FINANCIAL REPORTING- 6 PPE Flashcards
Recognition of PPE
PP&E is only recognized as an asset if the following criteria apply:
- It is probable that future economic benefits associated with the item will flow to the entity.
- The cost of the item can be measured reliably
When assessing whether there are economic benefits, it is important to consider the range of ways in which an asset can directly or indirectly benefit the entity. For example, it is easy to see how a piece of manufacturing machinery would generate long-term economic benefit by producing inventory that will be sold at a profit. However, a computer used in the accounting department also provides economic benefit and is equally qualified to be recognized as PP&E. It does not directly create cash flows; however, it does contribute to the overall operations of the entity, allowing it to run effectively, which generates benefit.
In most cases, the cost can be measured reliably. Purchased assets are reasonably straightforward.
Once it is determined that the expenditure meets the requirements to be capitalized as PP&E, the next question concerns what costs are capitalized.
What PPE costs are Capitalize
The cost of an asset capitalized as PP&E comprises three components:
- its purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates
- 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
- the initial estimate of the costs 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
What costs of Purchased Equipment are capitalize
For equipment that is purchased, you would capitalize the purchase price. Included in this would be any costs that are not refundable, such as import duties and sales taxes. Most sales taxes (such as GST and HST) may be recovered by the entity and are not included in the cost.
In addition to the purchase cost, the entity would include the cost to bring the asset into use. For example, the entity would also include the following in the cost of the asset:
- delivery of the asset
- installation of the asset
- testing that the asset is operational
What happens after costs of Purchased Equipment are capitalize
Once the asset is available for use, any costs going forward are excluded, such as maintenance. Training of employees related to the use of equipment is also excluded, as the entity is unable to control the future benefit from employees who may, in theory, leave at any time. An exception to this would be a condition to continue to operate the item, such as the regular inspection of a pipeline. When each major inspection occurs, its cost is recognized as the carrying amount of the item of PP&E. The remaining carrying amount of a previous inspection is then immediately derecognized.
What costs of Purchased Land and Equipment are capitalize
The acquisition of land and a building is very similar to the purchase of equipment. Directly attributable costs incurred become part of the cost of the land, including costs for the following:
- commissions
- legal fees
- title search
- property transfer taxes
Additionally, costs that are required to make the land and building usable for the company’s purposes are also capitalized. For example, preparation costs of the land, such as drainage or the removal of old buildings, would be included in the cost of the land.
How are land and building accounted for
Although land and building are often acquired together, they are separate assets and must be accounted for separately. This is especially critical because a building is a depreciable asset, and land is not.
For example, land and a building were purchased for $1,200,000. The appraisal indicated that 60% of the purchase value was for land, and 40% for the building. The cost of the bundled purchase must be separated into a land account, which is not depreciated, and a building account, which is depreciated. This allocation would be made based on relative fair market values of the land and the building using an appraisal — so, in this case, $720,000 would be allocated to land and $480,000 would be allocated to the building.
Componentization of PPE
In many situations, the PP&E purchased would have a usage pattern that is the same for the entire piece of equipment. For example, all of the components of a laptop computer would depreciate at the same rate, and therefore the entire laptop computer purchase would be allocated to one PP&E account called “Computers.”
However, some PP&E have significant parts with different usage rates within the asset. For example, a jet airplane’s engines would wear out faster than the fuselage. When this is the case, the overall asset cost has to be broken apart and componentized so that each major part will be depreciated at the appropriate rate. IFRS recommends that parts with similar useful lives be grouped together for purposes of depreciation. In the case of the airplane, the engines would be recorded in a separate account from the fuselage, and they would be depreciated based on their respective estimated useful lives.
Construction of an asset
When an asset is constructed, such as the building of a factory, all directly attributable costs of the construction can be capitalized. For the construction of a new building, the following costs can be capitalized as part of the building:
- construction permits
- site survey costs
- construction costs, including labour, direct management salaries, and materials
- direct borrowing costs incurred to finance the construction until the occupation permit is obtained (note ASPE difference here — see Section 4, Differences between IFRS and ASPE)
- professional fees
Spare parts, standby equipment, and servicing equipment
Spare parts that are immaterial in nature or have a short lifespan would be considered inventory. For example, an airline would have many things such as air filter replacements and spare fuel lines that would be used in the maintenance of the plane and classified as inventory.
However, for major spare parts (such as if an airline has a spare engine on hand), the part would be classified as PP&E. The engine would be expected to generate future economic benefit for the airline and has a measurable cost, so it meets the definition of PP&E. Additionally, it has a lifespan of greater than a year, so it would be considered capital. Similarly, standby or servicing equipment would be recorded as part of PP&E. For items that qualify as PP&E, but are not yet in use (such as standby equipment and major spare parts), the entity needs to determine whether the item is available for use in determining whether or not depreciation should commence.
Depreciation
Once the assets are initially recognized, the next step is to depreciate them. Depreciation is the systematic allocation of the cost of a long-lived asset into income over its useful life.
Useful life is either the period over which an asset is expected to be available for use by an entity or the number of production or similar units expected to be obtained from the asset by an entity (such as machine hours).
Depreciation methods
There are three methods of calculating depreciation:
- Straight-line method
- Declining balance method
- Units of production method
Depreciation methods in year of acquisition and disposal
Note that the entity has a choice of how to treat depreciation expense in the year of acquisition and disposal. For example, companies choose among the following:
- pro-rate depreciation based on the days in the year
- take half depreciation in the year of acquisition
- take no depreciation in the year of disposal
When does Depreciation begins
Depreciation begins when the asset is available for use and continues until the asset is derecognized. Even if the asset becomes idle, it would still continue to be depreciated, as it is still available for use. Also, the residual value and the useful life of an asset should be reviewed at least at each financial year end, and if expectations differ from previous estimates, any change is accounted for prospectively as a change in estimate.
Straight-line method 2.1.1 eg
The straight-line method of depreciation is the one that is most commonly used. It assumes that the benefit derived from the asset occurs evenly throughout the asset’s useful life.
The calculation of depreciation under the straight-line method is as follows:
Cost of the asset – Residual value
/
Estimated useful life
Declining balance method- 2.2.1 eg
The declining balance method assumes that the benefit derived from the asset is higher in its initial years and less as the asset ages. Management applies a rate for depreciation to the cost of the asset in the initial year. In subsequent years, the rate is applied to the carrying value of the asset, or net book value (cost less accumulated depreciation). This continues until the carrying amount equals the salvage value, and then depreciation stops.
The calculation of depreciation using the declining balance method would be as follows:
Cost of the asset × Depreciation rate
Note that while the salvage value is considered in determining whether the entity should stop depreciating the asset, it does not make up part of the calculation of depreciation
