STRATHMORE UNIVERSITY School of Finance and Applied Economics Accounting and Reporting II

2.1 Property, Plant and Equipment (IAS 16) 2.1.1 Definition

Property, plant and equipment (PPE) are tangible items that are held by an entity for use in the production or supply of goods or services, or for administrative purposes; and are expected to be used during more than one period. Main examples include: Land and Buildings (property) Plant and Machinery Furniture, fixtures and fittings Equipments (electronic) Motor vehicles Capital work in progress (Buildings under construction that will be used in the business when complete)

2.1.2 Recognition
All items of property, plant and equipment should only be recognised i.e. included in the financial statements if the following criteria are met: It is probable that future economic benefits associated with the item will flow to the entity The cost of the item can be measured reliably.

2.1.3 Measurement at recognition (Initial Measurement)

When an item of PPE meets the criteria for recognition then it should initially be measured at cost. Cost includes: Purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates Directly attributable costs of bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management, e.g. (a) employee benefit costs (b) cost of site preparation (c) initial delivery and handling costs (d) installation and assembly costs (e) costs of testing whether the asset is functioning properly (f) professional fees. Estimated cost of dismantling and removing the item and restoring the site on which it is located Due to obligation (IAS 37) incurred when the item is acquired or through use (other than to produce inventories). Finance costs capitalized, including interest, as required by IAS 23 Borrowing Costs.

2.1.4 Subsequent costs

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Subsequent costs are expenses incurred on property, plant and equipment when they are in use. Main examples of subsequent costs are repairs and maintenance. The rule is that all subsequent costs should be expensed in the relevant financial. However, if the costs lead to future economic benefits then they can be added to the value of the asset (for example, extending buildings to have more operating space or expenditure incurred on machines that would enhance the quality of output). 2.1.5 Measurement after recognition After recognition of an item of PPE as an asset at the end of each financial period, an asset can be measured using either the cost model or revaluation model. (a) Cost model Property, plant and equipment is carried at cost less accumulated depreciation and impairment losses. (b) Revaluation model Property, plant and equipment is carried at a revalued amount. Revalued amount is fair value at date of revaluation less subsequent accumulated depreciation and impairment losses. Fair value of land and buildings is usually determined from market-based evidence by appraisal by professionally qualified valuers. Fair value of plant and equipment is usually their market value determined by appraisal. Where there is no market-based evidence of fair value because of the item's specialized nature (and such items are rarely sold) it is valued using the cost model. The following rules apply to revaluation of assets (i) Where an item of property, plant and equipment is revalued, all other assets in the same class should also be revalued. No selective revaluation of assets in the same class. (ii) Revaluations should be made with sufficient regularity to ensure that the carrying amount does not differ materially from that which would be determined using fair value at the reporting date. (iii) If an item of PPE is revalued for the first time, then the difference between the new revalued amount and the net book value (also referred to as carrying amount) is referred to as either a gain (revalued amount is greater than the carrying amount) or a loss (revalued amount is less carrying amount) on revaluation. A gain on revaluation should be reported in the revaluation reserve while a loss (also considered to be impairment) should be reported in the income statement as an expense. (iv) Any revaluation gains arising from subsequent revaluations should first be reversed in the income statement if the firm reported a revaluation loss in previous periods and any excess transferred to the revaluation reserve. Similarly, a revaluation loss arising from subsequent revaluations should be charged first in the revaluation reserve and the excess reported as an expense in the income statement. (iv) The revaluation surplus may be transferred directly to retained earnings when the asset is derecognised. This may be when the asset is retired or disposed of. However, some of the surplus may be transferred as the asset is used, calculated as the difference between depreciation based on the revalued amount and depreciation based on original cost and so a reserve transfer may be made for this amount over the assets useful life.

2.1.6 Depreciation
The depreciable amount of an asset (cost/revalued amount less residual value) is allocated on a systematic basis over its useful life. Each part of an item of property, plant and equipment with a cost that is significant in relation to the item's total cost is depreciated separately. The useful life, residual value and depreciation method must be reviewed at each financial year end and adjusted where necessary. Depreciation of an asset begins when it is available for use, i.e. when it is in the location and condition necessary for it to be capable of operating in the manner intended by management 2

The depreciation method used shall reflect the pattern in which the assets future economic benefits are expected to be consumed by the entity. Several methods of depreciation can be used to allocate the depreciable amount of an asset on a systematic basis over its useful life. These methods include the straightline method, the diminishing balance method and the units of production method. Straight-line depreciation results in a constant charge over the useful life if the assets residual value does not change. The diminishing balance method results in a decreasing charge over the useful life. The units of production method results in a charge based on the expected use or output. The entity selects the method that most closely reflects the expected pattern of consumption of the future economic benefits embodied in the asset. That method is applied consistently from period to period unless there is a change in the expected pattern of consumption of those future economic benefits.

2.1.7 Derecognition
This is the removal of an asset from the financial statements. The carrying amount of an item of property, plant and equipment shall be derecognised on disposal or when no future economic benefits are expected from its use or disposal. The gain or loss arising from derecognition of an item of property, plant and equipment shall be included in the income statement when the item is derecognised. The gain or loss arising from the derecognition of an item of property, plant and equipment shall be determined as the difference between the net disposal proceeds, if any, and the carrying amount of the item.

2.1.8 Disclosures
In addition to the important policies regarding how property plant and equipment is measured and the method of depreciation, a firm is required to provide details of the classes, the movement in the costs, depreciation and carrying amounts from one financial period to the next. This is done by preparing a property, plant and equipment schedule. The format is provided as follows: Land Cost/valuation $ Balance as at 1.1 Additions (purchase) Revaluation gain/loss Disposal Balance as at 31.12 Depreciation Balance as at 1.1 Charge for the year Eliminated on disposal x x (x) x x (x) x x (x) x x (x) x x (x) x x x (x) x $ x x x (x) x Building Plant & Machinery Fixture, furniture & fittings $ x x (x) x Motor vehicle Total

$ x x (x) x

$ x x (x) x

$ x x (x) x

Eliminated on revaluation Balance as at 31.12 Net book value (NBV) As at 31.12

(x) x

(x) x

(x) x

(x) x

(x) x

Example 2.1 The broad principles of accounting for tangible non-current assets involve distinguishing between capital and revenue expenditure, measuring the cost of assets, determining how they should be depreciated and dealing with the problems of subsequent measurement and subsequent expenditure. IAS 16, Property, Plant and Equipment. has the intention of improving consistency in these areas. Required: (a) Explain: (i) How the initial cost of tangible non-current assets should be measured and; (4 marks) (ii) The circumstances in which subsequent expenditure on those assets should be capitalised. (3 marks) (b) Explain IAS 16s requirements regarding the revaluation of non-current assets and the accounting treatment of surpluses and deficits on revaluation and gains and losses on disposal. (8 marks) (c) (i) Broadoak has recently purchased an item of plant from Plantco, the details of this are: $ $ Basic list price of plant 240,000 Trade discount applicable to Broadoak 125% on list price Ancillary costs: Shipping and handling costs 2,750 Estimated pre-production testing 12,500 Maintenance contract for three years 24,000 Site preparation costs Electrical cable installation 14,000 Concrete reinforcement 4,500 Own labour costs 7,500 26,000 Broadoak paid for the plant (excluding the ancillary costs) within four weeks of order, thereby obtaining an early settlement discount of 3%. Broadoak had incorrectly specified the power loading of the original electrical cable to be installed by the contractor. The cost of correcting this error of $6,000 is included in the above figure of $14,000. The plant is expected to last for 10 years. At the end of this period there will be compulsory costs of $15,000 to dismantle the plant and $3,000 to restore the site to its original use condition. Required: Calculate the amount at which the initial cost of the plant should be measured. (Ignore discounting) (5 marks) (ii) Broadoak acquired a 12-year lease on a property on 1 October 1999 at a cost of $240,000. The company policy is to revalue its properties to their market values at the end of each year. Accumulated amortisation is eliminated and the property is restated to the revalued amount. Annual amortisation is calculated on the carrying values at the beginning of the year. The market values of the property on 30 September 2000 and 2001 were $231,000 and $175,000 respectively. The existing balance on the revaluation reserve at 1 October 4

1999 was $50,000. This related to some non-depreciable land whose value had not changed significantly since 1 October 1999. Required: Prepare extracts of the financial statements of Broadoak (including the movement on the revaluation reserve) for the years to 30 September 2000 and 2001 in respect of the leasehold property. (5 marks) Solution (a) (i) The cost of an item of property, plant and equipment comprises its purchase price and any other costs directly attributable to bringing the asset into a working condition for its intended use. This is expanded upon as follows: 1. Purchase price is after the deduction of any trade discounts or rebates (but not early settlement discounts), but it does include any transport and handling costs (delivery, packing and insurance), non-refundable taxes (e.g. sales taxes such as Value Added Tax, stamp duty, import duty). If the payment is deferred beyond normal credit terms this should be taken into account either by the use of discounting or substituting a cash equivalent price; 2. Directly attributable costs are the incremental costs that would have been avoided had the assets not been acquired. For self constructed assets this includes labour costs of own employees. Abnormal costs such as wastage and errors are excluded; 3. Installation costs and site preparation costs; and 4. Professional fees (e.g. legal fees, architects fees) 5. In addition to the traditional costs above two further groups of cost may be capitalised: a) IAS 23 Borrowing Costs requires directly attributable borrowing costs to be capitalised. Directly attributable borrowing costs are those that would have been avoided had there been no expenditure on the asset. b). IAS 37 Provisions, Contingent Liabilities and Contingent Assets also requires if the estimated costs of removing and dismantling an asset and restoring its site qualify as a liability, they should be provided for and added to the cost of the relevant asset. (ii) Subsequent expenditure: Traditionally, the appropriate accounting treatment of subsequent expenditure on non-current assets revolved around whether it represented a revenue expense, in effect maintenance or a repair, or whether it represented an improvement that should be capitalized. IAS 16 bases the question of capitalization of subsequent expenditure on whether it results in a probable future economic benefit in excess of the amount originally assessed for the asset. All other subsequent expenditure should be recognised in the income statement as it is incurred. Examples of circumstances where subsequent expenditure should be capitalised are where it: - Represents a modification that enhances the economic benefits of an asset (in excess of its previously assessed standard of performance). This could be an increase in its life or production capacity; - Upgrades an asset with the effect of improving the quality of output; or - Is on a new production process that reduces operating costs. (b) Under IAS 16 revaluations are permitted under its allowed alternative treatment rules for the measurement of assets subsequent to their initial recognition. Where an entity chooses to revalue a tangible non-current asset, it must also revalue the entire class of assets to which it belongs. Further, sufficiently regular revaluations should be made such that the carrying amounts of revalued assets should not differ materially to their fair values at the balance sheet date. Surpluses and deficits: These are measured as the difference between the revalued amounts and the book (carrying) values at the date of the valuation. Increases (gains) are taken to equity under the heading of revaluation surplus, unless, 5

and to the extent that, they reverse a previous loss (on the same asset) that has been charged to the income statement in which case they should be recognised as income. Decreases in valuations (revaluation losses) should normally be charged to the income statement. However, where they relate to an asset that has previously been revalued upwards, then to the extent that the losses do not exceed the amount standing to the credit of the asset in the revaluation reserve, they should be charged directly to that reserve (again this may pass through a STRGL). Any impairment loss on revalued property, plant and equipment, recognisable under IAS 36 .Impairment of Assets, is treated as a revaluation loss under IAS 16. Gains and losses on disposal: The gain or loss on disposal is measured as the difference between the net sale proceeds and the carrying value of the asset at the date of sale. In the past some companies reverted to historic cost values to calculate a gain on disposal thus inflating the gain (assuming assets had increased in value). All gains and losses should be recognised in the income statement in the period of the disposal. Any revaluation surplus standing to the credit of a disposed asset should be transferred to accumulated realised profits (as a movement on reserves). (c) (i) The initial measurement of the cost at which the plant would be capitalised is calculated as follows: . $ Basic list price of plant 240,000 Less trade discount of 125% on list price (30,000) 210,000 Shipping handling and installation costs 2,750 Estimated pre-production testing 12,500 Site preparation costs Electrical cable installation (14,000- 6,000) 8,000 Concrete reinforcement 4,500 Own labour costs 7,500 Dismantling and restoration costs (15,000 + 3,000) 18,000 Initial cost of plant 263,250 Note: The early settlement discount is a revenue item (probably deducted from administration costs). The maintenance cost is also a revenue item, although a proportion of it would be a prepayment at the end of the year of acquisition (the amount would be dependent on the date on acquisition). The cost of the specification error must be charged to the income statement. (ii) Broadoak Income statement extracts Depreciation Revaluation loss Statement of financial position Leasehold Revaluation reserve 30 September 2000 $ (20,000) 231,000 30 September 2001 $ (21,000) (25,000) 175,000

Balance 1 October 1999 Revaluation gain (see below) Balance 30 September 2000 Transfer to accumulated profits (11,000 x 1/11) Proportion of revaluation loss (see below) Balance 30 September 2001 6

50,000 11,000 61,000 (1,000) (10,000) 50,000

Workings: Cost 1 October 1999 240,000 Depreciation to 30 September 2000 (240,000/12 years) (20,000) 220,000 Revaluation gain 11,000 Carrying value 30 September 2000 231,000 Depreciation to 30 September 2001 (231,000/11 years) (21,000) 210,000 Revaluation loss directly to revaluation reserve (10,000) Remaining loss to income statement (25,000) Carrying value 30 September 2001 175,000