Accounting for Property, Plant and Equipment (Acquisition, Depreciation and Revaluation)

ACCG224 – Session 1, 2014

Week 4

Accounting for Property, Plant and

Equipment (Acquisition, Depreciation

and Revaluation)

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Readings (BEFORE the lecture!)

 ACCG224 textbook:

 Leo (9e): Chpt. 7

 Additional resources (available on iLearn):

 AASB 116, AASB 123

Please note:

The lectures will not strictly follow these slides. It is expected and required that you know the contents of the readings BEFORE the lecture. Consider these slides as a summary and guideline for the lectures (and later for your revision) where we will have more examples and discussions around the topics.

Also, this week’s slides have blanks within certain examples. It is a good exercise to try to fill the blanks BEFORE the lecture and compare your attempts with the solutions discussed in the lecture.

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Learning objectives

1. Understand the nature of property, plant and equipment (PPE); 2. understand the criteria for initial recognition of PPE;

3. understand how to measure PPE on initial recognition;

4. explain the alternative ways, in which PPE can be measured

subsequent to initial recognition;

5. understand the nature and calculation of depreciation; 6. explain the cost model of measurement;

7. explain the revaluation model of measurement;

8. understand the factors to consider when choosing which

measurement model to apply;

9. account for derecognition;

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Relation to weeks 2 and 3

 Conceptual framework:

general principles

about

 definition,

 recognition and

 measurement

of assets and liabilities.

 Now we look at

specific accounting standards

in relation to a

particular type of assets

:

 property, plant and equipment (PPE) (AASB 116).

 Including

tax implications

(AASB 112).

Overview AASB 116:

Property, Plant and Equipment (PPE)

 Definition

 Initial recognition of an asset  Subsequent measurement:

 Depreciation:

- allocating the depreciable amount of a non-current asset over the asset’s expected useful life;

- factors that must be considered in determining the useful life of a depreciable asset;

- various approaches (straight-line, sum-of-digits, declining balance, production basis) for this allocation;

 Cost Model

 Revaluation Model

 Derecognition

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The nature of PPE

 AASB 116 defines PPE as:

 tangible items;

 with a specific use within the entity;

 that are expected to be used during more than one period (ie. they are non-current in nature).

 AASB 116 specifically

excludes

:

 assets held for sale – AASB 5  biological assets – AASB 141  mineral rights/reserves – AASB 6

 For some purposes, PPE is

divided into classes

, e.g.

 land, buildings, machinery, ships, aircraft, motor vehicles, furniture and fixtures, office equipment.

also special rules for investment

property – AASB 140

Initial recognition of PPE

 Cost recognised as an asset if:

 it is

probable

that

economic benefits

will flow to the entity,

and

 the

cost

can be

reliably measured

.

 Where future economic benefits are not expected to flow to the

entity, costs incurred should be expensed.

 Component parts (with different useful lives) are required to be

separately accounted for:

 for example, an aircraft:

- the engine, frame and fittings of an aircraft are likely to have different useful lives.

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Initial measurement of PPE

 PPE is initially measured at

cost

, which includes:

 purchase price (at fair value);

 directly attributable costs required to bring the asset to the

location and condition necessary for it to operate;

 borrowing costs (AASB 123);

 Initial estimate of costs of dismantling, removing the item or restoring the site.

includes duties and taxes but excludes rebates and discounts

for example, an offshore oil platform more details on next slide

interest paid to finance acquisition, construction or production until ready for use, if for a substantial period of time

Directly attributable costs



„Directly attributable costs‟ include

a) costs of employee benefits arising from the construction or

acquisition of the item of property, plant and equipment;

b) costs of site preparation;

c)

initial delivery and handling costs;

d) installation and assembly costs;

e) costs of testing whether asset is functioning properly, after

deducting the net proceeds from selling any items

produced while bringing the asset to that location and

condition (e.g. samples);

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Measurement subsequent to initial

recognition

 AASB 116 allows a choice of two possible measurement models:

 cost model;

 revaluation model.

 Accounting policy choice of this decision based primarily on relevance of information.

 The policy that is chosen must be applied to a whole class of assets.

 May change policy, but only if it results in reliable and more relevant information.

 Under both models, PPE with a limited useful life need to be

depreciated.

Each model will be discussed in detail later

Depreciation – fundamentals

AASB 116 includes the following definitions:  Depreciation:

 the systematic allocation of the depreciable amount of an

asset over its useful life.

 Depreciable amount:

 the cost of an asset less its residual value (or other

appropriate amounts substituted for cost – eg. fair value).

 Residual value:

 the estimated value of the asset at the end of its useful life to

the entity.

 Useful life:

 the period over which an asset is expected to be used by an

entity/the number of production (or similar) units expected to be obtained by the entity.

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Depreciation – fundamentals (cont‟d)

 Depreciation is an allocation process designed to reflect the

decline in the value of the asset in a pattern consistent with the

consumption of economic benefits by the entity.

 AASB 116 does not specify how this allocation process should

be undertaken.

 Various depreciation methods are used in practice. Common

methods are discussed on the following slides.

 Please note

that depreciation applies to both the cost and the

revaluation model!

In all cases, depreciation expense is recognised with the following journal: DR Depreciation expense

Depreciation – common methods

 Straight-line method:

 assumption: asset

used evenly

throughout its life;

 this method is appropriate when benefits to be derived from

the asset are expected to be evenly received throughout the

asset’s useful life;

 annual depreciation amount:



cost (or revalued amount)- residual (salvage) value

useful life

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Depreciation – common methods

(cont‟d)

 Diminishing balance method:

 assumption:

more benefits

received

in earlier years

of the

life of asset;



depreciation expense is calculated on the asset’s opening

written-down value x depreciation rate;

 written-down value:

- cost (or revalued amount) less accumulated depreciation;

 depreciation rate:



1



residual value

cost or revalued amount

Depreciation – common methods

(cont‟d)

 Units of production method:

 based on

expected use or output

of asset;

 depreciation expense for the period is calculated as:



units produced in current period

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Depreciation – common methods

(cont‟d)

 Sum-of-digits method:

 this method is appropriate where useful life might be

related

more to production output than time

and when economic

benefits expected to be derived

are greater in the early

years

than later years

 depreciation expense:

- (cost - residual value) is multiplied by successively smaller fractions to calculate depreciation expense;

- numerator in fraction - changes each year, and is the years remaining of the asset’s useful life at the beginning of the period;

- example for the 2nd _{year if useful life = 5 years:}



(cost or revalued amt





Depreciation – useful life

 Management should consider the following factors when

estimating the useful life of an asset:

 expected use;

 physical wear and tear;

 technical or commercial obsolescence;

 legal or similar limits.

 Useful life is subject to periodic review.

 Land is not subject to depreciation as it does not have a limited

useful life.

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The cost model

 AASB 116 requires that assets are carried

at cost less any

accumulated

:

 depreciation;

 impairment losses

.

 Repair and maintenance costs are expensed as incurred, not

capitalised.

 Capitalisation requires (at time of expenditure) increased

probable future economic benefit:

 for example, replacement of car engine.

The revaluation model - fundamentals

 As an

alternative to the cost model AASB 116 allows the

revaluation model

to be used for classes of assets.

 Revaluation: adjustment of PPE’s carrying amount so that it

reflects its current fair value.

 Measurement

basis is fair value (FV).

 Frequency of revaluations is not specified, but must be

performed with sufficient regularity such that the carrying

amount of assets is not materially different from their FV.

 Revaluation performed on

a class basis

.

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The revaluation model – accounting on

an asset-by-asset basis

value Fair value

Increment/(d ecrement) Plant A 200,000 100,000 100,000 150,000 Plant B 140,000 40,000 100,000 80,000 TOTAL 340,000 140,000 200,000 230,000 50,000 (20,000) 30,000

 A Ltd has decided to change from the cost model to the

revaluation model to account for plant.

 At 30 June 2013 A Ltd owned the following plants:

 A revaluation increment will be recorded for Plant A and a

revaluation decrement will be recorded for Plant B.

class of assets

The revaluation model:

revaluation increments

 Increments

are



credited to equity: “asset revaluation surplus” (ARS)

account;

 through

other comprehensive income

(OCI);

 not

part of profit/loss (P&L) for the year.

 The revaluation of plant A would be recorded as follows:

Dr Accum. depreciation

100,000 *

Cr Plant

50,000 **

Cr Gain on revaluation (OCI)

50,000 ***

* Removal of existing accumulated depreciation

** Cost - FV

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The revaluation model:

revaluation increments (cont‟d)

 AASB 116 requires the tax effects of the revaluation to be considered and the ARS account to be recognised net of the resulting tax effect.  This is achieved by debiting a special type of income tax expense as

part of other comprehensive income (OCI) and crediting a deferred tax liability (DTL).

 An upwards revaluation of an asset creates a taxable temporary

difference (TTD) leading to a deferred tax liability (DTL).

 For plant A this would be calculated as:

CA – TB = TTD x 30% = DTL

150,000 – 100,000 = 50,000 x 30% = 15,000

Based on new FV of asset

Assumes that tax and acct. depn. rates

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The revaluation model:

revaluation increments (cont‟d)

 The tax effect for plant A would be recorded as follows: Dr Income Tax Expense (OCI) 15,000

Cr Deferred tax liability 15,000

 Combined entry:

Dr Accum. depreciation 100,000

Dr Income tax expense (OCI) 15,000

Cr Plant 50,000

Cr Deferred tax liability 15,000

Cr Gain on revaluation (OCI) 50,000

 At year end the OCI accounts are closed against the ARS: Dr Gain on revaluation (OCI) 50,000

Cr Income tax expense (OCI) 15,000

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The revaluation model:

revaluation decrements

 The accounting treatment of a

revaluation decrement

is as

follows:

 immediate recognition of an expense;

 no extra tax-effect entries beyond the tax-effect worksheet.

 The revaluation of Plant B would be recorded as follows:

Dr Accum. depreciation

40,000 *

Dr Loss on revaluation (P&L)

20,000 **

Cr Plant

60,000 ***

Please note: The loss on revaluation (P&L) leads to a temporary difference and deferred taxes as well. However, since it is part of the accounting profit (P&L) we deal with it together with all other differences between accounting profit and taxable income (see week 3 topic).

The revaluation model:

reversing previous increments

 A decrement reversing a previous increment

eliminates any ARS before recognising an expense.

 In relation to plant B, assume that a gross revaluation

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The revaluation model:

reversing previous increments (cont‟d)

 The revaluation of plant B would be recorded as

follows:

Dr Accum. depreciation

40,000

Dr Deferred tax liability

3,000

Dr Loss on revaluation (OCI)

10,000

Dr Loss on revaluation (P&L)

10,000

Cr Income tax expense (OCI)

3,000

Cr Plant

60,000

Workings for journal

Gross decrement 20,000

Reversal of prev. increment (10,000) – tax effect 3,000 DR to P&L 10,000

Please note: Here again, the loss on revaluation (P&L) leads also to a temporary difference and deferred taxes. We would deal with it together with all other differences between accounting profit and taxable income. What would the journal entry for this effect be?

The revaluation model:

reversing previous increments (cont‟d)

 At year end the OCI accounts are closed against

ARS:

Dr Income tax expense (OCI)

3,000

Dr Asset revaluation surplus (ARS)

7,000

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The revaluation model:

reversing previous decrements

 An increment reversing a previous decrement is

recognised through profit/loss (P&L).

 Any excess is recorded as other comprehensive

income (OCI) and increases ARS (net of related tax

effects).

 In relation to plant A, assume that a revaluation

decrement of $15,000 had been made in 2011.

The revaluation model: reversing

previous decrements (cont‟d)

 The revaluation of plant A would be recorded as

follows:

Dr Accum. depreciation

100,000

Dr Income tax expense (OCI)

10,500

Cr Plant

50,000

Cr Gain on revaluation (P&L)

15,000

Cr Gain on revaluation (OCI)

35,000

Cr Deferred tax liability

10,500

Working for journal

Gross increment 50,000

Reversal prev. decrement (15,000) (P&L) Gain on revaluation (OCI) 35,000

Less: tax effect (30%) (10,500) CR to ARS 24,500

Please note: The P&L part of the gain on

revaluation is a reversal of a previous loss on revaluation (P&L). It reverses also the

associated temporary difference and deferred taxes when we account for differences between accounting profit and taxable income.

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The revaluation model: reversing

previous decrements (cont‟d)

 At year end the OCI accounts are closed against

ARS:

Dr Gain on revaluation (OCI)

35,000

Cr Income tax expense (OCI)

10,500

The revaluation model:

depreciation of revalued assets

 When an asset is revalued, the depreciation charge

to be recorded over the remaining useful life of the

asset is recalculated by reference to the fair value of

the asset.

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The revaluation model:

comprehensive example

 On 30 June 2011 the statement of financial position of A LTD showed the following non-current assets after charging depreciation:

Description $

Building 300,000

Accumulated depreciation - Building (100,000)

Plant 120,000

The revaluation model:

comprehensive example (cont‟d)

 The company has adopted the revaluation model for the measurement of all property, plant and equipment. This has resulted in the

recognition in previous periods of an asset revaluation surplus for the building of $ 14,000. The plant consists of a machine purchased on the 1 July, 2010. On 30 June 2011, an independent valuer assessed the fair value of the building to be $160,000 and the plant to be $ 90,000. The income tax rate is 30%.

 Required:

1. Prepare the journal entries to revalue the building and the plant as at 30 June 2011.

2. Assume that the building and plant had remaining useful lives of 5 years and 4 years respectively, with zero residual value. Prepare the journal entries to record depreciation expense for the year ended 30 June 2012 using the straight line method.

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The revaluation model:

comprehensive example (cont‟d)

1. 30/06/2011

Dr Accumulated depreciation – building 100 000 Dr Loss on revaluation (OCI) 20 000 Dr Deferred tax liability 6 000 Dr Loss on revaluation (P&L) 20 000

Cr Income tax expense (OCI) 6 000 Cr Building 140 000 Dr Income tax expense (OCI) 6 000

Dr Asset revaluation surplus (ARS) – building 14 000

Cr Loss on revaluation (OCI) 20 000

Please note: If we did the journal entry for the tax effect of the loss on revaluation (P&L) right away it would look like

Dr DTA 6,000

The revaluation model:

comprehensive example (cont‟d)

1. 30/06/2011 (cont‟d)

Dr Accumulated depreciation – plant 40 000 Dr Income tax expense (OCI) 3 000

Cr Plant 30 000

Cr Gain on revaluation (OCI) 10 000 Cr Deferred tax liability 3 000 Dr Gain on revaluation (OCI) 10 000

Cr Income tax expense (OCI) 3 000 Cr Asset revaluation surplus (ARS) – plant 7 000

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The revaluation model:

comprehensive example (cont‟d)

2. 30/06/2012

Dr Depreciation expense – building 32 000

Cr Accumulated depreciation – building 32 000 ($160 000/5)

Dr Depreciation expense – plant 22 500

Cr Accumulated depreciation – plant 22 500 ($90 000/ 4)

The revaluation model:

transfers from ARS

 Transfers may be made from the ARS in the following

circumstances:

 When a

revalued asset is derecognised

(ie scrapped or

sold) → the balance in the ARS may be transferred to

retained earnings.

 When a

revalued asset is being depreciated

→ the ARS

may be progressively transferred to retained earnings over

the useful life of the asset.

 Bonus share issues

may be made from the ARS

DR ARS

CR Retained earnings

DR ARS

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Choosing between the models

 There is a cost disincentive to adopt the revaluation

model (Australian experience).

 Cost model harmonises with U.S. GAAP.

 Revaluation model provides increased relevance &

reliability.

Accounting for gains/losses from

derecognition

 Note: Assets classified ‘held for sale’ are treated according to AASB 5 → the following applies only to PPE which has not been classified as ‘held for sale’.

 Gain or loss from derecognition of an item of property, plant and

equipment is to be calculated as the difference between (AASB 116):

 net disposal proceeds (if any); and  the asset’s carrying amount.

 Derecognition

 the point in time when an asset is removed from the statement of financial position (balance sheet):

- when an asset is sold; or

- when no future economic benefits are expected from an asset’s use or disposal.

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Accounting for gains/losses from

derecognition (cont‟d)

 Example:

 A Ltd acquired a machine on 1 July 2007 for $50,000;  Useful life = 4 years; residual value = $10,000;

 On 1 July 2009 the machine was sold for $45,000.

 The journal entries to account for the sale are:

Dr Cash 45,000

Cr Proceeds on sale 45,000

Dr Carrying amount of asset 30,000

Dr Accumulated depreciation 20,000

Cr Machine 50,000

The gain on sale is $45,000 - $30,000 = $15,000 _{show this gain on} It is common to

sale net in the income statement

Accounting for gains/losses from

derecognition (cont‟d)

 When an

revalued

asset is sold, any resulting

balance in the revaluation surplus (AASB 116)

 may be transferred directly to retained earnings;

 cannot

be transferred to profit/loss (i.e. the so-called

‘recycling’ is not allowed);

 hence, for non-current assets under the revaluation

model any gain on sale shown in profit/loss will be less

than for assets under the cost model.

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Disclosure requirements

 For each class of property, plant and equipment the

following must be disclosed (AASB 116):

 measurement basis used for gross carrying amount;

 depreciation methods used;

 useful lives or depreciation rates used;

 gross carrying amount and accumulated depreciation

at beginning and end of period;

 reconciliation of carrying amount at beginning and end

of period.

Disclosure requirements (cont‟d)

 The required disclosures regarding asset revaluations

(AASB 116) are:

 effective date of revaluation;

 whether an independent valuer was involved;  methods and assumptions applied;

 extent to which fair values were determined, with reference to

observable prices in active markets or recent market transactions;  for each revalued class, the carrying amount if the cost model was

used;

 the revaluation surplus, indicating the change for the period and any restrictions on distribution of the balance to shareholders.