Property, plant and equipment

Part 1: Measurement and depreciation

This is the first of three articles which consider the main features of IAS^® 16, Property, Plant and Equipment. This standard deals with the four main aspects of financial reporting of property, plant and equipment (PPE) that are likely to be of major relevance in the FR exam, namely:

1. initial measurement
2. depreciation
3. revaluation
4. derecognition

The first two of these areas are covered in this article. Items three and four will be covered in the second article.

The third article will provide further summaries of all four areas as well as more examples for you to work through.

Overview

IAS 16 defines PPE as tangible items that are:

• held for use in the production or supply of goods or services, for rental to others, or for administrative purposes, and
• expected to be used during more than one period.

Initial measurement

IAS 16 requires that PPE should initially be measured at ‘cost’ and the cost of an item of PPE should be recognised if, and only if:

(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.

The cost of an item of PPE comprises:

(a) its purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates.

(b) any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management. These are costs that would have been avoided if the asset had not been purchased or constructed. Directly attributable costs include:

• costs of employee benefits arising directly from the construction or acquisition of the item of PPE
• costs of site preparation
• initial delivery and handling costs
• installation and assembly costs
• the cost of testing whether the asset is functioning properly, and
• professional fees.

(c) The initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located. This is a component of cost to the extent that it is recognised as a provision under IAS 37, Provisions, Contingent Liabilities and Contingent Assets. In accordance with the principles of IAS 37, the amount to be capitalised in such circumstances would be the amount of foreseeable expenditure appropriately discounted where the effect is material.

Where any of these costs are incurred over a period of time (such as employee benefits), the period for which the costs can be included in the cost of PPE ends when the asset is ready for use, even if the asset is not brought into use until a later date. As soon as an asset is capable of operating, it is ready for use. The fact that it may not operate at normal levels immediately (eg because demand has not yet built up), does not justify further capitalisation of costs in this period. Any abnormal costs (for example, wasted material) cannot be included in the cost of PPE.

IAS 16 does not specifically address the issue of whether borrowing costs associated with the financing of a constructed asset can be regarded as a directly attributable cost of construction. This issue is addressed in IAS 23, Borrowing Costs. IAS 23 requires the inclusion of borrowing costs as part of the cost of constructing the asset. To be consistent with the treatment of ‘other costs’, only those borrowing costs that would have been avoided if the asset had not been constructed are eligible for inclusion. If the entity has borrowed funds specifically to finance the construction of an asset, then the amount to be capitalised is the actual finance costs incurred. Where the borrowings form part of the general borrowing of the entity, then a capitalisation rate that represents the weighted average borrowing rate of the entity should be used.

Examples of costs that are not costs of an item of PPE include:

• costs of opening a new facility
• costs of introducing a new product or service (including costs of advertising and promotional activities)
• costs of conducting business in a new location or with a new class of customer (including costs of staff training), and
• administration and other general overhead costs.

These costs should be charged to the statement of profit or loss as they arise.

EXAMPLE 1
On 1 October 20X6, Omega began the construction of a new factory. Costs relating to the factory, incurred in the year ended 30 September 20X7, are as follows:

Note 1: The factory was constructed in the eight months ended 31 May 20X7. It was brought into use on 30 June 20X7. The employee benefit costs are for the nine months to 30 June 20X7.

Note 2: The production overheads were incurred in the eight months ended 31 May 20X7. This includes an abnormal cost of $200,000 which was incurred due to the need to rectify damage resulting from a gas leak.

Note 3: Omega Co took out a loan of $12m on 1 October 20X6 to partly fund the construction of the factory. The loan carries a rate of interest of 10% per annum.

Note 4: The factory has an expected useful life of 20 years. At that time the factory will be demolished and the site restored to its original condition. This restoration is a legal obligation that arose on signing the contract to purchase the land. The expected costs of fulfilling this obligation are $2m. An appropriate discount rate is 8% which represents a discount factor of 0.215 for the 20-year period.

Required
Calculate the initial cost of the factory.

Solution
 

Any costs not capitalised as part of the factory cost will be expensed to the statement of profit or loss as incurred.

The discount on the restoration costs will be unwound over the 20-year useful life and charged annually to finance costs in the statement of profit or loss.

Subsequent costs

Once an item of PPE has been recognised and capitalised in the financial statements, a company may incur further costs relating to that asset in the future. IAS 16 requires that subsequent costs should be capitalised if they meet the IAS 16 recognition criteria for initial costs noted earlier: 

(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.

All other subsequent costs should be recognised as an expense in the statement of profit or loss in the period that they are incurred. This includes costs such as day-to-day servicing or repairs and maintenance.

Some items of PPE may require certain parts to be replaced at regular intervals. For example, a furnace may require relining after a certain number of hours of use (see Example 3 below), or the PPE may require regular major inspections. In these circumstances, the cost of the replacement part or major inspection would be capitalised (if the IAS 16 recognition criteria are satisfied). Any remaining carrying amount of the part which had been replaced or of the previous inspection would be derecognised.

As with other items of PPE, replacement parts or major inspection costs which have been capitalised would be subject to depreciation.

Depreciation of PPE

IAS 16 defines depreciation as ‘the systematic allocation of the depreciable amount of an asset over its useful life’. The ‘depreciable amount’ is the cost of an asset or other amount substituted for cost (for example the fair value of an asset following a revaluation), less its residual value. Depreciation does not provide for loss of value of an asset, but is an accrual accounting technique that allocates the depreciable amount of the asset to the periods expected to benefit from the use of the asset. Therefore, assets that are increasing in value still need to be depreciated. 

IAS 16 requires that depreciation should be recognised as an expense in the statement of profit or loss unless it is permitted to be included in the carrying amount of another asset. An example of this practice would be a company using its own plant and machinery to construct the company’s new head office – the depreciation of the plant and machinery would be capitalised as part of the cost of construction.

A number of methods can be used to allocate depreciation to specific accounting periods. Two of the more common methods, specifically mentioned in IAS 16, are the straight-line method, and the reducing (or diminishing) balance method. These are the methods that would be examined in an FR examination.

The assessments of the useful life and residual value of an asset are extremely subjective. They will only be known for certain after the asset is sold or scrapped, and this is too late for the purpose of computing annual depreciation. Therefore, IAS 16 requires that the estimates should be reviewed at the end of each reporting period. If either changes significantly, then that change should be accounted for over the remaining estimated useful life in accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors. This would constitute a change in an accounting estimate. 

EXAMPLE 2
An item of plant was acquired for $220,000 on 1 January 20X6. The estimated useful life of the plant was five years and the estimated residual value was $20,000. The asset is depreciated on a straight-line basis. On 31 December 20X6 the remaining useful life of the plant was estimated to be three years, with an estimated residual value of $12,000.

Required
Explain how depreciation would be calculated for the plant for each year of its useful life.

Solution
At the date of purchase, the plant’s depreciable amount would have been $200,000 ($220,000 – $20,000). Therefore, depreciation of $40,000 would have been charged in 20X6, and the carrying amount would have been $180,000 ($220,000 – $40,000) at the end of 20X6. Given the reassessment of the useful life and residual value, the depreciable amount at the end of 20X6 is $168,000 ($180,000 - $12,000) which must be depreciated over the next three years. Therefore, the depreciation expense in 20X7, 20X8 and 20X9 will be $56,000 ($168,000 / 3 years) per year unless there are future changes in estimates.

Each part of an item of PPE with a cost that is significant in relation to the total cost of the item must be depreciated separately. Therefore, where an asset comprises two or more significant parts, each of those parts should be accounted for separately for depreciation purposes and depreciated over its own useful life. 

EXAMPLE 3
On 1 January 20X2, an entity purchased a furnace for $200,000. The estimated useful life of the furnace was 10 years, but its lining needs to be replaced every five years. The cost of the lining at 1 January 20X2 was $50,000. The lining was replaced on 1 January 20X7 at a cost of $70,000.

Required
Calculate the annual depreciation expense relating to the furnace for each year of its useful life.

Solution

20X2 – 20X6 inclusive:
The asset has two depreciable components:

(i) the lining element (allocated cost $50,000 with a useful life of five years), and
(ii) the balance of the cost (allocated cost $150,000 with a useful life of 10 years).

Therefore, the annual depreciation is $25,000 (($50,000 x 1/5) + ($150,000 x 1/10)). At 31 December 20X6, the ‘lining component’ has a carrying amount of zero. 

From 20X7:
The $70,000 spent on the new lining is treated as the replacement of a separate component of an asset and capitalised as part of PPE. The annual depreciation charge for the furnace is now $29,000 (($70,000 x 1/5) + ($150,000 x 1/10)). 

Written by a member of the Financial Reporting examining team