Chapter 17

Objectives By the end of this chapter, you should be able to: explain the meaning of PPE and determine its initial carrying value; account for subsequent expenditure on PPE that has already been recognised; explain the meaning of depreciation and compute the depreciation charge for a period;

account for PPE measured under the revaluation model; explain the meaning of impairment. compute and account for an impairment loss; explain the criteria that must be satisfied before an asset is classified as held for sale and account for such assets; explain the impact of alternative methods of accounting for PPE on key accounting ratios.

IAS 16 defines tangible assets PPE – also known as fixed assets or non-current assets – have a physical nature Expected to be used for more than one period as they provide future economic benefits that flow to the entity Held by a business For use in production For rental For administration

Characteristics of PPE they are acquired for use in the operations of the business – they are not for sale. they possess physical substance – that is, they have a physical form that can be seen and touched. they are long-term in nature and normally subject to depreciation. they are not for sale. If they are not used in the normal business operations, they should not be classified as property, plant and equipment. they are long-term in nature and normally subject to depreciation. These assets represent a bundle of future economic benefits that will be received by the company over the lives of the assets. The investment (cost) in these assets is allocated, through depreciation charges, to the years of economic benefits they provide

Determining costs The initial cost is recognized and measured as incurred it is its historical cost Purchase price + Import duties + Taxes – Discounts Costs making it ready to use Site preparation Delivery costs Installation costs Professional fees Dismantling and restoring site – or old items. Includes costs incurred in getting the asset to its place of use and making it ready for its intended use (IAS 37) Provisions, contingent liabilities and contingent assets).

Subsequent expenditure Normally expensed usually repairs and maintenance Capitalised if excess future economic benefits will flow – eg. Extending useful life and/or Capacity upgrade to improve quality Adopting new production processes to significantly reduce costs. (IAS 37) Provisions, contingent liabilities and contingent assets).

It is not a means of providing funds to replace the asset. Depreciation is the allocation of the cost of the asset over its useful life. It is not a means of providing funds to replace the asset. Generally, the replacement (new) asset will have a different cost and often will not be identical to the old asset. (IAS 37) Provisions, contingent liabilities and contingent assets).

Recognised as an expense in each period How much? Cost Less Residual Value Method – How ? Straight line Diminishing balance Units of production How long? (IAS 37) Provisions, contingent liabilities and contingent assets). Period – How long? Useful economic life – the time over which the asset is expected to provide value to the company e.g. technical obsolescence Useful life and residual value must be reviewed at least at the end of each financial year. Recognised as an expense in each period All methods are based either on the passage of time or of use (or activity). The method chosen should reflect the expected pattern of consumption of the economic benefits. It should be applied consistently from period to period.

Same amount is expensed in each accounting period. Straight line Appropriate where time is the main factor in establishing the asset’s useful life and it is expected that the future economic benefits will flow evenly. Same amount is expensed in each accounting period. (IAS 37) Provisions, contingent liabilities and contingent assets). Period – How long? Useful economic life – the time over which the asset is expected to provide value to the company e.g. technical obsolescence All methods are based either on the passage of time or of use (or activity). The method chosen should reflect the expected pattern of consumption of the economic benefits. It should be applied consistently from period to period.

Cost – residual value 100,000 – 10,000 Useful life 5 Example: Cost of asset $100,000 Estimated useful life 5 years Estimated residual (salvage)value $10,000 Productive life in hours 8,000 Depreciable value Cost – residual value Useful life 100,000 – 10,000 5 Depreciation = 18,000

Diminishing value (DV) methods A percentage (%) of each year’s opening book value. The depreciation charge is higher (or accelerated) in the early years and reduces during the life of the asset. When is it appropriate to use this method? Where assets are expected to produce greater economic benefits at the start of their lives, and these get smaller as the asset ages.

Depreciation Using the same figures as above, and a DV rate of 36.9%:

Units of Production depreciation is charged according to the actual usage of the asset. Higher depreciation is charged when their is higher activity and less is charged when there is low level of operation. Zero depreciation is charged when the asset is idle for the whole period. This method is similar to straight-line method except that life of the asset is estimated in terms of number of operations or number of machine hours etc. Such a method is useful where a company has many fixed assets with varying usage.

Units of Production Depreciation = Number of Units Produced × (Cost − Salvage Value) Life in Number of Units Example 1  A coal mine was purchased by X Corporation for $16 million. It was estimated that the mine has capacity to produce 200,000 tons of coal. The company extracted 46,000 tons during its first year of operation. Calculate the depreciation. Solution: Depreciation = (46,000/200,000) × $16 million = $3.68 million

Units of Production Depreciation = Number of Units Produced × (Cost − Salvage Value) Life in Number of Units Example 2:  A plant costing $110 million was purchased on April 1, 2010. The salvage value was estimated to be $10 million. The expected production was 150 million units. The plant produced 15 million units for the year ended December 31, 2011. Calculate the depreciation on the plant for the year ended December 31, 2011. Solution: Depreciation = (15/150) × ($110 million - $10 million) = $10 million

IAS 36 Value in use PV of future cash flows Discounted at rate for an equally risky investment.

Impairment causes or indicators External indicators a fall in the market value of the asset material adverse changes in regulatory environment material adverse changes in markets material long-term increases in market rates of return used for discounting Internal indicators material changes in operations major reorganisation loss of key personnel loss or net cash outflow from operating activities if this is expected to continue or is a continuation of a loss-making situation.

Impairment example At 01/01/X1, Tutuwai Cheeses Ltd (TCL) has plant and machinery with an expected economic life of 10 years. However, because of technological advances, the plant and machinery is expected to become obsolete on 31/12/X5. At 31/12/X1, the plant and machinery has a carrying value of $450,000, and the future net cash flows expected from use of the plant and machinery are:

Impairment There are seven steps that need to be taken in determining whether this plant and machinery needs to written down from its carrying value of $450,000. 1 Decide whether it is necessary to carry out an impairment test. 2 Determine the net selling price of the item. 3 Determine the future net cash flows expected from the item. 4 Establish the discount rate. 5 Calculate the value-in-use of the item. 6 Determine the recoverable amount of the item. 7 Determine whether the item needs to be written down.

Impairment Decide whether it is necessary to carry out an impairment test. The factors that need to be considered are: 1 Has the fair value fallen faster than would be expected due to normal wear and tear? – No 2 Has the entity suffered, or is expected to suffer, adverse economic impacts? – No 3 Have market interest rates, or other market rates of return, increased during the term and are these increases likely to affect the discount rate? - No

Impairment 4 Is the carrying amount of the net assets of the entity more than its market capitalisation? – No 5 Is there evidence of obsolescence or physical damage to the asset? – Yes, obsolescence 6 Has the economic usage of the asset changed, or is there expected to be significant change due to factors such as restructuring? No 7 Is there internal evidence suggesting the asset’s economic performance is or will be below expectations? – Yes

Impairment If the answer to any of these questions is “Yes” an impairment test is needed. The answers to Questions 5 and 7 are “Yes” Therefore, an impairment test is required.

Impairment Determine the net selling price of the item. Net selling price is defined as the fair value at a particular date less the costs of disposal that could reasonably be anticipated at that date. Net selling price is given as $150,000. Determine the future net cash flows expected from the item. These are given in the example.

Impairment Establish the discount rate. IAS 36 states that the present value of the future net cash flows is needed. Therefore, a discount rate must be determined. This can be a difficult exercise. However, for this example it is given as 14%. Calculate the value-in-use of the item. Value-in-use is the present value of the future net cash flows. The calculation is:

Impairment

Impairment Determine the recoverable amount of the item. The recoverable amount is the greater of net selling price and value-in-use As the value-in-use (the present value of the future net cash flows) is $183,303 and this is greater than the net selling price of $150,000, the recoverable amount is $183,303. If the net selling price had been greater than the value-in-use, it would be preferable for TCL to sell the asset.

Impairment Determine whether the item needs to be written down. As the recoverable amount ($183,303) is less than the carrying value ($450,000), and the item has not been revalued, the plant and machinery must be written down to its recoverable amount. The loss in value is recognised in the Income Statement. The journal entry is: Loss on plant and machinery $266,697 Plant and machinery $266,697 Being loss on plant and machinery due to impairment

Accounting treatment of impairment losses Asset not previously revalued – income statement Asset previously revalued – revaluation surplus Allocation of impairment losses First, reduce any goodwill in cash generating unit (CGU) Then, CGU’s other assets on pro-rata basis No asset reduced below the higher of net selling price, value in use, or zero.

IFRS 5 non-current assets held for sale Asset must be available for immediate sale in its present condition The sale must be highly probable.

IFRS 5 criteria for sale to be highly probable Appropriate level of management committed to the plan to sell • Active programme to locate a buyer initiated • Asset must be actively marketed for sale at a price that is reasonable in relation to current fair value • Sale expected to be completed within 1 year unless circumstances beyond seller’s control • Unlikely to be significant changes to the plan to sell.

References Elliott, Barry, Elliott Jamie, Financial Accounting and Reporting 15th Edition chapter 17