1. Slide 17.1 Chapter 17 Property, Plant and Equipment (PPE)

2. Slide 17.2 The main purpose of this chapter is to explain how to determine the initial carrying value of PPE and to explain and account for the normal movements in PPE that occur during an accounting period. Main purpose

3. Slide 17.3 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. Objectives

4. Slide 17.4 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.

5. Slide 17.5 Four accounting standards that relate to PPE What is PPE (IAS 16)? How is the cost of PPE determined (IAS 16 and IAS 23)? How is depreciation of PPE computed (IAS 16)? What are the regulations regarding carrying PPE at revalued amounts (IAS 16)? What is impairment and how does this affect the carrying value of PPE (IAS 36)? What are the key changes proposed by the IASB concerning the disposal of non-current assets (IFRS 5)?

6. Slide 17.6 IAS 16 defines tangible assets PPE – also known as fixed assets or non-current assets – have a physical nature Held by an enterprise for use –In production –For rental –For administration Expected to be used for more than one period –Consider materiality – low value items

7. Slide 17.7 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 service potential 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 service potential they provide. they possess physical substance – that is, they have a physical form that can be seen and touched.

8. Slide 17.8 Determining costs Initial recognition and measurement of non-current assets The initial recognition and measurement of a newly acquired non-current asset is its historical cost – the amount of cash or cash equivalents paid, or the fair value of the consideration given, at the time of acquisition or construction. (NZ IAS 16 para 15) Includes costs directly incurred in bringing the asset to its location and working condition necessary to prepare the asset for its intended use (NZ IAS 16, para 16) These costs include:

9. Slide 17.9 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  Si te 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).

10. Slide 17.10 Determining costs future economic benefits are recognised immediately. Consumption of these benefits over the economic life of the asset are recognised by way of periodic depreciation charges in the Income Statement.

11. Slide 17.11 Capitalisation of borrowing costs for self-constructed assets IAS 23 treatment  Qualifying asset – time criterion  Funds borrowed specifically – use actual rate  Funds borrowed generally – use weighted average  Capitalisation ceases when asset substantially prepared for its intended use or sale.  (We will not consider these costs)

12. Slide 17.12 Capitalisation of borrowing costs Should interest and finance costs of borrowing money to make or purchase an asset, be added to the recorded cost of that asset ? Yes, but only if BOTH of the following apply:  the asset takes a substantially long time to make or to get ready for its use or sale, and  the interest and finance costs ONLY OCCUR because the company purchased (or made) that asset The interest and finance costs that should be added to the cost of the asset, should ONLY be those costs that would NOT have occurred if the asset had NOT been purchased or made.

13. Slide 17.13 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.

14. Slide 17.14 Depreciation Systematic allocation of the cost of the asset  Funds already expended  Matching concept  Going concern concept ignores net realisable value Depreciable amount – the original cost Useful economic life – the time over which the asset is expected to provide value to the company

15. Slide 17.15 Useful economic life – IAS 16 definition Period of time in use Number of production units expected from an asset Freehold land – infinite life

16. Slide 17.16 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.

17. Slide 17.17 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

18. Slide 17.18 Depreciation Straight line method Under this method, the same amount of depreciation is expensed in each accounting period. Appropriate where time is the principal factor in establishing the asset’s useful life and it is expected that the future economic benefits will flow evenly.

19. Slide 17.19 Depreciation Example: Cost of asset $100,000 Estimated useful life 5 years Estimated residual value $10,000 Productive life in hours 8,000

20. Slide 17.20 Depreciation Diminishing value (DV) methods Calculated as a percentage of the 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 then taper off with age.

21. Slide 17.21 Depreciation Example: Using the same figures as above, and a DV rate of 39.6%:

22. Slide 17.22 Depreciation If the asset is sold for $12,000, what is the gain or loss? Gain of $2,000 – a recovery of over-charged depreciation, and is taxable. Another example: Assume that the asset worth $100,000 initially is a 9-seater minibus. Inland Revenue assumes a useful life of 5 years and a rate of 31.2%, which would produce the figures in this table:

23. Slide 17.23 Depreciation

24. Slide 17.24 Depreciation If this asset is also sold for $12,000, what is the gain or loss? Loss $3,415. This is, in effect, under- charged depreciation, so can be claimed for tax purposes.

25. Slide 17.25 Choice of depreciation method impacts on reported profit Figure 17.1 Effect of different depreciation methods

26. Slide 17.26 Depreciation Sum-of-years digits method This method is similar to the diminishing value method in that the depreciation charge is higher in the early years and tapers off with age. 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.

27. Slide 17.27 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

28. Slide 17.28 Depreciation For our $100,000 depreciable value example, depreciation is

29. Slide 17.29 Depreciation The depreciable amount is: 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

30. Slide 17.30 Depreciation – sum of the units method Figure 17.2 Sum of the units method Add the number periods – in this case, 5, thus 1+2+3+4+5 = 15. In year 1, depreciate 5/15, in year 2, 4/15 and so on, - or use the formula: n(n + 1)/2

31. Slide 17.31 Depreciation – annuity method Figure 17.3 Annuity method 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

32. Slide 17.32 Comparison of methods Year S/L D/V S/U Ann 1 2,0004,180 3,333 1,638 2 2,0002,592 2,667 1,802 3 2,0001,606 2,000 1,982 4 2,000 996 1,333 2,180 5 2,000 618 667 2,398 Total10,0009,99210,00010,000

33. Slide 17.33 Depreciation Annual review of useful life and depreciation method Each year, an entity is required to review the useful life and depreciation methods currently in force for each depreciable asset (NZIAS 16 paras 51 & 61) If any method is not appropriate, it is to be altered for the current and future accounting periods. The change is accounted for as a change in accounting estimate, and the depreciation charge for the current and future periods shall be adjusted.

34. Slide 17.34 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 equally risky investment.

35. Slide 17.35 IAS 36 approach Single asset or Cash Generating Unit  Judgemental  Beware concealing poor performance by grouping Carrying amount = depreciated HC or depreciated Revalued amount Impaired if Carrying > Recoverable amount Calculate a revised Carrying amount. The

36. Slide 17.36 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.

37. Slide 17.37 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:

38. Slide 17.38 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.

39. Slide 17.39 Impairment Decide whether it is necessary to carry out an impairment test. The indicative 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

40. Slide 17.40 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 Therefore, an impairment test is required.

41. Slide 17.41 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

42. Slide 17.42 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:

43. Slide 17.43 Impairment

44. Slide 17.44 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.

45. Slide 17.45 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

46. Slide 17.46 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 CGU  Then, CGU’s other assets on pro-rata basis  No asset reduced below net selling price, value in use or zero.

47. Slide 17.47 Example of the allocation of an impairment loss (p.452) Recoverable amount is £150,000 of a cash generating unit with the following assets: £ Goodwill70,000 Intangible assets10,000 PPE100,000 Inventory40,000 Receivables30,000 250,000

48. Slide 17.48 The review estimates for the example that The PPE includes a property with a carrying amount of £60,000 and a market value of £75,000 The net realisable value of the inventory is greater than its carrying values None of the receivables are considered doubtful.

49. Slide 17.49 Table to show the allocation of the impairment loss £££ Goodwill70,000(70,000)Nil Intangible assets10,000(6,000)4,000 PPE100,000(24,000)76,000 Inventory40,000Nil40,000 Receivables30,000Nil30,000 250,000(100,000)150,000 Pre- impairmentImpairmentPost-impairment

50. Slide 17.50 Notes to table The impairment loss is first allocated against goodwill. After this has been done £30,000 (£100,000 − £70,000) remains to be allocated No impairment loss can be allocated to the property, inventory or receivables because these assets have a recoverable amount that is higher than their carrying value The remaining impairment loss is allocated pro- rata to the intangible assets (carrying amount £10,000) and the plant (carrying amount £40,000 [£100,000 − £60,000]).

51. Slide 17.51 Illustration: value in use calculation (pp.453/4) (£)(£) £££ £

52. Slide 17.52 Illustration – revised carrying amount Carrying amount as at 31 December 20X3114,500 Net realisable value 70,000 Value in use100,565 Revised carrying amount100,565 £

53. Slide 17.53 Published accounts – British Sky example Tangible fixed assets – British Sky Broadcasting Group plc

54. Slide 17.54 Published accounts – British Sky example (Continued) Tangible fixed assets – British Sky Broadcasting Group plc For Equipment, F&F, 2010 net carrying figure is 1040 – 568 = 472

55. Slide 17.55 Asset must be available for immediate sale in its present condition The sale must be highly probable. IFRS 5 non-current assets held for sale

56. Slide 17.56 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.

57. Slide 17.57 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.

58. Slide 17.58 Discussion (Continued) What are the arguments in favour of the diminishing balance method? Why is it thought that the annuity method is theoretically more attractive? Explain why IAS 23 benchmark treatment is the preferred treatment.

59. Slide 17.59 Review questions 1.Define PPE and explain how materiality affects the concept of PPE. 2.Define depreciation. Explain what assets need not be depreciated and list the main methods of calculating depreciation. 3.What is meant by the phrases ‘useful life’ and ‘residual value’? 4.Define ‘cost’ in connection with PPE. 5.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.