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Understanding IAS 16: Property, Plant, and Equipment

Learn key concepts of Property, Plant, and Equipment accounting under IAS 16, including recognition of costs, subsequent cost treatment, and component approach with practical examples.

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Understanding IAS 16: Property, Plant, and Equipment

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  1. Accounting Prof. Riccardo Tiscini

  2. IAS 16: Property, Plant Equipment Accounting

  3. IAS 16: Property, Plant and Equipment • DEFINITION • Property, Plant and Equipment (PPE) are tangible items that: • Are held for use in the production or supply of goods or services, or for administrative purposes • Are expected to be used during more than one period. • They don’t include investment property (IAS 40) Accounting

  4. Property, Plant and Equipment • Property, Plant and Equipment are also called fixed assets FIXED ASSETS Used in operations Useful life longer than one accounting period A computer purchased to be reselled is reported as inventory. The same computer to be used in operations is fixed asset. Accounting

  5. IAS 16: Property, Plant and Equipment • RECOGNITION OF INITIAL COSTS (IAS/IFRS) • The cost of an item of Property, Plant and Equipment shall be recognized as an asset only if: • It is probable that future economic benefit associated with the item will flow to the entity; • The cost of the item can be measured reliably. According to IAS 16 the property is not necessary in order to record PPE Accounting

  6. IAS 16: Property, Plant and Equipment • RECOGNITION OF INITIAL COSTS (US GAAP) • The cost of an item of Property, Plant and Equipment shall be recognized as an asset only if: • It embodies a probable future benefit; • A particular entity can obtain the benefit and control others’ access to it; • The transaction or other event giving rise to the entity’s right to, or control of, the benefit has already occurred; • The cost of the expected benefits can be reliably measured at the time of initial recognition. Accounting

  7. IAS 16: Property, Plant and Equipment • COMPONENT APPROACH • If it is possible to distinguish different components with different useful life and with different benefits for the companies, each part of an item of property, plant and equipment with a cost that is significant in relation to the total cost of the item shall be accounted for separately. • For example land and buildings are separable assets and are accounted for separately Accounting

  8. IAS 16: Property, Plant and Equipment • COMPONENT APPROACH: EXAMPLE • A company has a machine whose useful life is expected to be 10 years. Instead, the engine of the machine is replaced every three years. • The total cost of the machine is € 100,000 while the cost of the engine is Euro 30,000. • The engine must be depreciated separately (3 years) from the machine (10 years) as it has a significant cost. Accounting

  9. IAS 16: Property, Plant and Equipment • RECOGNITION OF SUBSEQUENT COSTS Subsequent Costs Day-to-day Servicing (maintenance) Regular major inspection Replacement at regular interval Accounting

  10. IAS 16: Property, Plant and Equipment • RECOGNITION OF SUBSEQUENT COSTS Expense Day-to-day servicing capitalized, derecognising the carrying amount of the replaced part Replacement at regular interval capitalized, derecognising the carrying amount of the replaced part Regular major inspection Accounting

  11. IAS 16: Property, Plant and Equipment RECOGNITION OF SUBSEQUENT COSTS • Costs of day-to-day services, as repairs and maintenance are treated as an expense • Replacement costs and regular major inspection: these cost should be capitalized, derecognising the carrying amount of the replaced part, if: • It is probable that future economic benefit associated with the item will flow to the entity; • The cost of the item can be measured reliably. Accounting

  12. IAS 16: Property, Plant and Equipment • RECOGNITION OF SUBSEQUENT COSTS: EXAMPLE • The engine of an aircraft is replaced after 15 years; the cost of the new engine, Euro 400,000, may be capitalized increasing the value of the aircraft, but only after eliminating the net book value of the old engine to replace. • The cost of the plane was initially recorded without separating the cost of its engine, so the depreciation, based on a useful life of 20 years, was calculated on the cost of the plane including the motor. Accounting

  13. IAS 16: Property, Plant and Equipment • RECOGNITION OF SUBSEQUENT COSTS: EXAMPLE • Since the cost of the old engine was not recorded separately, for the calculation of net book value can be used, as a reference, the cost of the new engine. • In particular, we assume that the historical cost of the old engine is Euro 400,000, the annual depreciation is equal to Euro 20,000 (400,000/20) and the related accumulated depreciation, after 15 years of use of the plane, is Euro 300,000 (20,000 x 15). • Therefore, the net book value of the old engine to derecognize is Euro 100,000. Accounting

  14. IAS 16: Property, Plant and Equipment • MEASUREMENT AT INITIAL RECOGNITION • Property, Plant and Equipment are recorded initially at cost COST Acquisition cost (from external parties) Cost of Self-constructed assets All the expenditures necessary to get the asset in place and ready for use Accounting

  15. IAS 16: Property, Plant and Equipment • MEASUREMENT AT INITIAL RECOGNITION Acquisition Cost Purchase price Dismantling and Removing costs Direct costs Accounting

  16. IAS 16: Property, Plant and Equipment • MEASUREMENT AT INITIAL RECOGNITION • Acquisition Cost: • Purchase price (including duties, purchase taxes, assembling and unpacking costs, less cash discounts, lawyers’ fees, commission to real estate agents…); • Any costs directly attributable to bringing the asset to the location and condition necessary for it to perform as intended (installation and testing costs); • an estimate of the costs of dismantling and removing the item and restoring the site on which it is located. • Cost of self-constructed assets: • The cost is determined with the same principles as for an acquired asset. Accounting

  17. IAS 16: Property, Plant and Equipment • MEASUREMENT AT INITIAL RECOGNITION • Direct Costs: • Costs of employees benefits arising directly from the construction or acquisition (employees used to get the asset in the place and ready for use); • Costs of site preparation; • Initial delivery and handling costs; • Installation and assembly costs; • Costs of testing if the asset is functioning properly. Training costs of employees to make them able to use the asset are not included Accounting

  18. IAS 16: Property, Plant and Equipment APPLICATIONS: General Motors acquires a land and a building incurring in the following costs: • Purchase price of land with an existing building, Euro 1,000,000 • Fees paid to attorney in handling purchase contracts, Euro 10,000 • Transfer taxes paid to local real estate taxing authorities, Euro 2,000; • Salaries earned by management personnel during the search for the site and the negotiation, Euro 8,000; • Operating expenditures for company automobiles used during the search, Euro 375; • Depreciation charges for company automobiles used during the search, Euro 440; Accounting

  19. IAS 16: Property, Plant and Equipment APPLICATIONS: 7. Fees paid to consulting engineer for a report on the structural soundness of the building, its fair value and the estimated cost of making needed repairs, Euro 15,000; 8. Uninsured costs to repair automobiles damaged in a multi-vehicle accident during the search, Euro 3,000; 9. Profits lost on sales the company failed to make because, during the search, management paid insufficient attention to a potential new customer, Euro 20,000. What is the total cost of the land and the building? Accounting

  20. IAS 16: Property, Plant and Equipment APPLICATIONS: The total cost of the land and the building is Euro 1,020,815. How is it calculated? Accounting

  21. IAS 16: Property, Plant and Equipment APPLICATIONS: After calculating the total cost (Euro 1,020,815), GM should allocate the total cost between the two assets based on the relative fair values of the land and the building. Accounting

  22. IAS 16: Property, Plant and Equipment APPLICATIONS: If the fair value of the building is Euro 250,000 GM will allocate 25% (Euro 250,000/1,000,000) of the combined cost of Euro 1,020,815 to the building and the 75% to the land. - Items 7 could be considered as a part of the cost of the building; - Items 8 could be treated as an asset by some accountants; - Items 9 is only an opportunity cost not included in the assets. GM will depreciate only the building and not the land Accounting

  23. IAS 16: Property, Plant and Equipment • APPLICATIONS: • Land: • Let us assume that a company acquires a land for a new retail operation. The net purchase price is Euro 340,000. The company also pays brokerage fees of Euro 12,000, legal fees of Euro 4,000, Euro 20,000 to have an old building on the site torn down and Euro 2,000 to have the site graded. It receives Euro 8,000 in salvage from the old building. What is the total cost of the land? Accounting

  24. IAS 16: Property, Plant and Equipment Cost of the land • Net purchase price 340,000 • Brokerage fees 12,000 • Legal fees 4,000 • Tearing down old building 20,000 • Less salvage - 8,000 • Grading 2,000 • Total 370,000 Accounting

  25. IAS 16: Property, Plant and Equipment • MEASUREMENT AFTER INITIAL RECOGNITION (IAS/IFRS) MEASUREMENT COST MODEL REVALUATION MODEL • Fair Value at the date of revaluation less any subsequent accumulated depreciation and any accumulated impairment • Cost less any accumulated depreciation and any accumulated impairment losses Accounting

  26. IAS 16: Property, Plant and Equipment • MEASUREMENT AFTER INITIAL RECOGNITION (US GAAP) MEASUREMENT COST MODEL REVALUATION MODEL • NOT ALLOWED • Cost less any accumulated depreciation and any accumulated impairment losses Accounting

  27. IAS 16: Cost Model - Depreciation • DEPRECIATION • Is the systematic allocation of the depreciable amount of an asset over its useful life. • The depreciation charge for each period is an expense unless it is included in the carrying amount of another asset. • Each part of an item of property, plant and equipment with a cost that is significant in relation to the total cost of the item shall be depreciated separately (e.g. land and buildings) • It begins when the asset is available for use (when it is in the location and condition necessary to be capable of operating) Accounting

  28. IAS 16: Cost Model - Depreciation • DEPRECIATION • Component approach: each part of an item of property, plant and equipment with a cost that is significant in relation to the total cost of the item shall be depreciated separately. • Land and buildings are separable assets and are accounted for separately (land has an unlimited useful life and it is not depreciated. Buildings have a limited useful life and are depreciated) Accounting

  29. IAS 16: Cost Model - Depreciation • DEPRECIATION • Is the process of allocating the cost of a fixed asset as an expense in the accounting periods benefiting from it FACTORS Residual Value Useful life Cost Accounting

  30. IAS 16: Cost Model - Depreciation • DEPRECIATION • Cost consists of all expenditures to acquire the asset • Residual Value is an estimate of the asset’s value at the end of its benefit period. It’s the amount the owner expects to receive from disposing of the asset • Useful life is the length of time the asset is productively used in a company’s operations. It is related to: • Wear and tear from use in operations • Obsolescence due to new inventions and improvements Accounting

  31. IAS 16: Cost Model - Depreciation • DEPRECIATION METHODS • They are methods to allocate fixed assets cost over the accounting period in their useful life. METHODS Units-of-production method Declining-balance method Straight-line method Accounting

  32. IAS 16: Cost Model - Depreciation • DEPRECIATION METHODS • Straight-line method • It charges the same amount of expense to each period of the asset’s useful life • Units-of-production method • It charges a varying amount of expense to each period depending on the asset’s useful life • Declining-balance method • It uses a depreciation rate multiple of the straight-line rate applied to the asset’s beginning-of-period book value Accounting

  33. IAS 16: Cost Model - Depreciation • Examples • Machinery Cost Euro 5,000 • Residual Value Euro 200 • Depreciable cost Euro 4,800 Useful life 5 years • Straight-line method • Depreciation Expense Dr 960* • Accumulated Depreciation Cr 960 • * (5,000 – 200)/5 Accounting

  34. IAS 16: Cost Model - Depreciation • Examples • Truck Cost Euro 54,000 • Residual Value Euro 4, 000 • Depreciable cost Euro 50,000 200,000 miles of use before retirement • 24,000 miles in 1 year Units-of-production method Depreciation Expense Dr 6,000* Accumulated Depreciation Cr 6, 000 *Depreciation per mile is Euro 0.25 (54,000-4,000)/200,000. Depreciation for one year is 0.25 * 24,000 = 6,000 Accounting

  35. IAS 16: Cost Model - Depreciation • Examples • Machinery Cost Euro 5,000 • Residual Value Euro 200 • Depreciable cost Euro 4,800 Useful life 5 years • Declining-balance method • Depreciation Expense Dr 2,000* • Accumulated Depreciation Cr 2,000 • * ((5,000/5) x 2) Accounting

  36. IAS 16 – Depreciation: Changes useful lives/res. value A company: • acquires an office machine for Euro 9,200; • estimates the use of the machine for 15 years; • estimates a residual value of Euro 200. On December 31st of the sixth year, the firm analyses its estimates of useful life and residual value. In light of new information the firm estimates that: • The machine will have a total useful life of only 10 years; • The residual value estimate of Euro 200 is still reliable. What happens to depreciation? Accounting

  37. IAS 16 – Depreciation: Changes useful lives/res. values • FIVE YEARS: • The depreciation charge recorded for each of the first five years under the straight line method is: • Euro 600 (9,200-200)/15. • SIXTH YEAR: • The acquisition cost to be depreciated before the change of the sixth year is Euro 6,000* • *(9,200 – 200)-(5 x 600). • The change for this year produces a depreciation of Euro 1,200* • * (6,000/5) Accounting

  38. IAS 16: Cost Model - Depreciation WORK CASE Markam Corporation acquires a new machine costing Euro 20,000 on January 1, 2009. The firm expects: • To use the machine for five years; • To operate it for 24,000 hours during that time; • To recoup an estimated residual value of Euro 2,000 at the end of five years. • Calculate the depreciation charge for each of the five years using: • The straight – line method; • The units of production method. The expected operating times are 5,000 hours each year for four years and 4,000 hours in the fifth year. Accounting

  39. IAS 16 – Depreciation: Changes useful lives/res. values • WORK CASE • Central States Electric Company constructs a nuclear power plant at a cost of Euro 200 million. It estimates the useful life of the plant to be 50 years and the cost to dismantle and retire the asset from service to be Euro 20 million. • These “decommissioning” costs include the costs to dismantle the plant and dispose of the radioactive materials. The firm computes and charges straight line depreciation once per year at year end. • During the company’s 11th year of operating the plant, Congress enacts new regulations governing nuclear waste disposal. The estimated decommissioning costs increase from Euro 20 million to Euro 24 million. During the 31st year of operation, the firm revises the estimated service life of the plant to 60 years in total. Accounting

  40. IAS 16 – Depreciation: Changes useful lives/res. values WORK CASE QUESTIONS • What is the depreciation charge for the first year? • What is the depreciation charge for the 11th year? • What is the depreciation charge for the 31st year? Accounting

  41. IAS 16: Impairment • IMPAIRMENT • Both IAS/IFRS and US GAAP require firms to recognize decreases in fair value as an impairment loss. • To determine whether an item of property, plant and equipment is impaired, an entity applies IAS 36. Accounting

  42. IAS 16: Subsequent Measures • MEASUREMENT AFTER INITIAL RECOGNITION (IAS/IFRS) MEASUREMENT COST MODEL REVALUATION MODEL • Fair Value at the date of revaluation less any subsequent accumulated depreciation and any accumulated impairment • Cost less any accumulated depreciation and any accumulated impairment losses Accounting

  43. IAS 16: Revaluation model • REVALUATION FAIR VALUE • Amount for which an asset could be exchanged between knowledgeable, willing • parties in an arm’s-length transaction • The fair value of land and buildings is estimated by professionally qualified • Valuers (a fairness opinion is required) • The fair value of plant and equipment could be the market value according • to the appraisal normally undertaken by professionally qualified valuers. • If there is no market-based evidence fair value is estimated using a • depreciated replacement cost approach Revaluation shall be made with regularity to ensure that the carrying amount does not differ materially form that which would be determined using fair value at the end of the reporting period Accounting

  44. IAS 16: Revaluation model • REVALUATION • Increases: • If an asset’s carrying amount is increased as a result of a revaluation • the increase shall be recognised in OCI and accumulated in equity • Under the heading revaluation surplus. • The increase shall be recognised in profit and loss to the extent that • it reverses a revaluation decrease of the same asset previously recognised • in profit or loss. • Decreases: • If an asset’s carrying amount is decreased as a result of a revaluation • the decrease shall be recognised in profit and loss. • The decrease shall be recognized in OCI to the extent of any credit balance • existing in the revaluation surplus in respect of this asset. The decrease recognised • in OCI reduces the amount accumulated in equity under the revaluation surplus. Accounting

  45. IAS 16: Revaluation model • REVALUATION – FIRST CHANGE: EXAMPLE (I METHOD) • Hp: A Plant with a historical cost of 500 and the accumulated depreciation of 100. The net carrying amount is 400. • The fair value is 800 Accounting

  46. IAS 16: Revaluation model • REVALUATION - FIRST CHANGE: EXAMPLE (II METHOD) • Hp: A Plant with a historical cost of 500 and the accumulated depreciation of 100. The net carrying amount is 400. • The fair value is 800 Accounting

  47. IAS 16: Revaluation model • REVALUATION: EXAMPLE Accounting

  48. IAS 16: Revaluation model LAND: I YEAR • Land Dr 20,000 • Revaluation surplus Cr 20,000 II YEAR • Land Dr 30,000 • Revaluation surplus Cr 30,000 Accounting

  49. IAS 16: Revaluation model • REVALUATION: EXAMPLE Accounting

  50. IAS 16: Revaluation model BUILDING: I YEAR • Loss on revaluation Dr 50,000 • Building Cr 50,000 II YEAR • Building Dr 10,000 • Recovery of loss Cr 10,000 Accounting

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