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IAS 16 Property, Plant and Equipment 2011

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TACIS project partners included Rosexpertiza (Russia), ACCA (UK), Agriconsulting (Italy), FBK (Russia), and European Savings Bank Group (Brussels). The help of Philip W. Smith (editor of the third edition) and Allan Gamborg, project managers and Ekaterina Nekrasova, Director of PricewaterhouseCoopers, who managed the production of the Russian version (2008-9) is gratefully acknowledged. Glyn R. Phillips, manager of the first two projects conceived the idea, designed the workbooks and edited the first two versions. We are proud to realise his vision. Robin Joyce Professor of the Chair of International Banking and Finance Financial University under the Government of the Russian Federation

Visiting Professor of the Siberian Academy of Finance and Banking Moscow, Russia 2011 Reviewed

IAS 16 Property, Plant and EquipmentCONTENTS

1. Introduction 4

2. Bank accounting: property, plant and equipment 5

3. Definitions 8

4. Recognition 11

5. Measurement at Recognition 13

6. Measurement after Recognition 17

7. Depreciation 24

8. Impairment 35

9. Disclosure 38

10. Appendix – IAS 16 rules for users other than banks. 42

11. Multiple choice questions 52

12. Numerical Questions 58

13.Answers to multiple choice questions 58

14. Answers to numerical questions 59

Note: Material from the following PricewaterhouseCoopers publications has been used in this workbook:

Applying IFRS , IFRS News, Illustrative Corporate Financial Statements 2007, Illustrative consolidated financial statements 2006 – Banks

Property, Plant and Equipment

1. Introduction

The difference between capital expenditure (including Property, Plant and Equipment) and revenue expenditure is an important distinction in accounting.

Generally, revenue expenditure is accounted for in the current period (excepting deferred expenditure) and capital expenditure is spread over a number of accounting periods that benefit from the capital expenditure.

One view of depreciation is that it represents this spreading of capital expenditure costs.

AimThe aim of this workbook is to assist the individual in understanding Property, Plant and Equipment according to IFRS.

ObjectiveProperty, Plant and Equipment are the subject of IAS 16.

The objective of IAS 16 is to: prescribe the accounting treatment for property, plant and

equipment (‘PPE’) inform users of financial statements on the investment in

PPE and any movements in these accounts over the period.

The main issues in accounting for property, plant and equipment are:

the recognition of the assets; the determination of their carrying amounts; the determination of the useful life; the depreciation charges; and impairment losses to be recorded.

ScopeIAS 16 will be applied in accounting for property, plant and equipment, except when another Standard requires, or permits, a different accounting treatment.

IAS 16 does not apply to:

(1) biological assets related to agricultural activity (see IAS 41 Agriculture workbook); nor to

(2). property, plant and equipment classified as held for sale

in accordance with IFRS 5;

(3) investment property covered by IAS 40.

(4). the recognition and measurement of exploration and evaluation assets (see IFRS 6 workbook); or

(5) mineral rights and mineral reserves such as oil, natural gas and similar non-regenerative resources.

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However, IAS 16 applies to property, plant and equipment used to develop, or maintain, the assets described in (1) to (4).

LeasesOther Standards may require recognition based on a different approach from that in IAS 16. For example, IAS 17 Leases (see IAS 17 workbook) requires you to evaluate recognition of a leased item on the basis of the transfer of risks and rewards.

Other aspects of the accounting treatment for these assets, including depreciation, are prescribed by IAS 16.

Other Comprehensive Income

IAS 1 has introduced Other Comprehensive Income as a financial statement. All movements into and out of Revaluation Reserves in Equity are recorded here.

2. Bank accounting: property, plant and equipment

Summary

i. PropertyMost banks are heavily involved in property: their own property and that of their clients. Their clients often use property as collateral, as well as using bank funds to finance the purchase and sometimes the construction of property. As a bank’s involvement in property increases, so does the need for banks to employ their own property experts.

Banks’ primary involvement in property is where it owns a building and only uses it (all, or in part) for banking. The parts it

uses for banking are subject to IAS16. Investment property is covered by IAS 40.

In general, banks will not build up a portfolio of properties unless the profits from these are considerably higher than those that can be earned from banking activities. (Banks will prefer to use their funds in their banking business.)

Properties involve medium and long-term financing, and therefore utilize the liquidity of banks. Many branches are therefore leased, if they were not privatised from the state.

Banks may acquire properties when they foreclose on clients’ loans. Usually such properties will be shown as ‘’held for sale’’ (see IFRS 5 workbook). If the properties are to be sold, they are normally disposed of swiftly, as bank regulations of the Central Bank may demand that the value of such properties are reduced in the books of the banks holding them.

The bank may decide to maintain ownership of the properties (having completed any outstanding legal steps) either for its own use (IAS16) or as investment properties (IAS 40).

The bank may acquire an unfinished building when it forecloses on a loan. It may decide to complete the building rather than sell it in its unfinished state.

ii. Plant and equipment

Banks use many assets for the banking business, including computers, security systems, safes and furniture, fixtures and fittings. Leasehold improvements comprise changes to existing




properties that are held under lease. Whilst certain improvements to all premises may be capitalised, repairs and general maintenance must be expensed in the current period when incurred.

iii Scope of IAS 16

IAS 16 covers all property, plant and equipment, except investment property (IAS 40), leases (IAS 17), assets held for sale (IFRS 5) and assets held under IAS 41 and IFRS 6 (see above).

Concerns for Bankers

i. Property

IFRS primarily concerns the economic value and profit of transactions, whilst bankers are deeply concerned about liquidity and cash flows.

Properties are often not easily saleable. It may also be difficult to find tenants to fill a vacant property. There may be a potential for liquidity problems arising as a result.

Credit officers need to understand the impact of IAS 16 in the financial statements of clients. Where clients use the revaluation model for accounting for property, plant and equipment, increased asset values will appear in the balance sheet and reserves will increase, even if they have not been realised. Such unrealised gains have not generated cash flows, and may become losses in future periods.

Appraisers used to provide valuations for clients should be recognised by the bank as acceptably professional and

knowledgeable in the locations and type of buildings being appraised.

Clients should provide professional appraisals based on all recognized approaches, including the Income Approach, from which the future cash flows can be analysed for possible impairment.

Clients may use the cost model for their property, especially during the building of the property. Any impairment charges need to be examined by the bank to decide whether there is evidence that the bank’s loan is at risk.

Impact of Property Value Decreases

Property values tend to decrease in economic recessions, but also decrease in specific towns (or areas of towns) if a major employer (private sector or public sector) moves away from that location.

As people leave, bank branches may close, or the bank may use smaller premises. Some of the property may be left empty.

Banks financing such property may see the value of their collateral decrease, based on cash flows, and may experience late payments and defaults.

In reviewing loans for impairment, the bank may have to change its discount rate to reflect investors’ new expectations of yields in the new market conditions.

Critically, if the property needs to be sold, the number of buyers will be less than in more-favourable economic times. Investors may be expecting to pay extremely-low ‘’fire-sale’’ prices, rather




than higher prices that were being paid a few months before. The property market may have a surplus of sellers and too-few buyers, resulting in lower prices.

ii. Plant and equipment

Banks work in a global banking network, and need to ensure that their technology and security matches business requirements. The useful lives of current equipment may be considerably shorter than national depreciation rates dictate. Today’s state-of-the-art technology may only have scrap value in two years’ time. This may also apply to their clients’ equipment.

Useful lives of plant and equipment will be limited by the remaining length of lease of the building that houses them, unless they can be transferred elsewhere at the end of the lease.

When taking plant and equipment as collateral, banks need to establish the net realisable value of that plant and equipment. For specialist plant and equipment, the market may be inactive or even non-existent. Even if the plant and equipment can be sold, transport costs to a new owner will have to be anticipated. Some installation costs that have been capitalised may not be recoverable if assets are moved. Holes drilled into walls for pipes and cables may have been capitalised, but are not transferable.

Corporate reorganisations are popular with many banks and with their clients. These often involve restructuring offices and

other buildings and the scrapping of some plant and equipment, as new items take their place.

Low rates of depreciation of plant and equipment, indicating long useful lives of those items, may inflate annual profits. They may also impede investment in new technology, because the new technology would result in larger write-offs of the book values of existing assets that would be replaced.

Revaluations of plant and equipment need to be considered carefully. The market for most plant and equipment is more limited than that for most property. Therefore, valuations may be less reliable when the assets are realised. Also, increases in values of plant and equipment will result in higher annual depreciation charges. Banks need to consider whether a revaluation of plant and equipment has been undertaken when otherwise the result would be a breach of loan covenants.

iii Accounting for bank branches –property cost

Many bank branches are located in town centre, or high street premises. Such property is usually in the premium sector of commercial property. If the branch were to close, buyers for the property would normally be found reasonably easily.

In evaluating the operating performance of such branches, management should use current market rents for similar properties in the location, rather than the original cost, or rental payments that are below current market rents.

This will identify whether each branch is earning sufficient profits to justify its occupation of premium property.

iv Annex – IAS 16 rules for users other than banks




For completion, we have included examples that relate to IAS 16, but for users other than banks (bridges, aircraft, mine operators) in an annex.

3. Definitions

Carrying amount is the amount at which an asset is recorded in the balance sheet (SFP), after deducting any accumulated depreciation and accumulated impairment losses.

Cost is the amount of cash (or cash equivalents) paid and the fair value of any other consideration, given to acquire an asset at the time of its acquisition, or construction.

Depreciable amount is the cost of an asset, or valuation, less its residual value.

Depreciation is the spreading of the depreciable amount of an asset over its useful life.

Fair value is.the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date. (IFRS 13)

Impairment loss is the amount by which the carrying amount of an asset exceeds its recoverable amount.

Property, plant and equipment (‘PPE’) are tangible items that:

(1) are held for use in the production, or supply, of goods or services, for rental to others, or for administrative purposes; and

(2) are expected to be used during more than one reporting period.

Recoverable amount is the higher of an asset’s fair value less costs to sell, and its value in use.

Residual value is the estimated amount that you would currently obtain from disposal of the asset, after deducting the estimated costs of disposal, if the asset were already of the age, and in the condition expected at the end of its useful life.

Useful life(1) the period over which an asset is expected to be available

for use by an undertaking; or

(2) the number of production, or similar, units expected to be obtained from the asset by an undertaking.

In the following examples, I/B refers to Income Statement and Balance Sheet (SFP).EXAMPLE residual value 1Your policy is to keep company vehicles for 4 years. You have just bought a new vehicle for $20.000. Today’s market price, less selling costs, of a similar vehicle that is 4 years old is $6.000, which is a reasonable estimate of the residual value of the new vehicle. The depreciable amount will be $20.000-$6.000= $14.000, and the annual depreciation charge will be $14.000 / 4 years = $3.500.At the end of the 4 years, you will sell the vehicle.




I/B DR CRDepreciation I 3.500Accumulated depreciation B 3.500Annual depreciationProperty, plant & equipment B 20.000Accumulated depreciation B 14.000Cash B 6.000Sale of vehicle,assuming the cash received = residual value

EXAMPLE residual value 2You buy an air-conditioning system for your bank branch for $200.000. It is estimated to have a life of 5 years, with no residual value.You depreciate it at the rate of $40.000 per year.

I/B DR CRDepreciation I 40.000Accumulated depreciation B 40.000Annual depreciation

EXAMPLE depreciation per unitYou buy a printing machine for $100.000 for a seasonal promotional publication. You estimate that it will be able to print 20.000 units over its life. No residual value is anticipated. Every time a unit is printed, depreciate the machine by $5.

I/B DR CRDepreciation I 5Accumulated depreciation B 5Unit depreciation




Property type- different accounting treatment applied to properties under IFRS depending on their current and future uses and their ownershipStandard Standard Name Valuation

Owner-occupied property IAS 16 Property, plant and equipment (see also IAS 20 Government grants)

Cost or revaluation.

Property acquired in an exchange of assets

IAS 16 Property, plant and equipment Fair value or the carrying amount of the assets given up.

Investment property IAS 40 Investment property Cost or fair value. Investment property being redeveloped for continuing use as investment property.

IAS 40 Investment property Cost or fair value.

Investment property held for sale without development (unless it meets the criteria of IFRS 5 – see below).

IAS 40 Investment property Cost or fair value.

Property held under an operating lease classified as an investment property

IAS 40 Investment property Fair value (accounted for as a finance lease under IAS 17).

Property held under a finance lease IAS 17 Leases. Owner-occupied IAS 16, Investment property IAS 40.

The lower of fair value and the present value of the minimum lease payments.

Property held under an operating lease – owner -occupied

IAS 17 Leases Leasing costs expensed.

Property lease to another party under a finance lease

IAS 17 Leases Account receivable equal to the net investment in the lease.

Property sale and leaseback IAS 17 Leases As operating lease or finance lease, as appropriateTrading properties – property (including investment property) intended for sale in the normal course of business, or being built, or developed for that purpose

IAS 2 Inventories (Properties held for sale that meet the criteria of IFRS 5 should be recorded according to IFRS 5 – see below. These are generally not in the normal course of business.)

Lower of cost and net realisable value.

Property held for sale, or included in a disposal group that is held for sale.

IFRS 5 Non-current assets held for sale and discontinued operations

Lower of carrying amount and fair value less costs to sell.

Assets received in exchange for loans (taking possession of collateral)

IFRS 5

IAS 16

Non-current assets held for sale and discontinued operationsProperty, plant and equipment (see Property acquired in an exchange of assets above)

Lower of fair value less costs to sell and carrying amount of the loan net of impairment at the date of exchange. (see HSBC plc Annual Report 2005 page 247)

Property provided as part of a construction contract

IAS 11 Construction contracts Stage of contract completion or cost.

Future costs of dismantling, removal and site restoration.

IAS 37 Provisions, contingent liabilities and contingent assets (see also IFRIC 1, IFRIC 5)

Present value of the expected costs, using a pre-tax discount rate.



Notes to the table on the previous page.

The table above identifies the different accounting treatment applied to properties under IFRS, depending on their current and future uses and their ownership.

Note 1: Where an asset is revalued, increases in carrying amounts above cost are recorded as revaluation surplus, in equity.

Using fair values, all changes in fair value are recorded in the income statement. Reductions below cost are recorded in the income statement under both methods.

Note 2. In the cases where the asset is subject of cost or revaluations, the carrying value will be reduced by accumulated depreciation and accumulated impairment (see IAS 36 workbook).

Workbooks are available on our website on each standard that explain each accounting treatment, with examples.

4. Recognition

The cost of property, plant and equipment will be recorded as an asset if:(1) it is probable future benefits will be generated; and

(2) the cost of the item can be measured reliably.

Spare parts and servicing equipmentThese are usually carried as inventory, and recorded in the income statement as consumed.

However, major spare parts and stand-by equipment qualify as property, plant and equipment, if they will be used during more than one period.

Also, if the parts and servicing equipment can be used only in connection with an item of property, plant and equipment, they are accounted for as property, plant and equipment.

IAS 16 does not specify what constitutes an item of property, plant and equipment.

It may be appropriate to aggregate individually-insignificant items, such as computer spare parts, as one asset.

Safety and environmental costsItems may be acquired for safety or environmental reasons. The benefit is the undertaking’s continuance in business, as a result of their use.

EXAMPLE Can equipment with no immediate value to an undertaking’s operation be capitalised as an asset?

IssueExpenditure for property, plant and equipment is recorded as an asset when:

i) it is probable that future economic benefits will flow to the undertaking; and

ii) cost can be reliably measured.

Property, plant and equipment may be acquired for safety, or environmental reasons. Such property, plant and equipment may

not increase the future economic benefits of existing items of property, plant and equipment.

However, it may be necessary for an undertaking to obtain the future economic benefits from its other assets. This type of property, plant and equipment can be recognised as an asset because the undertaking can derive economic benefits from related assets.

Can management capitalise expenditure in respect of an asset that has no immediate value to an undertaking’s operations?

BackgroundA bank runs a network of branches. New health and safety legislation is introduced which requires all branch owners throughout the country to install a sprinkler system. The addition of the new system will not increase the banks’ business.

The branches have not suffered any fires, and management considers that there is only a remote chance of a fire occurring in the future. The installation of the sprinkler is therefore not expected to reduce the operating costs of the branches.

SolutionYes. Management should recognise the sprinkler system as an asset, to the extent that the resulting carrying amount of each branch (assuming that each branch is a separate cash-generating unit) does not exceed its recoverable amount (see impairment section below).

The acquisition of safety equipment, which does not increase any future economic benefits, qualifies for recognition as an asset if it enables future economic benefits to be obtained from related assets.

Management can only earn future economic benefits from the branches by installing the sprinkler system, because the authorities are likely to close branches without such systems.

However, the cost of the sprinkler system should not be recognised until it has been installed. No provision should be made for the future installation of health and safety equipment.

Repairs and maintenance costsThe costs of the day-to-day servicing (‘repairs and maintenance’) are recorded in the income statement as incurred. These costs exclude items that significantly add value.

Material parts of some items may require replacement at regular intervals. For example, motors of air conditioning systems may require replacement several times during the life of the system.

Items may also be acquired to make a less-frequently recurring replacement, such as replacing the interior walls of a building, or to make a non-recurring replacement.

The cost of the replacement is added to the cost of the asset and the cost of the old part is subtracted.

New carrying cost = old carrying cost + new part cost - old part cost

EXAMPLE replacing partsYour building has a carrying amount of $1 mln. New interior walls cost $0,2 mln. The original walls have a carrying amount of $0,1mln. Add the cost of the new walls, and remove the carrying amount of the old walls:$1 + $0,2 - $0,1= $1,1mln. is the new carrying amount.

I/B DR CR

Property, plant & equipment B $0,2 mlnCash B $0,2 mlnDepreciation I $0,1 mlnProperty, plant & equipment B $0,1 mlnThis records the purchase of the new walls and disposal of the old walls

5. Measurement at Recognition

Property, plant and equipment will be measured at cost.

Elements of costThe cost comprises:

(1) buying price, including import duties and non-refundable taxes, after deducting trade discounts and rebates;

(2) any costs directly attributable to bringing the asset to the location, and installation, necessary for it to be capable of operating in the manner intended by management.

(3) the initial estimate of the costs of dismantling, and removing the item, and restoring the site on which it is located.

Examples of directly attributable costs are:

staff costs arising directly from the construction, or acquisition, of the item of property, plant and equipment;

site preparation costs;

initial delivery and handling costs;

installation and assembly costs;

costs of testing whether the asset is functioning properly, after deducting the net proceeds from any samples, or sundry income; and

professional fees.

EXAMPLE Components of cost of property, plant and equipment

IssueProperty, plant and equipment shall initially be measured at cost.

The cost of an item includes any directly attributable costs of bringing the asset to the location and condition for enabling operation as intended by management.

The following are examples of the types of costs that can or cannot be included in the cost of property, plant and equipment.

SolutionCosts included

Costs necessary for the construction of PPE should be capitalised.

i) Legal costs specific to the purchase and construction of the specific asset;ii) Initial delivery and handling costs;iii) Import duties;iv) Installation costs;v) Purchase transaction costs;vi) Property transfer taxes;vii) Architect and engineering costs specific to the asset (costs of alternative designs that were subsequently rejected should not be

capitalised);viii) Site clearance costs;ix) Construction labour and materials;x) Interest during period of construction (see IAS 23); andxi) Start-up costs necessary for working condition of asset (including plant commissioning and test production).

Costs excluded

Costs associated with the planning stages, while necessary for good governance of an undertaking’s resources, may not be necessary for the construction of the final asset.

Such costs, for example costs concerned with the selection of designs, identification of sites and requirements, etc, are not directly necessary for the construction of the final asset.

Costs that are not necessary are expensed and not capitalised.

i) Feasibility study costs;ii) Start-up costs (unless necessary for working condition of the asset);iii) Initial operating losses before planned operating levels;iv) Abnormal wasted materials, labour or other resources;v) Interest or other costs after the property, plant and equipment is

available for use even if not yet in use in the business;vi) Staff training;vii) Cost of relocating certain equipment in the plant to allow

installation of the new equipment; andviii) General administrative costs not directly attributable to the

acquisition, construction or commissioning of the asset.

EXAMPLE Capitalisation of rental expenses

Issue

The cost of an item of PP&E comprises, inter alia, any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner that management intends. Should an operator capitalise rental expenses?

Background

X is constructing a computer network between its head office and branches. X has entered into rental agreements with various providers for line rentals. X pays 1,000 a month for the rental of the telephone lines. X will pay the same level of rental expense after the network is launched.

Solution

Operator X should expense the rental of 1,000 as incurred throughout the network’s construction stage.

Line rental costs will be incurred before and during the network operating stage. The costs are not incremental and they are not directly attributable to the process of bringing the network to its working condition. Therefore, they should be expensed as incurred.

The rentals are part of the start-up costs, which should be expensed as incurred.

Lease payments under an operating lease should be recognised on a straight-line basis over the lease term unless another systematic basis is representative of the time pattern of the user’s benefit.

X derives benefit from the lease from day one, because it has access to the lines in order to install its equipment. Therefore, the

straight-line basis of recognising the lease payments is appropriate.

Rentals incurred before the network is operational should not be capitalised.

Expensed CostsCosts that should be expensed in the income statement (and not capitalised), include:

(1) costs of opening a new facility;

(2) costs of introducing a new product, or service (including advertising and promotional activities);

(3) costs of running a business in a new location, or with a

new class of customer (including staff training); and

(4) administration and other general overhead costs.

Stopping cost recognitionRecognition of costs ceases when the item is in the location, and capable of operating in the manner intended by management.

Therefore, costs incurred in using, relocating, or redeploying are not included in the carrying amount of the item.

For example, the following costs are not included in the carrying amount :

(1) costs incurred while an operation, capable of operating in the manner intended by management, has yet to be brought into use, or is operated at less than full capacity;

(2) initial operating losses, such as those incurred while business in the operation builds up; and

(3) costs of relocating, or reorganising part, or all, of a bank’s operations.

EXAMPLE Capitalisation of pre-opening costs

IssueThe cost of an item of property, plant and equipment includes directly attributable expenditure necessary to bring the asset to the location and condition for it to be capable of operating in the manner intended by management.

Should management capitalise the expenditure made before opening a branch?

Background

K, which operates a major branch network of banks, has acquired a new branch location. The new location requires significant renovation expenditure.

Management expects that the renovations will last for 3 months during which the branch will be closed.

Management has prepared the budget for this period including expenditure related to construction and remodelling costs, salaries of staff who will be preparing the branch before its opening, and related utilities costs.

SolutionYes. Management should capitalise the costs of construction, security, communications and remodelling the branch, because they are necessary to bring the branch to the condition necessary for it to be capable of operating in the manner intended by management.

The branch cannot be opened without incurring the remodelling expenditure, and thus the expenditure should be considered part of the asset.

However, the cost of salaries, utilities and storage of goods are operating expenditures which would be incurred if the branch was open.

These costs are not necessary to bring the branch to the condition necessary for it to be capable of operating in the manner intended by management and should be expensed.

Incidental costs / incomeSome incidental operations may occur before, or during, the construction, or development activities.

For example, income may be generated by using a building site as a car park, until construction starts.

The income and related expenses of incidental operations are recorded in the income statement, and included in their respective classifications of income and expense.

Self Constructed AssetsThe cost of a self-constructed asset is determined using the same principles as for an acquired asset.

If an undertaking makes similar assets for sale in the normal course of business, the cost of the asset is usually the same as the cost of constructing an asset for sale.

Any internal profits are eliminated from such costs.

EXAMPLE Salaries recognised as part of an asset’s cost

IssueThe cost of an item of property, plant and equipment includes 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.

Should management capitalise, or expense, the salaries of employees who are constructing an asset?

BackgroundM’s management has started to construct a new branch. Part of the ordinary workforce will be working full time on the project of constructing the plant.

The estimated time of construction is 3 months. The total salary costs for these employees, including the cost of pension benefits and annual leave, totals 500,000 a year.

SolutionManagement should capitalise 125,000 (3/12 x 500,000) as part of the cost of the branch. The salary cost of the employees working full time on the project can be directly attributable to the construction of the asset.

Administration and other general overheads are examples of costs that are not a component of the cost of property, plant and equipment.

Similarly, the cost of abnormal amounts of wasted material, labour, or other resources incurred in self-constructing an asset, is not included in the cost of the asset.

IAS 23 Borrowing Costs details the criteria for the recognition of interest as a component of the carrying amount of a self-constructed asset.

Measurement of costThe cost is the cash-price equivalent at the recognition date. If payment is deferred beyond normal credit terms, the difference between the cash price equivalent and the total payment is recorded as interest over the period of credit, unless such interest is recorded as a borrowing cost in the carrying amount of the item, in accordance with IAS 23..EXAMPLE cost measurementYou can pay $1mln cash for a building, or pay for it over 3 years for a total cost of $1,3 mln. Using either payment method, the cost will be $1mln. If the second payment option is used (see above), the $0,3 mln. will be treated as interest.

I/B DR CRProperty, plant & equipment B $1 mln.Accounts payable B $1 mln. Being the buying of the buildingInterest expense I $0,1 mln. Interest payable B $0,1 mln. Annual interest charge

The cost held by a lessee under a finance lease is determined under IAS 17 Leases.

The carrying amount may be reduced by government grants, in accordance with IAS 20 Government Grants.

6. Measurement after Recognition

An undertaking will choose either the cost model, or the revaluation model, as its accounting policy, and will apply that policy to an entire class of property, plant and equipment.

Cost modelAn item will be carried at its cost, less any accumulated depreciation, and any accumulated impairment losses (see impairment section below).

Revaluation modelAn item whose fair value can be measured reliably may be carried at revaluated amount (fair value) less subsequent accumulated depreciation and accumulated impairment losses.

Revaluations will be made with sufficient frequency to ensure that the carrying amount does not differ materially from fair value at the balance sheet date.

The fair value of land and buildings is usually determined by professionally-qualified valuers using market-based evidence.

The fair value of plant and equipment is usually their market value, determined by appraisal.

If there is no market-based evidence of fair value, estimate the fair value. For example:

present value of future income

or

replacement cost less depreciation.

The higher the market volatility, the greater the frequency of revaluations.

If there is a big difference between the carrying amount and fair value then a revaluation should be made.

Some items necessitate annual revaluation due to frequent changes in fair value.

Frequent revaluations are usually unnecessary for property, plant and equipment. They are usually revalued every 3-5 years unless investment property is involved (see IAS 40), when more-frequent valuations are common.

Depreciation - Revaluation model

Depreciable amount is the cost of an asset, or valuation, less its residual value.

Depreciation is the spreading of the depreciable amount of an asset over its useful life.

If an asset is revalued and the valuation is more than the cost, the depreciable amount will increase and the depreciation charge for each period will also increase.

Should the valuation show a fall in value from the current carrying cost, the depreciable amount and the depreciation charge for each period will decrease.

EXAMPLE Revaluation – increase in the depreciation charge

You build your own head office at a cost of $40 million. It is revalued at $60 million of the day the building is ready for use. (The cost of land is ignored in this example.)

The expected life of the building is 40 years.

The annual depreciation charge will be $1,5 million ($60 million / 40 years), not $1 million ($40 million / 40 years)

When an item is revalued, any accumulated depreciation is treated in one of the following ways, both of which result in the net carrying amount being equal to the revaluation figure:

(1) Depreciation restated proportionately, with the change in the gross carrying amount of the asset.

The carrying amount of the asset after revaluation equals its revalued amount.

This method is often used when an asset is revalued by means of applying an index to its depreciated replacement cost.

EXAMPLE depreciation restated proportionately

A cash-counting machine cost $6.000 and has been depreciated by $1.000, leaving a net book value of $5.000. It has been revalued. The value has risen by 25% since the machine was bought.The new cost is therefore $7.500 (6.000x125%), depreciation $1.250 (1.000x125%) and the carrying amount based on this $6.250.

This can be shown as:

Cost ValuationCost = Gross carrying amount - Valuation

$6.000. $7.500

Accumulated Depreciation $1.000 $1.250Carrying amount of the asset $5.000 $6.250

I/B DR CRProperty, plant & equipment B 1.500Accumulated depreciation B 250Equity - Revaluation Reserve B 1.250This records the revaluation of the cash-counting machine.

(2) Depreciation eliminated against the gross carrying amount of the asset.The net amount is restated to the revalued amount of the asset.

(3) Depreciation begins again based on the remaining useful life.

This method is often used for the revaluation of buildings.

EXAMPLE Depreciation eliminated2. A building cost $5 mln. and has been depreciated by $2 mln., leaving a net book value of $3 mln. It is revalued to $6 mln.

This can be shown as:

Cost Valuation

Cost = Gross carrying amount - Valuation

$5 mln. $6 mln.

Accumulated Depreciation $2 mln. $0Carrying amount of the asset $3 mln. $6 mln.

I/B DR CRProperty, plant & equipment B $1

mlnAccumulated depreciation B $2

mlnEquity - Revaluation Reserve B $3

mlnThis records the revaluation of the building,cancelling the accumulated depreciation under alternative Two.

EXAMPLE How to adjust accumulated depreciation for the revaluation of a depreciable asset?

IssueWhen an item of property, plant and equipment is restated, any accumulated depreciation at the date of the revaluation is either:

i) restated proportionately with the change in the gross carrying amount of the asset so that the asset’s carrying amount after revaluation equals its revalued amount; or

ii) eliminated against the asset’s gross carrying amount and the net amount restated to the revalued amount of the asset.

How should management adjust accumulated depreciation for the revaluation of a depreciable asset?

BackgroundA bank bought a machine for 30,000 on 1 January 20X4. The machine’s useful life is 10 years with zero residual value. The revalued amount of the machine is 36,000 on 31 December 20X4.

SolutionThe two methods of adjusting accumulated depreciation are as follows:

Method 1: The accumulated depreciation is restated proportionately with the change in the asset’s gross carrying amount.

Before adjustment

Adjustment for

revaluation surplus

Afteradjustment

Cost

As at 31 December

30,000 10,000 40,000

[30,000 x 36,000/27,000]

Accumulated depreciation

As at 31 December

(3,000) (1,000) (4,000)

[3,000 x 36,000/27,000]

Net carrying amount

27,000 9,000 36,000

Method 2: The accumulated depreciation is eliminated against the asset’s gross carrying amount.

Before adjustment

Adjustment for

revaluation surplus

Afteradjustment

Cost

As at 31 December

30,000 6,000[ 9,000-

3,000]

36,000

Accumulated Depreciation

As at 31 (3,000) 3,000 0

December

Net carrying amount

27,000 9,000 36,000

The above method is often used for buildings that are revalued to their market value.

Revaluation in classesIf an item is revalued, the entire class to which that asset belongs will also be revalued.

A class is a grouping of assets of a similar nature and use. The following are examples of common separate classes:(1) land;

(2) land and buildings;

(3) machinery;

(4) ships;

(5) aircraft;

(6) motor vehicles;

(7) furniture and fixtures; and

(8) office equipment.

It should be noted that land is not depreciated.

The items within a class are revalued simultaneously (or not at all) to avoid selective revaluation of assets, and the reporting of

amounts that are a mixture of costs and values as at different dates.

A class of assets may be revalued on a rotating basis, provided revaluation of the class of assets is completed within a short period, and provided the revaluations are kept up to date.

EXAMPLE rotating valuationYou own various offices. You decide to revalue them every 3 years. The revaluations may be done at the same time, or one third of the properties may be revalued each year.

Carrying Amount IncreaseIf an asset’s carrying amount is increased as a result of a revaluation, the increase will be credited directly to equity under the heading of Equity - Revaluation Reserve.

EXAMPLE carrying amount increaseYour computer centre, carrying value of $15 mln. has been revalued at $17 mln. The $2 mln. surplus will be credited to the revaluation surplus reserve within equity.



mlnThis records the revaluation of the computer centre

However, the increase will be recorded in the income statement to the extent that it reverses a revaluation decrease of the same asset previously recorded in the income statement.

EXAMPLE prior revaluation decreaseYour computer centre had a carrying value of $20 mln. It has been revalued at $19 mln. The $1mln. shortfall is expensed to the income statement.

I/B DR CRAccumulated impairment B $1 mln Impairment loss I $1

mln This records the revaluation of the computer centre in the first year

At the next valuation (Year 2), it is revalued at $23 mln. $1 mln. of the surplus will be credited to the income statement (to offset the first year’s charge). The remaining $3 mln. surplus will be credited directly to the revaluation surplus reserve within equity, without appearing on the income statement.


mlnAccumulated impairment B $1

mlnImpairment gain I $1


mlnThis records the revaluation of the computer centre in the second year

Carrying Amount DecreaseIf an asset’s carrying amount is decreased as a result of a revaluation, the decrease will be recorded in income statement. .

EXAMPLE carrying amount increase following decrease Your computer centre had a carrying value of $10 mln. It has been revalued at $12 mln. The $2 mln. surplus is credited to the revaluation surplus reserve within equity.

I/B DR CRProperty, plant & equipment B $2 mln Equity - Revaluation Reserve B $2

mln This records the revaluation of the computer centre in the first year

At the next valuation, it is revalued at $7 mln. $2 mln. of the shortfall will be charged to the revaluation surplus reserve. The remaining $3m shortfall will be charged to the income statement.

I/B DR CREquity - Revaluation Reserve B $2

mln Impairment loss I $3

mln Property, plant & equipment B $5

mln This records the revaluation of the computer centre at the next valuation in the second year

Asset write offWhen the asset is eliminated from the balance sheet, the revaluation surplus included in equity may be transferred directly to retained earnings.

EXAMPLE asset write offYour computer centre had a cost of $22 mln. It has been revalued at $28 mln. The $6 mln. surplus has been credited to the revaluation surplus reserve within equity.


mln Equity - Revaluation Reserve B $6

mlnThis records the revaluation of the computer centre

It is sold for $30 mln. $2 mln. is shown as a gain in the income statement. The $6 mln. is transferred directly from the revaluation surplus to retained earnings, with no impact on the income statement.

I/B DR CRCash B $30 mln Property, plant & equipment B $28 mln Profit sale of computer centre I $2 mln This records the sale of the computer centreEquity - Revaluation Reserve B $6 mlnEquity - Retained earnings B $6 mln

This records the transfer from Equity - Revaluation Reserve to retained

earnings

Asset used – transfer part to retained earningsAs the asset is used some of the Equity - Revaluation Reserve may be transferred to retained earnings.

The amount transferred is the difference between depreciation on revalued carrying amount and depreciation on original cost.

Transfers from Equity - Revaluation Reserve to retained earnings are not made through income statement.

(Revaluations may generate deferred tax adjustments. These are explained in the IAS 12 Income Taxes workbook.)

EXAMPLE transfer part to retained earningsYour computer centre had a cost of $60 mln. It is being depreciated over 20 years. It has been revalued at $80 mln. The $20 mln. surplus has been credited to the Equity - Revaluation Reserve within equity.

I/B DR CRProperty, plant & equipment B $20 mln Equity - Revaluation Reserve B $20 mln This records the revaluation of the computer centre

Depreciation = 5%, and is now increased to $4 mln. per year.This is charged to the income statement each year.

I/B DR CRAccumulated depreciation B $4

mln Depreciation I $4

mln Annual depreciation charge

Each year, $1 mln. of the revaluation surplus (5%) can be transferred from the Equity - Revaluation Reserve directly to retained earnings, with no impact on the income statement. (Depreciation on revalued amount $4 mln. – depreciation on original valuation $3 mln.). This transfers $1 mln. of non-

distributable reserves to distributable reserves. This calculation ignores deferred tax.

I/B DR CREquity - Revaluation Reserve B $1

mln Retained earnings B $1

mln This records the annual transfer from

Equity - Revaluation Reserve to retained earnings

7. Depreciation

Depreciable amount and depreciation periodThe depreciable amount of an asset will be allocated on a systematic basis over its useful life.

EXAMPLE Immediate write-off of immaterial assets

IssueThe depreciable amount of an asset is allocated on a systematic basis over its useful life.

Can management expense an immaterial item of PPE even though its useful life exceeds one year?

Background

A bank acquires approximately 10,000 different assets each year, each of which has a useful life of more than one year. The total cost of 50% of the assets (by number) is less than 5% of the total value of acquisitions.

Management proposes that the assets that fall below a pre-determined value be expensed rather than capitalised and depreciated. Consequently the 50% of assets that have less than 5% of the total value of additions will not be capitalised.

SolutionManagement should only expense assets with a useful life of more than one year if the value of the assets, individually and collectively, is not material. Management should also consider the cumulative effect of non-capitalisation when assessing materiality. The longer the assets’ useful lives, the more likely that the cumulative effect will be material.

Assets with a value of less than 5% of total additions for the year and a short useful life are likely to be immaterial; however, professional judgement should be exercised in determining whether this reasonable.

Management should review the value of assets expensed each year to confirm that they continue to be immaterial. All IFRS requirements apply only to material items.

EXAMPLE Depreciation of property, plant and equipment carried at revalued amount (This example includes deferred tax.)

IssueThe depreciable amount of an item of property, plant and equipment should be allocated on a systematic basis over its useful life.

Does management need to depreciate property, plant and equipment carried at revalued amount, since the revalued amount reflects the fair value of the property, plant and equipment?

BackgroundA bank bought a cash-counting machine for 30,000 on 1 January 20X1. The cash-counting machine’s useful life is 10 years and it is estimated to have zero residual value.

The bank accounts for the machine at cost until 31 December 20X3, depreciating it at 3.000 per year.

At 31 December 20X3, the cash-counting machine was revalued at 36,000. The (deferred) tax rate for capital gains is 24%.

SolutionManagement should depreciate the cash-counting machine over its remaining useful life because the consumption of the computer is reflected through the depreciation charge.

IAS 16 permits some of the revaluation surplus to be transferred to retained earnings in each period; the amount of the surplus that may be transferred is the difference between depreciation based on the revalued carrying amount of the asset and depreciation based on its original cost.

The amount to be recognised as depreciation and the amount which may be transferred to retained earnings are as follows:

Asset purchased on 1.1.20x1 for 30.000 20X3 20X4 20X5

Life = 10 years As at 1 January Revaluation N.A 36 000 36 000 Cost 30 000 N.A N.A Accumulated Depreciation -6 000 0 -5 143 Carrying amount 24 000 36 000 30 857

Depreciation charge for the year -3 000 -5 143 -5 143 Impact of revaluation (difference of carrying amount and net book value) 15 000 N.A N.A

As at 31 December Revaluation 36 000 36 000 36 000 Accumulated Depreciation (eliminated at date of revaluation) 0 -5 143 -10 286 Carrying amount 36 000 30 857 25 714

Revaluation reserve account

As at 1 January N.A 11 400 9 771

Transfer to retain earnings N.A -1 629 -1 629(11.400 / 7

years)(9.771 / 6

years) Revaluation - 31 December 15 000 N.A N.A

Revaluation - deferred tax x 24% -3 600 N.A N.A

As at 31 December 11 400 9 771 8 143

At the end of the useful life (10 years) the asset will have been fully depreciated. The carrying amount of the asset will be zero.

The deferred tax liability of 3.600 will remain until the gain is recognised, subject to future valuation increases or decreases and changes in the tax rate, if any.

The bookkeeping for this example is as follows:

Bookkeeping in 20X1 and 20x2I/B DR CR

Property, plant & equipment B 30 000

Cash B 30 000

This records the purchase of the cash-counting machine

I/B DR CRDepreciation I 3 000Accumulated depreciation B 3 000

This records the 20X1 depreciation of the cash-counting machine



Bookkeeping in 20X3



I/B DR CRProperty, plant & equipment B 6 000Accumulated depreciation B 9 000Equity - Revaluation Reserve Account B 15

000This records the revaluation of the cash-counting machine and elimination of the accumulated depreciation on 31 December 20X3

I/B DR CREquity - Revaluation Reserve Account B 3 600Deferred tax liability B 3 600This records the setting up of the liability for deferred tax at 24% of the 15.000 gain on revaluation

Bookkeeping in 20X4



I/B DR CREquity - Revaluation Reserve Account B 1 629Equity – Retained Earnings B 1 629

This records the annual transfer from the revaluation reserve account to retained earnings

Bookkeeping in 20X5 (identical to that of 20X4)



I/B DR CREquity - Revaluation Reserve Account B 1 629Equity – Retained Earnings B 1 629This records the annual transfer from the revaluation reserve account to retained earnings

The residual value, and the useful life, of an asset will be reviewed at least at each financial year-end and, any changes will be accounted for as a change in an accounting estimate in accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors.

EXAMPLE review of assetsYour computers are being depreciated over 4 years. Each has a residual value of $2 mln.

Industry practice recommends 5 years of useful life, but reduces residual value to $0,8 mln.

Your management takes expert advice, and agrees to follow industry practice with regard to both the depreciation period, and the residual value.

These changes should be accounted for under IAS 8. (see workbook on IAS 8)

Depreciation is recorded, even if the fair value of the asset exceeds its carrying amount, as long as the asset’s residual value does not exceed its carrying amount.

EXAMPLE fair value > carrying amountThe carrying amount of your asset is $4 mln. The fair value is $5 mln. The asset will continue to be depreciated.(It may be revalued to fair value, if all assets in its class are revalued.)

EXAMPLE fair value = carrying amountThe carrying amount of your asset is $3 mln. The residual value is also $3 mln. No further depreciation will be charged.

Repair and maintenance of an asset do not negate the need to depreciate it.

EXAMPLE maintenanceYour branch computer network has a programme of upgrading and maintenance to sustain its value. Nevertheless, it must be depreciated.(The branches may be revalued to take account of value of the improvements, but only if they cause an increase in the fair value of the branches.)

Residual valueThe residual value is the net value of the asset at the end of its useful life. The initial residual value is determined at the start of the asset’s life using judgment.

An undertaking is required to measure the residual value of an item of property, plant and equipment as:

the amount it estimates it would receive currently for the asset if the asset were already of the age, and in the condition, expected at the end of its useful life.

The depreciable amount of an asset is determined after deducting its residual value.

EXAMPLE residual valueYour vehicle costs $20.000. You will sell it in 4 years time. The residual value is $8.000. The depreciable amount is $12.000 ($20.000-$8.000).The depreciation charge is $3.000 ($12.000/4) per year

I/B DR CRProperty, plant & equipment B 20.000Cash B 20.000This records the buy of the vehicleDepreciation I 3.000Accumulated depreciation B 3.000Annual depreciation

The residual value of an asset is often insignificant, and therefore immaterial in the calculation of the depreciable amount.

EXAMPLE Difference between useful life and economic life

Issue

Useful life is defined as either:

i) the period of time over which an asset is expected to be available for use by an undertaking; or

ii) the number of production units the undertaking expected to be produced by the asset.

What is the difference between an asset’s useful life and economic life?

BackgroundT’s management operates a branch. The fixtures and fittings in the branch have an economic life of ten years. The branch is located in a section of a leasehold building. The lease period is seven years and an extension of the lease appears unlikely.

SolutionThe useful life of the fixtures and fittings is seven years because T is unlikely to use them after the lease expires.

Useful life is the period over which management expects to use an asset. This is different from the asset’s economic life, which is the total period of time the asset is capable of providing economic benefits, whether to the bank or to a subsequent owner.

A useful life that is shorter than the economic life may, however, result in a higher residual value at the end of the asset’s useful life. The level of the residual value will affect the calculation of the depreciation charge.

The residual value of an asset may increase to an amount equal to, or greater than, the asset’s carrying amount.

If it does, the asset’s depreciation charge is zero until its residual value subsequently decreases to an amount below the asset’s carrying amount.

EXAMPLE increase in residual valueYour vehicle costs $20.000. You will sell it in 4 years time. The estimated residual value is $8.000. The depreciation charge is $3.000 per year.

At the end of year 3, the carrying amount is $11.000. The residual value has increased to $9.000, due to increases in the prices of secondhand (used) vehicles.

The depreciation charge for year 4 is reduced from $3.000 to $2.000, so the carrying value is the same as the residual value of $9.000.

No change is made to depreciation charged in previous years.I/B DR CR

Depreciation I 2.000Accumulated depreciation B 2.00

0Depreciation for year 4

Unless the residual value of an asset is guaranteed, the residual value will only be an estimate of the amount that the undertaking will receive when it disposes of the asset.

The higher the residual value, the lower will be the cost to the undertaking in depreciation charges. If the estimated residual value is too high, this will result in a loss on disposal and inflated profits in the periods before disposal.

Where PPE represents a material part of the asset structure, such as undertakings that lease PPE, the accuracy of residual values is the key to the accuracy of results.

Depreciation - start and end

Depreciation of an asset starts when the asset is available for use, That is when it is in the location and condition necessary for it to be capable of operating in the manner intended by management.

Depreciation of an asset ceases at the earlier of the date that:(1) the asset is classified as held for sale (or included in a

disposal group that is classified as held for sale) - see IFRS 5 and

(2) the date that the asset is derecognised (written out of the balance sheet) or is fully depreciated.

EXAMPLE When should depreciation of property, plant and equipment start?

IssueDepreciation of an asset begins when it is available for use. That is when the asset is in the location and condition necessary for it to be capable of operating in the manner intended by management. Depreciation of an asset ceases at the earlier of when the asset is classified as held for sale, or is when the asset is derecognised.

When should management start to charge depreciation on an asset?

BackgroundA bank has built an office for its own use. The construction was completed on 1 November 20X3, but the office was not used until 1 March 20X4.

Management uses the straight-line depreciation method for such equipment.

SolutionManagement should start to charge depreciation when the office is available for use. That is on 1 November 20X3.

Periods when the asset is available for use but before actual usage commences should not affect the annual depreciation charge if the straight-line method of depreciation is used.

Management should take into account the asset's expected usage when determining its useful life. Depreciation should be provided on a systematic basis over the asset's useful life.

Depreciation does not cease when the asset becomes idle, or is retired from active use, and held for disposal, unless the asset is fully-depreciated.

EXAMPLE Should depreciation cease when an item of PPE is temporarily idle?

IssueDepreciation of an asset begins when it is available for use. That is when the asset is in the location and condition necessary for it to be capable of operating in the manner intended by management.

Depreciation of an asset ceases at the earlier of when the asset is classified as held for sale, or is when the asset is derecognised.

Should management continue to provide depreciation when an item of PPE is idle?

BackgroundA bank owns a branch, which is shut down for six weeks during the year for restyling. The bank provides depreciation on the branch assets using the straight-line method.

SolutionManagement should continue to provide depreciation when the branch is idle because depreciation of an asset only ceases when the asset is classified as held for sale, or derecognised.

Shut-down periods should not affect the annual depreciation charge if the straight-line method of depreciation is used. Management should take into account the asset's expected usage and maintenance periods when determining its useful life.

However, a usage-based depreciation method (see Annex) for plant and machinery, for example unit-of-production, results in no depreciation during a shut-down period because no units would be produced.

EXAMPLE Calculation of depreciation for additions during the year


When should management start to provide depreciation in respect of assets acquired during the year?

BackgroundK has a financial year to 31 December. K acquired a computer

centre on 1 March 20X1 for 2 million. The computer centre has a useful life of 25 years.

Management proposes to charge a full year’s depreciation on assets acquired in the first half of the year. No depreciation will be charged on assets acquired in the second half of the year until the following year.

Management proposes to charge a full year’s depreciation charge in the year of disposal.

SolutionManagement should provide for depreciation from the date when an asset is ready for use until the date of disposal. The new policy it is proposing is not consistent with this requirement.

The depreciation charge for 20X1, calculated from the date on which the assets were ready for use and on management’s proposed basis, is illustrated below:

Depreciation from date of availability for use

Depreciation on management’s proposed basis

Difference

Computer centre (cost 2 million, 25 year life)

66,667 80,000 13,333 (20%)

The short-cut approach to the calculation of depreciation that management is proposing has resulted in a 20% overstatement of depreciation, compared with the more precise calculation based on the date from which the asset became available for use.

Asset Useful lifeFactors, such as technical, or commercial obsolescence, and wear and tear (even when the asset is idle), often reduce life.

Consequently, all of the following are considered in determining the useful life of an asset:1. expected usage of the asset.

2. expected physical wear and tear, which depends on operational factors, such as the number of hours for which the asset is to be used, the amount of repair and maintenance.

3. technical, or commercial obsolescence, arising from changes or improvements in production, or from a change in the market demand for the product, or service output, of the asset.

4. legal, or similar, limits on the use of the asset, such as safety limitations or the expiry dates of asset leases.

5. the asset management policy may involve the disposal of assets after a specified time. Therefore, the useful life of an asset may be shorter than its economic life.

The estimation of the useful life of the asset is a matter of judgement, based on the experience of the undertaking with similar assets.EXAMPLE useful lifeYour vehicle costs $20.000. You will sell it in 4 years time, or after 150.000 km., whichever is sooner. The residual value is estimated at $8.000. The vehicle will have an economic life longer than its useful life to the firm. This is reflected in the residual value.

The longer the life of an asset, the more years it will be depreciated, and the less each year’s depreciation charge will be for the same asset.

If the estimated life is too long, this will result in a loss on disposal and inflated profits in the periods before disposal.

Land and buildings

Land and buildings are separable assets, and are accounted for separately, even when they are acquired together.

Though there are some exceptions, such as quarries and sites used for landfill, land has an unlimited useful life and therefore is not depreciated.

Buildings have a limited useful life, and therefore are depreciable assets. An increase in the value of the land on which a building stands does not affect the determination of the depreciable amount of the building.

EXAMPLE land and buildingYou buy a building including the land. The price is split between the land $1 mln. and the building $0,2 mln. You depreciate the building over 20 years, at $10.000 per year. The land is not depreciated.4 years later, the land is revalued at $1.4. The building continues to be depreciated, despite the land’s revaluation surplus.

I/B DR CRProperty, plant & equipment (land) B $1 mln

Property, plant & equipment (building)

B $0,2 mln

Cash B $1,2 mln This records buying the propertyDepreciation I 10.000Accumulated depreciation B 10.000Annual depreciation of the building

Land costIf the cost of land includes the costs of site dismantlement, removal and restoration, the restoration cost portion of the land asset is depreciated over the period of benefits obtained by incurring those costs.

EXAMPLE non-depreciation of landYou buy a piece of land for a security complex. The price is $1 mln.

I/B DR CRProperty, plant & equipment (land) B $1

mlnCash B $1

mln This records the buying of the property

The preparation for the security complex costs $0.1 mln, and the restoration at the end of the project will cost $0.3 mln.

I/B DR CR

Property, plant & equipment (land) B $0,4 mln

Cash B $0,1 mln

Provision for restoration B $0,3 mln

This records the preparation and provision for restoration of the property

The calculation for the provision is covered in IAS 37 and will be the net present value of the liability.

The security complex will have an economic life of 20 years, after which the land will be redeveloped for other purposes. The preparation and restoration costs totaling $0,4 mln should be depreciated over the 20 year life of the security complex.

I/B DR CRDepreciation I 5.000Provision for restoration B 15.000Accumulated depreciation B 20.000Annual depreciation of the preparation and provision for restoration of the property

The $1 mln. cost of the land should not be depreciated, if its value is sustained over that period, and it will be worth $1 mln. at the end of the period, after restoration.

In some cases, the land itself may have a limited useful life, in which case it is depreciated in a manner that reflects the benefits to be derived from it.

If the land is leased, under a finance lease, its useful life is limited to that of the lease. (If there is a purchase option at the end of the

lease, the same approach will apply only if the purchase option will not be exercised).

EXAMPLES depreciation of landYou buy a piece of land for shredding and storing confidential documents. The cost price is $1 mln.The land will have an economic life of 10 years, after which the land will be reduced in value to $0,0 (nil) as the restoration costs will be equal to the value of the land.The $1mln. depreciable amount of the land should be written off over the 10 year life of the land.

I/B DR CRProperty, plant & equipment (land) B $1 mln Cash B $1 mln This records buying the propertyDepreciation I $0,1

mlnAccumulated depreciation B $0,1

mlnAnnual depreciation on $1 mln

EXAMPLES depreciation of leased land You lease some land for a building for a period of 15 years, with no option to buy it. The value of the lease is $450.000. The first year’s capital repayment is $10.000. The land will need to be depreciated over the 15-year period.

I/B DR CRProperty, plant & equipment (land) B 450.000Finance lease creditor - current B 10.000Finance lease creditor – non-current

B 440.000

This records the lease of the property

Depreciation I 30.000Accumulated depreciation B 30.000Annual depreciation (450.000/15)

Depreciation methodsThe depreciation method used will reflect the pattern in which the asset’s future benefits are likely to be consumed.

The depreciation method applied to an asset will be reviewed at least at each financial year-end and, any significant change in the expected pattern of its future benefits, will cause the method to be changed to reflect this.

Changes will be accounted for as a change in an accounting estimate, in accordance with IAS 8. No change is made to depreciation charged in previous years.

Changes in asset life are common, as these are estimated in advance of asset usage. Changes in depreciation methods are rare.

A variety of depreciation methods can be used, including the straight-line method, the diminishing balance method and the units of production method.

Straight line methodStraight-line depreciation results in a constant charge over the useful life.

EXAMPLE straight line depreciationYour vehicle costs $40.000. You will sell it in 4 years time. The estimated residual value is $16.000. The total amount of depreciation will be $24.000 ($40.000 - $16.000).The depreciation charge is $6.000 per year, or $500 per month.

I/B DR CRProperty, plant & equipment B 40.000Cash B 40.000This records the buy of the vehicleDepreciation I 6.000Accumulated depreciation B 6.000Annual depreciation straight line on (40.000-16.000) = 24.000/4=6.000

Diminishing balance methodThe diminishing balance method results in a decreasing charge over the useful life and loads the early years with a much higher charge.

EXAMPLE diminishing balance methodYou buy a machine for $10.000. It has high risk of technical obsolescence. You depreciate it at 50% as follows:Year 1 $5.000 (50% of 10.000)Year 2 $2.500 (50% of 5.000)Year 3 $1.250 (50% of 2.500)Year 4 $ 625 (50% of 1.250)

Units of production method (more detail and examples in the Annex)The units of production method results in a charge based on the expected use, or output.

The selected method will closely reflect the expected pattern of future benefits flow. The method is then applied consistently, unless there is a change in the expected benefit pattern.

8. Impairment and Derecognition

Impairment is presented in the income statement as:

Impairment losses or impairment gains if presenting the income statement by nature of expense, or an expense within the function if presenting the income statement by function.

Impairment gains represent reversals of impairment losses (see below).

Impairment is presented in the balance sheet as:

Accumulated impairment:

Beginning of 2XX9 Goodwill

Identifiable

assets

Total

Historical cost (or valuation)

1,000 2,000 3,000

Accumulated depreciation (2XX9)

0 (167) (167)

Carrying amount 1,000 1,833 2,833

Accumulated impairment

(1,000) (473) (1,473)

Carrying amount after impairment loss

0 1,360 1,360

Accumulated impairment is never a positive number.

IFRS 3 Business Combinations workbook explains how to account for an impairment relating to acquisitions.

To determine whether an asset is impaired, apply IAS 36 Impairment of Assets, which explains how to review the carrying amount, the recoverable amount and when to recognise, or reverse the recognition of, an impairment loss.

Compensation for impairment

Compensation from third parties (such as insurance organisations) for assets that were impaired, lost, or given up, will be included in the income statement, when the compensation becomes receivable. The compensation will be an offset to impairment losses previously recorded.

Separate Economic EventsThe following are separate economic events, and are accounted for separately:

(1) impairments of items of property, plant and equipment are recorded under IAS 36;

An impairment is a reduction in value of an asset that is still in use. The reduction may be caused by damage (to a car, for example). It may be due to new, cheaper technology having eroded the fair value of the firm’s current equipment.

(2) derecognition of items of property, plant and equipment retired, or disposed of, is determined under IAS 16; This is the action of eliminating an asset from the books, to reflect that it is no longer in use. Any gain, or loss, on disposal will be recorded at this time.

(3) compensation from third parties for assets that were impaired, lost, or given up, is included in determining the income statement when it becomes receivable; Compensation may

become payable from an insurance policy or if the state nationalises assets, either wholly or partly, in order to build a new road over the land on which the building stands, or to rebuild an area for government purposes.

(4) the cost of items of property, plant and equipment restored, bought, or constructed as replacements is determined under IAS 16.

Replacements should be treated as new assets. The old asset is eliminated from the books, and the new asset introduced as an addition.

Derecognition (Eliminated from the balance sheet -SFP)

The carrying amount of an asset will be derecognised:(1) on disposal; or

(2) when no future benefits are expected from its use or disposal.

The gain, or loss, arising from the derecognition of an asset will be included in the income statement when the asset is derecognised (unless IAS 17 requires otherwise e.g. on a sale and leaseback).

Gains will not be classified as revenue but will be shown as gains (or losses) on disposal of property, plant and equipment in the income statement.

However, an entity that, in the course of its ordinary activities, routinely sells items of property, plant and equipment that it has held for rental to others shall transfer such assets to inventories at their carrying amount when they cease to be rented and are held for sale.

The proceeds from the sale of such assets shall be recognised as revenue in accordance with IAS 18 Revenue. This would primarily apply to lessors.

EXAMPLE sale at a profitYour policy is to keep company vehicles for 4 years. You have bought a new vehicle for $30.000. $16.000 is the estimated residual value of the vehicle.

The depreciation amount was $30.000-$16.000= $14.000, and the annual depreciation charge is $14.000 / 4 years = $3.500.

At the end of the 4 years, you sell the vehicle for $18.000.You record a gain of $2.000 ($18.000-$16.000) in the income statement.

I/B DR CRCash B 18.000Property, plant & equipment B 30.000Accumulated depreciation B 14.000Gain on disposal of vehicle I 2.000Sale of vehicle for cash at a profit of 2.000

The disposal may occur in a variety of ways (for example: by sale, by entering into a finance lease, or by donation). In determining the date of disposal, an undertaking applies the criteria in IAS 18 Revenue for recording revenue from the sale of goods. IAS 17 Leasing applies to disposal by a sale and leaseback.

The gain, or loss, arising from derecognition is the difference between the net disposal proceeds and the carrying amount.

The consideration receivable on disposal is recorded initially at its fair value.

If payment for the item is deferred, the consideration received is recorded initially at the cash equivalent.

The difference between the nominal amount of the consideration and the cash equivalent is recorded as interest revenue under IAS 18, reflecting the effective yield on the receivable.

EXAMPLE fair value of disposalA vehicle that cost $30.000 is fully depreciated to its residual value of $16.000.

You offer to sell it for $18.000 cash, or for $19.000 payable in 1 year’s time.

You record a gain of $2.000 ($18.000-$16.000) in the income statement for either payment method.

I/B DR CRCash B 18.000Property, plant & equipment B 30.000Accumulated depreciation B 14.000Gain on disposal of vehicle I 2.000Sale of vehicle for cash

If the buyer pays $19.000 in 1 year’s time, the extra $1.000 will be treated as interest receivable.

I/B DR CRAccounts receivable B 19.000Accumulated depreciation B 14.000Property, plant & equipment B 30.000Gain on disposal of vehicle I 2.000Unexpired interest income B 1.000Sale of vehicleCash B 19.000

Accounts receivable B 19.000Unexpired interest income B 1.000Interest income I 1.000Cash receipt and recognition of interest

EXAMPLE Does property, plant and equipment carried at revalued amount need to be revalued at the date of disposal?

IssueThe gain or loss on derecognition of property, plant and equipment is included in the income statement when the item is derecognised. Gains are not classified as revenue.

The gain or loss is calculated as the difference between the net disposal proceeds, if any, and the asset’s carrying amount.

Should management revalue property, plant and equipment at the date of disposal before calculating the gain or loss on sale?

BackgroundManagement revalues a bank’s owner-occupied building at the end of each calendar year. As at 31 December 20X3, the revalued amount of the building is 20 million. The building was sold on 30 June 20X4 for 21.5 million. The carrying amount of the building on 30 June 20X4 was 19.9 million.

SolutionManagement does not have to revalue an asset at the date of disposal, provided revaluations are reasonably frequent. Any gain or loss arising in the period should therefore be recognised in the income statement.

However, a gain or loss arising on disposal of revalued PPE may indicate that the remainder of that class of assets should be

revalued in order to ensure that the carrying amount is not materially different from fair value.

9. Disclosure

GeneralThe financial statements will disclose, for each class of property, plant and equipment:(1) the measurement bases used for determining the gross

carrying amount;(2) the depreciation methods used;(3) the useful lives, or the depreciation rates used;(4) the gross carrying amount and the accumulated depreciation

(aggregated with accumulated impairment losses) at the beginning, and end, of the period; and

(5) a reconciliation of the carrying amount at the beginning and end of the period showing:(i) additions;(ii) disposals;(iii) acquisitions through business combinations;(iv) increases, or decreases, resulting from revaluations

and from impairment losses recognized, or reversed, directly in equity under IAS 36;

(v) impairment losses recorded in the income statement under IAS 36;

(vi) impairment losses reversed in the income statement under IAS 36;

(vii) depreciation;(viii) the net exchange differences arising on the translation

of the financial statements from the functional currency into a different presentation currency, including the translation of a foreign operation into the presentation currency of the reporting undertaking; and

(ix) other changes.

The financial statements will also disclose:(1) the existence and amounts of restrictions on title, and

property, plant and equipment pledged as security for liabilities;

(2) the amount of expenditures recorded in the carrying amount in the course of its construction;

(3) the amount of contractual commitments for the acquisition of property, plant and equipment; and

(4) if it is not disclosed separately on the face of the income statement, the amount of compensation from third parties for items that were impaired, lost or given up that is included in the income statement.

DepreciationSelection of the depreciation method and estimation of the useful life of assets are matters of judgement. Therefore, disclosure of the methods adopted, and the estimated useful lives, or depreciation rates, should be disclosed. Also, it is necessary to disclose:(1) depreciation, whether recorded in the income statement or as a

part of the cost of other assets, during a period; and(2) accumulated depreciation at the end of the period.

Accounting estimatesUnder IAS 8, an undertaking discloses the nature and effect of a change in an accounting estimate that has an effect in the current period, or will have an effect in subsequent periods. For property, plant and equipment, such disclosure may arise from changes in estimates with respect to:(1) residual values;(2) the estimated costs of dismantling, removing, or restoring

items;(3) useful lives; and(4) depreciation methods.

RevaluationIf items are stated at revalued amounts, the following will be disclosed:(1) the effective date of the revaluation;(2) whether an independent valuer was involved; (3) the methods, and significant assumptions, applied in

estimating the items’ fair values;(4) the extent to which the items’ fair values were determined

directly by reference to observable prices in an active market, or recent market transactions on arm’s length terms, or were estimated using other valuation techniques;

(5) for each revalued class of property, plant and equipment, the carrying amount that would have been recorded had the assets been carried under the cost model; and

(6) the revaluation surplus, indicating the change for the period, and any restrictions on the distribution of the balance to shareholders.

Under IAS 36, an undertaking discloses further information on impaired property, plant and equipment.Undertakings are encouraged to disclose the following information:(1) the carrying amount of temporarily idle property, plant and

equipment;(2) the gross carrying amount of any fully depreciated items still

in use;(3) the carrying amount of items retired from active use and held

for disposal; and(4) when the cost model is used, the fair value of property, plant

and equipment, when this is materially different from the carrying amount.

Sample Accounting Policy (taken from Illustrative consolidated financial statements 2006 – Banks)

Property, plant and equipment

Land and buildings comprise mainly branches and offices. All property, plant and equipment is stated at historical cost less depreciation. Historical cost includes expenditure that is directly attributable to the acquisition of the items.

Subsequent costs are included in the asset’s carrying amount or are recognised as a separate asset, as appropriate, only when it is probable that future economic benefits associated with the item will flow to the Group and the cost of the item can be measured reliably.

All other repairs and maintenance are charged to other operating expenses during the financial period in which they are incurred.

Land is not depreciated.

Depreciation of other assets is calculated using the straight-line method toallocate their cost to their residual values over their estimated useful lives, as follows:• Buildings 25-40 years,• Leasehold improvements 25 years, or over the period of the lease

if less than 25 years,• Equipment and motor vehicles 3-8 years.The assets’ residual values and useful lives are reviewed, and adjusted if appropriate, at each balance sheet date.

Assets that are subject to amortisation are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. An asset’s carrying

amount is written down immediately to its recoverable amount if the asset’s carrying amount is greater than its estimated recoverable amount.

The recoverable amount is the higher of the asset’s fair value less costs to sell and value in use.

Gains and losses on disposals are determined by comparing proceeds with carrying amount. These are included in other operating expenses in the income statement.

Sample Accounting Policy (taken from Illustrative Corporate Financial Statements 2007, PWC)

Property, plant and equipment Land and buildings comprise mainly factories, retail outlets and offices. Land and buildings are shown at fair value, based on periodic, but at least triennial, valuations by external independent valuers, less subsequent depreciation for buildings.

Any accumulated depreciation at the date of revaluation is eliminated against the gross carrying amount of the asset, and the net amount is restated to the revalued amount of the asset. All other property, plant and equipment is stated at historical cost less depreciation.

Historical cost includes expenditure that is directly attributable to the acquisition of the items. Cost may also include transfers from equity of any gains/losses on qualifying cash flow hedges of foreign currency purchases of property, plant and equipment.

(Management may choose to keep these gains/(losses) in equity until the acquired asset affects profit or loss. At this time, management should reclassify the gains/(losses) into profit or loss.) Subsequent costs are included in the asset’s carrying amount or recognised as a separate asset, as appropriate, only when it is probable that future economic benefits associated with the item will flow to the group and the cost of the item can be measured reliably. The carrying amount of the replaced part is derecognised. All other repairs and maintenance are charged to the income statement during the financial period in which they are incurred. Increases in the carrying amount arising on revaluation of land and buildings are credited to other reserves in shareholders’ equity. Decreases that offset previous increases of the same asset are charged against other reserves directly in equity; all other decreases are charged to the income statement. Each year the difference between depreciation based on the revalued carrying amount of the asset charged to the income statement and depreciation based on the asset’s original cost is transferred from ‘other reserves’ to ‘retained earnings’. Land is not depreciated. Depreciation on other assets is calculated using the straight-line method to allocate their cost or revalued amounts to their residual values over their estimated useful lives, as follows:

– Buildings 25-40 years– Machinery 10-15 years– Vehicles 3-5 years

– Furniture, fittings and equipment 3-8 years

The assets’ residual values and useful lives are reviewed, and adjusted if appropriate, at each balance sheet date.

An asset’s carrying amount is written down immediately to its recoverable amount if the asset’s carrying amount is greater than its estimated recoverable amount (note 2.7 see below). Gains and losses on disposals are determined by comparing the proceeds with the carrying amount and are recognised within ‘Other (losses)/gains – net’ in the income statement. When revalued assets are sold, the amounts included in other reserves are transferred to retained earnings.

Note 2.7 Impairment of non-financial assets Assets that have an indefinite useful life, for example goodwill, are not subject to amortisation and are tested annually for impairment. Assets that are subject to amortisation are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable.

An impairment loss is recognised for the amount by which the asset’s carrying amount exceeds its recoverable amount. The recoverable amount is the higher of an asset’s fair value less costs to sell and value in use.

For the purposes of assessing impairment, assets are grouped at the lowest levels for which there are separately identifiable cash flows (cash-generating units). Non-financial assets other than goodwill that suffered an impairment are reviewed for possible reversal of the impairment at each reporting date.

10. Annex – IAS 16 rules for users other than banks.

This annex provides examples of the application of IAS16 which are rarely found in banks (bridges, pipelines, aircraft and mines).

Recognition of Assets

EXAMPLE Undivided interest in pipeline

Issue Energy and utilities undertakings may take an ownership interest in shared assets such as a pipeline where the group of users is too wide for joint control to be practical. It also may result where the investor wishes to retain influence and access to information but not joint control.

How is such an investment accounted for if the investment is not in an undertaking but rather directly in the asset and the investor does not retain control nor joint control over that asset?

Background

X owns a 5% share in a pipeline that it uses together with the other investors in order to transport the minerals it produces. X does not have control or joint control over the pipeline. It is only obliged to compensate for its share of costs incurred to operate and maintain it and has the right to use 5% of the pipeline’s capacity.

X’s management proposes that the 5% share in the pipeline should be accounted for as property, plant and equipment (PPE) under IAS 16. Is this appropriate?

Solution

No. The 5% share in the pipeline is not an item of PPE to be accounted for under IAS 16 because X does not control the pipeline.

Rather this is an undivided interest that should be classified as a non-current investment and carried at cost less accumulated depreciation and accumulated impairment.

Repairs and maintenance costs

Some equipment may need regular major inspections for faults, regardless of whether parts of the item are replaced. E.g. aircraft, bridges, dams.

When each major inspection is performed, its cost is recorded in the carrying amount.

Any remaining carrying amount of the cost of the previous inspection (as distinct from physical parts) is written off.

EXAMPLE regular inspectionsYour aircraft has a carrying amount of $10 mln. The latest inspection cost $0,2 mln.The original inspection has a carrying amount of $0,1 mln. Add the cost of the new inspection, and remove the carrying amount of the old inspection:$10 + $0,2 - $0,1 = $10,1 mln.

I/B DR CRProperty, plant & equipment B $0,2 mlnCash B $0,2 mlnThis records the cost of the new inspectionDepreciation I $0,1 mlnProperty, plant & equipment B $0,1 mlnThis records the removal of the old inspection cost, now written off as depreciation

If there was no cost attributable to the initial major inspection, an estimate should be used.

Measurement at Recognition - Elements of cost

The cost comprises:(1) buying price, including import duties and non-refundable

taxes, after deducting trade discounts and rebates;

(2) 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.

(3) the initial estimate of the costs of dismantling, and removing the item, and restoring the site on which it is located.

IFRIC 1 (from IFRS News - February 2005)IFRIC 1 requires all changes of decommissioning liabilities arising from the change in the cash flows required to settle the obligation, or a change in the discount rate, to be accounted for prospectively.

Measurement – cost modelThe change in the obligation adjusts the carrying value of the related asset. If the decrease in liability exceeds the carrying amount of the asset, the excess is recognised immediately in profit and loss (ie, no negative asset balances).

If the adjustment increases the value of the asset, it may be an indication of impairment.

Measurement - revaluation modelA decrease in the obligation adjusts the revaluation surplus in equity. Any increase in the decommissioning obligation reduces the valuation surplus until it reaches zero. Any remaining increase in

the liability is recorded immediately in the income statement.

The interpretation also amends IFRS 1, allowing an exemption for first-time adopters from reconstructing all past changes in decommissioning liabilities. The liability can be calculated at the date of transition to IFRS, with the corresponding debit included as part of the cost of the asset.

Companies that also report under US GAAP will have a continuing difference. SFAS 143, Accounting for Asset Retirement Obligations, does not require the decommissioning obligation to reflect the changes in the discount rate. Reductions in the decommissioning liability are also treated differently.

EXAMPLE Recognition of decommissioning and site restoration expenses

IssueThe cost of an item of property, plant and equipment should include the initial estimate of the costs of dismantling and removing the asset and restoring the site on which it is located.

How should management recognise the estimated cost of dismantling and removing the asset and restoring the site?

BackgroundAn oil company has an obligation, at the date of installation, to decommission an oil rig at the end of its thirty-year life, in accordance with the local legislative requirements.

The decommissioning costs for the rig are estimated to be 140,000,000 with a net present value of 8,023,197, based on a discount rate of 10%.

Solution

Management should include 8,023,197, the net present value of the decommissioning cost, in the carrying amount of the oil rig at the time of its installation.

A provision for 8,023,197 is created because the obligating event is the installation of the oilrig.

The amount included in PPE will be depreciated with the rest of the cost of the oil rig in the usual way. The accretion of the discount after the initial recognition of the provision should be recognised as interest expense.

The double entry required for the recognition of the asset and the liability will be:

Dr PPE - plant and machinery 8,023,197Cr Provision - decommissioning 8,023,197

EXAMPLE Changes in discount rate and the unwinding of the discount

IssueChanges in the measurement of an existing decommissioning, restoration or similar liability that result from changes in the estimated timing or amount of the outflow of cash flows or other resources, or a change in the discount rate, adjust the carrying value of the related asset under the cost model.

Adjustments may not increase the carrying amount of an asset beyond its recoverable amount or reduce it to a negative value.

The periodic unwinding of the discount is recognised in profit or loss as a finance cost as it occurs. Capitalisation under IAS 23 is not permitted.

How should management account for the changes in discount rate and the unwinding of the discount?

Background

C has an oil rig measured under the cost model and a related decommissioning liability. The oil rig started operating on 1 January 20X0. The oil rig has a useful life of 40 years. Its initial cost was 120,000; this included an amount for decommissioning costs of 10,000. This represented 70,400 in estimated cash flows payable in 40 years, discounted at a risk-adjusted rate of 5 per cent.

The oil rig is 10 years old on 31 December 20X9. Accumulated depreciation is 30,000 (120,000 x 10/40 years). The decommissioning liability has grown from 10,000 to 16,300 as a result of the unwinding of the discount. The interest was recorded in the income statement as a finance cost.

The risk-adjusted rate changes to 7 per cent on 31 December 20X9. The net present value of the decommissioning liability has decreased by 8,000.

SolutionThe decommissioning liability is reduced from 16,300 to 8,300 as follows: Dr decommissioning liability 8,000 Cr cost of asset 8,000

The carrying amount of the asset is 82,000 (120,000 - 8,000 - 30,000).

This will be depreciated over the remaining 30 years of the asset’s life giving a depreciation expense for the next year of 2,733 (82,000 ÷ 30). The next year’s finance cost for the unwinding of the discount will be 581 (8,300 x 7 per cent).

An undertaking applies IAS 2 Inventories to the costs of obligations for dismantling, removing and restoring the site on which an item is located, having used the item to produce inventories during that period.

The obligations for costs accounted for in accordance with IAS 2 or IAS 16 are recorded and measured in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets.

Measurement of cost

The cost is the cash price equivalent at the recognition date. If payment is deferred beyond normal credit terms, the difference between the cash price equivalent and the total payment is recorded as interest over the period of credit, unless such interest is recorded as a borrowing cost in the carrying amount of the item, in accordance with IAS 23.

EXAMPLE cost measurementYou can pay $1mln cash for a building, or pay for it over 3 years for a total cost of $1,3 mln. Using either payment method, the cost will be $1mln. If the first payment option is used (see above), the $0,3 mln. will be treated as interest.

I/B DR CRProperty, plant & equipment B $1 mln.Accounts payable B $1 mln. Being the buying of the buildingInterest expense I $0,1 mln. Interest payable B $0,1 mln. Annual interest charge

EXAMPLE What should be the cost of the property, plant and equipment when the vendor provides extended credit?

IssueProperty, plant and equipment is initially measured at cost.

Cost is defined as the amount of cash and cash equivalents paid, or the fair value of the other consideration given, to acquire an asset at the time of its acquisition or construction.

When payment for an item of PPE is deferred beyond normal credit terms, its cost is the cash price equivalent; the difference between this amount and the total payments is recognised as interest expense over the period of credit, unless it is capitalised in accordance with IAS 23.

How should management determine the cash price equivalent in respect of an individually negotiated item of PPE?

Background

P manufactures computer chips and undertaking B constructs the machinery used to manufacture the chips. Each machine that B manufactures is built to the customer’s specifications. Due to the downturn in the chip market, P’s management negotiates extended payment terms for a new machine to be constructed by B.

P will pay B 25,000,000 18 months after delivery of the new equipment. Due to the individual nature of the equipment, there is no list price to determine the equivalent price under normal credit terms.

SolutionA’s management should record the asset when P receives it at the present value of the amount payable.

The present value should be determined by discounting the amount payable at a pre-tax rate that reflects current market assessments of the time value of money and the risks specific to the liability.

Assuming the relevant discount rate for P is 7%, the PPE and the price payable to B should be recorded at 22,587,301 (25,000,000 discounted at 7% for 1.5 years). The following double entry should be recorded:

Dr PPE - plant and machinery 22,587,301Cr Accounts payable - long term 22,587,301 The accretion of the discount on the liability should be charged to interest expense in the income statement from the date of receipt of the asset to the date of payment.

The cost of the asset of 22,587,301 will be depreciated to residual value over the asset’s useful life.

One, or more, items may be acquired in exchange for a non-monetary asset or assets, or a combination of monetary and non-monetary assets. This system of accounting would be used for barter transactions involving PPE.

The cost of such an item is measured at fair value unless: (1) the exchange transaction lacks commercial substance or

(2) the fair value of neither the asset received nor the asset given up is reliably measurable.

If the acquired item is not measured at fair value, its cost is measured at the carrying amount of the asset given up plus extra cash payment (or minus payment by another company, which gives your company an asset).

EXAMPLE asset exchangeYou exchange $1 mln. cash and an aircraft worth $4m for a building with a carrying value $4 mln, in the books of the other party. If the building cannot be measured at fair value, its cost should be taken to be $5 mln.

I/B DR CRProperty, plant & equipment (building)

B $5 mln.

Cash B $1 mln. Property, plant & equipment (aircraft)

B $4 mln.

This records the exchange of aircraft and cash for the building.

The cost held by a lessee under a finance lease is determined under IAS 17 Leases.

The carrying amount may be reduced by government grants, in accordance with IAS 20 Government Grants.

Revaluation in classes

EXAMPLE Assets of the same class should be revalued at the same time

IssueAll assets in the same class shall be revalued at the same time when an asset in that class is revalued. A class of property, plant and equipment is defined as a grouping of assets of a similar nature and use in an undertaking’s operations.

How should management determine the class of assets?

SolutionExamples of classes given in IAS 16are:

i) land;ii) land and buildings;iii) machinery;iv) ships;v) aircraft;vi) motor vehicles;vii) furniture and fixtures; andviii) office equipment.

Further analysis of such classes of assets into smaller classes is acceptable if this provides relevant and useful information to the user of the financial statements. A reporting undertaking might separately classify land it uses for agricultural purposes and land it uses for industrial purposes.

Full disclosure must be given for every class of asset presented.

Depreciation

Assets in PartsAn asset may be recorded in parts each of which is depreciated separately.

EXAMPLEAircraft: Airframe and engines of an aircraft are depreciated separately.

For depreciation, parts with the same life may be grouped.

EXAMPLE

If the airframe and engines of an aircraft have the same useful life, it may be appropriate to depreciate them grouped as one asset.

If a part is depreciated separately then the remaining parts must also be depreciated. Parts that are individually not significant may be aggregated before being depreciated.

EXAMPLEYour airline accounts for the airframe, engines, mechanics and seating as separate items. Other items are considered as the ‘remainder’ of the aircraft and are aggregated and depreciated over their useful lives.

The depreciation charge for a period is usually recorded in the income statement.

EXAMPLE Non-depreciation of assets subject to regular replacement


Can management avoid charging depreciation by expensing the acquisition costs of replacement assets instead?

BackgroundA group operates several hotels. The total carrying amount of hotel equipment such as bed linen, dishes etc, remains consistent from year to year.

Management replaces all linen and dishes etc, every few years to ensure that high standards are maintained. Management has

introduced a rolling replacement programme such that the cost of replacement assets remains at a consistent level from year to year.

Management is keen to reduce administration, and proposes that it no longer depreciates the hotel equipment but expenses the cost of replacements each year.

SolutionManagement should capitalise all assets with useful lives of more than one year and depreciate them over their useful lives.

Management could, for efficiency purposes, capitalise groups of similar assets, for example bed sheets bought for one hotel, as one asset. Management should then calculate depreciation for all the bed sheets for that particular hotel as if it they were one asset.

Management should not, however, follow the proposed policy of expensing all replacement assets purchased during the year and not providing depreciation on the asset capitalised.

Tough transition question of the month IAS 16 component approach - How far to go - IFRS News July 2004The component approach requires each element of a larger item of PPE with a cost significant to the total cost to be separately identified and depreciated (the ‘component requirement’). Once components have been identified and useful lives established, salvage values must be determined and depreciation methods chosen.

If some of the separate elements have similar useful lives, they can be grouped for depreciation purposes. There is no exemption in IFRS 1 for first-time adopters. Companies in many industries will be challenged by this requirement as they adopt IFRS - often for very different reasons.

The standard uses an aircraft as the example of an asset that needs to be componentised. This is an example that is intuitively understood and simple to account for. The aircraft body (air frame) and the engines are most often acquired from different manufacturers and have different maintenance requirements. The useful life of an aircraft engine is much shorter than the life of the airframe. Engines must be regularly replaced to meet air-worthiness criteria. The separate elements of cost at acquisition are apparent and can be used to allocate historical cost or fair value at the date of transition to IFRS.

The separate identification of the engines as a component enables them to be depreciated over their useful life. The cost is then depreciated to nil or salvage value at the date of replacement. The remaining cost of the component is derecognised and the replacement components’ cost capitalised when the new engines are installed.

Of course, real life for most preparers is not as straightforward as the accounting standards might imply. Management of a privatised utility, such as an urban water and sewage network, will have a much larger task on their hands.

Any retail distribution network for a ‘utility’, such as water, power or landline telecommunications, will present a similar set of challenges. Many will have been founded and owned by government - often for decades. The network will self-evidently provide service (put water in, turn the tap, get water out). The details of the system in between may literally be buried underground, with documentation of cost and elements lost in the mists of time. The record may be further muddied by the privatisation itself - with a lump sum fair value being assigned to network assets. The company might have little practice of distinguishing between maintenance and enhancements or replacements that need to be capitalised.

How can management practically apply the requirements of IAS

16 in these circumstances? A practical approach will involve the company’s engineers and operational personnel as well as accounting and finance staff. The elements of the system should be analysed - looking first at the major elements of the system, especially those that have high-value machinery associated with them. For example, a water company might identify the treatment facilities for sewage, major pumping stations, large aqueducts and reservoirs. Machinery scheduled for replacement or removal from service for refit is a good indicator of separate components. A company’s long-term capital budget can be a good source of data for this exercise.

Following this exercise, management might look to find similar groups of assets that can be combined for depreciation purposes. This might be groups of similar high-voltage lines in an electricity transmission grid or an extended gas pipeline network with pipes of similar dimensions and age.

Each identified component (asset or group of similar assets) is then assigned a depreciation method and an economic useful life, including consideration of technological obsolescence.

The search for components could be carried down to the level of the pipe fittings and fixtures. However, IAS 16 does not seem to require this level of detail for most companies. The cost benefit of finding and maintaining that level of detailed information may not make it a worthwhile exercise.

Management of most affected companies will find themselves between the two extremes of challenge. However, the requirements of the standard will bring most capital-intensive preparers within its scope. A few other examples of substantial fixed assets that will require component analysis are gas pipeline systems (compressors), steel mills (furnaces), ships (engines and refits), oil and chemical refineries (corrosive chemicals) and specialised factory buildings (clean rooms).

IFRS 1 will require a ‘project-type’ exercise for first-time adopters that have not been using components. Management also will need to ensure that the financial accounting and internal control systems properly account for newly acquired assets as well as tracking the depreciation of all identified components.

Assets producing other assetsSometimes asset are used to produce other assets. In this case, the depreciation charge constitutes part of the cost of the other asset, and is included in its carrying amount.

For example, the depreciation of manufacturing plant and equipment is included in the costs of conversion of inventories (see IAS 2).

EXAMPLEYou buy a product-testing machine for $100.000. You estimate that it will be able to test 20.000 units over its life. No residual value is anticipated. Every time a unit is tested, depreciate the machine by $5. This depreciation is debited to inventories. It is then transferred to cost of sales when the goods are sold.

I/B DR CRInventory – (Testing) depreciation B 5Accumulated depreciation B 5Unit depreciation on production testingCost of Sales I 2.500Inventory B 2.500Testing costs of 500 units sold. Transferred to cost of sales

EXAMPLE Capitalisation of depreciation charges

IssueThe depreciation charge for each period is recognised as an

expense unless it is included in the carrying amount of another asset.

When is it appropriate to capitalise depreciation?

BackgroundM manufactures car components for the automotive industry, and uses self-made tools in its production process, depending on the model of the car in which the component will be used. M’s customers, the car manufacturers, continually introduce new models or redesign existing models. M must therefore continually develop new tools for use in its production processes.

The costs of the tools developed are capitalised and depreciated over 3 years, the expected useful life of the tools.

M has one factory in which all of its production takes place. Management uses 10% of the factory for the development and construction of the tools. The building is depreciated using the straight-line method.

SolutionManagement should include 10% of the factory depreciation charge in the costs of the tools, which are capitalised and depreciated. The factory’s depreciation charge is part of the cost of producing the tools.

Similarly, depreciation of items used for development activities may be included in the cost of an intangible asset, recorded under IAS 38 Intangible Assets.

EXAMPLE How to choose an appropriate depreciation method?

IssueThe selection of the depreciation method used for an asset is based on the expected pattern of consumption of economic benefits while the asset is used.

The method is applied from period to period unless there is a change in the expected pattern of consumption of economic benefits from that asset.

Which factors determine the pattern of economic benefits consumed?

BackgroundB manufactures industrial chemicals. Management uses blending machines in the production process. The output of the blending machines is consistent from year to year and they can be used for different products.

However, maintenance costs increase from year to year, and a new generation of machines with significant improvements over existing machines is available every five years.

Management has questioned what method of depreciation should be used for the blending machines.

SolutionManagement should determine the depreciation method based on production output. The straight-line depreciation method should be adopted because the production output is consistent from year to year.

The economic benefit embodied in an item of property, plant and equipment is consumed principally by its use. Consequently, the

pattern of economic benefits consumed is principally determined by the output produced by using the asset.

Factors such as maintenance costs or technical obsolescence should be considered in determining the blending machines’ useful life.

Time method

EXAMPLE time methodAn air-conditioning machine costs $200.000. It is estimated to have a life of 5 years, with no residual value.You depreciate it at the rate of $40.000 per year.The factory is closed for 4 months for the installation of new machines. Depreciation of the air-conditioning machines continues through this period

I/B DR CRProperty, plant & equipment B 200.000Cash B 200.000This records the buy of the machineDepreciation I 40.000Accumulated depreciation B 40.000Annual depreciation irrespective of use.

Units of production methodHowever, if you are using the units of production method of depreciation, the depreciation charge can be zero, when there is no production.

EXAMPLE units of production methodYou buy a product-testing machine for $100.000 for a seasonal product. You estimate that it will be able to test 20.000 units over its life. No residual value is anticipated. Every time a unit is tested, depreciate the machine by $5. In the reporting period 3.200 units are tested,

I/B DR CRProperty, plant & equipment B 100.000Cash B 100.000This records buying of the machineDepreciation I 16.000Accumulated depreciation B 16.000Depreciation on 3.200 units

EXAMPLE units of production methodFor safety reasons the factory had a 4 month shutdown. No production took place, so no depreciation is charged.

Depreciation methods

Straight line methodStraight-line depreciation results in a constant charge over the useful life.

Diminishing balance methodThe diminishing balance method results in a decreasing charge over the useful life and loads the early years with a much higher charge.

Units of production methodThe units of production method results in a charge based on the expected use, or output.

EXAMPLE units of production methodYou buy a product-testing machine for $100.000 for a seasonal product. You estimate that it will be able to test 20.000 units over its life. No residual value is anticipated.

Every time a unit is tested, depreciate the machine by $5. So in a period where output is 1000 units, depreciation is $5.000.

I/B DR CRProperty, plant & equipment B 100.000Cash B 100.000This records the buy of the machineDepreciation I 5.000Accumulated depreciation B 5.000Depreciation on 1000 units

11. Multiple choice questions

1. Residual value is specifically:1. Scrap value.2. The net cash amount that you will receive from the

ultimate sale of the asset, at the end of its life3. The gross cash amount that you will receive from the

ultimate sale of the asset, at the end of its life.

2. Useful life of an asset refers to the life:1.Of the asset throughout its life, in the hands of any number

of owners.2. Of the asset whilst it is available for use in the firm.3. The average of 1 & 2.

3. Spare parts and servicing equipment are usually accounted for as:

1. Expenses written off to the income statement on purchase.2. Inventory.3. A separate class of fixed assets.

4. Major spare parts and stand-by equipment qualify as property, plant and equipment when:

1. They are expected to be used during more than one period.

2. The firm is in the oil industry.3. The parts cost more than 20% of the equipment they are

supporting.

5. Individually-insignificant items, such computer spare parts may be:

1. Ignored.2. Expensed on purchase.3. Aggregated as one asset.

6. Repairs and maintenance costs are normally:1. Capitalised.2. Expensed in the income statement as incurred.3. Recorded as deferred expenses.

7. If the costs of a major inspection (for example, aircraft) are capitalised:

1. They must be shown as a separate asset.2. Any remaining costs of a previous inspection must be

written off.3. The board of directors must be notified immediately.

8. If the costs of a major inspection (for example, aircraft) are capitalised, and there was no cost for the initial major inspection in the asset cost:

1. No cost should be deducted from the asset.

2. An estimate of the initial inspection cost should be made to be deducted from the carrying amount of the asset and to be replaced by the cost of the replacement part.

3. The cost of the new inspection must be expensed.

9. Elements of cost are:i. The purchase priceii. Any costs directly attributable to bringing the asset to the

location.iii. The initial estimate of the costs of dismantling, and

removing the item.iv. Overheads of the purchasing department relating to the

buy of the asset.1. i2. i-ii3. i-iii4. i-iv

10. Directly attributable costs include:i. staff costs of arising directly from the construction, or

acquisition, of the item of property, plant and equipment;

ii. site preparation costs;

iii. initial delivery and handling costs;iv. installation and assembly costs; andv. costs of testing whether the asset is functioning

properly, after deducting the net proceeds from any samples, or sundry income; and

vi. professional fees.vii. costs of opening a new facility;viii. costs of introducing a new product, or service (including

costs of advertising and promotional activities);ix. costs of running a business in a new location, or with a

new class of customer (including costs of staff training); and

x. administration and other general overhead costs.

1. i-vi2. i-vii3. v-x4. i-x

11. Recognition of costs (to be capitalised) ceases when:1.The accounting period ends.2.The item is in the location and capable of operating.3. Full production capacity has been reached.

12. The following costs (i) costs incurred while an item, capable of operating in the

manner intended by management, has yet to be brought into use, or is operated at less than full capacity;

(ii) initial operating losses, such as those incurred while demand for the item’s output builds up; and

(iii) costs of relocating, or reorganising part, or all, of an undertaking’s operations.

should be accounted for as:

1. Extraordinary items.2. (Capitalised as) fixed assets.3. Expenses.

13. Incidental income and expenses (such as using a site as a temporary car park) should be:

1.Capitalised into the asset.2.Taken to the income statement.3.Ignored.

14. Internal profits generated, when creating a self-constructed asset, should be:

1. Eliminated from the asset cost.2. Depreciated over the life of the asset.3. Included from the asset cost.

15. The cost of abnormal amounts of wasted material, labour, or other resources incurred in self-constructing an asset should be:

1.Capitalised.2.Expensed.3.Deferred.

16. If payment for a fixed asset is deferred beyond normal credit terms, any additional payment above the cash cost of the asset will be accounted for as:

1. Cost of fixed asset.2. Borrowing cost.3. Repairs and maintenance.

17. If one or more assets are exchanged for a new asset, the new asset is valued at:

1.Replacement cost.2.Fair value.

3.Residual value.

18. In the case of an exchange of assets, if the acquired asset cannot be valued:

1.The cost of the asset given up is used.2. The residual value is used.3. The asset cannot be capitalised.

19. An undertaking can choose either the cost model or the revaluation model, as its accounting policy. It must apply the chosen model to:

1. All fixed assets.2. An entire class of fixed assets.3. Major assets.

20. Using the cost model, the asset in accounted for at:1.Cost.2.Cost less accumulated depreciation.3. Cost less accumulated depreciation and any impairment

losses.

21. Using the revaluation model, can fair values be estimated, if there is no market-based evidence?

1. No.2. Yes, if the asset is specialized, and rarely sold, by using

an income, or a depreciated replacement cost approach.3. Yes, if the asset is specialized, and rarely sold, by using

indexation.

22. Revaluations are required:1. Annually.2. Every 3-5 years.3. When fair values change, or are expected to change.

23. When an item is revalued, any accumulated depreciation at the date of the revaluation is treated in which of the following ways:

(1) Restated proportionately, with the change in the gross carrying amount of the asset, so that the carrying amount of the asset after revaluation equals its revalued amount.

(2) Eliminated against the gross carrying amount of the asset and the net amount restated to the revalued amount of the asset.

(3) Either (1) or (2).

24. Examples of separate classes of fixed assets are:(i) land.(ii) land and buildings.(iii) machinery.(iv) ships.(v) aircraft.(vi) motor vehicles.(vii) furniture and fixtures. (viii) office equipment.(ix ) stationery

1. i-v2. i-viii

3. i-ix4. vi-ix25. A class of assets may be revalued on a rolling basis, provided:

1.The revaluation is completed in a short period, and the revaluations are kept up to date.2. Only one class of assets is involved.3. It is noted on the face of the balance sheet.

26. If an asset’s carrying amount is increased by revaluation, the increase is;

1. Shown as a gain in the income statement.2. Taken to revaluation surplus, via the income statement.3. Taken to revaluation surplus, directly, without being

recorded in the income statement.

27. If an asset’s carrying amount is decreased by revaluation and there is no revaluation reserve, the decrease should be:

1. Capitalised.2. Expensed.3. An extraordinary item.

28. Transfers of amounts between Equity - Revaluation Reserve and retained earnings are allowed:

1. Only on asset disposal.2. On asset disposal, and in each period, being the

difference between the depreciation charged on a revalued amount and the depreciation of the cost amount.

3. When retained earnings are negative.

29. Depreciation charges for a period are recorded:1. Only in the income statement.2. As an exceptional item.

3. In the income statement, or as part of the cost another asset (such as inventories).

30. Changes in the estimated useful life should:1. Be accounted for under IAS 8.2. Be expensed immediately.3. Be noted on the face of the balance sheet.

31. The carrying value of your asset is $10. Its fair value is $12 .Do you continue depreciation?

1. No.2. Yes, until the end of its useful life.3. Yes, but at half the previous rate.

32. The carrying value of your asset equals the residual value.Do you continue to depreciate it?1. No.2. Yes, until the end of its useful life.3. Yes, but at half the previous rate.

33. Regular repair and maintenance preserves the value of your hotel.

Do you continue to depreciate it?1. No.2. Yes, until the end of its useful life.3. Yes, but at half the previous rate.

34. Your asset has a residual value.Do you continue to depreciate it?1. No.2. Yes, until the end of its useful life, but deduct the amount

of the residual value from the amount to be depreciated.3. Yes, but at half the previous rate.

35. Depreciation can cease when an asset is idle.1.False.2.Only due to factory closure.3. Only under a units of production method.

36. In determining the useful life of an asset, consider:(i) Expected usage of the asset.(ii) Expected physical wear and tear.(iii) Technical, or commercial obsolescence.(iv) Legal, or similar, limits on the use of the asset.(v) Interest rates.

1. i-ii2. i-iii3. i-iv4. i-v

37. Land and buildings are separate assets, as:1.They can always be sold separately.2.Land usually has an unlimited life, but buildings do not.3.Buildings can be revalued, but land cannot.

38. You buy land and building. The land is revalued at double its cost.

Do you continue to depreciate the building?1. No.2. Yes, until the end of its useful life.3. Yes, but at half the previous rate.

39. If your land is leased under a finance lease, do you depreciate it?

1. No.2. Yes, until the end of the lease.3. Only if it has a building on it.

40. A variety of depreciation methods can be used. These methods include the straight-line method, the diminishing balance method and the units of production method. The choice of depreciation method is governed by:

1. Tax laws.2. The lowest cost option.3. The expected pattern of consumption of the asset.

41. Compensation from third parties for items impaired, lost or sequestrated should be recorded as income:

1. When the item is lost.2. When the compensation is receivable.3. When the cash is received.

42. The carrying amount will be derecognised (written out of the balance sheet):

(1) On disposal.(2) When no future benefits are expected from its use.(3) Either.

43. A gain on the sale of an asset should be recorded as:1. A capital gain in equity.2. A gain in the income statement.3. Revenue.

44. The gain, or loss, arising on the sale of an asset is:1.The cash proceeds.2. The net proceeds minus the carrying value of the asset. 3. The net proceeds minus the residual value of the asset.

12. Numerical Questions

1. The asset costs 80. Its life is 15 years. (Straight line) depreciation of 4 per year is charged. What is the residual value?

2. The asset costs 500.000. It will produce 25.000 units. What is the unit depreciation charge?

3. You give an aircraft worth 8, and cash of 3 for a building. What is the cost of the building, if the fair value cannot be measured?

4. Cash cost of the asset is 200. Payment for the same asset with 5 years’ credit = 275. What is the annual interest charge?

5. A building cost 7.000 and has been depreciated by 1.000, leaving a net book value of 6.000. It is revalued to $10.000.

This can be shown as one of two alternatives (please fill in the boxes):

One TwoValuationDepreciationNet book value

6. You buy a vehicle for 40. You depreciate it at 6 per year. You sell it after 5 years for 8. What is the profit, or loss, on disposal?

13.Answers to multiple choice questionsQuestion Answer1. 22. 23. 24. 1

5. 36. 27. 28. 29. 310. 111. 212. 313. 214. 115. 216. 217. 218. 119. 220. 321. 222. 323. 324. 225. 126. 327. 228. 229. 330. 131. 232. 133. 234. 235. 336. 337 238 2

39 240 341 242 343 244 2

14. Answers to numerical questions

1. 20. (80 – (15*4) = 20).

2. 20.(500.000/25.000=20)

3. 11 (8+3 = 11)

4. 15 ((275-200) / 5 years = 15)

5. One Two

Valuation 11.667

10.000

Depreciation

1.667 0

Net book value

10.000

10.000

6. Carrying value = 40 – (6*5) = net carrying amount of 10 Disposal proceeds = 8

Loss on disposal = 2

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