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CPD technical article
Many entities are grappling with the move to International Financial Reporting Standards (IFRS), particularly in emerging economies but also wherever local government agencies and institutions are about to move to IFRS. One of the issues facing these entities is the componentisation of property, plant and equipment (PPE).
This article was first published in the June 2011 edition of Accounting and Business magazine.
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At first sight, the componentisation of property, plant and equipment (PPE) seems a fairly straightforward process, but the devil lies in the detail.
The rationale of componentisation is simple: the various elements or components of PPE assets do not have identical useful lives. They may wear out or depreciate at different rates, and some may have a higher risk of impairment or obsolescence than others.
IAS 16, Property, Plant and Equipment, sets out the criteria for recognising, valuing and depreciating non-current assets. The standard requires the various components of an asset to be identified and depreciated separately if they have differing patterns of benefits and are significant relative to the total cost of the item. Entities must ensure that the overall value of an asset is split fairly between significant components that need to be accounted for separately, and that the components’ useful lives and the method of depreciation are determined on a reasonable and consistent basis.
Where a significant component is expected to wear out more quickly than the overall asset, it is depreciated over a shorter period and any subsequent expenditure on restoring or replacing it is capitalised. This approach means that different depreciation periods may be used for each component of PPE.
Examples of components of property can be land, roof, walls, boilers and lifts. These individual components would be depreciated over their respective useful lives. Significant parts of an asset with similar useful lives and patterns of consumption can be grouped together. There is no minimum requirement for how many parts of an asset should be identified. The number of parts may vary depending on the nature and complexity of the asset. All relevant parts of an asset are identified at the date of initial recognition and the number of identified parts should not vary after the date that the asset is ready for use.
When the International Accounting Standards Board (IASB) modified IAS 16 to require the allocation of components, it did not anticipate a large change in practice. The IASB wanted to eliminate the practice of accruing the costs of major future overhauls or inspections before they were incurred. In such circumstances, no obligation for the expenditure exists at the date of accrual, and the resulting debit created does not represent an existing asset. The IASB decided to require the allocation of the cost of an asset into its components for the purposes of depreciation to allow entities to reflect the effect of a pending overhaul.
Componentisation can be a challenging process for entities especially where there is insufficient detail held on the values of the different components. For example, when a valuation is carried out on a property, it is unusual for the various component parts to be valued.
Consequently, there may be a need to involve company personnel in the analysis of the data to arrive at the component elements, and there may be a need to consider whether the entity’s current systems can perform the required calculations. Application of component accounting to all assets will involve a significant amount of work and some difficulties in estimating the value of components.
The challenge is to determine how far the asset should be broken down into components for the purpose of separate recognition by applying the concept of ‘materiality’. To perform materiality testing, a de minimis limit is normally set, below which assets are excluded from component accounting. Materiality may be considered in terms of the effect on the reported depreciation cost and the carrying values of assets but essentially it is a matter of professional judgment.
Once a materiality level has been set, the meaning of ‘significant component’ needs to be considered and applied to individual assets. A significant component may be one that has a significant value compared to the asset as a whole but a significantly shorter useful life and will require replacement on at least one occasion during the life of the asset as a whole. Clearly, any measure used to determine components is subjective.
Asset registers may need to be rewritten if spreadsheet systems are no longer suitable for managing the asset register. Deficiencies in historical records may also prevent entities from splitting some asset values into their constituent components, and significant cost may be incurred in providing bespoke information.
Where a component is replaced or restored, the carrying amount of the old component is derecognised to avoid double-counting and the new component reflected in the carrying amount, subject to the recognition principles. Recognition and derecognition occur regardless of whether the replaced part has been depreciated separately. Derecognition of a PPE component takes place when no future economic benefits are expected from its use – that is, its service potential is used up.
Where it is not possible to determine the carrying amount of the replaced part of an item of PPE, best estimates are required. Entities often use the cost of the new part to estimate the cost of the replaced part at the time of its acquisition or construction. This may involve using the replacement cost of the component, indexed back to the original component’s inception and adjusted for any subsequent depreciation and impairment. This can cause complexity especially where the asset has been revalued.
Where an item of PPE has been revalued, the value will be apportioned over the significant components already recognised for separate depreciation. Judgment is required to determine the most appropriate method to achieve that apportionment and the treatment of any revaluation surplus thus created.
When a component is replaced, the written-down value of the component replaced should be charged to the income statement and the cost of the new component recognised in the statement of financial position. The componentisation of an item of PPE is not required where depreciating the item as a single asset is unlikely to result in a material misstatement of either the depreciation charges or the carrying amount of PPE. However, entities will need to collect the evidence required to demonstrate that a material misstatement has not occurred.
The general rule is that there should be retrospective application of IAS 16 and componentisation. However, the component approach may be applied prospectively from the date of transition to IFRS. The entity can apply the ‘fair value as deemed cost’ exemption to restate the asset to fair value at the date of transition. The fair value is then allocated to the different significant parts of the asset.
For example, in the UK, local authorities have decided not to apply retrospectively the IAS 16 requirements for componentisation, on the basis that retrospective application is not expected to have a material impact on their accounts, as the IAS 16 requirement does not differ significantly from the existing UK standard. In this case, the prospective requirements are applicable to enhancement expenditure incurred, acquisition expenditure incurred, and revaluations carried out.
An item of PPE is enhanced when a new component is added to the asset, an existing asset component is refurbished or upgraded, or an asset component is replaced. Although there is no requirement to depreciate investment property, component accounting will apply in respect of the recognition and derecognition of components when enhancement expenditure is incurred on these properties. Componentisation also applies to assets recognised under IFRIC 12, Service Concession Arrangements, and IAS 17, Leases.
Componentisation has significant implications for the provision for deferred tax when the period in which the expense is allowed for tax purposes does not coincide with the life expectancy of the capitalised expense. There is a possibility that the earnings per share figure could be affected and impairment calculations will have to be revisited. The accounting treatment of PPE can be subjective in the determination of the life expectancy and residual values of assets, and the determination of the value of an asset.
Componentisation adds to this subjectivity, as can be seen from the example on this page. The additional depreciation charge can be significant. Alternatively, because of the subjective nature of the assessment, it is possible to arrive at the same depreciation charge by adjusting assets’ lives accordingly.
Accountants and other professionals must use their professional judgment when establishing significance levels, assessing the useful lives of components and apportioning asset values over recognised components. Discussions with external auditors will be key during this process.
Graham Holt is an examiner for ACCA and executive head of the accounting and finance division at Manchester Metropolitan University Business School
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