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Chapter 17

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

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Chapter 17

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  1. 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. Five accounting standardsthat 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 calculated (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)?

  5. 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

  6. 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.

  7. 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)

  8. 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).

  9. 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.

  10. 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 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.

  11. 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.

  12. 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 Useful economic life – the time over which the asset is expected to provide value to the company

  13. Useful economic life – IAS 16 definition Period of time in use, or Number of production units expected from an asset Freehold land – infinite life, therefore is not depreciated

  14. 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.

  15. 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

  16. 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.

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

  18. 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 these get smaller as the asset ages.

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

  20. 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 small passenger bus. Inland Revenue assumes a useful life of 5 years and a rate of 31.2%, which would produce the figures in this table:

  21. Depreciation

  22. 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.

  23. Choice of depreciation method impacts on reported profit Figure 17.1 Effect of different depreciation methods – textbook example p.444 (p.310)

  24. 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 1 + 2+ 3+ 4+ 5 = 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.

  25. 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

  26. Depreciation • For our $100,000 example, the depreciable value is $90,000 and depreciation is

  27. 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

  28. Depreciation – sum of the units method Figure 17.2 Sum of the units method – textbook example p.444 (p.311) 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

  29. Depreciation – annuity method Figure 17.3 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

  30. Comparison of methods - textbook example p.444/445 (p.310/311) Year S/L D/V S/U Ann • 1 2,000 4,180 3,333 1,638 • 2 2,000 2,592 2,667 1,802 • 3 2,000 1,606 2,000 1,982 • 4 2,000 996 1,333 2,180 • 5 2,000 618 6672,398 Total 10,000 9,992 10,000 10,000

  31. 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.

  32. 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.

  33. 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.

  34. 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:

  35. 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.

  36. 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

  37. 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

  38. 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.

  39. 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

  40. 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:

  41. Impairment

  42. 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.

  43. 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

  44. 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.

  45. 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.

  46. 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.

  47. 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?

  48. 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.

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