PROPERTY, PLANT AND EQUIPMENT (PPE)

Learning outcomes After this lecture students should: a) Appreciate many of the problems associated with accounting for PPE; b) Understand how accounting standards resolve those problems to ensure reasonable comparability of accounts. Introduction Basic regulatory framework relevant to PPE (tangible fixed assets): IAS 16 - "Property, plant and equipment"; IAS 23 Borrowing costs. IAS 36 Impairment of assets. Inatangible fixed assets and goodwill are beyond the scope of this lecture. Defintion of Property, Plant and Equipment IAS 16 defines PPE as tangible assets that are: a) held by an enterprise for use in the production or supply of goods and services, for rental to others, or for administrative purposes, and b) are expected to be used during more than one period. Would normally be found in the non-current section of the balance sheet. Determination of cost Per IAS 16: 1. Purchase price or 2. Expenditure incurred in production (e.g. materials, labour, appropriate proportion of relevant overheads) and 3. Expenditure incurred in bringing the fixed asset to working condition for its intended use (e.g. Site preparation, installation costs, carriage, professional fees). 4. Initial estimate of dismantling, removing and restoring if significant.

Problem areas 1. Subsequent expenditure on an asset-how should it be treated? a). Repairs & maintenance - write off as an expense to the income statement. b) Enhancement costs - capitalise & write off over useful life of asset. IAS 16 - "where it is probable that future economic benefits in excess of the originally assessed standard of performance of the existing asset will, as a result of the expenditure, flow to the enterprise. (e.g. increase in capacity, output of higher quality). Major components that require regular replacement should be treated as a separate asset with a different economic life. (e.g. components of an aircraft). 2. Borrowing costs for construction of an asset - should they be capitalised? For: -part of total cost required to bring asset into use -comparability-included in purchase price of a bought in asset Against: -often difficult to link borrowing costs with specific assets -the cost of an asset whose construction is financed by borrowings might be different from a similar asset financed out of retained profits. Capitalisation is widely adopted especially in retail & property development sectors as it boosts short term profits & some key indicators (e.g. interest cover). IAS 23 General rule is that borrowings should be regarded as an expense in the period in which they are incurred. Alternative permitted treatment is that borrowing costs that are directly attributable to the acquisition, construction or production of qualifying asset (one that takes a substantial amount of time to bring into use) are included in the cost of an asset. The higher cost will mean an increase in the depreciation charge in subsequent years. So companies have the choice to capitalise directly attributable borrowing costs or not, however, they must apply the policy consistently & disclose their policy. Revaluations Should companies revalue their tangible non-current assets? For: Provides useful current information to users of accounts. Against: Selective revaluations undermine the integrity of historic cost accounting. Loss of comparability. IAS 16 makes it clear that the benchmark treatment is to carry PPE at cost less accumulated 2

depreciation (i.e. historical cost). However there is a permitted alternative treatment that PPE should be carried at its fair value at date of revaluation less accumulated depreciation. Fair value is the amount an asset could be sold for in a normal market transaction. Therefore IAS 16 leaves revaluation as a matter of choice for company directors but has further rules to bring a measure of order to the situation: -all PPE (e.g. land and buildings) in a particular class must be treated the same way. -valuations must be current - how often will depend on the rate of inflation. When a fixed asset is revalued, the surplus should be credited to a revaluation reserve. Depreciation to be based on valuation - higher charge (usually). IAS 16 states profit /loss on disposal should be based on valuation and shown as part of the income statement. Lecture Example 1 Horace Ltd. acquired an asset for 20,000 at the start of year 1. Its estimated useful life is 10 years and its estimated residual value is 0. The company uses straight line depreciation. At the start of year 3 the asset is revalued to 24,000. How is this dealt with in the accounts? Solution Net book value at the time of revaluation is 16,000 (2 years depreciation at 2,000 p.a.). All the accumulated depreciation is reinstated (i.e. 4,000) and the balance is charged to cost: DR. Asset (cost) 4,000 Asset (accumulated depreciation) 4,000 CR. Revaluation reserve

8,000

What will be shown in the accounts at the end of year 3? The revalued asset will be written off over the remaining useful life (24,000 / 8 years) so the revised depreciation charge will be 3,000 p.a. Therefore the net book value of the asset will be 21,000. It is normal to make an annual transfer between reserves, based on the extra depreciation charge, to demonstrate that the revaluation reserve is being used up: DR. Revaluation reserve 1,000 CR. Profit and loss account 1,000 What if the asset is then sold for 25,000? 3

Profit on disposal per income statement will be (25,000 - 21,000) = 4,000. As the gain is now realised the balance on the revaluation reserve can now be transferred to the profit and loss account balance (but not part of reported profit for the year). DR. Revaluation reserve (BS) CR. Profit & loss account (BS) 7,000 7,000

Revaluation losses are normally written off to the income statement. Rationale for depreciation Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life. (IAS 16). It is the application of the matching concept in an accounting period when we enjoy the benefits of using an asset, we charge an appropriate proportion of the cost of that asset. It is NOT a means of saving up for a new asset OR a way of ensuring that the asset is shown at its real value in the balance sheet. Factors affecting depreciation Three factors need to be considered in assessing total depreciation to be assigned to future periods: 1. Cost or value; 2. Expected useful life; Economic life may not be the same as total working life. (e.g. technological changes). 3. Residual value. IAS 16 defines as: As the estimated amount that the entity would currently obtain from disposal of the asset, after deducting the estimated costs of disposal. Depreciable amount = Cost or value Residual value Lecture example 2 A business buys a thwacking machine for 25,000. Delivery costs are 800, and it costs a further 3,100 to install the machine using its own employees. It is expected that the machine will last 8 years, and have a residual value of 7,500. What is the depreciable amount?

Cost Residual value Depreciable amount Will turn into an expense over an 8 year period.

28,900 7,500 21,400

How should the depreciable amount be allocated over future periods? E.g. straight line method, diminishing or reducing balance method. IAS 16: "The depreciation method should reflect the pattern in which the assets future economic benefits are expected to be consumed." Straight line method dominates in practice because it is simple and because of the inherent subjectivity involved in the process. Changes in estimated useful life If a change is considered appropriate, the current NBV should be written off over the revised estimated useful life. Scope for creative accounting e.g. British Airports Authority. Lecture example 3 An asset is purchased for 10,000 with an estimated useful life of 10 years. After 5 years , total life is estimated at 15 years. How much depreciation should be charged in each year? Solution Original depreciation charge = 10,000 / 10 years = 1,000 p.a. Revised depreciation charge: After 5 years it still has a useful life of a further 10 years. Net book value = 5,000 / 10 years = 500 p.a. Depreciation of property Many companies (e.g.brewers) do not charge depreciation on property, arguing that: 1.The assets are maintained to a high standard so they do not have a finite life; 2.Residual value higher than current NBV; 3.Property appreciates in value, why depreciate?

View of IASB: Land and buildings are separate assets and are dealt with separately for accounting purposes, even when they are acquired together. Land normally has an unlimited life and, therefore, is not depreciated. Buildings have a limited life and therefore are depreciable assets. An increase in 5

the value of the land on which a building stands does not affect the determination of the useful life of the building. Depreciation on buildings would appear to be compulsory under IAS 16. Impairment Quite apart from the need to depreciate PPE, IFRS requires that non-current assets are carried in the books at no more than their recoverable amount (i.e. are not overvalued). This is defined as the higher of: a) net realisable value; b) value in use (present value of future cash flows generated by the asset discounted by a market rate of return suitable for level of risk). IAS 36 sets out procedure for impairment review. PPE will be required to be reviewed for impairment only if there is an indication that it has occurred e.g. expected future losses Any impairment loss is to be written off to the profit and loss account (unless the asset was previously revalued upwards and the impairment loss arises from falling prices in which case it will be offset against the previous revaluation surplus). Key disclosures Measurement base used (i.e. cost or valuation). Depreciation methods used and indication of useful lives. A note reconciling opening cost and depreciation to closing balances at the year end. See relevant notes in published accounts. A full example Lecture example 4 At 31 December 20x5 Johnson plc had the following PPE balances: Accumulated Cost depreciation 000 000 Land & buildings 5,880 388 Plant & equipment 3,930 1,180 Fixtures & fittings 1,200 420 Total 11,010 1,988

Net book value 000 5,492 2,750 780 9,022

The standard rates of depreciation charged are as follows: Buildings (which account for 3,880 of the cost of land and buildings) 2% straight line basis; 6

Plant & equipment 20% straight line basis; Fixtures & fittings 10% straight line basis. It is the companys practice to make a full years charge on new items in the year of purchase.

The following additional information is relevant for the year ended 31 December 20x6: a) On 1 January 20x6 the land & buildings were revalued at 8.4 million (of which the building accounts for 6.9 million). They had originally been acquired on 1 January 20x1. b) Fixtures & fittings costing 400,000 were acquired during the year. Installation costs for these items were 10,000 and maintenance costs were 3,000. Also plant & machinery costing 560,000 was purchased. c) A machine purchased on 1 January 20x3 for 500,000 was sold during 20x6 for 240,000. d) An item of plant purchased on 1 January 20x5 for 600,000 is now expected to have a total useful economic life of just 4 years. Required: Prepare a schedule of PPE movements suitable for inclusion in the companys published accounts for 31 December 20x6. Solution Johnson plc Schedule of property, plant and equipment movements for year ended 20x6. Land & Buildings 000 Cost or value Beginning of year Additions Disposals Revaluation End of year Depreciation Beginning of year Disposals Revaluations Depreciation charge End of year Carrying amount at 1 January 20x6 Carrying amount at 31 December 20x6 5,880 2,520 8,400 Plant & Machinery 000 3,930 560 (500) 3,990 Fixtures & Fittings 000 1,200 410 1,610

Total 000 11,010 970 (500) 2,520 14,000

388 (388) 153 153

1,180 (300) 838 1,718

420 161 581

1,988 (300) (388) 1,152 2,452

5,492

2,750

780

9,022

8,247

2,272

1,029

11,548 7

WORKINGS 1.Revaluation of land & buildings Net book value at time of revaluation is 5,492,000 so a revaluation to 8,400,000 is an increase of 2,908,000. Accumulated depreciation of 388,000 is reinstated, and the balance of 2,520,000 is charged to cost. DR. Land & buildings (cost) 2,520,000 DR. Land & buildings (accumulated depreciation) 388,000 CR. Revaluation reserve 2,908,000 Depreciation for 20x6 will now be based on the new carrying value for the buildings of 6,900,000. Total estimated useful economic life is 50 years, 5 years had elapsed before the revaluation, so 45 years remain. Revised annual depreciation charge 6,900,000 / 45 = 153,333. 2. Additions. Fixtures & fittings include installation costs, but maintenance costs are not part of the cost of bringing the asset into a working condition total cost 410,000. Plant & machinery, no complications total cost 560,000. 3. Disposals. For an asset which has been sold it is necessary to deduct cost and relevant accumulated depreciation Cost is given 500,000. Accumulated depreciation can be calculated: 500,000 x 20% = 100,000 x 3 years = 300,000. The selling price is irrelevant unless you are specifically required to calculate profit or loss on disposal. Selling price net book value = Profit or loss on disposal of asset. In this case: 240,000 (500,000 - 300,000) = 40,000 profit. DR. Plant & machinery (accumulated depreciation) 300,000 DR. Sale proceeds 240,000 CR. Plant & machinery (cost) CR. Profit on disposal of PPE

500,000 40,000

This would be included in the income statement but does not appear in the PPE schedule. 4. Calculate depreciation charge for 20x6. Land & buildings already covered see working note 1. Fixtures & fittingsNo complications so just apply standard rate on year end cost. Cost at 31 December 20x6 = 1,610,000 x 10% = 161,000. 8

Plant & machinery Non-standard item with revised estimated useful life. Net book value at 31 December 20x5 = 600,000 ( 600,000 x 20% x 1 year) = 480,000. This needs to be written off over the remaining 3 years of life: 480,000 / 3 years = 160,000. Standard items Cost at 31 December 20x6 3,990,000 Less cost of non standard item 600,000 Cost of standard items 3,390,000 Apply standard rate of depreciation: 3,390,000 x 20% = 678,000 Total depreciation charge for plant & machinery 838,000. Conclusion IAS 16 has improved standardisation in this area, but much remains judgemental.

Property, plant and equipment Seminar questions 1. In the year to 31 December 20x9, Amy bought a new item of plant and made the following payments in relation to it: 12,000 1,000

Cost as per suppliers list Less: agreed discount Delivery charge Erection charge Maintenance charge Additional component to increase capacity Replacement parts

11,000 100 200 300 400 250

Required: a) State and justify the cost figure which should be used as the basis for depreciation. b) What does depreciation do, and why is it necessary? 2 .Jospin plc has the following plant, property and equipment at 1 April 2005: Accumulated Depreciation 000 600 440 1,080 2.120 Net Book Value 000 3,400 784 1,346 5,530

Cost 000 Freehold factory Plant and machinery Fixtures and fittings 4,000 1,224 2,426 7,650

You are given the following information for the year ended 31 March 2006: (i) Depreciation is provided on cost on a straight line basis. The rates used are 2% for freehold buildings, 20% for plant and machinery and 10% for fixtures and fittings. (ii) It is the companys policy to charge a full years depreciation in the year of acquisition, and none during the year of disposal. (iii) On 1 April 2005 the factory was revalued to 6,000,000 (buildings 4,400,000 and land 1,600,000). It had been purchased on 1 April 1995. (iv) Major repairs were carried out to a machine costing 30,000. This included a new filter costing 10,000 which increased the efficiency of the equipment by 50%. (v) Fixtures and fittings costing 480,000 on 1 June 2000 were sold for 440,000. (vi) A new machine was purchased for 140,000 plus installation costs of 10,000 10

(vii) Fixture and fittings were purchase for 50,000 plus delivery costs of 4,000 and a 2,000 warranty against mechanical defects for three years. (viii) On 1 April 2005, when reviewing the expected lives of its PPE, the directors decided that due to changes in technology it was desirable to reduce the remaining life of a machine purchased on 1 April 2004 to two years. It would then be scrapped with an expected nil residual value. The original cost of the machine was 764,000.

REQUIRED: (a) Prepare a schedule of PPE movements and balances (i.e. reconciling opening balances with closing balances) suitable for inclusion in the companys published accounts for the year ended 31 March 2006. A company has the following accounting policy: Freehold and long leasehold properties are maintained to a standard that preserves likely residual values at a level at least equal to total book values. Accordingly no provision has been made for depreciation as the amount involved would not be material. Evaluate this policy against the requirements of IAS 16 and IAS 36.

(b)

3. Herring plc has the following non-current assets at 1 April 20x8. Net book Value 000 1,296 1,711 255 305 3,567

Cost 000 Freehold factory 1,440 Plant & equipment 1,968 Motor vehicles 449 Office equipment & fixtures 888 4,745

Depreciation 000 144 257 194 583 1,178

You are given the following information for the year ended 31 March 20x9: (i) (ii) The factory was acquired in June 20x4 and is being depreciated over 50 years. Depreciation is provided on cost on a straight line basis. The rates used are 20% for fixtures and fittings, 25% for motor vehicles and 10% for plant and equipment. During the year the factory was revalued to an open market value of 2.2 million and an extension was built costing 500,000. Plant and fixtures for the factory extension cost 75,000 and 22,000 respectively. The directors decided to change the method of depreciating motor vehicles to 30% 11

(iii)

(iv)

reducing balance to give a fairer presentation of the results and of the financial position. (v) (vi) Two cars costing 17,500 each were bought in May. When reviewing the expected lives of its non-current assets the directors felt that it was necessary to reduce the remaining life of a two year old grinding machine to four years when it will be sold for 8,000 as scrap. The machine originally cost 298,000 and at 1 April 20x8 had related accumulated depreciation of 58,000. It is the companys policy to charge a full years depreciation in the year of acquisition.

(vii)

REQUIRED Prepare the disclosure notes for PPE for the year ended 20x8 in a form suitable for publication in a set of company accounts.

12