F INANCIAL A CCOUNTING T HEORY

Class Notes

P RE SE NTA TI O N A P P R OA C H
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IAS 16 Property, Plant and Equipment
1.0 Objective
The objective of IAS 16 is to prescribe the accounting treatment for property, plant, and equipment. The principal issues are the recognition of assets, the determination of their carrying amounts, and the depreciation charges and impairment losses to be recognised in relation to them.

2.0 Scope
IAS 16 does not apply to assets classified as held for sale in accordance with IFRS 5 exploration and evaluation assets (IFRS 6) biological assets related to agricultural activity (see IAS 41) or mineral rights and mineral reserves such as oil, natural gas and similar non-regenerative resources The standard does apply to property, plant, and equipment used to develop or maintain the last two categories of assets. [IAS 16.3]

3.0 Recognition
Items of property, plant, and equipment should be recognised as assets when it is: [IAS 16.7] it is probable that the future economic benefits associated with the asset will flow to the entity, and the cost of the asset can be measured reliably. This recognition principle is applied to all property, plant, and equipment costs at the time they are incurred. These costs include costs incurred initially to acquire or construct an item of property, plant and equipment and costs incurred subsequently to add to, replace part of, or service it. IAS 16 does not prescribe the unit of measure for recognition what constitutes an item of property, plant, and equipment. [IAS 16.9] Note, however, that if the cost model is used each part of an item of property, plant, and equipment with a cost that is significant in relation to the total cost of the item must be depreciated separately. [IAS 16.43] 3.1 Cost of Replacements and Inspections IAS 16 recognises that parts of some items of property, plant, and equipment may require replacement at regular intervals. The carrying amount of an item of property, plant, and equipment will include the cost of replacing the part of such an item when that cost is incurred if the recognition criteria (future benefits and measurement reliability) are met . The carrying amount of those parts that are replaced is derecognised in accordance with the derecognition provisions of IAS 16.67-72. [IAS 16.13] Also, continued operation of an item of property, plant, and equipment (for example, an aircraft) may require regular major inspections for faults regardless of whether parts of the item are replaced. When each major inspection is performed, its cost is recognised in the carrying amount of the item of property, plant, and equipment as a replacement if the recognition criteria are satisfied. If necessary, the estimated cost of a future similar inspection may be used as an indication of what the cost of the existing inspection component was when the item was acquired or constructed. [IAS 16.14]

4.0 Initial measurement

An item of property, plant and equipment should initially be recorded at cost. [IAS 16.15] Cost includes all costs necessary to bring the asset to working condition for its intended use. This would include not only its original purchase price but also costs of site preparation,

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delivery and handling, installation, related professional fees for architects and engineers, and the estimated cost of dismantling and removing the asset and restoring the site (see IAS 37 Provisions, Contingent Liabilities and Contingent Assets). [IAS 16.16-17]

If payment for an item of property, plant, and equipment is deferred, interest at a market rate must be recognised or imputed. [IAS 16.23] 4.1 Measurement in Exchanges If an asset is acquired in exchange for another asset (whether similar or dissimilar in nature), the cost will be measured at the fair value unless (a) the exchange transaction lacks commercial substance or (b) 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. [IAS 16.24]

5.0 Measurement subsequent to initial recognition

IAS 16 permits two accounting models: Cost model. The asset is carried at cost less accumulated depreciation and impairment. [IAS 16.30] Revaluation model. The asset is carried at a revalued amount, being its fair value at the date of revaluation less subsequent depreciation and impairment, provided that fair value can be measured reliably. [IAS 16.31] 5.1 The revaluation model Under the revaluation model, revaluations should be carried out regularly, so that the carrying amount of an asset does not differ materially from its fair value at the balance sheet date. [IAS 16.31] If an item is revalued, the entire class of assets to which that asset belongs should be revalued. [IAS 16.36] Revalued assets are depreciated in the same way as under the cost model. If a revaluation results in an increase in value, it should be credited to other comprehensive income and accumulated in equity under the heading "revaluation surplus" unless it represents the reversal of a revaluation decrease of the same asset previously recognised as an expense, in which case it should be recognised as income. [IAS 16.39] A decrease arising as a result of a revaluation should be recognised as an expense to the extent that it exceeds any amount previously credited to the revaluation surplus relating to the same asset. [IAS 16.40] When a revalued asset is disposed of, any revaluation surplus may be transferred directly to retained earnings, or it may be left in equity under the heading revaluation surplus. The transfer to retained earnings should not be made through the income statement (that is, no "recycling" through profit or loss). [IAS 16.41] 5.2 Depreciation (cost and revaluation models) For all depreciable assets: The depreciable amount (cost less residual value) should be allocated on a systematic basis over the asset's useful life [IAS 16.50]. The residual value and the useful life of an asset should be reviewed at least at each financial year-end and, if expectations differ from previous estimates, any change is accounted for prospectively as a change in estimate under IAS 8. [IAS 16.51] The depreciation method used should reflect the pattern in which the asset's economic benefits are consumed by the entity [IAS 16.60]; The depreciation method should be reviewed at least annually and, if the pattern of consumption of benefits has changed, the depreciation method should be changed prospectively as a change in estimate under IAS 8. [IAS 16.61] Depreciation should be charged to the income statement, unless it is included in the carrying amount of another asset [IAS 16.48]. Depreciation begins when the asset is available for use and continues until the asset is derecognised, even if it is idle. [IAS 16.55]

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5.3 Recoverability of the carrying amount

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IAS 36 requires impairment testing and, if necessary, recognition for property, plant, and equipment. An item of property, plant, or equipment shall not be carried at more than recoverable amount. Recoverable amount is the higher of an asset's fair value less costs to sell and its value in use. Any claim for compensation from third parties for impairment is included in profit or loss when the claim becomes receivable. [IAS 16.65]

6.0 Derecognition (retirements and disposals)

An asset should be removed from the balance sheet on disposal or when it is withdrawn from use and no future economic benefits are expected from its disposal. The gain or loss on disposal is the difference between the proceeds and the carrying amount and should be recognised in the income statement. [IAS 16.67-71] If an entity rents some assets and then ceases to rent them, the assets should be transferred to inventories at their carrying amounts as they become held for sale in the ordinary course of business. [IAS 16.68A]

7.0 Disclosures
For each class of property, plant, and equipment, disclose: [IAS 16.73] basis for measuring carrying amount depreciation method(s) used useful lives or depreciation rates gross carrying amount and accumulated depreciation and impairment losses reconciliation of the carrying amount at the beginning and the end of the period, showing: additions disposals acquisitions through business combinations revaluation increases or decreases impairment losses reversals of impairment losses depreciation net foreign exchange differences on translation other movements Also disclose: [IAS 16.74] restrictions on title expenditures to construct property, plant, and equipment during the period contractual commitments to acquire property, plant, and equipment compensation from third parties for items of property, plant, and equipment that were impaired, lost or given up that is included in profit or loss If property, plant, and equipment is stated at revalued amounts, certain additional disclosures are required: [IAS 16.77] the effective date of the revaluation whether an independent valuer was involved the methods and significant assumptions used in estimating fair values the extent to which 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 for each revalued class of property, the carrying amount that would have been recognised had the assets been carried under the cost model the revaluation surplus, including changes during the period and any restrictions on the distribution of the balance to shareholders

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Expanded Discussion
1.0 Characteristics of Property, Plant and Equipment 1. PPE are acquired for use in operations and not for resale. 2. They are long term in nature and subject to depreciation. 3. They possess physical substance. 2.0 Classification of PPE The following must be shown separately on the balance sheet (or footnotes) at original cost (historical cost):

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1. 2. 3. 4. 5.

Land (property) Buildings (plant) Equipment Maybe show machinery, tools, furniture and fixtures separately, if these categories are significant. Accumulated Depreciation Account (contra-asset) May be combined for two or more asset categories. PPE are Nonmonetary Assets a. A monetary asset (or liability) is fixed in currency regardless of changes in specific prices or changes in the general price level (e.g., cash, accounts and notes receivable, etc.). b. A nonmonetary asset (or liability) is not fixed in currency and instead fluctuates with changes in the price level (e.g., inventory, property, plant, equipment, etc.).

3.0 Valuation of PPE Under IFRS Under IFRS, PPE are initially recognized at the cost to acquire the asset. Subsequent to acquisition, PPE can be valued using the cost model or the revaluation model. 3.1. Cost Model Under the cost model, PPE are reported at historical cost adjusted for accumulated depreciation and impairment. Carrying value = Historical cost - Accumulated depreciation - Impairment 3.2. Revaluation Model Under the revaluation model, a class of PPE is revalued to fair value and then reported at fair value less subsequent accumulated depreciation and impairment. Revaluations must be made frequently enough to ensure that carrying amount does not differ materially from fair value at the end of the reporting period. When fair value differs materially from carrying value, a further revaluation is required. Carrying value = Fair value at revaluation date - Subsequent accumulated depreciation - Subsequent impairment Revaluation must be applied to all items in a class of PPE, not to individual PPE. Land and buildings, machinery, furniture and fixtures, and office equipment are examples of fixed asset classes. When PPE are reported at fair value, the historical cost equivalent (cost - accumulated depreciation - Impairment) must be disclosed. Income Effects of Revaluation 1. Revaluation Losses When PPE are revalued, revaluation losses (fair value < carrying value before revaluation) are reported on the income statement. 2. Revaluation Gains Revaluation gains (fair value> carrying value before revaluation) are reported in other comprehensive income and accumulated in equity as revaluation surplus. 3. Impairment If revalued PPE subsequently become impaired, the impairment is recorded by first reducing any revaluation surplus to zero with further impairment losses reported on the income statement Illustrative Exercise (adapted) On December 31, Year 1, an entity chose to revalue all of its fixed assets under IFRS. On that date, the fixed assets had the following carrying values and fair values: Carrving Value Fair Value Land 10,500,000 11,100,000 Buildings 6,400,000 6,000,000 Equipment 3,300,000 3,600,000

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Compute the revaluation gain and loss to be reported on the December 31, Year 1 financial statements. 4.0 Measurement 4.1 Land When land has been purchased for the purpose of constructing a building, all costs incurred up to excavation for the new building are considered land costs. All the following expenditures are included. Land cost includes: 1. Purchase price

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2. 3. 4. 5. 6. 7. 8. 9. 10.

Brokers' commissions Title and recording fees Legal fees Draining of swamps Clearing of brush and trees Site development (e.g., grading of mountain tops to make a "pad") Existing obligations assumed by buyer, including mortgages and back taxes Costs of razing (tearing down) an old building (demolition) Less: Proceeds from sale of existing buildings, standing timber, etc.

4.2 Land Improvements Land Improvements (are depreciable), such as: 1. Fences 2. Water systems 3. Sidewalks 4. Paving 5. Landscaping 6. Lighting 4.3 Buildings Costs of buildings include: 1. Purchase price, etc. 2. All repair charges neglected by the previous owner ("deferred maintenance") 3. Alterations and improvements 4. Architect's fees 5. Possible addition of construction period interest When preparing the land for the construction of a building: Land cost - filling in a hole or leveling Building cost - digging a hole for the foundation 4.4 Equipment Equipment is office equipment, machinery, furniture, fixtures, and factory equipment. All expenditures related directly to their acquisition or construction. 1. Invoice price 2. Less cash discounts and other discounts (if any) 3. Add freight-in (and insurance while in transit and while in construction) 4. Add installation charges (including testing and preparation for use) 5. Add sales and federal excise taxes 6. Possible addition of construction period interest (see section IX) 4.5 Capitalization of Subsequent Costs Proper accounting is determined based upon the purpose of the disbursement. 1. 2. Additions Additions increase the quantity of fixed assets Improvements and Replacements Improvements (betterments) improve the quality of fixed assets and are capitalized to the fixed asset account. A better asset is substituted for the old one (e.g., a tile or steel roof is substituted for an old asphalt roof). In a replacement, a new similar asset is substituted for the old asset (e.g., an asphalt shingle roof Is replaced with a new roof of similar material). a. If the carrying value of the old asset is known, remove it and recognize any gain or loss. Capitalize the cost of the improvement/replacement to the asset account. b. If the carrying value of the old asset is unknown, and: (1) The asset's life is extended, debit accumulated depreciation for the cost of the improvement / replacement. (2) The usefulness (utility) of the asset is increased; capitalize the cost of the Improvement/replacement to the asset account Repairs a. Ordinary repairs should be expensed as repair and maintenance.

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3.

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b.

Extraordinary repairs should be capitalized. Treat the repair as an addition, improvement, or replacement as appropriate.

Summary of Accounting Treatment for Subsequent Costs Type of Subsequent Cost Additions (increase quantity) Improvement / Replacement Extend life Increase usefulness Ordinary Repair Extraordinary Repair Extend life Increase usefulness Accounting Treatment Capitalize

Debit to Accumulated Depreciation Capitalize Expense Debit to Accumulated Depreciation Capitalize

4.6 Interest / Borrowing Costs Interest costs during construction period should be added to cost of land improvement based on weighted average of accumulated expenditures (refer to Borrowing Costs). 4.7 "Basket Purchase" of Land and Building Allocate the purchase price based on the ratio of appraised values of individual items. 4.8 Construction of PPE Costs Include: 1. Direct materials and direct labor. 2. Repairs and maintenance expenses that add value to the fixed asset. 3. Overhead, including direct items of overhead (any "idle plant capacity" expense). Include construction period interest (refer to Borrowing Costs) * Do not include profit

DEPRECIATION
The basic principle of matching revenue and expenses is applied to long-lived assets that are not held for sale in the ordinary course of business. The systematic and rational allocation used to achieve "matching" is usually accomplished by depreciation, amortization, or depletion, according to the type of long-lived asset involved. 1.0 Types of Depreciation 1. Physical Depreciation This type of depreciation is related to an asset's deterioration and wear over a period of time. Functional Depreciation Functional depreciation arises from obsolescence or inadequacy of the asset to perform efficiently. Obsolescence may result from diminished demand for the product that the depreciable asset produces or from the availability of a new depreciable asset that can perform the same function for substantially less cost.

2.

2.0 Terms Residual Value Salvage or residual value is an estimate of the amount that will be realized at the end of the useful life of a depreciable asset. Frequently, depreciable assets have little or no residual value at the end of their estimated useful life and, if immaterial, the amount(s) may be ignored in calculating depreciation. Estimated Useful Life Estimated useful life is the period of time over which an asset's cost will be depreciated. It may be revised at any time but any revision must be accounted for prospectively, in current and future periods only (change in estimate) 3.0 Depreciation Method The goal of a depreciation method should be to provide for a reasonable, consistent matching of revenue and expense by systematically allocating the cost of the depreciable asset over its estimated useful life.

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The actual accumulation of depreciation in the books is accomplished by using a contra account, such as accumulated depreciation or allowance for depreciation. The amount subject to depreciation is the difference between the cost and residual or salvage value and is called the depreciable base. Under IFRS, the depreciation method used should reflect the expected pattern of fixed asset consumption. Additionally, under IFRS, estimated useful life, salvage value, and the depreciation method used should be reviewed for appropriateness at each balance sheet date. 3.1 Component Depreciation IFRS require component depreciation when depreciating complex depreciable assets composed of several parts with different estimated useful lives. Separate significant components of a fixed asset with different lives should be recorded and depreciated separately. The carrying amount of parts or components that are replaced should be derecognized. Illustrative Example On January 1, Year 1, an entity that uses IFRS acquired a machine with a cost of 250,000 and an estimated life of 20 years. The cost of the machine included the cost of a cylinder that must be replaced every 5 years for 20,000 and an inspection cost of 5,000. The machine must be re-inspected every 10 years at an additional cost of 5,000 per inspection. Compute for the annual depreciation.

4.0 Basic Depreciation Formulas 4.1 Straight-line The straight-line depreciation is the most basic depreciation method which assumes that the cost of a PPE is allocated over its useful life equally. Straight-line depreciation is determined by the formula:

Where: Estimated useful life is usually stated in periods of time, such as years or months Advantages a. Simple to compute. b. Applies to virtually all assets. c. Consistent from year to year. d. Wide acceptability. e. Similar to treatment of prepaid items. Disadvantages a. Does not reflect difference in usage of asset from year to year. b. Does not accurately match costs with revenue. 4.2 Sum-of-the-Years-Digits (SYD) The sum-of-the-years'-digits method is one of the accelerated methods of depreciation that provides higher depreciation expense in the early years and lower charges in the later years.

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To find the sum-of-the-years'-digits (SYD), each year is progressively numbered and then added. The SYD may also be computed as follows: ( Where: N = Estimated Useful Life )

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The sum-of-the-years'-digits becomes the denominator. The numerator is the remaining life of the asset at the beginning of the current year. For example, the first year's depreciation for a five-year life would be 5/15 of the depreciable base of the asset. 4.3 Declining Balance The most common of these accelerated methods is the double-declining-balance method, although other alternative (less than double) methods are acceptable. Under double-declining balance, the first year's depreciation rate is double the straight-line rate. In succeeding years, the same percentage is applied to the remaining book value. Double-declining balance depreciation is calculated using the following formula: ( Where: N = Estimated Useful Life Residual Value No allowance is made for residual value because the method always leaves a remaining balance, which is treated as residual value. However, the asset should not be depreciated below the estimated residual value. The only methods that ignore residual value in the annual calculation of depreciation are the declining-balance methods. Residual value is only used as the limitation on total depreciation Advantages of Accelerated Depreciation Methods a. Matches costs to revenues since greater utility is reflected in greater depreciation during earlier years. b. As the amount of depreciation decreases, repairs and maintenance charges increase thereby tending to balance out one another. Disadvantages of Accelerated Depreciation Methods a. Does not reflect changes in the activity of the asset. b. Computation can be complex. c. Greater disparity in amount of depreciation between earlier years and later years. d. Possibility that with decreasing depreciation and increasing repairs and maintenance, income is artificially smoothed over the years. 4.4 Units-of-Production (productive output) The units-of-production method relates depreciation to the estimated production capability of an asset and is expressed in a rate per unit or hour. The formula is: )

( Advantages a. Matches costs with revenues. b. Reflects activity of the enterprise.

Disadvantages a. If no activity, no depreciation expensed; however, in reality, ali assets depreciate. b. Cannot be used for all assets (e.g., buildings). c. Can be complex because it requires clerical work and records.

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