to depreciate each significant component separately over its useful life. In this respect, IFRS attempts to portray the economic activity of an organization in a more accurate manner than Canadian GAAP. That’s the theory anyway.
So when is a component considered to be significant? This is where professional judgement will be required. A rule of thumb is to look for items that will require an overhaul before the end of the asset’s useful life, and to treat these items as components. In terms of dollar value, this will depend on the size of the organization and whether the component and related depreciation will have a material effect on the financial statements.
The best way to understand componentization is to walk through an example. Take for instance the example of an airplane. It may have several engines and a body that have very different useful lives. The engines may need to be replaced several times during the overall life of the airplane. The useful life of the body may be 20 years, whereas the useful life of the engine may be 10 years. The body would be set up as a separate component and depreciated over 20 years, while the engines would be depreciated over 10 years or perhaps based on the number of flight hours (similar to units of production method).
So far, so good but what happens when the engines need to be replaced? The requirement under IFRS will be to “derecognize” the engines as they are taken out of operation, by writing off the remaining Net Book Value (NBV) as a period cost. The replacement engines would be capitalized and depreciated over their useful life of flight hours. If the asset was not componentized, and then subsequently needs to be replaced, the NBV of the replaced component will again need to be written off as a period cost, and the replacement component capitalized.
Note that “IFRS 1” is available on a one-time only basis when a company initially transitions to IFRS to alleviate this – by allowing the election of Fair Value (FV) of an asset at date of transition as “deemed cost” (IAS 16 paragraph 16-19) and use the FV as a basis for future accounting. Another reason that companies should begin the IFRS project early so that these types of decisions can be made after a thorough review of the business and data.
I hope this helps. This is one of a series of blogs that is meant to convey information relating to Canada’s transition from Canadian GAAP to IFRS.
For further information, please refer to the ongoing series of IFRS blogs on the Edelkoort Smethurst Schein CPA’s LLP web-site and please remember to contact your CGA or other accounting professional for further guidance.
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