Slide 17.1

Chapter 17

Property, Plant and Equipment (PPE)

Slide 17.2

The main purpose of this chapter is to explain how to determine the initial carrying value of PPE and to explain and account for the normal movements in PPE that occur during an accounting period.

Main purpose

Slide 17.3

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.

Objectives

Slide 17.4

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.

Slide 17.5

Four 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 computed (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)?

Slide 17.6

IAS 16 defines tangible assets

• PPE – also known as fixed assets or non-current assets – have a physical nature

• Held by an enterprise for use

– In production

– For rental

– For administration

• Expected to be used for more than one period

– Consider materiality

– low value items

Slide 17.7

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 service potential 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 service potential they provide.

they possess physical substance – that is, they have a physical form that can be seen and touched.

Slide 17.8

Determining costs

Initial recognition and measurement of non-current assets

The initial recognition and measurement of a newly acquired non-current asset is its historical cost – the amount of cash or cash equivalents paid, or the fair value of the consideration given, at the time of acquisition or construction. (NZ IAS 16 para 15)

Includes costs directly incurred in bringing the asset to its location and working condition necessary to prepare the asset for its intended use (NZ IAS 16, para 16)

These costs include:

Slide 17.9

How is cost determinedIncludes all the costs needed to make the asset

ready for use:Purchase priceImport dutiesDirectly attributable costs bringing to working

condition 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).

Slide 17.10

Determining costs

future economic benefits are recognised immediately.

Consumption of these benefits over the economic life of the asset are recognised by way of periodic depreciation charges in the Income Statement.

Slide 17.11

Capitalisation of borrowing costs for self-constructed assets

IAS 23 treatment Qualifying asset – time criterion Funds borrowed specifically – use actual rate Funds borrowed generally – use weighted average Capitalisation ceases when asset substantially prepared

for its intended use or sale. (We will not consider these costs)

Slide 17.12

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 that should be

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.

Slide 17.13

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.

Slide 17.14

Depreciation

Systematic allocation of the cost of the asset Funds already expended 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

Slide 17.15

Useful economic life – IAS 16 definition

Period of time in use

Number of production units expected from an asset

Freehold land – infinite life

Slide 17.16

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.

Slide 17.17

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

Slide 17.18

Depreciation

Straight line method Under this method, the same amount of

depreciation is expensed in each accounting period.

Appropriate where time is the principal factor in establishing the asset’s useful life and it is expected that the future economic benefits will flow evenly.

Slide 17.19

Depreciation

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

Slide 17.20

Depreciation

Diminishing value (DV) methodsCalculated 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 then taper off with age.

Slide 17.21

Depreciation

Example: Using the same figures as above, and a DV rate

of 39.6%:

Slide 17.22

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 9-seater minibus. Inland Revenue assumes a useful life of 5 years and a rate of 31.2%, which would produce the figures in this table:

Slide 17.23

Depreciation

Slide 17.24

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.

Slide 17.25

Choice of depreciation method impacts on reported profit

Figure 17.1 Effect of different depreciation methods

Slide 17.26

Depreciation

Sum-of-years digits method This method is similar to the diminishing value

method in that the depreciation charge is higher in the early years and tapers off with age.

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.

Slide 17.27

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

Slide 17.28

Depreciation

For our $100,000 depreciable value example, depreciation is

Slide 17.29

Depreciation

The depreciable amount is: 100,000 – 10,000 = 90,000Year 1 depreciation is:5/15 x 90,000 = 30,000Year 2 depreciation is:4/15 x 90,000 = 24,000

Slide 17.30

Depreciation – sum of the units method

Figure 17.2 Sum of the units method

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

Slide 17.31

Depreciation – annuity method

Figure 17.3 Annuity method

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

Slide 17.32

Comparison of methods

Year S/L D/V S/U Ann1 2,000 4,180 3,333 1,6382 2,000 2,592 2,667 1,8023 2,000 1,606 2,000 1,9824 2,000 996 1,333 2,1805 2,000 618 667 2,398

Total 10,000 9,992 10,000 10,000

Slide 17.33

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.

Slide 17.34

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.

Slide 17.35

IAS 36 approach

Single asset or Cash Generating Unit Judgemental Beware concealing poor performance by grouping

Carrying amount = depreciated HC or depreciated Revalued amount

Impaired if Carrying > Recoverable amountCalculate a revised Carrying amount.

The

Slide 17.36

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.

Slide 17.37

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:

Slide 17.38

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.

Slide 17.39

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

Slide 17.40

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

Therefore, an impairment test is required.

Slide 17.41

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

Slide 17.42

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:

Slide 17.43

Impairment

Slide 17.44

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.

Slide 17.45

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

Slide 17.46

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 CGU Then, CGU’s other assets on pro-rata basis No asset reduced below net selling price, value in use

or zero.

Slide 17.47

Example of the allocation of an impairment loss (p.452)

Recoverable amount is £150,000 of a cash generating unit with the following assets:

£Goodwill 70,000

Intangible assets 10,000

PPE 100,000

Inventory 40,000

Receivables 30,000

250,000

Slide 17.48

The review estimates for theexample that

The PPE includes a property with a carrying amount of £60,000 and a market value of £75,000The net realisable value of the inventory is greater than its carrying valuesNone of the receivables are considered doubtful.

Slide 17.49

Table to show the allocation of the impairment loss

£ £ £

Goodwill 70,000 (70,000) Nil

Intangible assets 10,000 (6,000) 4,000

PPE 100,000 (24,000) 76,000

Inventory 40,000 Nil 40,000

Receivables 30,000 Nil 30,000

250,000 (100,000) 150,000

Pre- impairment Impairment Post-impairment

Slide 17.50

Notes to table• The impairment loss is first allocated against goodwill. After this has been done £30,000 (£100,000 − £70,000) remains to be allocated• No impairment loss can be allocated to the property, inventory or receivables because these assets have a recoverable amount that is higher than their carrying value• The remaining impairment loss is allocated pro-rata to the intangible assets (carrying amount £10,000) and the plant (carrying amount £40,000 [£100,000 − £60,000]).

Slide 17.51

Illustration: value in use calculation (pp.453/4)

(£)

£ £ £

£

Slide 17.52

Illustration – revised carrying amount

Carrying amount

as at 31 December 20X3 114,500

Net realisable value 70,000

Value in use 100,565

Revised carrying amount 100,565

£

Slide 17.53

Published accounts – British Sky example

Tangible fixed assets – British Sky Broadcasting Group plc

Slide 17.54

Published accounts – British Sky example (Continued)

Tangible fixed assets – British Sky Broadcasting Group plc

For Equipment, F&F, 2010 net carrying figure is 1040 – 568 = 472

Slide 17.55

• Asset must be available for immediate sale in its present condition

• The sale must be highly probable.

IFRS 5 non-current assets held for sale

Slide 17.56

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.

Slide 17.57

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.

Slide 17.58

Discussion (Continued)

What are the arguments in favour of the diminishing balance method?

Why is it thought that the annuity method is theoretically more attractive?

Explain why IAS 23 benchmark treatment is the preferred treatment.

Slide 17.59

Review questions

1. Define PPE and explain how materiality affects the concept of PPE.

2. Define depreciation. Explain what assets need not be depreciated and list the main methods of calculating depreciation.

3. What is meant by the phrases ‘useful life’ and ‘residual value’?

4. Define ‘cost’ in connection with PPE.5. 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.