1. Property, Plant and Equipment (PPE)
Chapter 17
Property, Plant and Equipment (PPE)

2. 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.

3. Objectives (Continued)
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.

4. IAS 16 defines tangible assets
PPE – also known as fixed assets or non-current assets – have a physical nature
Held by a business for use
In production
For rental
For administration
Expected to be used for more than one period
Consider materiality
– low value items

5. Charateristics of PPE The major characteristics of these assets are:
they are acquired for use in the operations of the business – 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.
they possess physical substance – that is, they have a physical form that can be seen and touched.

6. Determining costs
Initial recognition and measurement of non-current assets
The initial recognition and measurement is its historical cost. (NZ IAS 16 para 15)
Includes costs directly incurred in getting the asset to its place of use and making it ready for its intended use (NZ IAS 16, para 16)

7. How is cost determined
Includes all the costs needed to make the asset ready for use:
Purchase price
Import duties
Directly attributable costs bringing to working condition (making it ready to use).
Site preparation
Delivery costs
Installation costs
Professional fees
Dismantling and restoring site – a provision, as costs are often only an estimate (IAS 37 Provisions, contingent liabilities and contingent assets).

8. Determining costs
future economic benefits are recognised immediately (the capital cost).
Consumption of these benefits over the economic life of the asset are recognised by way of periodic depreciation charges in the Income Statement.

9. 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.

10. Depreciation Systematic allocation of the cost of the asset
Funds already spent
Matching concept
Going concern concept ignores net realisable value
Depreciable amount – the original cost (see slide 7 above)
Useful economic life – the time over which the asset is expected to provide value to the company

11. Useful economic life – how determined
Economic life differs from working life – eg computers
Consider factors such as:
Repair costs
Availability of replacement parts
Comparative cash flows of alternative assets
Lower life to compensate for inflation to advance the depreciation charge
Technological obsolescence.

12. Depreciation Methods of depreciation
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, and
It should be recognised as an expense in each period

13. Depreciation Straight line method
Under this method, the same amount of depreciation is expensed in each accounting period.
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.

14. Depreciation Example: Cost of asset $100,000
Estimated useful life years
Estimated residual value $10,000
Productive life in hours ,000

15. Depreciation Diminishing value (DV) methods
Calculated as 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.

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

17. Depreciation
If the asset is sold for $12,000, what is the gain or loss?
Gain of $2,000 – this is a recovery of over-charged depreciation, and is taxable.
Another example:
Assume that the asset worth $100,000 initially is a small passenger bus. Inland Revenue assumes a useful life of 5 years and a rate of 31.2%, which would produce the following figures:

18. Depreciation

19. Depreciation
If this asset is also sold for $12,000, what is the gain or loss?
Loss $3,415. This, in effect, is under-charged depreciation, so can be claimed for tax purposes.

20. Choice of depreciation method impacts on reported profit
Figure Effect of different depreciation methods – textbook example p.444 (p.310)

21. Depreciation Sum-of-years digits (SYD) method
This method is similar to the diminishing value method in that the depreciation charge is higher in the early years and gets smaller as the asset ages.
The depreciation charge is based on a decreasing fraction of the depreciable amount.
Each fraction uses the sum of the years of useful life as the denominator, and the number of years of estimated useful life remaining as the numerator. Eg for a 5 year life, the denominator is = 15, and the numerator in year 1 is 5, in year 2 it is 4. So, year 1 fraction is 5/15, year 2 fraction is 4/15 and so on.

22. Depreciation The formula for calculating the fraction is:
The formula for calculating the fraction denominator is:
n(n + 1)/2,
where n = the number of periods for which depreciation is to be charged. Eg., if the depreciable life is 5 years, the denominator is:
5(5 + 1)/2 = 15

23. Depreciation
For our $100,000 example, the depreciable value is $90,000 and depreciation is
Note: The depreciation charge is calculated on the original depreciable value each year.

24. Depreciation The depreciable amount is: 100,000 – 10,000 = 90,000
100,000 – 10,000 = 90,000
Year 1 depreciation is:
5/15 x 90,000 = 30,000
Year 2 depreciation is:
4/15 x 90,000 = 24,000

25. Depreciation – sum of the units method
Figure Sum of the units method – textbook example p.444 (p.311)
Add the number of periods – in this case, 5, thus = 15. In year 1, depreciate 5/15, in year 2, 4/15 and so on, - or use the formula: n(n + 1)/2

26. Depreciation – annuity method
Figure Annuity method – textbook example p.445 (p.311)
To calculate the annual payment, $10,000 is divided by the 10% present value annuity factor for 5 years, i.e 10,000/3.791 = $2,638

27. Comparison of methods - textbook example p.444/445 (p.310/311)
Year S/L D/V S/U Ann
1 2,000 4, , ,638
2 2,000 2, , ,802
3 2,000 1, , ,982
4 2, , ,180
5 2, ,398
Total 10,000 9,992 10,000 10,000

28. IAS 36 impairment of assets
Impairment occurs when the carrying value of an asset exceeds its recoverable amount.
Report at no more than recoverable amount
Higher of net selling price and value in use
Net selling price
Disposal value less direct selling costs
Value in use
PV of future cash flows
Discounted at rate for an equally risky investment.

29. Indications of impairment
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.

30. 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:

31. 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.

32. Impairment
Decide whether it is necessary to carry out an impairment test.
The factors that need to be considered, listed in NZ IAS 36, paragraph 12, 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

33. 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?
7 Is there internal evidence suggesting the asset’s economic performance is or will be below expectations? – Yes

34. 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.

35. Impairment Determine the net selling price of the item.
Net selling price is defined in NZ IAS 36 as the fair value at a particular date less the costs of disposal (para 6) 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

36. Impairment Establish the discount rate.
Paragraph 6 of NZ 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:

37. Impairment

38. Impairment Determine the recoverable amount of the item.
The recoverable amount is the greater of net selling price and value-in-use (NZ IAS 36, para 6).
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.

39. 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

40. 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.

41. 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.

42. 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.

43. Discussion Explain the effect of revaluation on ratios
Explain three factors that could lead to revision of estimate of useful economic life
Explain why depreciation policies may make intercompany comparison of ROCE and EPS misleading.
What are the arguments in favour of the diminishing balance method?

44. Review questions
Define PPE and explain how materiality affects the concept of PPE.
Define depreciation. Explain what assets need not be depreciated and list the main methods of calculating depreciation.
What is meant by the phrases ‘useful life’ and ‘residual value’?
Define ‘cost’ in connection with PPE.
What effect does revaluing assets have on gearing (or leverage)?
8.‘Depreciation should mean that a company has sufficient resources to replace assets at the end of their economic lives.’ Discuss.