This post prescribes rules regarding the recognition, measurement, and disclosures relating to property, plant, and equipment (often referred to as fixed assets) that would enable users of financial statements to understand the extent of an entity’s investment in such assets and the movements therein [adapted from IAS 16].
IAS 16 principal issues involved relate to the recognition of items of property, plant, and equipment, determining their costs, and assessing the depreciation and impairment losses that need to be recognized. The requirements of IAS 16 are applied to accounting for all property, plant, and equipment unless another Standard permits otherwise, except:
- Property, plant, and equipment classified as held for sale in accordance with IFRS 5
- Biological assets relating to agricultural activity under IAS 41
- Mineral rights, mineral reserves, and similar non-regenerative resources
Recognition Of An Asset
An item of property, plant, and equipment should be recognized as an asset if and only if it is probable that future economic benefits associated with the asset will flow to the entity and the cost of the item can be measured reliably.
Any expenditure incurred that meets these recognition criteria must be accounted for as an asset. The Standard makes reference to individually insignificant items that can be aggregated. However, very often, in practice, entities adopt an accounting policy to expense items that are below a predetermined de-minimis level in order to avoid undue cost in maintaining the relevant records, which includes tracking the whereabouts of the asset. The definition and recognition criteria can also be applied to spare parts, although these are often carried as inventory and expensed as and when utilized. However, major spare parts are usually recognized as property, plant, and equipment.
For many years the issue of replacement of part of an asset (“subsequent costs”), often involving significant expenditure, was a difficult matter to address; merely adding the cost of the replacement part to the cost of the original asset posed certain logical flaws vis-à-vis the preexisting, and the replaced, part. This was particularly the case when the replaced part was not separately identified in the overall cost of the original asset. This problem also existed for major inspection costs, such as those for ships and aircraft, which were usually required to retain sea- or airworthiness.
The matter was further exacerbated by an additional recognition criterion that subsequent costs should add to the utility or useful life of the asset; in some circumstances, this criterion resulted in day-to-day repairs being capitalized. This issue was partly addressed by an interpretation of the Standing Interpretations Committee (SIC) that permitted adding major overhaul or inspection costs to the original asset if an amount representing the major overhaul or inspection component of the original cost of the asset was separately identified on initial recognition and was separately depreciated, and thereby could be written out of the asset records.
The current standard applies the two basic recognition criteria referred to above to all expenditures (and dispenses with the increased utility or increased useful life criteria). If the two basic criteria are satisfied, then the cost should be recognized as an asset. If the cost of the replaced asset was not separately identifiable, then the cost of the replacement can be used as an indication of the cost of the replaced item, which should be removed from the asset record.
Recognition Case Example [Subsequent Costs]
Lie Dharma Truckers Inc. has acquired a heavy Lie Dharma transporter at a cost of $100,000 (with no breakdown of the component parts). The estimated useful life is 10 years. At the end of the sixth year, the power train requires replacement, as further maintenance is uneconomical due to the off-Lie Dharma time required. The remainder of the vehicle is perfectly Lie Dharma worthy and is expected to last for the next four years. The cost of a new power train is $45,000.
The question is: Can the cost of the new power train be recognized as an asset, and, if so, what treatment should be used?
The new power train will produce economic benefits to Lie Dharma Truckers Inc., and the cost is measurable. Hence the item should be recognized as an asset. The original invoice for the transporter did not specify the cost of the power train; however, the cost of the replacement—$45,000—can be used as an indication (usually by discounting) of the likely cost, six years previously. If an appropriate discount rate is 5% per annum, $45,000 discounted back six years amounts to $33,500 [$45,000 / (1.05)]6, which would be written out of the asset records. The cost of the new power train, $45,000, would be added to the asset record, resulting in a new asset cost of $111,500 [$100,000 – $33,500 + $45,000].
Measurement at Recognition
An item of property, plant, and equipment that satisfies the recognition criteria should be recognized initially at its cost. IAS 16 specifies that cost comprises:
- Purchase price, including import duties, nonrefundable purchase taxes, less trade discounts and rebates.
- Costs directly attributable to bringing the asset to the location and condition necessary for it to be used in a manner intended by the entity.
- Initial estimates of dismantling, removing, and site restoration if the entity has an obligation that it incurs on acquisition of the asset or as a result of using the asset other than to produce inventories.
Examples of directly attributable costs include:
- Employee benefits of those involved in the construction or acquisition of an asset
- Cost of site preparation
- Initial delivery and handling costs
- Installation and assembly costs
- Costs of testing, less the net proceeds from the sale of any product arising from test production
- Borrowing costs to the extent permitted by IAS 23, Borrowing Costs
- Professional fees
Examples of costs that are not directly attributable costs and therefore must be expensed in the income statement include:
- Costs of opening a new facility (often referred to as preoperative expenses)
- Costs of introducing a new product or service
- Advertising and promotional costs
- Costs of conducting business in a new location or with a new class of customer
- Training costs
- Administration and other general overheads
- Costs incurred while an asset, capable of being used as intended, is yet to be brought into use, is left idle, or is operating at below full capacity
- Initial operating losses
- Costs of relocating or reorganizing part or all of an entity’s operations
Case Example [Directly Attributable Costs]
Dharma Putra Inc. is installing a new plant at its production facility. It has incurred these costs:
1. Cost of the plant (cost per supplier’s invoice plus taxes) = $2,500,000
2. Initial delivery and handling costs = $200,000
3. Cost of site preparation = $600,000
4. Consultants used for advice on the acquisition of the plant = $700,000
5. Interest charges paid to supplier of plant for deferred credit = $200,000
6. Estimated dismantling costs to be incurred after 7 years = $300,000
7. Operating losses before commercial production = $400,000
The question is: Which costs of Dharma Putra Inc. can be capitalized in accordance with IAS 16?
According to IAS 16, these costs can be capitalized:
1. Cost of the plant $2,500,000
2. Initial delivery and handling costs 200,000
3. Cost of site preparation 600,000
4. Consultant’s fees 700,000
5. Estimated dismantling costs
to be incurred after 7 years 300,000
Total Cost Capitalized $4,300,000
Interest charges paid on “deferred credit terms” (see discussion under the “Measurement of Cost” section) to the supplier of the plant (not a qualifying asset) of $200,000 and operating losses before commercial production amounting to $400,000 are not regarded as directly attributable costs and thus cannot be capitalized. They should be written off to the income statement in the period they are incurred.
Measurement of Cost
The cost of an asset is measured at the cash price equivalent at the date of acquisition. If payment is “deferred” beyond normal credit terms, then the difference between the cash price and the total price is recognized as a finance cost and treated accordingly.
If an asset is acquired in exchange for another asset, then the acquired asset is measured at its fair value unless the exchange lacks commercial substance or the fair value cannot be reliably measured, in which case the acquired asset should be measured at the carrying amount of the asset given up, where carrying amount is equal to cost less accumulated depreciation and impairment losses. For impairment losses, reference should be made to IAS 36. In this context, any compensation received for impairment or loss of an asset shall be included in the income statement.
Measurement After Recognition
After initial recognition of an item of property, plant, and equipment, the asset should be measured using either the cost model or the revaluation model. Once selected, the policy shall apply to an entire class of property, plant, and equipment. This means that an entity cannot “cherrypick” those assets to measure at cost or at revaluation, which would result in like assets having different measurement bases.
The cost model requires an asset, after initial recognition, to be carried at cost less accumulated depreciation and impairment losses. The revaluation model requires as asset, after initial recognition, to be measured at a revalued amount, which is its fair value less subsequent depreciation and impairment losses. In this case, fair value must be reliably measurable. Revaluations must be made with sufficient regularity to ensure that the carrying amount is not materially different from fair value. However, if an asset is revalued, then the entire class of asset must be revalued, again to avoid “cherry-picking” and a mixture of valuation bases.
When an asset is revalued, any increase in carrying amount should be credited to a revaluation reserve in equity. Any reduction in value arising from a revaluation should first be debited to any revaluation surplus in equity relating to the same asset and then charged off to the income statement.
The revaluation reserve may be released to retained earnings in one of two ways:
- When the asset is disposed of or otherwise derecognized, the surplus can be transferred to retained earnings.
- The difference between the depreciation charged on the revalued amount and that based on cost can be transferred from the revaluation reserve to retained earnings. Under no circumstances can the revaluation surplus be credited back to the income statement.
Example of Treatment of Revaluation
Putra Assets Inc. has an item of plant with an initial cost of $100,000. At the date of revaluation, accumulated depreciation amounted to $55,000. The fair value of the asset, by reference to transactions in similar assets, is assessed to be $65,000. The entries to be passed would be:
[Debit]. Accumulated depreciation = $55,000
[Credit]. Asset cost = $55,000
Being elimination of accumulated depreciation against the cost of the asset:
[Debit]. Asset cost = $20,000
[Credit]. Revaluation reserve = $20,000
Being uplift of net asset value to fair value. The net result is that the asset has a carrying amount of $65,000: $100,000 – $55,000 + $20,000.
Each part of an item of property, plant, and equipment with a cost that is significant in relation to the whole shall be depreciated separately, and such depreciation charge shall be charged to the income statement unless it is included in the cost of producing another asset.
Depreciation shall be applied to the depreciable amount of an asset on a systematic basis over its expected useful life. Expected useful life is the period used, not the asset’s economic life, which could be appreciably longer.
The depreciable amount takes account of the expected residual value of the assets. Both the useful life and the residual value shall be reviewed annually and the estimates revised as necessary in accordance with IAS 8.
Depreciation still needs to be charged even if the fair value of an asset exceeds its residual value. The rationale for this is the definition of residual value, detailed above. Residual value is the estimated amount, less estimated disposal costs, that could be currently realized from the asset’s disposal if the asset were already of an age and condition expected at the end of its useful life. This definition precludes the effect of inflation and, in all likelihood, will be less than fair value.
Depreciation commences when an asset is in the location and condition that enables it to be used in the manner intended by management. Depreciation shall cease at the earlier of its de-recognition [sale or scrapping] or its reclassification as “held for sale”. Temporary idle activity does not preclude depreciating the asset, as future economic benefits are consumed not only through usage but also through wear and tear and obsolescence. Useful life therefore needs to be carefully determined based on use, maintenance programs, expected capacity, expected output, expected wear and tear, technical or commercial innovations, and legal limits.
Example of a Change in Useful Life and Residual Value
Never Mind Inc. owns an asset with an original cost of $200,000. On acquisition, management determined that the useful life was 10 years and the residual value would be $20,000. The asset is now 8 years old, and during this time there have been no revisions to the assessed residual value. At the end of year 8, management has reviewed the useful life and residual value and has determined that the useful life can be extended to 12 years in view of the maintenance program adopted by the company. As a result, the residual value will reduce to $10,000. These changes in estimates would be effected in this way:
The asset has a carrying amount of $56,000 at the end of year 8: $200,000 (cost) less $144,000 (accumulated depreciation).
Accumulated depreciation is calculated as Depreciable amount equals cost less residual value = $200,000 – $20,000 = $180,000.
Annual depreciation = depreciable amount divided by useful life = $180,000 / 10 = $18,000. Accumulated depreciation = $18,000 × no. of years (8) = $144,000.
Revision of the useful life to 12 years results in a remaining useful life of 4 years (12 – 8). The revised depreciable amount is $46,000: carrying amount of $56,000 – the revised residual amount of $10,000). Thus depreciation should be charged in future at $11,500 per annum ($46,000 divided by 4 years).
The carrying amount of an item of property, plant, and equipment shall be derecognized on disposal or when no future economic benefit is expected from its use or disposal. Any gain on disposal is the difference between the net disposal proceeds and the carrying amount of the asset. Gains on disposal shall not be classified in the income statement as revenue.
IFRC Interpretation 1
This interpretation applies to changes in the measurement of any existing decommissioning, restoration, or similar liability that is both:
- Recognized as part of the cost of an item of property, plant, and equipment in accordance with IAS 16; and
- Recognized as a liability in accordance with IAS 37.
According to the IFRIC 1 “consensus”, changes in the measurement of an existing decommissioning, restoration, and similar liability that result from changes in the estimated timing or amount of the outflow of resources, or a change in the discount rate, shall be accounted differently based on whether the related asset is measured under IAS 16 using the “cost model” or the “revaluation model”:
(a) If the related asset is measured using the “cost model” (under IAS 16) then changes in the liability shall be added to, or deducted from, the cost of the related asset in the current period; the amount deducted from the cost of the asset shall not exceed its carrying amount and if the adjustment results in an addition to the cost of the related asset the entity shall consider whether there is an indication of “impairment” in accordance with IAS 36.
(b) If, on the other hand, the related asset is measured using the “revaluation model” (under IAS 16) then changes in the liability affect the “revaluation surplus” or “deficit” previously recognized on that asset, as set out below:
- A decrease in the liability shall be credited directly to “revaluation surplus” in equity, except when it reverses a revaluation deficit that was previously recognized in profit or loss, in which case it shall be recognized in profit or loss;
- An increase in the liability shall be recognized in profit or loss, except that it shall be debited to “revaluation surplus” in equity (to the extent of any credit balance existing in the “revaluation surplus” in respect of the asset). In the event that a decrease in liability exceeds the carrying amount that would have been recognized had the asset been carried under the “cost model,” the excess shall be recognized immediately in profit or loss.
Further, a change in the liability is an indication that the asset may have to be revalued in order to ensure that the carrying amount remains closer to fair value at the balance sheet date. Any such revaluation shall be taken in determining the amounts to be taken to profit or loss and equity. (If a revaluation is necessary, all assets of that class shall be revalued together instead of piecemeal revaluations.)
Lastly, as required by IAS 1, change in “revaluation surplus” resulting from a change in the liability shall be separately disclosed in the “statement of changes in equity”. The adjusted depreciated amount of the asset is depreciated over its useful life. Therefore, once the related asset has reached the end of its useful life, all later changes in liability shall be recognized in profit or loss as they occur. [This applies whether the “cost model” or the “revaluation model” is used].
Disclosures with respect to each class of property, plant, and equipment are extensive and comprise:
- Measurement bases for determining gross carrying amounts
- Depreciation methods
- Useful lives or depreciation rates used
- Gross carrying amount and accumulated depreciation (aggregated with accumulated impairment losses) at the beginning and end of the period
- Assets classified as held for sale
- Acquisitions through business combinations
- Increases and decreases arising from revaluations and from impairment losses and reversals thereof
- Net exchange differences recognized under IAS 21
- Other changes
- Existence and amounts of restrictions on ownership title
- Assets pledged as security for liabilities
- Assets in the course of construction
- Contractual commitments for the acquisition of property, plant, and equipment
Compensation for assets impaired, lost, or given up. If property, plant, and equipment are stated at revalued amounts, these items must be specified:
- The effective date of the valuation
- Whether an independent valuer was involved
- Methods and significant assumptions used in assessing fair values
- The extent to which fair values were measured by reference to observable prices in an active market, recent market transactions on an arm’s-length basis, or were estimated using other techniques
- For each class of asset revalued, the carrying amount that would have been recognized if the class had not been revalued
- The revaluation surplus, indicating the change for the period and any restrictions on distributions to shareholders