ACCA FA Chapter 9

IAS 16 Property, Plant and Equipment

IAS 16 Property, Plant and Equipment (PPE)

IAS 16 Property, Plant and Equipment prescribe the accounting treatment for tangible non-current assets. This standard outlines the initial measurement of assets, the determination of their carrying amount, the depreciation charge, and any impairment losses to be recognised.

The principal issues prescribed in the standard are:

• The initial recognition of assets at acquisition
• The determination of an asset’s carrying amount
• The depreciation charges of assets
• Any impairment losses to be recognised

Initial Measurement of PPE

Cost of Tangible Non-Current Assets

IAS 16 states that a tangible non-current asset should be initially recorded at its cost, which includes:

Purchase Cost

Any Cost directly attributable to bringing the asset to the condition and location necessary to enable it to be used for its intended purpose

Estimated cost of dismantling and site restoration

The total cost to be recognised as non-current assets is the following:

Directly Attributable Costs

Directly attributable costs are costs of bringing the asset to the location and condition necessary for operation. These costs must be classified as capital expenditure (assets) in the statement of financial position.

Examples of directly attributable costs are:

• Cost of employee benefits that arise directly from the construction or acquisition of the non-current asset (For example, wages and salaries)
• Cost of site preparation (For example, laying of new concrete floor in the factory of new machinery)
• Initial delivery and handling cost
• Installation and assembly cost
• Testing cost on whether the asset is functioning properly
• Professional fees (For example, consultancy, legal, architect fees and stamp duties)
• Cost of extension to buildings
• Interest on the loan used to finance the acquisition of the asset

A business may construct tangible non-current assets. For example, a carpentry business makes furniture for its use, or a construction business builds its own offices.

In such cases, all the expenditure incurred to get that asset ready for use can be included in its cost. This includes:

• raw material costs (such as timber, paint)
• labour costs (used in the construction of the asset)
• other directly incurred costs (such as energy used in the construction, any rent paid for the space used for construction).

Note that only costs that arise as a result of construction can be included. Any general business expenses, such as insurance or administration, cannot be included. (Such costs are often called general overheads.)

Activity 1

Rhocat Co is in the business of manufacturing carpets. The management of Rhocat Co has decided to purchase and install a new carpet-weaving machine. As a result, Rhocat Co incurred several expenditures that need to be accounted for as part of the cost of the tangible non-current asset.

Match the item of expenditure on the left column to their corresponding description on the right.

Categories of Non-Current Assets

A business’s tangible non-current assets can include various types of assets. Each asset type will have its ledger account in the general ledger.

Categories of tangible non-current assets (Property, Plant and Equipment) are:

• Land and Buildingssuch as building premises
• Plant and Machinerysuch as factory machinery that may be fixed or mobile
• Fixtures and Fittingssuch as shelving in a shop and shop display unit
• Office Equipmentsuch as computers, printers and cash registers
• Motor Vehiclessuch as delivery vans and company cars

There are several categories into which tangible non-current assets are classified, and each class and its accumulated depreciation have its ledger account.

The final total of these ledger accounts will be included in the Statement of Financial Position and is classified under Property, Plant and Equipment. The final figure for tangible non-current assets will be presented in the statement of financial position:

The carrying amount is the cost of the non-current asset less the accumulated depreciation. The statement of financial position will reflect each asset category’s carrying amount.

Double-entry for PPE Acquisition

Once the cost to be capitalised has been calculated, the amount is posted to the general ledger using journal entries.

The journal entry to record the acquisition of non-current assets using cash is:

The amount to be entered into these accounts is the capital cost.

The journal entry to record the acquisition of non-current assets on credit or using a bank loan is as follows:

When the business pays the credit supplier the amount owed, the journal entry is:

As the business pays back the outstanding bank loan sum, the journal entry is:

#What is Depreciation?

An asset is a resource used by a business to generate profits.

For example, a production machine is an asset that allows a business to manufacture goods to be sold to customers, which helps the business generate profit. Usage or consumption of the asset leads to depreciation.

As non-current assets are used (consumed), they wear out and devalue over time, and this consumption needs to be reflected as a cost to the business on an annual basis. This cost is depreciation.

Depreciation is the expense charged to the statement of profit or loss in each accounting period to reflect how much of the economic benefit associated with a tangible non-current asset has been used up in the accounting period.

• Useful Economic Life

The useful economic life of a non-current asset is the estimated period over which the asset will be consumed until it is worn out or until the business no longer wishes to use it. It is the period over which an asset will be useful and generate economic benefit for the business.

• Residual Value

Non-current assets may be sold before they are completely worn out. This can be due to a newer asset model being required or because the asset is no longer needed. The estimated proceed from selling the non-current asset is the residual value.

• Depreciable Amount

The depreciable amount is the cost of the non-current asset less any expected residual value. The depreciable amount of an asset is used to calculate the depreciation charge each year.

The purpose of depreciation is to match the revenue and expense in the same accounting period in line with the accruals principle of accounting.

Non-current assets generate profits for a business. Depreciation is the cost of the business using the non-current asset. Therefore, the depreciation cost is included as an expense in the statement of profit or loss so that the cost of using the asset matches the profits generated from it. This is an application of the accruals principle.

Activity 2

For the below statements, answer if they are True or False:

Depreciation is a measure of the cost to the business of consuming the economic benefits associated with a tangible non-current asset for an accounting period.

Depreciation measures how much the market value of a tangible non-current asset falls during an accounting period.

All tangible non-current assets need to be depreciated.

Calculating Non-Current Asset Depreciation

Depreciation spreads the depreciable amount of the non-current asset over its useful economic life. The depreciation charge is recorded in the statement of profit or loss as an expense.

There are two methods of calculating the depreciation cost in an accounting period:

• Straight-Line method
• Diminishing-balance method

Straight-Line Method

The straight-line method of charging depreciation is where the total depreciable amount is charged in equal instalments over the asset’s expected useful life.

In a straight-line method, the depreciation charge is calculated as follows:

or

At the end of the year, the asset value will decrease by the depreciation charge. The value after the depreciation charge is known as the carrying amount.

Activity 3

What are the annual depreciation charges for each of the scenarios below?

Tareq purchases a second-hand delivery vehicle for $15,000, which has an estimated useful life of three years and zero residual value.

Tareq purchases a new mixing machine for $22,000. This has an estimated useful life of eight years and a residual value of $2,000.

Tareq purchases new office furniture for $3,400. This has an estimated useful life of six years and a residual value of $340.

Tareq purchases a new printer for $2,500. The depreciation rate for all office equipment is 20%.

Diminishing Balance Method

In the straight-line method, depreciation charged is expressed as a fixed percentage of the asset’s cost. In contrast, the diminishing-balance (reducing-balance) method expresses depreciation as a fixed percentage of the asset’s carrying amount.

The diminishing-balance method uses a percentage applied to the carrying amount of an asset rather than its cost.

In the diminishing-balance method, the depreciation percentage is applied to a reduced figure each year, resulting in a lower depreciation charge each year.

Activity 4

Tareq purchases a new delivery truck for $40,000. The diminishing-balance rate of depreciation is 25%.

What is the depreciation charge in year two?

Tareq purchases a new industrial freezer unit for $14,000. The diminishing-balance rate of depreciation is 35%.

What is the carrying amount of the industrial freezer unit after three years?

Which Depreciation Method to Use?

A business selects the depreciation method based on how they expect to use the asset’s economic benefits.

If the business expects equal benefits each year, the straight-line method is used.

For example, a business owns a furniture piece. Since the furniture is not expected to vary its benefit contributions to the business throughout its useful life, the straight-line depreciation method should be applied.

If the business expects greater benefits in earlier years, they use the diminishing-balance method. This is when an asset becomes increasingly less productive for each year of use.

For example, a business owns a manufacturing machine. It is expected that the machine will produce more output in the early years of its useful life, which decreases over the years. Since greater benefits are expected in its earlier years, the machine should apply the diminishing-balance depreciation method.

Pro Rata Depreciation

A business may purchase an asset at any point during a financial year. In such cases, is it appropriate to calculate a full year’s depreciation charge? The answer to this question varies from business to business.

A business will have a policy stating whether it uses the full-year or pro−rata option.

Full-Year Depreciation Policy − A full year’s depreciation charge is calculated in the year an asset is purchased. A zero-depreciation charge is applied in the year the asset is disposed of.

Pro-Rata Depreciation Policy − The depreciation charge is calculated pro rata in the year an asset is purchased and when it is disposed of.

Changes in Depreciation Method, Useful Life or Residual Value

It is a requirement of IAS 16 that the depreciation method used for an asset is reviewed regularly. If the way that the asset generates economic benefit alters, then the method to calculate depreciation should be changed accordingly.

At the date of the change in depreciation method, the asset is depreciated using the carrying amount of the asset and its remaining useful life.

The useful life (UL) or residual value (RV) of a non-current asset may change during the lifetime of an asset. Such a scenario may occur as the asset’s useful life and residual value are estimated at the acquisition point. Therefore, these may change over time.

Dealing with useful life or residual value changes is similar to depreciation method changes. The asset’s carrying amount at the change date is depreciated over the revised useful life and residual value.

Journal Entries for NCA Depreciation

Once the depreciation charge for the year is calculated, it is posted to the general ledgers using journal entries. The depreciation charge is reported as an expense in the Statement of Profit or Loss and reduces the asset carrying amount in the Statement of Financial Position.

Disposal of Non-Current Asset

A business purchases tangible non-current assets to generate profits over several years. These assets will remain with the business until they can no longer be used and have been fully depreciated.

A business may also decide to sell or dispose of an asset before it has reached the end of its useful economic life. Examples of such situations include:

• A newer and more efficient model of an asset (such as a computer) is available
• An asset has become redundant. the asset no longer undertakes the activity that it was used for
• The asset is broken but can be sold for its scrap value.

The four elements to consider when disposing of a non-current asset are:

• Cost of the Asset

When an asset is sold, the business no longer has the asset to use in the business. This means the asset’s original cost must be removed from the relevant Non-current asset − cost account.

• Accumulated Depreciation of the Asset

When disposing of a non-current asset, all aspects of the asset’s balances are removed from the general ledgers. The asset’s accumulated depreciation must be removed from the relevant Non-current asset − accumulated depreciation account.

The asset is removed from the statement of financial position altogether.

• Sale Proceeds

For non-current assets with residual values, the sales proceeds received from the business by disposing of such assets will affect the Cash/Bank ledger account.

• Profit or Loss on Disposal

The difference between the sales proceeds and the carrying amount of an asset (cost − accumulated depreciation) determines whether the sale generates a profit or a loss on disposal.

Accounting for NCA Disposal

Calculating the Gain or Loss on Disposal

The profit or loss on disposal of a tangible non-current asset is calculated as:

If the sales proceeds exceed the carrying amount = profit on disposal

if the sales proceeds are less than the carrying amount = loss on disposal

Journal Entries for NCA Disposal

There are four steps to follow in recording the disposal of non-current assets. The double-entry steps revolve around the Disposal Account.

The steps to record the non-current asset disposal are:

• Remove asset from the Cost account
• Remove asset from the Accumulated depreciation account
• Record sale proceeds
• Record profit or loss on disposal

1. Remove Asset from the Cost Account

First, the business removes the asset’s cost from the non-current asset − cost account by transferring it to the disposal account.

2. Remove Asset from the Accumulated Depreciation Account

Next, the accumulated depreciation is removed from the Asset − accumulated depreciation account by transferring the amount to the Disposal account.

3. Record Sales Proceeds

The sales proceeds received are recorded in the Disposal and Cash/Bank accounts. If the disposal of the asset generates no sales proceeds, this entry is omitted.

4. Record Profit or Loss on Disposal

Finally, the Disposal account is closed off. The balance c/d is the profit or loss on disposal and is recorded as an income or expense in the Statement of Profit or Loss.

If the sales proceeds exceed the carrying amount (profit on disposal), the journal entry is:

If the sales proceeds are less than the carrying amount (loss on disposal), the journal entry is:

The Disposal account is created for each non-current asset disposal. The journal entries that are included in the Disposal account are summarised as follows:

Subsequent Measurement

All property, plant and equipment is initially measured at cost. The cost of an asset is its purchase price and other expenses necessary to bring the asset to working condition for its intended use. These non-current assets are depreciated, and their carrying amount is reflected in the statement of financial position.

However, there may be assets whose market value (the price at which the asset can be sold in an open market) is considerably higher than their carrying amount. The financial statements will not show a faithful representation of the value of these assets if they are included in the statement of financial position at depreciated cost.

Therefore, an asset may be subsequently revalued.

IAS 16 and Revaluation

IAS 16 permits the value of property, plant and equipment to be measured after the initial recognition.

The two accounting policy permitted in the subsequent measurement is:

Depreciated Cost Model – the asset’s original purchase cost of the asset is depreciated over its useful life

Revaluation Model – the asset is carried at a revalued amount based on its fair value. The revaluation exercise is carried out regularly to keep the carrying amount in line with fair value. Following a revaluation, the revalued amount of the asset is depreciated over its remaining useful life.

The Revaluation Model

When a business opts for the revaluation model of its assets, the following must apply:

Class of Assets

All assets of the same class must be revalued. For example, all buildings are revalued, or all motor vehicles are revalued. This means that a business cannot choose only those assets that have increased in value.

Consistent Application

The revaluation policy has to be applied consistently. This means that a business cannot revalue one year and then revert to the original cost of the asset the next. It needs to be consistent; otherwise, a business could revalue when market values have increased and revert to the original cost when market values have fallen.

Fair Value can be Measured Reliably

The carrying amount of an asset is revalued to the fair value only if the fair value can be measured reliably. It must be the actual market value of the asset and can be sold for the price in an open market.

Accounting for Revaluation

Typically when assets are first revalued, this will usually be an upward revaluation where the market value of the assets is higher than the cost. This results in the assets being stated at a revalued amount. These assets still need to be depreciated. The revised depreciation is calculated as the revalued amount divided by the asset’s remaining useful life.

Double-entry for NCA Revaluation

Five adjustments are relevant to property, plant and equipment revaluation. These adjustments are:

• Upward Revaluation of Assets
• Revised Depreciation Charge
• Excess Depreciation Transfer

Upwards or Downwards Revaluation for assets previously revalued

Disposal of Revalued Assets

Upward Revaluation of Assets

When the business revalues its assets, the journal entry to be posted is:

The balance on the revaluation surplus at the year-end will appear in the statement of financial position as part of capital and reserves. Any revaluation surplus that arises during the year will be shown as part of other comprehensive income in the statement of profit or loss and other comprehensive income.

Revised Depreciation Charge

After an asset has been revalued, it still needs to be depreciated.

The revised depreciation charge is calculated as = Revalued amount ÷ Remaining useful life

The journal entry to record the revised depreciation is similar to any depreciation charge:

Excess Depreciation Transfer

IAS 16 allows excess depreciation to be transferred within the capital accounts that appear in the statement of financial position. The transfer will be from the Revaluation Surplus account to the Retained Earnings account (which is the account that includes the accumulated profits and losses of the business).

It is up to the business to adopt this transfer adjustment; it is not mandatory.

The excess depreciation is the difference between the revised depreciation charge and the original depreciation charge had there been no revaluation.

The journal entry to transfer the excess depreciation is:

This is simply a transfer between the equity accounts and has no impact on the profit for the year, as reported in the statement of profit or loss.

Upwards/Downwards Revaluation on previously Revalued Assets

Under the revaluation model, assets must be revalued regularly to ensure that the asset’s carrying amount is not materially different from its fair value.

If the asset is revalued upwards, then the steps to undertake are as Point 1 (Upward Revaluation of Assets).

If the asset is revalued downwards, the revaluation adjustment is calculated by comparing the carrying amount and the revaluation amount. The journal entry to adjust for the downward revaluation of a previously revalued asset is:

The revaluation adjustment is debited to the revaluation surplus up to the initial revaluation surplus credit. If the downward revaluation exceeds the amount previously credited, the excess is expensed off to profit or loss.

Disposals of Revalued Assets

The disposal of a revalued asset is accounted for in the same manner as a typical asset mentioned in Section 3.2.2. The only difference is that any balance that remains in the revaluation surplus account is transferred to the retained earnings as the gain in revaluation can now be realised with the sale of the asset.

Purpose and Function of Non-Current Asset Register

The acquisition, depreciation and disposal of tangible non-current assets recorded in the general ledger accounts show the transaction balance of each asset category. It does not retain any detail about individual assets once it is closed off at the end of the year.

A business keeps track of individual assets’ cost, carrying amount, depreciation and disposal using a separate record known as the non-current asset register.

The non-current asset register has information on each asset:

• Date of Purchase
• Description
• Location
• Useful Economic Life
• Depreciation Method
• Depreciation Amount
• Carrying amount
• Ultimate Disposal proceeds

The non-current asset register is useful for a business as it is used to verify the existence of assets within a business. The business can perform an asset count at each location according to the non-current asset register.

Elements of a Non-Current Asset Register

Since the same information concerning the non-current asset is recorded in the general ledger and the asset register, the two balances should agree. Therefore, the asset register also acts as a source of supporting documentation to verify the accuracy of balances in the ledger accounts.

Differences between the two reports should not occur in a computerised system, as the same information automatically updates the ledgers and the asset register simultaneously with the input of non-current assets transactions.

However, businesses with manual systems may encounter differences between these balances due to entry omissions of purchase costs or depreciation charges from one of the reports.

Discrepancies involving omissions or errors should be corrected by posting entries into the omitted or erroneous report.

Property, Plant and Equipment Disclosure

Disclosure Requirements

The following information is required to be disclosed in the financial statements for each class of property, plant and equipment:

• Measurement bases used for determining gross carrying amount.
• Depreciation methods used.
• Useful lives or the depreciation rates used.
• Gross carrying amount and accumulated depreciation at the period’s beginning and end. (Comparatives are not required.)
• A reconciliation of the carrying amount at the beginning and the end of a period showing:
• Additions
• Disposals
• increases or decreases resulting from revaluations
• depreciation
• other movements