Automotive entities reporting under IFRS are required to follow the requirements of all IFRS standards.
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Additional Applying IFRS solutions for automotive entities have been developed to supplement the general version of Applying IFRS. The objective of these solutions is to address specific areas where automotive entities may encounter difficulty in the application of IFRS.
Impact of IFRS on the automotive industry
Publicly traded companies in the European Union and a number of other countries are required to present and publish consolidated financial statements in compliance with International Financial Reporting Standards from 1 January 2005. The standards require comparable information to be presented for the most recent financial year and the previous financial year. Presentation of financial information under IFRS should result in increased transparency and comparability. Comparability between companies will not, however, be fully realised until further progress is made on the standard setters’ convergence project aligning IFRS with US GAAP. Major differences between the two frameworks remain, such as accounting for development costs.
Besides the general conversion effects, the annual reports of automotive companies show the major impact of the adoption of IFRS as being in the accounting for development costs and tooling, as well as in revenue recognition on buyback arrangements.
The table below summarises the impact of transition on opening balance sheet equity of some major companies in the automotive sector.
Overview of the automotive industry
This chapter includes a short overview of the automotive industry and a “jargon buster” to explain key industry terms.
The chain in the automotive industry can be illustrated as follows:
Automobile manufacture was, historically, vertically integrated from parts manufacturing through to exclusive dealerships. The shape of the industry has shifted substantially in recent years. The big vehicle manufacturers have shed car parts suppliers, many becoming big listed companies in their own right. Many independent car parts suppliers have appeared as well. Now various tiers of suppliers are playing an increasing role in production and taking over some of this assembly. Dealers are responsible of the sale of the vehicles, finance and insurance products and after market sales. After market products and services (spares and repairs) are a lucrative part of the chain, involving suppliers, vehicle manufacturers, dealers and other outlets.
The vehicle manufacturer may be assembling largely purchased parts into its vehicles. “Just in tTime” inventory management (or ‘KANBAN’) have made the operational links very close despite the financial independence of many suppliers. The relationship between vehicle manufacturer and car parts suppliers have evolved over time. Tier 1 suppliers, especially, have a semi-permanent interactive relationship with the vehicle manufacturer. Suppliers are involved in finding solutions, using their own R&D facilities, for components to be embedded into cars newly designed by the vehicle manufacturer. The vehicle manufacturer approaches the suppliers (in most cases Tier 2 and Tier 3 and to a lesser extent Tier 1) with a certain design and asks suppliers to quote for the product (contract tendering). The relationships between the vehicle manufacturer and the suppliers of parts can be complex and create accounting issues. One example of an accounting issue is when car parts suppliers are located on the assembly site and the manufacturer is the sole customer. This can give rise to lease accounting with the car parts suppliers and facilities being recognised on the vehicle manufacturer’s balance sheet. The complex arrangements can also have unexpected consequences for revenue recognition.
The sales side of the industry is also less straightforward than previously. Many vehicle manufacturers make large fleet sales to rental car companies and corporate lessors. These arrangements often include re-purchase terms that can mean recognition of sales is not appropriate. Fleet ‘sales’ may actually be operating leases from the manufacturer to the rental car company. Relations between dealerships and vehicle manufacturers have also evolved. Dealers are usually independent of the vehicle manufacturer, but may buy cars on consignment (the cars are stored with the vehicle manufacturer until they are sold by the dealer) or only sell cars to order based on cars in the showroom. Dealers in many countries now sell more than one manufacturer’s cars. Trade loading, with incentives and promotions are increasingly important and need to be scrutinised to ensure revenue recognition reflects the substance of the arrangements. The consumer has also become more demanding. Sales incentives, financing, insurance and extended warranties have introduced further complexity to revenue recognition.
Jargon buster
Definitions of the terms used in the automotive industry.
How to use this chapter
This chapter contains an overview of the main issues and solutions in the automotive industry.
The solutions are categorised as follows:
a) Tooling
b) Intangible assets including research and development;
c) Impairment of non-financial assets;
d) Sale of goods and other revenue;
e) Property, plant and equipment; and
f) Depreciation;
Tooling
Many vehicle manufacturers enter into production arrangements whereby they outsource to car parts suppliers the production of certain car parts (called “modules”). Such agreements may or may not include the production of the tool to be used in the series production process.
There is no specific guidance on accounting for such arrangements under IFRS. The accounting treatment is determined by the agreement’s commercial substance. This requires a careful review of each set of specific facts and circumstances.
The most two common elements in a production arrangement are:
1.constructing the tools, and
2.producing and supplying the parts / modules.
Both elements are usually negotiated together and may be included in one legal agreement. The form of the legal agreement is less relevant than its substance. Management should assess how to account for each component. Factors to consider are whether the asset and the service are to be delivered separately; can the vehicle manufacturer use the asset separately from the service and whether a reliable measure of revenue for the asset and the service can be obtained? Other questions would be whether risks and rewards with respect to the tools have transferred or whether there is a lease arrangement for the tools.
The accounting for the different components is discussed in more detail below:
Constructing tools for own use
The car parts supplier constructs the tools for their own use (i.e. the significant risks and rewards of the tools remain with the car parts supplier) and should account for the tools as property, plant and equipment under IAS 16 . A contribution received from the vehicle manufacturer should be accounted for as deferred income and recognized over the life of the contract and/or useful live of the tools . The vehicle manufacturer should account for a partial contribution to the car parts supplier as a prepayment to be amortised based on the unit of production method .
Constructing tools to be sold to the vehicle manufacturer
The car parts supplier only constructs the tools for the vehicle manufacturer (i.e. the significant risks and rewards of the tools are transferred to the vehicle manufacturer). The car parts supplier should follow the guidance for construction contract accounting as it is typically construction activity and meets the definition of a construction contract in IAS 11 . The vehicle manufacturer’s accounting should mirror the car parts supplier’s .
Constructing tools, costs are recovered through the sale of parts / modules
The tooling contract can contain a lease. The car parts supplier should assess whether the vehicle manufacturer has the right to use a specific asset [IFRIC 4.6]. This determination should be made on an asset-by-asset basis and at the inception of the arrangement. This includes obtaining a precise understanding of the use of the asset. Does the vehicle manufacturer have the ability or right to operate the asset or direct others to operate the asset? Does the vehicle manufacturer have the ability or right to control physical access to the underlying asset? Is it remote that one or more parties other than the vehicle manufacturer will take more than an insignificant amount of the output? Is the price paid contractually fixed per unit of output or equal to the current market price per unit of output at the time of delivery [IFRIC 4.9].? If the contract is deemed to contain a lease, both car parts supplier and vehicle manufacturer shall apply the requirements of IAS 17, Leases. The classification of the lease (finance versus operating) will drive the accounting requirements. In the case of a finance lease, the lessor (the car parts supplier) will recognisze a lease receivable equalling the net present value of the minimum lease payments. The vehicle manufacturer will recognise the tools as an asset and a lease liability at the lower of the fair value of the asset or the net present value of the minimum lease payments .
Producing and supplying modules
Producing and supplying the modules is in substance a supply arrangement between a vehicle manufacturer and a car parts supplier, which falls under IAS 18, Revenue.
Other components
The car parts supplier may be paid to perform research and development activities before it constructs the tools. The parts supplier should recognise the revenue and costs associated with this contract as revenue and expenses respectively by reference to the stage of completion of the contract activity at the balance sheet date similar to the accounting for construction contracts prescribed by IAS 11 [IAS 18.21(R.05)] .
Intangible assets including research and development
Development costs
Different phases can be identified in the development process. A simplified example of different R&D phases a supplier may use:
Expenditure during the concept phase (stage 1 and 2) is treated as research costs and should be expensed as incurred. Development costs should be accounted for in accordance with IAS 38R.57. Once all the criteria are met, development costs are capitalised. One of the trigger points is management’s confirmed intention to proceed with developing a model . The treatment of development costs should be consistent with disclosures, such as press releases, investor briefings or annual reports in the public domain.
Impairment of non-financial assets
The automotive industry is a capital intensive industry. The industry is dealing with overcapacity and consequently issues relating to impairment are relevant. The general principles of impairment apply to the measurement of all non-financial assets of automotive entities .
Indicators of impairment
Under-utilised capacity or a reduced life cycle of a vehicle model might be an indicator that the related assets are impaired . Car parts suppliers need to be aware of potential impairments to their own assets arising from changes in market conditions affecting vehicle manufacturers.
Vertically integrated operations
External prices should be used for determining value in use for a CGU in a vertically-integrated operation. Suppliers may produce parts in low cost countries and sell these parts at an internal transfer price (for example cost + 2%) before these parts are further used in a module. Management should use external prices in an impairment calculation when determining value in use for a CGU in a vertically-integrated operation .
Abandoned PPE
Impairment should be identified for the individual asset, where possible. A production line no longer belongs to a larger CGU, if it is no longer in use. The CGU is the production line itself and any impairment loss should be recognised .
Restructuring costs and impaired assets to be replaced
Many suppliers and vehicle manufacturers are restructuring their business, moving their production facilities to lower cost countries and ‘rightsizing’ their operations. One of the questions is how to take into account (expected) restructuring costs and expected benefits in value in use calculation for impairment calculations. Planned restructuring costs and related expected benefits are excluded from value in use calculations [IAS36R.33 (b)(R.05)]. The expected benefits from reorganising business activities are included in the expected cash flows, once management is committed to the restructuring and has recorded a restructuring provision. Cash flows from the restructuring itself are not included to avoid double-counting [IAS36R.43 (b)(R.05)] [IAS36R.IE44(R.05)].
Management should not consider the cash flows expected from any replacement asset when determining the recoverable amount of an existing asset .
Foreign currencies
When assessing impairment of assets where future cash flows will be generated in foreign currency, the spot rate at the date of the impairment review should be used .
Capitalisation of borrowing costs on impaired assets
Management should continue to capitalise borrowing costs for an asset already identified as impaired. These borrowing costs should then be written down to reflect the impairment loss .
Sale of goods and other revenue
Sale and repurchase agreement
Vehicle manufacturers or car dealers may sell cars and at the same time enter into repurchase agreements with the consumer, meaning that they commit themselves to buy back the cars after a certain period for a price, which is fixed at inception. The repurchase agreement may be:
a) a firm commitment or;
b) occur at the option of the “consumer”.
There is no specific guidance on accounting for sale and repurchase agreements under IFRS. The accounting treatment is determined by the agreement’s commercial substance. This requires a careful review of each set of specific facts and circumstances.
The most relevant guidance related to revenue recognition arising from such transactions is disclosed in IAS 18 and IAS 17.
Generally, revenue from the sale of cars should be recognised immediately under IAS 18 only when certain conditions have been satisfied [IAS 18.14(R.05)].
A sale accompanied by an obligation to repurchase or by a put option that transfers the significant risks and rewards of ownership of the cars to the purchaser should be accounted for as a sale provided all other recognition criteria as per IAS 18.14(b)-(e) are satisfied .
A sale accompanied by an obligation to repurchase or by a put option that does not transfer the significant risks and rewards of ownership of the cars to the purchaser should be accounted for as an operating lease by the lessor under IAS 17 .
When the option is not exercised, the car should be transferred from PPE (IAS 16) to inventory (IAS 2) and the revenue is recorded at the fair value attributable to the sale from the total consideration .
The repurchase may not be reasonably certain because the put option is expected to be out of the money. Other factors should then be taken into account to assess whether there is a valid expectation of repurchase. For example, one key consideration is the history of repurchase. The likelihood of repurchase should be assessed in considering whether the sale and repurchase transactions are two linked transactions such that the commercial effect cannot be understood without reference to these transactions as a whole [IAS 18.13(R.05)]. It is unlikely that the seller has transferred significant risks and rewards of ownership of the car to the consumer if there is a realistic expectation, based on all available evidence, of repurchase.
Bill and hold sales Car dealer - consumer
Bill and hold sales are those where a consumer obtains title to vehicles, but requests that the vehicles are not delivered immediately. The vehicles are held by the car dealer until the consumer requests delivery or collects them. Criteria for recognition of revenue in a bill and hold sale are stated in paragraph 1 of Appendix 1 to IAS 18 .
Vehicle manufacturer – car parts supplier
A vehicle manufacturer and a car parts supplier may agree that parts are delivered at the vehicle manufacturer’s site, but that title has not transferred until the vehicle manufacturer has notified the supplier .
Trade loading
Vehicle manufacturers may introduce incentives for their dealerships so that they purchase as many vehicles as possible towards the end of a reporting period. These incentives enable the manufacturers to meet their sales targets. The incentives and the arrangements provided by different companies vary significantly. The nature of the incentives may mean that immediate revenue recognition is not appropriate. For example the car dealers are offered additional discounts in combination with a right of return of unsold cars .
Multiple element arrangements
The car may often be sold with maintenance support for one advantageous total price. The revenue recognition criteria should be applied to the separately identifiable components (which are the car and the maintenance contract) of a single transaction in order to reflect the substance of the transaction .
Reimbursement of advertising expenses
The vehicle manufacturer may provide a certain amount of advertising allowance to a car dealer for promotion of the vehicle manufacturer’s products. If the benefit provided through the reimbursement of advertising expenses is not separable from the sale of cars, the revenue recognition criteria should be applied to these two transactions together .
Property, plant and equipment
The automotive industry is a capital intensive industry and issues relating to property, plant and equipment are relevant. The general principles of recognition and measurement apply to all classes of property, plant and equipment of automotive entities
Safety and environmental investments
Investments made for safety and environmental reasons are assets, to the extent that the resulting carrying amount of the relevant item of PPE does not exceed its recoverable amount. Future economic benefits will only occur if these investments are made, because the authorities are likely to close productive installations that do not comply with current environmental legislation .
Demonstration cars
Demonstration cars are used by executives and other employees. They are also provided, occasionally, to dealerships. Demonstration cars are not held for sales during the period they are used, thus they do not form part of inventory. Demonstration vehicles should be capitaliszed as part of PPE where they are not held for immediate sale and are expected to be used in more than one period .
Extended credit for PPE
A vendor may provide extended credit for PPE. The related asset should be recognised at the present value of the amount payable. The difference between this amount and the amount to be settled is treated as interest expense .
Depreciation
The general principles of recognition and measurement of depreciation also apply to automotive entities .
Management should continue to depreciate an asset that is temporarily idle unless a usage-based depreciation method is being applied to the asset. For example when an assembly line is put out of use until the new model is ready for production, management should continue depreciating the assembly line, unless depreciation is based on usage .
Depreciation is discontinued when an asset is held for sale .
Many businesses have a threshold amount below which assets are not capitalised. The immediate write-off of low value assets with a useful life of more than one year is only permitted where the amounts involved are immaterial. Management should consider the cumulative effect of non-capitalisation when assessing materiality .
The factory’s depreciation charge may be capitalised where it is part of the cost of producing the tools or equipment with a useful life of more than one year
Depreciation should start when the related asset is available for use rather than when it is first used in production .
Depreciation is charged over the useful life of an asset which may differ from its economic life .
A change in the life cycle of a vehicle model may lead to a change in the useful life of the related production asset which then should be accounted for prospectively as a change in accounting estimate
