chapter 5 - property, plant and equipment (ias16, ias23, ias20, ias40)

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Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011

Chapter 5 - PROPERTY, PLANT AND

EQUIPMENT(IAS16, IAS23, IAS20, IAS40)

ACTG 6580

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Definition of Property, Plantand Equipment

(a) are held for use in the production or supply of goods or services, for rental to others, or for administrative purposes; and

(b) are expected to be used during more than one period."

IAS16 defines property, plant and equipment as "tangible items that:

This definition covers the majority of the tangible non-current assets that might normally be held by a business entity.

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Recognition of Property, Plantand Equipment

(a) it is probable that future economic benefits associated with the item will flow to the entity concerned, and

(b) the cost of the item can be measured reliably.

An item of property, plant and equipment should be recognised as an asset if and only if:

Routine servicing, repair and maintenance costs are not capital expenditures. But the cost of major replacements should be treated as capital expenditures and recognised as an addition to the carrying amount of the asset concerned.

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Initial Measurement ofProperty, Plant and Equipment

• Purchase price, including import duties and non-refundable purchase taxes, less trade discounts

• Costs that are directly attributable to bringing the item to the location and condition necessary for it to be operated as intended

• The estimated costs of dismantling and removing the item and restoring the site on which the item is located, as long as the obligation to meet these costs is incurred when the item is acquired

On initial recognition, property, plant and equipment should be measured at cost. Cost includes:

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Subsequent Measurement of Property, Plant and Equipment

• The cost model; items are carried at cost less any accumulated depreciation and less any accumulated impairment losses.

• The revaluation model; items are carried at fair value at the date of revaluation, less any subsequent accumulated depreciation and less any subsequent accumulated impairment losses.

After initial recognition, items of property, plant and equipment may be measured using either:

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Periodic ValuationCarrying value

US GAAP• Revaluation

of fixed assets is not allowed.

IFRS► If a company chooses to account for PP&E and

natural resources at fair value using the revaluation method:► Cost or fair value must be applied to an entire class of

PP&E.► Different classes can have different policies.► Fair value is the amount at which an asset could be

exchanged in an arm’s length transaction between knowledgeable and willing parties.

► A professional appraiser may be used to establish fair value.

► Revaluations must be performed periodically to ensure the carrying value of that asset class is not materially different than its fair value.

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Periodic valuationCarrying value

IFRS► Accounting for revaluation:

► Increases in value should be credited through OCI to a revaluation surplus account in equity, unless it reverses a loss that was previously expensed, in which case that portion may be credited to income.

► Decreases in value should be expensed unless it reverses a previous revaluation surplus account relating to the same asset. That portion can be debited through OCI to the revaluation surplus account in equity.

► If the revalued basis of an asset exceeds the cost basis, there will be an increase in annual depreciation. To the extent there is an increase in depreciation expense, per IAS 16.4-1, an entity may reverse the portion of reserve surplus related to this increase by debiting revaluation surplus and crediting retained earnings. Alternatively, this transfer may be computed upon disposal.

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IFRS► Accounting for revaluation (continued):

► When an asset is disposed of, any remaining related revaluation surplus account in equity may be transferred to retained earnings. The revaluation surplus can never be credited to income.

► If an asset is revalued, an entity may account for the accumulated depreciation at the date of revaluation in two ways:► Depreciation elimination method: The accumulated depreciation can be

eliminated against the asset itself.► Proportionate restatement method: The accumulated depreciation can be

restated proportionately with the change in the gross carrying value of the asset so that the carrying value of the asset after revaluation equals its revalued amount.

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► In 2006, Ernst & Young LLP provided an overview of 65 selected large, multinational companies reporting using IFRS. Only one company used the revaluation option for any of its PP&E.

► In a recent study, Hans B. Christensen and Valeri Nikolaev of the University of Chicago Booth School of Business looked at the valuation choices made by 1,539 German and UK companies in the first year of preparing IFRS financial statements. They found that only 3% of the companies chose to use fair value accounting for at least one class of assets.

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Example 1:

A company that reports using IFRS acquired weight-lifting equipment on January 1, 2011, at a cost of $10,000. This is the company’s only equipment. The company uses fair value for its equipment using IAS 16. On December 31, 2012, the net book value is $8,000 (cost of $10,000 less accumulated depreciation of $2,000), while the fair value is determined to be $8,800.

– What journal entries would be required to record the revaluations in 2012?

Periodic Valuation

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Example 1 solution:

Accumulated depreciation $ 2,000Equipment $ 2,000

(To eliminate accumulated depreciation.)

Equipment $ 800Revaluation surplus – equipment (OCI) $ 800

(To write equipment up to fair value.)


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Example 2:

A company that reports using IFRS acquired an excavator on January 1, 2010, at a cost of $10,000. This excavator represents the company’s only piece of equipment. The company uses fair value for its equipment using IAS 16. This excavator is being depreciated on a straight-line basis over its 10-year useful life. There is no residual value at the end of the 10-year period. In both 2010 and 2011, depreciation would be $1,000. On December 31, 2011, the fair value is determined to be $8,800. On December 31, 2013, the fair value is determined to be $5,000. The company’s accounting policy is to reverse a portion of revaluation surplus related to the increased depreciation expense.

– Determine what accounts would be impacted if this activity is recorded for 2010 through 2013.

Periodic Valuation

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Periodic valuationExample 2 solution:2010:Equipment $ 10,000

Cash $ 10,000(To record purchase of equipment.)

Depreciation expense $ 1,000Accumulated depreciation $ 1,000

(To record depreciation.)

2011:Depreciation expense $ 1,000

Accumulated depreciation $ 1,000(To record depreciation.)Accumulated depr. $ 2,000

Equipment $ 1,200Revaluation surplus – equipment (OCI) 800

(To record revaluation.)

2012:Depreciation expense $ 1,100

Accumulated depreciation$ 1,100

(To record depreciation.) Reval. surplus – equip. (OCI) $ 100

Retained earnings$ 100

(To reverse portion of reserve surplus related to increased depreciation expense. Note that this journal entry is optional.)

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Periodic valuationExample 2 solution (continued):2013:Depreciation expense $ 1,100

Accumulated depreciation $ 1,100

(To record depreciation.) Reval. surplus – equip. (OCI) $ 100

Retained earnings$ 100

(To reverse portion of reserve surplus related to increased depreciation expense. Note that this journal entry is optional.)

Accumulated depreciation $ 2,200Reval. surplus – equip. (OCI) 600Loss 1,000

Equipment$ 3,800

(To record devaluation of equipment.)

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Depreciation

IAS16 defines depreciation as "the systematic allocation of the depreciable amount of an asset over its useful life".

Depreciable amount is "the cost of an asset, or other amount substituted for cost, less its residual value".

Residual value is "the estimated amount that an entity would currently obtain from disposal of the asset, after deducting the estimated costs of disposal…".

Useful life is "the period over which an asset is expected to be available for use by an entity …".

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Purpose of depreciation

• The depreciation process makes no attempt to show assets at their current values.

• Charging depreciation does not guarantee that there will be funds available to replace assets when they come to the end of their useful lives.

The sole purpose of charging depreciation is to allocate an expense between accounting periods. In particular:

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Review of residual values and useful lives

The residual value and useful life of property, plant and equipment should be reviewed at least at the end of each financial year.

If expectations differ from previous estimates, these should be accounted for as a change in an accounting estimate in accordance with IAS8.

The asset's depreciable amount is revised to reflect any change in residual value and then this amount is allocated as depreciation over the remainder of the asset's expected useful life.

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Depreciation methods

• the straight-line method;

• the diminishing balance method;

• the units of production method.

The depreciation method chosen in relation to an item of property, plant and equipment should match the usage pattern of that item.

Available depreciation methods include:

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Review of depreciation methods

The depreciation method applied to an item of property, plant and equipment should be reviewed at least at the end of each financial year. If the usage pattern of the asset has changed, the depreciation method should be changed accordingly.

A change in depreciation method is accounted for as a change in an accounting estimate in accordance with the requirements of IAS8.

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Cost allocation issuesDepreciation

US GAAP

• Depreciable base: component depreciation is allowed, but is rarely done because it complicates the accounting.

IFRS

► Depreciable base: IAS 16.43 states, “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.”

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Example 3:

A company acquires a truck at a cost of $60,000. The service life is expected to be four years. Based on reliable historical data, the company believes the truck can be sold at the end of four years for $10,000. Additionally, the tires must be replaced every two years. The transmission must be replaced every three years. On the initial date of acquisition, the tires have a cost of $4,000 and the transmission has a cost of $6,000.

– What is the depreciable base and service life using US GAAP and IFRS?

– Assume the company chooses not to use component

depreciation using US GAAP.

Depreciation

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Example 3 solution:

Depreciable base

Service life US GAAP IFRSTruck 4 years $ 50,000 $ 40,000Tires 2 years – 4,000Transmission 3 years – 6,000

$ 50,000 $ 50,000

Depreciation

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Example 3 solution:Service life Depr. Basis Depr.

Truck 4 years $ 40,000 $ 10,000Tires 2 years 4,000 2,000Transmission 3 years 6,000 2,000

$ 50,000 $ 14,000

IFRS Depreciation

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Example 4:

A company acquired its only building on January 1, 2010, at a cost of $4 million. The building has a 20-year life and is being depreciated on a straight-line basis. On December 31, 2011, the net book value of the building was $3.6 million. The company revalued the building when the fair value of the building was $3.78 million on December 31, 2011. On December 31, 2013, the company sold the building for $3.6 million.

The company’s accounting policy is to reverse a portion of the surplus account related to increased depreciation expense.

– Show the journal entry to record the sale.

Disposition

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Example 4 solution:The entry to record the sale would be as follows:

Cash $ 3,600,000Accumulated depreciation 420,000Revaluation surplus (OCI) 160,000

Building cost 3,780,000Gain on sale 240,000Retained earnings 160,000

Note: if the asset hadn’t been revalued, the NBV of the building would have been $3.2 million (cost of $4.0 million less $200,000 depreciation x 4 years). If the building was sold for $3.6 million, the gain would have been $400,000.

Since the building was revalued, the depreciation expense over the four years was $820,000 ($200,000 in 2010 and 2011 and $210,000 in 2012 and 2013). Reserve surplus was reduced by $20,000 during this period with the credit applied directly to retained earnings. Reserve surplus can never be credited to income. Therefore, after reversing the remaining reserve surplus of $160,000 to retained earnings, the resulting gain is $240,000.

Disposition

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Main disclosure requirements of IAS16

• The measurement bases used;• The depreciation methods used;• The 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.

For each class of property, plant and equipment:

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Borrowing costs

IAS23 defines borrowing costs as "interest and other costs that an entity incurs in connection with the borrowing of funds".

Borrowing costs that are directly attributable to the acquisition, construction or production of a "qualifying asset" must be capitalised as part of the cost of that asset.

Other borrowing costs are recognised as an expense in the period in which they are incurred.

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Qualifying assets

Qualifying assets are those which take a substantial period of time to get ready for use or sale.

The capitalisation of borrowing costs should begin when:

(a) expenditure is being incurred on the asset;

(b) borrowing costs are being incurred, and(c) activities are in progress that are necessary so as to

prepare the asset for its intended use or sale.

Capitalisation ends when substantially all of the activities necessary to prepare the asset for its intended use or sale are complete.

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Acquisition Interest costs during construction

US GAAP• Interest costs are capitalized to

the extent that these costs could have been avoided had the expenditures been used to repay the debt rather than to acquire or construct the asset.

IFRS► Borrowing costs related to a loan

obtained specifically to acquire or construct the asset are capitalized in their entirety (reduced by any income from temporary investment of these funds).

► Borrowing costs related to funds obtained for a purpose other than acquisition or construction of the asset are determined by applying an average capitalization rate to the expenditures on the asset.

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Acquisition Interest costs during construction

US GAAP• Interest revenue cannot be

netted against interest cost.

IFRS► Interest revenue is netted

against interest cost. When funds borrowed to finance the acquisition of a qualified asset are temporarily invested, the interest cost should be reduced by any investment income earned on these funds.

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Example 5:

To finance construction of a qualifying asset, the company borrows $250,000 on January 1, 2011, at an interest rate of 8%. The company makes the following disbursements during the 24-month construction period: $100,000 on January 1, 2011; $50,000 on June 30, 2011; $50,000 on January 1, 2012, and $50,000 on June 30, 2012. Construction of the asset is completed on December 31, 2012, and it is ready for its intended use. During the construction period, excess funds are invested, which earn 5% in 2011 and 4% in 2012.

What is the amount of interest that should be capitalized using US GAAP and IFRS?

AcquisitionInterest costs during construction

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Example 5 solution:

US GAAP: The interest cost capitalized for the two-year period of $28,000 is calculated by determining the portion of the interest cost the company incurs during the construction of the building that theoretically could have been avoided. Interest revenue is not netted against interest expense.


DateAmount

disbursedMonths

outstandingWeighted

disbursement

January 1, 2011 $ 100,000 24/12 $ 200,000

June 30, 2011 50,000 18/12 75,000

January 1, 2012 50,000 12/12 50,000

June 30, 2012 50,000 6/12 25,000

Weighted-average accumulated expenditures $ 350,000

Interest capitalized at an 8% interest rate $ 28,000

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Example 5 solution (continued):

IFRS: IAS 23 allows all the interest cost incurred of $40,000 (250,000 x 8% x 2 years) to be capitalized less the income earned from temporary investment of those borrowings (paragraph 12). Therefore, under IFRS, the investment income earned is calculated as follows:

Thus, the net interest cost to be capitalized for this asset is $32,750 ($40,000-$7,250) using IFRS.


DateAmount available

Earnings rate Year

Investment income

January 1, 2011 $ 150,000 5% 1/2 $ 3,750

June 30, 2011 100,000 5% 1/2 2,500

January 1, 2012 50,000 4% 1/2 1,000

June 30, 2012 – 0% 1/2 –

$ 7,250

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Government Grants (IAS20)• Government grants should be recognised in profit or

loss "over the periods in which the entity recognises as expenses the related costs which the grants are intended to compensate".

• Therefore a grant for the acquisition of an asset should be recognised when calculating profit or loss for the periods in which depreciation is charged on that asset.– The grant may be credited to a deferred income

account and then systematically transferred to the statement of comprehensive income over the useful life of the asset, or

– The grant may be deducted from the carrying amount of the asset. This will result in reduced depreciation charges over the asset's useful life.

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Investment Property (IAS40)

Investment property is property (land and buildings) which is “held ... to earn rentals or for capital appreciation or both, rather than:

(a) for use in the production or supply of goods or services;

(b) for administrative purposes, or

(c) for sale in the ordinary course of business".

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Measurement of Investment Property

• The fair value model; the property is carried at fair value; gains and losses on adjusting fair value are recognised in the calculation of profit or loss each year. No depreciation taken.

• The cost model; the property is carried at cost less any accumulated depreciation and less any accumulated impairment losses.

Initial measurement is at cost. Subsequently, investment property may be measured using either:

chapter 5 - property, plant and equipment (ias16, ias23, ias20, ias40)

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