IFRS adoption: A country adopting IFRS is implementing IFRS into itslegislation in exact form as issued by IASB. Most of the countries adopted IFRS,rather than converged.
IAS 16 refers to tangible non-current assets as property, plant and equipment (PPE) and recognizes that they possess a physical substance, are held for use in the production of goods or delivery of services or for an administrative purpose, and are expected to be used for more than one accounting period. In practice this definition causes few problems. PPE includes freehold and leasehold land, buildings and plant and machinery. The objective of IAS 16 is to prescribe in relation to PPE the accounting treatment for:
- The recognition of assets;
- The determination of their carrying amounts; and
- The depreciation charges and any losses relating to them.
IAS 16 should be followed when accounting for PPE unless another IAS or IFRS requires a different treatment.
BUT WHEN SHOULD BUSINESS RECOGNIZE AN ASSET….. ???
A business should recognize an asset when the risks and rewards associated with the asset pass on to the business. The asset is under the control of the business, the control is as a direct result of a past transaction or event and future economic benefit will arise. The risks are the costs of repairs and maintenance and any loss arising from the asset. There should be an expectation that future economic benefits will flow to the owner and any costs can be measured reliably. This is in line with the definition of an asset as set out in the IASB Framework for the Preparation and Presentation of Financial Statements.
NOW HOW TO MEASURE THE COST OF PPE….???
The cost of PPE can be measured reliably in the case of an acquired asset by the cost of the market transaction (purchase price). The directly attributable costs of bringing the asset to the location and the condition for use will include incidental costs of acquisition, such as import duties, site preparation and professional fees such as architects’ fees. The inclusion of these costs should cease once substantially all activities necessary to get the asset ready for use are completed, even if the asset has not yet been brought into use.
Costs that would be excluded include: cost of opening new facility, administration and general overhead costs and cost of introducing new products.
Where, as a result of the acquisition of an item of PPE, an obligation arises to dismantle it at the end of its useful life and/or to restore the site, then that obligation must be recorded as a liability at the same time the asset is recognized (e.g. decommissioning costs associated with nuclear power stations). In the case of a self-constructed asset, the cost of the acquired materials, labour and other costs must be recognized. It should be noted that legal ownership of an item of PPE is not a requirement, provided economic benefits arising from the asset flow to the organization using the asset. For example, under IAS 17 leases, an item of PPE held under a finance lease is treated as an asset belonging to the user (lessee).
Omega Ltd incurs the following costs in relation to the construction of a new factory and the introduction of its products to the local market.
Site preparation costs
Labour costs, including 90,000 incurred during an industrial dispute. No construction occurred during the period of the dispute.
Testing of various processes in factory
Consultancy fees re installation of equipment
Relocation of staff to new factory
Costs to dismantle the factory at end of its useful life in 10 years time
How much of the costs should be capitalised?
Site preparation costs 240
Materials used 1,500
Labour costs (3,190 – 90) 3,100
Testing of various processes in factory 150
Consultancy fees re installation of equipment 220
Relocation of staff to new factory –
General overheads –
Costs to dismantle the factory at end of its useful life in 10 years’ time100
- There are a number of costs which arise subsequent to acquisition which may be capitalized throughout the life of the asset. Enhancement costs which significantly enhance the economic benefits by increasing the capacity, improving the quality of output, extending the economic life of the asset can be capitalized. The replacement costs of major components and overhaul costs which improve the economic benefit that can be generated can also be capitalized.
Where PPE consists of a number of assets of different economic lives, it may be appropriate to recognize and account for each component separately for depreciation and inclusion of subsequent expenses. The component approach is also applied where regular major inspections of an asset are a condition of continuing to use it. The cost of each inspection is treated as a separate item (replacement) of PPE, provided recognition criteria are satisfied. Any remaining carrying amount in respect of the previous inspection is derecognized.
(a) A company buys an aircraft for 9,000,000. Under civil aviation rules, the aircraft requires a major inspection every three years at a cost of 200,000. Three years after the purchase of the aircraft it undergoes its first major inspection. The costs in relation to the inspection amounted to 220,000.
(b) On 1 June 2009, a company spent 100,000 to replace the wall lining of one of its two furnaces. The furnace had been acquired six years previously and had a carrying value, at 1 June 2009, amounting to 420,000. Of this amount, 20,000 related to the original wall lining.
Explain how each of these matters should be accounted for in accordance with the requirements of IAS 16.
The original carrying value would have been allocated as follows:
Original costs of inspection
New costs of inspection
The original cost of inspection will be derecognized and the new inspection costs will be recognized in the carrying amount of the asset. Therefore, the new inspection costs are accounted for as an asset addition and the original inspection costs as an asset disposal.
(b) The cost of replacement wall lining should be recognized as an asset and the carrying amount of the original lining should be derecognized. The carrying amount of the furnace becomes 500,000 (420,000 + 100,000 – 20,000). The gain or loss on the disposal of the old lining is included in the calculation of the company’s statement of comprehensive income (SCI) for the accounting period in which de- recognition occurs. This will be the amount received on disposal less the carrying amount of 20,000.
Measurement of PPE after initial recognition IAS 16 sets out two models for measuring PPE subsequent to its initial recognition as an asset. These are the
- ‘cost model’ and the
- ‘revaluation model’.
Under the cost model an item of PPE is carried at cost less any accumulated depreciation and any accumulated impairment losses. Under the revaluation model an item of PPE is carried at a revalued amount, being fair value less accumulated depreciation and impairment losses. IAS 16 defines fair value as ‘the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction’. The choice of model is an accounting policy choice, which must be applied across an entire class of PPE. Therefore, where an item of PPE is revalued, all other assets in the same class should also be revalued. This is to prevent companies being selective about which items to revalue. IAS 16 provides examples of separate classes of assets including: land; land and buildings; machinery; motor vehicles; and office equipment. Revaluations should be made with sufficient regularity to ensure the carrying amount does not differ materially from that which would be determined using fair value at the end of the reporting period.
- Accounting for revaluations If the carrying amount of an item of PPE is increased as a result of a revaluation, the increase must normally be credited to a revaluation reserve and shown as ‘other comprehensive income’ in the entity’s SCI.
Depreciation and disclosure IAS 16 defines depreciation as the systematic allocation of the depreciable amount of an asset over its useful life. Each significant part of an item of PPE should be depreciated separately, although they may be grouped together for depreciation charge purposes if they have the same useful lives and depreciation methods.
Thus, an aircraft’s engines would be depreciated separately from the main airframe when they have different useful lives. Land and buildings are separable assets and are accounted for separately. The residual value and useful life of an asset must be reviewed at least each year end; any change would be a change in accounting estimate and must be accounted for under IAS8 Accounting Policies, Changes in Accounting Estimates and Errors. IAS 16 outlines extensive disclosure requirements but the main ones include:
- For each class of PPE: The measurement basis used The depreciation methods used Useful lives or depreciation rates used Gross carrying amount and accumulated depreciation at the beginning and end of the accounting period A reconciliation of the carrying amount at the beginning and end of the period, showing additions, disposals, revaluation increases and decreases, depreciation, impairment losses and any other movements.
- The amount of any PPE pledged as security for liabilities.