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Recognition
Extract from FRS 102 – Section 17.4-17.8
17.4 An entity shall apply the recognition criteria in paragraph 2.27 in determining whether to recognise an item of property, plant or equipment. Therefore, the entity shall recognise the cost of an item of property, plant and equipment as an asset if, and only if:
(a) it is probable that future economic benefits associated with the item will flow to the entity; and
(b) the cost of the item can be measured reliably.
17.5 Spare parts and servicing equipment are usually carried as inventory and recognised in profit or loss as consumed. However, major spare parts and stand-by equipment are property, plant and equipment when an entity expects to use them during more than one period. Similarly, if the spare parts and servicing equipment can be used only in connection with an item of property, plant and equipment, they are considered property, plant and equipment.
17.6 Parts of some items of property, plant and equipment may require replacement at regular intervals (e.g. the roof of a building). An entity shall add to the carrying amount of an item of property, plant and equipment the cost of replacing part of such an item when that cost is incurred if the replacement part is expected to provide incremental future benefits to the entity. The carrying amount of those parts that are replaced is derecognised in accordance with paragraphs 17.27 to 17.30. Paragraph 17.16 provides that if the major components of an item of property, plant and equipment have significantly different patterns of consumption of economic benefits, an entity shall allocate the initial cost of the asset to its major components and depreciate each such component separately over its useful life.
17.7 A condition of continuing to operate an item of property, plant and equipment (e.g. a bus) may be performing regular major inspections for faults regardless of whether parts of the item are replaced. When each major inspection is performed, its cost is recognised in the carrying amount of the item of property, plant and equipment as a replacement if the recognition criteria are satisfied. Any remaining carrying amount of the cost of the previous major inspection (as distinct from physical parts) is derecognised. This is done regardless of whether the cost of the previous major inspection was identified in the transaction in which the item was acquired or constructed. If necessary, the estimated cost of a future similar inspection may be used as an indication of what the cost of the existing inspection component was when the item was acquired or constructed.
17.8 Land and buildings are separable assets, and an entity shall account for them separately, even when they are acquired together.
OmniPro comment
Section 17.5 makes it clear that spare parts and standby equipment are classified as property plant and equipment when they are expected to be used during more than one period or only used in connection with an item of property plant and equipment. Where this is the case the spare part is depreciated over its useful life which cannot be more than the useful life of the main asset for which the spare parts are utilised. In the notes to the financial statements, an entity should disclose the depreciation rate on spare parts.
Example 1: Spare parts
A manufacturing company holds a significant stock of critical spare parts for its production equipment. Given that these spare parts are specific to the production equipment itself, and given that they will be used over more than one period, these assets are classified as PPE and depreciated over their expected useful life. In reality on transition the value if previously included in inventory should equal the cost to be transferred to PPE.
A similar example would be where plastic boxes are used for carrying and distributing the main products e.g. vegetables boxes which are used again and again and are not provided to customers on a long term basis as they must be returned. These are classified as fixed assets as opposed to spare parts.
Section 17 does not provide much detail on how to classify items where minimum levels of inventory are maintained i.e. to classify these as inventory or PPE. Generally, where an item of inventory is not held for sale or consumed in the production process or during the process of rendering services, but is necessary to operate or benefit from an asset during more than one operating cycle and cannot be recouped through sale, this item is then accounted for as a PPE item.
Where some items of PPE require replacement at regular intervals, which provide future economic benefits then the element replaced/updated needs to be derecognised and the additional expenditure capitalised and depreciated over its useful life. Where the previous expenditure was not separately identified from the main asset, an entity can use the depreciated replacement cost i.e. what would the cost have been based on current cost to update/replace less accumulated depreciation from the date it was acquired.
Where each major component of an item of PPE have significantly different patterns of consumption, there is a requirement to separately depreciate these over their useful life.
Example 2: Replacement of a major component which was previously not separated
In 2015 a company purchases a new piece of production equipment for CU2,000,000. This equipment incorporates a pump which at the date of acquisition is assumed to have the same useful life of the whole asset of 20 years. However, in year 10, the pump fails, and a new pump has to be purchased for CU400,000. Given that the pump is a large component of the main asset and given that the replacement pump will provide future economic benefits, the new pump will need to be capitalised and the old pump derecognised. At the date of acquisition, the company did not separate the CU2,000,000 cost between the pump and main asset. Therefore, at the date of purchasing the new pump, the company can use the cost of the replacement part to estimate the carrying value of the original pump at the end of year 10 i.e. the estimated NBV of the pump would then be CU200,000 (CU400,000 / 20 years * 10 years). Therefore, in year 10 a loss on disposal of CU200,000 would be posted to the P&L and a CU400,000 addition capitalised and depreciated from that date over the remaining 10 years of the main asset. It cannot be depreciated for longer than the remaining useful life of the main asset of 10 years.
Example 3: Periodic replacement
A company purchased a warehouse for CU2,000,000 which has a specialised ventilation unit which requires replacement every 5 years. The useful life of the warehouse itself is 50 years with no residual value. In accordance with Section 17, each major component part needs to be separately identified and the useful life determined for each. On acquisition, the company can use the estimated future cost of replacing the ventilation unit every 5 years (with no residual value), which was CU300,000. Therefore, at the end of year 5, the company will dispose of the specialist equipment at which stage there is a nil NBV and at the same time capitalise the cost of the new specialised ventilation unit.
Land and buildings are required to be separately identified, even when they are acquired together. This will mean that on acquisition, an exercise will have to be carried out to separate the land element from the buildings element and then depreciate the buildings element accordingly based on the useful life.
Example 4: Separation of land and buildings
Company A purchased a property on one acre of land for CU1,000,000. Under Section 17, it will be necessary for the company to allocate the purchase price between the land and property. The company asks a valuer to split the CU1,000,000 between these two components. It was determined the allocation of CU400,000/CU600,000 to land and buildings respectively was appropriate. The building cost of CU600,000 is depreciated over its useful life from the date of acquisition.
Measurement at initial recognition
Extract from FRS 102 – Section 17.9-17.13
17.9 An entity shall measure an item of property, plant and equipment at initial recognition at its cost.
17.10 The cost of an item of property, plant and equipment comprises all of the following:
(a) Its purchase price, including legal and brokerage fees, import duties and non-refundable purchase taxes, after deducting trade discounts and rebates.
(b) Any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management. These can include the costs of site preparation, initial delivery and handling, installation and assembly, and testing of functionality.
(c) The initial estimate of the costs, recognised and measured in accordance with Section 21 Provisions and Contingencies, of dismantling and removing the item and restoring the site on which it is located, the obligation for which an entity incurs either when the item is acquired or as a consequence of having used the item during a particular period for purposes other than to produce inventories during that period.
(d) Any borrowing costs capitalised in accordance with paragraph 25.2 (Section 17.10).
17.12 The income and related expenses of incidental operations during construction or development of an item of property, plant and equipment are recognised in the profit and loss if these operations are not necessary to bring the item to its intended location and operating condition.
17.13 The cost of an item of property, plant and equipment is the cash price equivalent at the recognition date. If payment is deferred beyond normal credit terms, the cost is the present value of all future payments.
OmniPro comment:
Costs which would deem to meet the condition of a directly attributable cost on top of initial delivery, handling, installation and assembly are:
- The cost of employees that arise directly from construction and acquisition of the item. This includes social security and pension costs.
- Installation and assembly costs;
- Professional fees (however, costs on speculative projects, and cost of aborted plans should be expensed);
- Cost of site preparation and site selection but only for the final site;
- Cost of testing whether the asset is working.
Example 5: Employee costs during construction
A retail outlet is moving into a new premises and incurs the cost of renovation for the store. It also has to incur salary costs for putting stock into the store. In this instance the cost of renovation can be capitalised even where own staff are used, however, the salary costs of employees stocking the shelves must be expensed.
Examples of items which are not directly attributable costs given in Section 17.11 are:
- costs of opening a new facility (note operating rental costs cannot be capitalised which incurred during the fit out stage and getting the store ready for opening);
- costs of introducing a new product or service (including costs of advertising and promotional activities);
- costs of conducting business in a new location or with a new class of customer (including costs of staff training); and
- administration and other general overhead costs.
Decommissioning costs
Section 17 makes it clear that the cost of decommissioning, dismantling and removing an item to restore it to its original condition should be included in the cost of the asset but only where it meets the requirements for a provision as detailed in Section 21 (i.e. there is a present obligation as a result of a past event where there is a constructive obligation). This is particularly relevant for manufacturing companies or companies who have premises which are leased and have been altered substantially. The amount to be capitalised is the present value of the future obligation for the cost of decommissioning or restoring the site with a provision recognised for the same amount. This amount should then be depreciated over the life of the lease or up to the period when the liability crystallises. It is particularly relevant where a company enters into a lease for a period of time and alters the property for its own purposes (dilapidation provision).
There may be circumstances where the liability does not arise initially on recognition but instead after a new environmental regulation is introduced. It is at that time that the asset should be capitalised.
Once the related asset has reached the end of its useful economic life i.e. when it is no longer in use, any further movement on the provision is posted directly to the profit and loss (IFRIC 1 paragraph 7).
Given the degree of estimation involved in determining the cost of remediation at the date of recognition, where a change to the estimate is made no retrospective adjustment is required. Where an increase in the liability is required the additional amount is added to the related asset in that period (i.e. no retrospective adjustment required) subject to a review for impairment to ensure it is not over stating the asset or where a decrease in the liability is required, it is deducted from the related asset and if it is more than the carrying amount it is posted to the profit and loss. The updated asset carrying amount is then depreciated over its remaining useful economic life. The unwinding of the discount is posted to interest cost in the profit and loss over the 50 year life. This is discussed further in Section 21of this website. Note the cost is not allowable for capital allowance purposes on initial recognition.
Example 5A: Decommissioning
A manufacturing plant which leases land for 50 years and constructs a factory on this. As part of the lease agreement it must reinstate the land to its original condition. It builds a plant on the land. At that point a provision is made in the books at its estimated present value cost in 50 years time of CU500,000. The accounting required for this transaction is:
|
|
CU |
CU |
|
Dr Fixed Assets |
500,000 |
|
|
Cr Provision |
|
500,000 |
Being journal to recognise the decommissioning cost
On a yearly basis depreciation is charged to write it down over the 50 year life i.e. CU10,000 per annum.
In year 10 the new estimate of the present value cost to reinstate the land is CU600,000. The NBV at that date is CU400,000 (CU500,000/50 yrs*10yrs). The liability included in the accounts after unwinding of the discount is at that time is CU550,000. The journals required at this time are as follows:
|
|
CU |
CU |
|
Dr Fixed Assets (600,000-550,000) |
50,000 |
|
|
Cr Provision |
|
50,000 |
Being journal to write the liability up to the new estimate
From that date the new carrying amount of the asset is CU450,000 (NBV of CU400,000+change in estimate of CU50,000). The depreciation over the remaining life is as follows: New cost of CU450,000/40 yrs =CU11,250
|
|
CU |
CU |
|
Dr Depreciation |
11,250 |
|
|
Cr Accumulated Depreciation |
|
11,250 |
Being journal to reflect the depreciation to be charged from year 10 on.
For revalued assets, where an increase in the liability is required, the additional amount is posted to the OCI and then to the revaluation reserve up to the point where the revaluation surplus is nil and at that stage the remainder is recognised in the profit and loss. Where a decrease in the liability occurs, the credit is posted to the OCI and then to the revaluation reserve except where this is reversing a previous revaluation surplus posted to the profit and loss account. Included in the disclosure section of this manual is an example of an accounting policy for decommissioning and restoration costs.
Self-constructed assets
The principals outlined above are still applicable. However, the cost of abnormal amounts of wasted material, labour or resource incurred in the construction process are expensed. This includes cost of design errors, industrial disputes, idle capacity and production delays.
Only labour costs directly attributable to the assets construction should be capitalised. Therefore, any costs which would have been incurred regardless of whether the item was constructed or not is ignored in relation to administrative expenses for those individuals. Only labour costs for work on that property should be capitalised.
Cessation of capitalisation
Costs recognition should cease once an item of PPE is in the location and condition for it to be capable of operating in the manner intended by management. This is usually the date of practical completion of the physical asset. In essence, the recognition of relocation and reorganisation costs, costs incurred during the run up to full use once an item is ready to be used, and any initial operating costs is not allowed.
Computer software
Computer software for a machine that cannot operate without specific software is an integral part of the machine and is treated as PPE. However, where software is not an integral part it is treated as an intangible. This differs from old GAAP so transition adjustments may be required. A computer which includes both software and hardware is classified as PPE. However, website development costs and specific software is a separate asset and should be classified as an intangible asset.
Property, plant and equipment are stated at cost less depreciation. Software which is considered to be an integral part of the related hardware is capitalised as property, plant and equipment.
Deferred payment terms – measurement of cost
The cost of an item of property, plant and equipment is the cash price equivalent at the recognition date. If payment is deferred beyond normal credit terms, the cost is the present value of all future payments.
Example 6: purchasing on deferred credit terms
A company purchased a piece of equipment from a related party supplier on preferential terms for CU300,000. The company does not have to pay for the equpment until 2 years after delivery. Under normal trading conditions, the company would have to pay on delivery. As a result, the Company must present value the CU300,000 using the rate of interest that would be charged on this balance by a third party. Assume the interest that would be charged by a bank for 2 years on a loan of CU300,000 is 7%. The amount to be recognised as an asset is the present value for the future payment.
CU300,000 / (1+.07)^2 = CU262,031.
The difference of CU37,969 (CU300,000-CU262,031) is posted as an interest cost over the two year period assuming it does not meet the requirements for capitalising borrowing costs under Section 25 i.e. it is a qualifying asset where the asset takes a period of time to complete. This CU37,969 is charged to the profit and loss account under the effective interest rate method as detailed in Section 11 of this website.
Extract from FRS 102 – Section 17.14
An item of property, plant or equipment may be acquired in exchange for a non-monetary asset or assets, or a combination of monetary and non-monetary assets. An entity shall measure the cost of the acquired asset at fair value unless:
(a) the exchange transaction lacks commercial substance; or
(b) the fair value of neither the asset received nor the asset given up is reliably measurable. In that case, the asset’s cost is measured at the carrying amount of the asset given up.
OmniPro comment
In respect to part (b) above, the carry amount is defined as the amount at which the asset is recognised after deducting any accumulated depreciation and accumulated losses. Where the consideration received comprises both a combination of monetary and non-monetary assets the fair value is adjusted by the amount of the monetary assets.
In deciding whether a transaction has commercial substance regard should be had to the guidance contained in IAS 16, it is regarded as having commercial substance, if:
- The configuration (risk, timing and amount) of the cash flows of the asset received differs from the configuration of the cash flows of the asset transferred; or
- The entity specific value of the portion of the entity’s operations effected by the transaction changes as a result of the exchange. Entity specific value is the present value of the cash flows an entity expects to arise from the continuing use of the asset and from its disposal at the end of its useful life or expects to incur when settling the liability. The post tax cash flows should be used.
- The difference in (a) and (b) is significant relative to the fair value of the assets exchanged (IAS 16.25).
As can be seen judgement will be required as to whether a transaction has commercial substance. However, in order for it to be shown at fair value it not only needs to have commercial substance, but also needs to be able to be reliably measured. If it cannot be reliably measured then it should be stated at the cost of the asset given up.
Example 7: Exchange of assets- assets that lack commercial substance
Company A exchanges van X with a book value of CU20,000 and a fair value of CU25,000 for cash of CU2,000 and van Y with a fair value of CU23,000. This transaction lacks commercial substance as cash flows are not expected to change as a result of the exchange, they are in the same position as before the transaction. Therefore, the company recognises the cost of VAN Y at the CU20,000. Hence accounting entries are to debit bank CU2,000, debit fixed assets CU18,000, credit profit/loss on disposal CU20,000 which is set against the disposal of the NBV of Van X to show a no profit/no loss.
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