Chapter 3: PPE

Question 1

What are directly attributable costs?

Answer 1

• Costs of employee benefits arising directly from the construction or acquisition of the PPE
• Costs of site preparation
• Initial delivery and handling costs
• Installation and assembly costs
• Costs of testing…after deducting the net proceeds from selling any items produced
• Professional fees
• All direct costs of construction (e.g. materials, labour, borrowing costs)
• The present value of the initial estimate of costs to dismantle and remove the asset and restore the site at the end of the useful life, if there is an obligation to do so

Question 2

What are excluded costs?

Answer 2

Should be written off to the SPL

• administration costs
• general overheads
• abnormal costs e.g. as a result of labour strikes or planning errors
• costs incurred after the asset is capable of normal operation

Question 3

Can incidental income be deducted from the costs of the asset?

Answer 3

No - it is not allowed to be deducted from the cost of the asset. It is treated as other income in the SPL:
- e.g. income from using a building site as a car park before construction commences

Question 4

Can subsequent costs on an item of PPE be capitalised?

Answer 4

Only if it enhances the economic benefit provided by the item

Question 5

What is a qualifying asset?

Answer 5

IAS 23: an asset that takes a substantial period of time to get ready for its use or intended sale

Question 6

Where borrowings are specific to the asset, what should you capitalise?

Answer 6

Add: Borrowing costs incurred
Less: Income from temporary investment of surplus borrowings
—————

Question 7

Where funds are taken from general borrowings, what should you capitalise?

Answer 7

Weighted average cost of borrowing x expenditure on asset

This should be pro-rated for the period of capitalisation

Question 8

Stepney Ltd has the following loans outstanding:
 £1 million at an interest rate of 7%
 £500,000 at an interest rate of 5.5%

It is using some of these funds to construct a new office block, at a cost of £250,000.

The building work will take six months.

What amount will be capitalised in respect of the office block?

Answer 8

Weighted average cost of borrowings:

((£1m x 7%) + (£500,000 x 5.5%)) / £1.5m x 100%=

£97,500 / £1.5m x 100%

= 6.5%

Total cost of asset:
Cost of construction     £250,000
Borrowing costs
6.5% x £250,000 x 6/12  £8,125
------------
258,125

Question 9

When should capitalisation of borrowing costs begin, suspend or cease according to IAS 23?

Answer 9

Commence:
- When expenditure on asset incurred simultaneous to borrowing costs and activities to prepare asset for sale/use are in progress

Suspend:
- During extended periods in which it suspends active development of a qualifying asset

Cease:
- ‘When substantially all activities necessary to prepare the asset for use/sale are complete’

Question 10

What is the residual value?

Answer 10

The estimated amount that an entity would currently obtain from disposal of the asset if it were already at the end of its useful life

Question 11

Where is depreciation charged?

Answer 11

Depreciation is charged to the statement of profit or loss except where accounting standards allow it to be included within the cost of another asset

E.g.: plant and machinery depreciation may be included within the cost of the inventory which it produces

Question 12

When do you review depreciation?

Answer 12

• The method of depreciation should be reviewed at each year end and changed if it no longer reflects the pattern of use of the asset
• The residual value and useful life should be reviewed at each year end and changed if expectations differ from previous estimates

Question 13

How do you treat separate components when depreciating?

Answer 13

• Some items of PPE are made up of different components with different useful lives.
   E.g. An aircraft’s interior will require replacement several times during the life of the aircraft body.
   The cost of replacing components may be capitalised.
   Prior to the capitalisation of the new component, the old component must be derecognised.
   Each major component is depreciated separately over its useful life.

Question 14

What are the two valuation models for PPE?

Answer 14

• The cost model
  Cost less any accumulated depreciation, less accumulated impairment losses
• The revaluation model
  The CA should be: its fair value at revaluation, minus any subsequent AD, minus any subsequent accumulated impairment losses

Question 15

Why should revaluations be updated regularly? What is fair value?

Answer 15

• Revaluations should be updated regularly to ensure that the SOFP value does not differ materially from fair value
• Fair value is generally considered to be market value

Question 16

What is the double entry for an upwards revaluation?

Why does the credit entry go where it goes?

Answer 16

DR Cost (to increase the cost of the asset to fair value)
DR AD (to eliminate the depreciation to date)
CR Revaluation Surplus (balancing figure = fair value - carrying amount)

The credit entry is to the revaluation surplus rather than the statement of profit or loss to reflect the fact that the gain is not yet realised

A credit entry could arise for the top line, if the accumulated depreciation exceeds the amount of the revaluation surplus

Question 17

Where do you present revaluation gains?

Answer 17

Revaluation gains are part of comprehensive income and should be presented in the SOCI as follows:

Other comprehensive income for the year

PFY  (add) 
Other comprehensive income
Gain on property revaluation (add)
-------------------------
Total comprehensive income

Question 18

How does depreciation based on a revalued amount differ to that on historical cost?

Answer 18

• Depreciation based on a revalued amount will exceed depreciation based on historical cost
• Therefore as a result of an upwards revaluation, subsequent periods’ profits will decrease, despite no income being recognised from the revaluation gain in the SPL
• This reduces retained earnings out of which dividends may be paid

Question 19

How do you avoid a revaluation policy adversely affecting shareholders?

Answer 19

In order that a revaluation policy does not adversely affect shareholders in this way, IAS 16 allows that the amount of excess depreciation charged each year due to the revaluation, is transferred into retained earnings from the revaluation surplus:

Dr Revaluation Surplus
Cr Retained Earnings

(excess depreciation is difference between old and new depreciation)

Question 20

How do you revalue an asset downwards when it has not been previously revalued upwards?

Answer 20

The decrease in value of the asset is recognised in the SPL:
Dr SPL Balancing Figure (CA - fair value)
Cr CA of asset (to reduce the asset’s carrying amount to fair value)

Question 21

How do you revalue an asset downwards where the asset has previously been revalued upwards?

Answer 21

• The debit entry should first be charged to the revaluation surplus to the extent that it relates to the asset in question
• Any balance is charged to the statement of profit or loss:

DR Revaluation Surplus (to the extent the surplus relates to the asset)
DR SPL Balancing figure (if necessary)
CR CA of asset (To reduce the asset’s carrying amount to fair value)

Question 22

What does IAS 36 identify as an indicator of impairment? (External)

Answer 22

External indications
 Decline in the market value of an asset.
 Adverse changes to the environment in which the entity operates (which may reduce the future economic benefits expected of the asset).
 Increases in interest rates (which affect the discount rate used to calculate the present value of future cash flows generated by the asset).
 The value of the entity as a whole is less than its net asset value.

Question 23

What does IAS 36 identify as an indicator of impairment? (Internal)

Answer 23

• An asset is obsolete or damaged.
• Changes have occurred within the entity which mean that an asset will not generate the benefits previously expected of it, e.g. it is left idle.
• Evidence is available to suggest an asset will not perform as well as expected.

Question 24

How do you account for an impairment loss on assets valued using the cost model?

Answer 24

The impairment loss is recognised in the statement of profit or loss as an expense immediately:

DR SPL
CR CA of Asset

Question 25

How do you account for an impairment loss on assets valued using the revaluation model?

Answer 25

• The impairment loss is charged to the revaluation surplus to the extent that it reverses any previous upward revaluation of the asset
• Any excess is charged to the statement of profit or loss:

Dr Revaluation Surplus
Dr SPL (balancing figure)
Cr CA of asset

Question 26

How do you charge depreciation on an impaired asset?

Answer 26

(New CA - Estimated residual value) / Remaining UL

Question 27

When can an asset be held for sale?

Answer 27

IFRS 5 Non-current Assets Held for Sale and Discontinued Operations states that for this to be the case:
 the asset must be available for immediate sale in its present condition
 the sale must be highly probable, meaning that:
– management are committed to a plan to sell the asset
– there is an active programme to locate a buyer; and
– the asset is being actively marketed
 the sale is expected to be completed within 12 months of its classification as held for sale
 it is unlikely that the plan will be significantly changed or will be withdrawn

Question 28

How do you make an asset held for sale using the cost model?

Answer 28

Step 1 When an asset is classified as held for sale, measure it at the lower of:
 carrying amount and
 fair value less costs to sell.
Step 2 This will result in the immediate recognition of an impairment loss if fair value less costs to sell is less than the carrying amount.
Step 3 Cease depreciation.
Step 4 Present the asset separately on the statement of financial position (normally underneath the sub-total of current assets).
Step 5 When the asset is sold, calculate and record any gain or loss as normal in the statement of profit or loss.

Question 29

What happens if the end of a reporting period falls between when the asset is classified as ‘held for sale’ and the disposal date?

Answer 29

The fair value less costs to sell may fall below (or rise
above) the figure used in the original classification.
 Any fall is treated as a further impairment loss.
 A rise will reduce the original impairment loss (up to the assets carrying amount).

Question 30

How do you make an asset held for sale using the revaluation model?

Answer 30

The treatment of a revalued asset is the same as cost, although with one extra step before Step 1:
– prior to classification as held for sale, the asset should be revalued (using the normal IAS 16 Property, Plant and Equipment rules). Carrying amount will therefore = fair value
– when the asset is then classified as held for sale, step 1 (above) will result in the immediate recognition of the costs to sell as an impairment loss
– the remaining steps are as for an asset held under the cost model

Step 1 When an asset is classified as held for sale, measure it at the lower of:
 carrying amount and
 fair value less costs to sell.
Step 2 This will result in the immediate recognition of an impairment loss if fair value less costs to sell is less than the carrying amount.
Step 3 Cease depreciation.
Step 4 Present the asset separately on the statement of financial position (normally underneath the sub-total of current assets).
Step 5 When the asset is sold, calculate and record any gain or loss as normal in the statement of profit or loss.

Question 31

How do you treat an asset that is to be scrapped? (abandoned)

Answer 31

If an asset is to be scrapped:
 continue to classify it as a non-current asset
 continue to depreciate it until it is scrapped
 when the asset is scrapped, recognise any profit or loss on disposal as the difference between the proceeds (if any) and carrying amount.

Question 32

What should a disclosure be made of?

Answer 32

• the measurement bases used (cost or revaluation model) for each class of PPE
• depreciation methods used
• useful lives/depreciation rates used
• changes in accounting estimates
• a PPE reconciliation.

Question 33

What should there be for each material impairment loss?

Answer 33

For each material impairment loss there should also be a disclosure of the nature and amount of loss

Question 34

What are the ethical and judgement issues associated with IAS 16?

Answer 34

There may be pressure on accountants to incorrectly capitalise borrowing costs or overstate costs of PPE.

The following ethical principles set out in the ICAEW Code of Ethics need to be demonstrated when accounting for PPE:
 professional competence and due care
 objectivity