Part 3: Summary and detailed examples
This is the final article in the series of three which consider the accounting for property, plant and equipment by applying IAS® 16, Property, Plant and Equipment. This is a particularly important area of the Financial Reporting (FR) syllabus and is also important assumed knowledge for the Strategic Business Reporting (SBR) exam.
This article is designed to summarise some of the key issues outlined in the previous two articles and provide further examples for you to attempt, including some more detailed requirements.
As outlined in the first two articles, the four key areas when accounting for PPE that you must ensure that you are familiar with are:
One of the easiest ways to remember what should be included in the initial cost of an item of PPE is that you should capitalise all costs to bring an asset to its present location and condition for its intended use.
Elements of the cost of an item of PPE include:
EXAMPLE 1
On 1 March 20X0 Yucca Co acquired a machine from Plant Co under the following terms:
| $ | ||
|---|---|---|
| List price of machine | 82,000 | |
| Import duty | 1,500 | |
| Delivery fees | 2,050 | |
| Installation costs | 9,500 | |
| Pre-production testing | 4,900 | |
| Purchase of a five-year maintenance contract with Plant Co | 7,000 |
In addition to the above information, Yucca Co was granted a trade discount of 10% on the initial list price of the machine and a settlement discount of 5% if payment was received within one month of purchase. Yucca Co paid for the machine on 25 March 20X0.
Required
Explain how the above information should be accounted for in the financial statements of Yucca Co for the year ended 28 February 20X1.
(See 'Related links' for the solution to Example 1.)
EXAMPLE 2
Construction of Ham Co’s new store began on 1 April 20X1. The following costs were incurred on the construction:
| $000 | ||
|---|---|---|
| Cost of land | 4,500 | |
| Architect fees | 620 | |
| Site preparation costs | 1,650 | |
| Materials | 7,800 | |
| Direct labour costs | 11,200 | |
| Legal fees | 2,400 | |
| General overheads | 940 |
The store was completed on 1 January 20X2 and brought into use following its opening on the 1 April 20X2. Ham Co took out a $25m loan on 1 April 20X1 to aid construction of the new store (which meets the definition of a qualifying asset per IAS 23, Borrowing Costs). The loan carried an interest rate of 8% per annum and is repayable on 1 April 20X4.
Required
Calculate the amount to be included as PPE in respect of the new store and describe the impact that the above information would have on the statement of profit or loss (if any) for the year ended 31 March 20X2.
(See 'Related links' for the solution to Example 2.)
Subsequent costs
Subsequent costs related to an item of PPE can only be recognised if they meet the normal recognition criteria:
(a) it is probable that future economic benefits associated with the item will flow to the entity; and
(b) the cost of the item can be measured reliably.
Most subsequent expenditure is likely to be related to accessing the economic benefits already available (eg repairs and maintenance). Costs such as these should be charged to the statement of profit or loss in the period that they are incurred. However, if any costs do meet the recognition criteria noted above, then they should be capitalised as part of PPE.
EXAMPLE 3
On 1 March 20X2, Yucca Co purchased an upgrade package from Plant Co at a cost of $18,000 for the machine it originally purchased in 20X0 (Example 1). The upgrade work took a total of two days where new components were added to the machine. Yucca agreed to purchase the upgrade package as the new components would lead to a reduction in production time per unit of 15%. This will enable Yucca to increase production without the need to purchase a new machine.
Required
Explain whether the additional expenditure should be capitalised as part of PPE or expensed to the statement of profit or loss for the year ended 28 February 20X3.
(See 'Related links' for the solution to Example 3.)
Depreciation
Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life. In other words, depreciation applies the accruals concept to the capitalised cost of a non-current asset and matches this cost to the period that it relates to.
Depreciation methods
There are many methods of depreciating a non-current asset with the most common being:
EXAMPLE 4
An item of plant was purchased on 1 April 20X0 for $200,000 and is being depreciated at 25% on a reducing balance basis.
Required
Prepare the extracts of the statement of financial position and statement of profit or loss for the year ended 31 March 20X2.
(See 'Related links' for the solution to Example 4.)
Useful life and residual value
IAS 16 requires that estimates of useful life and residual value be reviewed at the end of each reporting period. If either changes significantly, the change should be accounted for over the useful life remaining. This is referred to as a prospective adjustment rather than a retrospective adjustment.
EXAMPLE 5
A machine was purchased on 1 April 20X0 for $120,000. It was estimated that the asset had a residual value of $20,000 and a useful life of 10 years at this date. On 1 April 20X2, the residual value was reassessed as being only $15,000 and the remaining useful life was considered to be only five years.
Required
Demonstrate how the machine should be accounted for in the years ended 31 March 20X1, 20X2 and 20X3 and prepare extracts of the statement of profit or loss and statement of financial position for each year.
(See 'Related links' for the solution to Example 5.)
Depreciation of significant parts
Some assets may comprise more than one significant part (ie where the cost of each part is significant in relation to the total cost of the item). Where this is the case, each of those parts must be depreciated separately over their own individual useful lives.
EXAMPLE 6
A company purchased a property with an overall cost of $100m on 1 April 20X1. The separate components of the property are made up as follows:
| $000 | Estimated life | ||
|---|---|---|---|
| Land and buildings (Land element $20,000) | 65,000 | Land: indefinite Building: 50 years | |
| Fixtures and fittings | 24,000 | 10 years | |
| Lifts | 11,000 | 20 years | |
| 100,000 |
Required
Calculate the annual depreciation charge for the property for the year ended 31 March 20X2.
(See 'Related links' for the solution to Example 6.)
IAS 16 principles
IAS 16 permits the choice of two possible treatments in respect of PPE:
If the revaluation model is adopted, this should be applied to all assets in the entire class (ie if you revalue a building, you must revalue all land and buildings in that class of asset). Revaluations must also be carried out with sufficient regularity so that the carrying amount does not differ materially from that which would be determined using fair value at the end of the reporting period.
Accounting for a revaluation
There are a series of accounting adjustments that must be undertaken when revaluing a non-current asset. These adjustments are indicated below.
The initial revaluation
You may find it useful in the exam to first determine if there is a gain or loss on the revaluation with a simple calculation to compare:
| Carrying amount of non-current asset at revaluation date | X |
| Valuation at fair value of non-current asset | X |
| Difference = gain or loss on revaluation | X |
Revaluation gains
Where an asset’s carrying amount is increased as a result of a revaluation (ie a revaluation gain), this gain is normally recognised in other comprehensive income and accumulated in equity under the heading of revaluation surplus. However, the gain should be recognised in the statement of profit or loss to the extent that it reverses a revaluation decrease (ie a revaluation loss) of the same asset which had previously been recognised in profit or loss.
Journal entry:
Dr Non-current asset cost [difference between valuation and original cost/valuation]
Dr Accumulated depreciation [eliminate any accumulated depreciation]
Cr Revaluation surplus [gain on revaluation recognised in other comprehensive income]
EXAMPLE 7
A company purchased a building on 1 April 20X1 for $100,000. The asset had a useful life at that date of 40 years. On 1 April 20X3 the company revalued the building to its fair value of $120,000.
Required
Calculate the revaluation gain and prepare the journal entry to account for the revaluation.
(See 'Related links' for the solution to Example 7.)
Revaluation losses
A revaluation loss should be charged to profit or loss. However the loss should be recognised in other comprehensive income and debited to the revaluation surplus to the extent of any credit balance existing in the revaluation surplus in respect of that asset. Any additional loss must be charged as an expense in the statement of profit or loss.
Journal entry:
Dr Revaluation surplus [to maximum of original gain/balance in revaluation surplus if lower]
Dr Statement of profit or loss [any additional loss]
Dr Accumulated depreciation [eliminate any accumulated depreciation]
Cr Non-current asset cost [difference between valuation and original cost/valuation]
EXAMPLE 8
The carrying amount of Zen Co’s property at the end of the year amounted to $108,000 (cost/value $125,000 and accumulated depreciation $17,000). On this date the property was revalued and was deemed to have a fair value of $95,000. The balance on the revaluation surplus relating to a previous revaluation gain for this property was $10,000.
Required
Calculate the revaluation loss and prepare the journal entry to account for the revaluation.
(See 'Related links' for the solution to Example 8.)
Depreciation of revalued assets
The asset must continue to be depreciated following the revaluation. However, now that the asset has been revalued the depreciable amount has changed. In simple terms the revalued amount should be depreciated over the asset’s remaining useful life.
Reserves transfer
The depreciation charge on the revalued asset will be different to the depreciation that would have been charged based on the historical cost of the asset. As a result of this, IAS 16 permits a transfer to be made of an amount equal to the excess depreciation from the revaluation surplus to retained earnings.
Journal entry:
Dr Revaluation surplus
Cr Retained earnings
Be careful, in the exam a reserves transfer is only required if the examiner indicates that it is company policy to make a transfer to retained earnings in respect of excess depreciation on revalued assets. If this is not the case, then a reserves transfer is not necessary.
This movement in reserves should also be disclosed in the statement of changes in equity, as should any revaluation gains and losses which impact the revaluation surplus.
EXAMPLE 9
A company revalued its property on 1 April 20X1 to $20m ($8m of which related to land). The property originally cost $10m ($2m of which related to land) 10 years ago. The original useful life of 40 years for the buildings is unchanged. The company’s policy is to make a transfer to retained earnings in respect of excess depreciation.
Required
(a) Prepare any necessary journal entries to account for this property during the year ended 31 March 20X2.
(b) Prepare extracts from the following financial statements for the year ended 31 March 20X2:
(See 'Related links' for the solution to Example 9.)
Exam focus
In the exam you must make sure that you pay attention to the date that the revaluation takes place. If the revaluation takes place at the start of the year, then the revaluation should be accounted for immediately and depreciation should be charged in accordance with the rule above.
However, if the revaluation takes place at the year-end, then the asset would first be depreciated for a full 12 months based on the original depreciation of that asset. This will enable the carrying amount of the asset to be known at the revaluation date, at which point the revaluation can be accounted for.
A further situation may arise if the examiner states that the revaluation takes place mid-way through the year. If this were to happen the carrying amount would need to be found at the date of revaluation, and therefore the asset would be depreciated based on the original depreciation for the period up until revaluation. Once the asset has been revalued, the remaining depreciation for the year will be based on the revalued amount. This will be the most complicated situation and you must ensure that your workings are clearly structured to show the different amounts of depreciation charged across the year.
EXAMPLE 10
A company purchased a building on 1 April 20X1 for $100,000 at which point it was considered to have a useful life of 40 years. At the year-end of 31 March 20X6, the company revalued the building to its fair value of $98,000. The company’s policy is to make a transfer to retained earnings in respect of excess depreciation.
Required
(a) Prepare any necessary journal entries to account for this building during the year ended 31 March 20X6.
(b) Prepare extracts from the following financial statements for the year ended 31 March 20X6:
(See 'Related links' for the solution to Example 10.)
EXAMPLE 11
At 1 April 20X1, HD Co carried its office building in its financial statements at its original cost of $2 million less accumulated depreciation of $400,000 (based on its original life of 50 years). HD Co revalued the office building on 1 October 20X1 to its fair value of $2.2m. The remaining useful life was reassessed at the time of valuation and is considered to be 40 years at this date. The company’s policy is to make a transfer to retained earnings in respect of excess depreciation.
Required
(a) Prepare any necessary journal entries to account for this building during the year ended 31 March 20X2.
(b) Prepare extracts from the following financial statements for the year ended 31 March 20X2:
(See 'Related links' for the solution to Example 11.)
Derecognition
PPE should be derecognised when it is disposed of or no future economic benefits are expected from its use or disposal.
When PPE is to be derecognised, a gain or loss on disposal is calculated. This can be found by comparing the difference between:
| Disposal proceeds | |
| Carrying amount | |
| Gain or loss on disposal |
When the disposal proceeds are greater than the carrying amount there is a gain on disposal and when the disposal proceeds are less than the carrying amount there is a loss on disposal.
EXAMPLE 12
An asset that originally cost $16,000 and had accumulated depreciation of $8,000 was disposed of during the year for $5,000 cash.
Required
Explain how the disposal should be accounted for in the financial statements.
(See 'Related links' for the solution to Example 12.)
Disposal of previously revalued assets
When an asset is disposed of that has previously been revalued, a gain or loss on disposal is to be calculated (as above). Any remaining surplus on the revaluation surplus should be transferred to retained earnings as:
Journal entry:
Dr Revaluation surplus
Cr Retained earnings
Summary
Accounting for PPE is an important topic that features regularly in the FR exam. With much of what is examinable feeding though from the Financial Accounting exam, you must ensure that you are comfortable with the basics of dealing with PPE as well as the more advanced aspects. This will then become assumed knowledge for the SBR exam.
Written by a member of the Financial Reporting examining team