07 PPE Cost PDF

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Answers to GAAP graded questions...

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Solutions to GAAP : Graded Questions

Property, plant and equipment: cost model

Solution 7.1 a) True: Cost is reduced by trade discounts and rebates. See IAS 16.16 b) False: IAS 16 states only that cost should be reduced by ‘trade discounts’. See IAS 16.16(a) c) False: It includes all costs that are directly attributable to getting the asset to a location and condition that enables it to be used as intended by management. See IAS 16.16(b) d) True: The initial cost of acquiring an item of property, plant and equipment would include, where applicable, the initial estimate of the future costs of dismantling and removing the item and restoring the site on which it is located, the obligation for which an entity incurs when the item is acquired. See IAS 16.16 e) True: The entity must choose whether to use the cost model or revaluation model for each class of its property, plant and equipment. See IAS 16.29 f) False: the depreciable amount must be depreciated on a systematic basis over the estimated useful life of the asset – not the cost. See IAS 16.50 g) False: It is expensed unless it qualifies to be capitalised instead. h) True: See IAS 16.2 A i)

j)

False: all methods of depreciation involve the estimation of a residual value: •

both the straight-line and units of production methods depreciate the depreciable amount (depreciable amount = cost – residual value)

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the diminishing balance method depreciates the asset by applying a rate of depreciation to the opening carrying amount where this rate of depreciation is calculated in such a way that it takes into account the estimated residual value (i.e. the residual value is built into the rate of depreciation). IAS 16.50

True: depreciation does not cease when the asset is idle. See IAS 16.55

k) False: depreciation ceases at the earlier date of derecognition or when the asset meets the criteria to be classified as held for sale, if applicable. See IAS 16.55 l)

True: Depreciation starts when an asset first becomes available for use.

See IAS 16.55

m) True: the CA could be too high because the depreciation processed to date has been underestimated (i.e. the depreciation processed in the past is insufficient), and thus once the necessary extra depreciation is processed, this CA may drop below RA, in which case it is not impaired. Continued on the next page

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Chapter 7: Page 1

Solutions to GAAP : Graded Questions

Property, plant and equipment: cost model

Solution 7.1 continued … n) False: The impairment loss reversed would be less than C100 000. This is because the asset is a depreciable asset and, when measuring the asset under the cost model, the carrying amount may not be increased above the depreciated historic cost. For your interest: Proof: Imagine that your asset is non-depreciable and has a cost of C1 000 000, its carrying amount will be C1 000 000 at the end of year 1. If we then impair it by C100 000 to C900 000 at the end of year 1, this carrying amount would still be C900 000 at the end of year 2 (because it is not depreciated). If the difference between the RA exceeds the CA by C300 000 at the end of year 2, it means that the RA is now C1 200 000. However, we may only increase the CA back up to its depreciated historic cost/ original carrying amount (cost) of C1 000 000. Thus, the impairment reversal would be limited to C100 000. However, the asset in question is a depreciable asset and thus the depreciated historic cost at the end of year 2 (the limit) would be lower than the depreciated historic cost at the end of year 1 (because it would have been further depreciated during year 2) and thus the impairment reversal at the end of year 2 would be smaller than the impairment at the end of year 1. E.g. Imagine that a depreciable asset has a cost of C1 000 000 and is depreciated over 5 years. Its depreciated historic cost is C800 000 at the end of year 1 and C600 000 at the end of year 2. If the RA is C700 000 at the end of year 1, it will be impaired by C100 000. This would then mean that the CA would then be C525 000 at the end of year 2, after depreciation (Opening CA: C700 000 – Depreciation: (C700 000 -0)/ 4 remaining years). If we are told the RA is C300 000 higher than the CA et the end of year 2, it means the RA is C825 000 at the end of year 2 (525 000 + 300 000). Since the RA exceeds the CA and this asset had been previously impaired, it means we obviously need to process an impairment reversal. However, we will need to remember we can only increase the CA back up to the depreciated historic cost at the end of year 2 of C600 000. So the impairment reversal would only be C75 000 (RA of 825 000, limited to depreciated historic cost: 600 000 - CA 525 000). So you can see that, although the impairment in year 1 was C100 000, the impairment reversal at the end of year 2 is less than C100 000 due to the fact that the requirement that any impairment reversal may not result in the CA exceeding the depreciated historic cost and since the asset is depreciable, this depreciated historic cost will have reduced by the end of year 2. o) False: IAS 16 states that the ‘depreciation’ per class of property, plant and equipment be presented in the financial statements (within the reconciliation between opening and closing carrying amounts of each of these classes). The depreciation per class of property, plant and equipment may be different to the ‘depreciation expense per class’ because some of the depreciation per class may have been capitalised to another asset (e.g. some or all of the depreciation on factory machinery may be capitalised to inventory). See IAS 16.73(e)

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Chapter 7: Page 2

Solutions to GAAP : Graded Questions

Property, plant and equipment: cost model

Solution 7.2

ZETA SHIPPING IAS 16, Treatment of significant parts (components)

Significant parts •

IAS 16, Property, Plant and Equipment requires each part of an item of property, plant and equipment with a cost that is significant in relation to the total cost of the item to be depreciated separately. See IAS 16.43

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These are referred to by IAS 16 as ‘significant parts’ (in prior versions of IAS 16, they were referred to as ‘components’).

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In relation to a ship, significant parts could be, for example, the hull; propulsion systems; steering systems; holds, compartments and superstructure and equipment.

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The entity then allocates the amount (cost) initially recognised in respect of an item of property, plant and equipment to each of its significant parts and depreciates each of these significant parts separately. See IAS 16.44

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Chapter 7: Page 3

Solutions to GAAP : Graded Questions

Property, plant and equipment: cost model

Solution 7.2 continued … 1. Recognition: significant parts •

Upon initial recognition the total cost of the item of PPE needs to be allocated to each of the significant parts that are identified.

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For example: the total cost of the ship can be allocated as follows:

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Ship Component

Cost - CU

Hull

20 000 000

Propulsion system

7 000 000

Steering system

8 000 000

Holds, compartments and superstructure

35 000 000

Equipment (masts, anchors, safety equipment and cranes)

10 000 000

TOTAL VESSEL COST

80 000 000

If there are parts that are not individually significant, these are recognised together as one group of insignificant parts.

2. Measurement: significant parts 2.1 Initial measurement: • •

Initial measurement refers to measurement on date of recognition. Initial measurement is always at cost: the cost of the entire item of PPE is allocated to each of the significant parts and to the group of insignificant parts.

2.2 Subsequent measurement: •

The subsequent measurement involves:  depreciation and  checking for impairment losses and  choosing between the cost model and revaluation model.

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Depreciation is affected if significant parts (components) are identified:  The cost of each significant part of an item of property, plant and equipment is depreciated separately and checked for impairment separately. See IAS 16.44  The remaining parts that are not individually significant are grouped together and are depreciated separately. See IAS 16.46

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Chapter 7: Page 4

Solutions to GAAP : Graded Questions

Property, plant and equipment: cost model

Solution 7.2 continued … 2.2 Subsequent measurement – continued… •

It is important to identify significant parts (components) as each of these may have a useful life and depreciation method that is different to other parts.

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In the case of the above example, it would not be appropriate to depreciate the ship with a cost of C80 000 000 over an average or general useful life (e.g. we cannot depreciate the entire ship based on the useful life of the main structure)

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Instead, we must first identify the various significant parts and estimating each part’s useful life, residual value and determining an appropriate depreciation method.

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A significant part of an item of property, plant and equipment may have a useful life and a depreciation method that are the same as the useful life and the depreciation method of another significant part of that same item. Such parts may be grouped in determining the depreciation charge. IAS 16.45 For example, the equipment and the propulsion equipment may happen to have the same useful life, residual value and depreciation method.

2.3 Subsequent recognition and measurement issues: Replacement of parts •

In the event that a significant part (component) has to be replaced due to damage or when no future economic benefits are expected from its use, the individual component will be derecognized at its carrying amount.

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The cost of the replacement part will then be capitalized to the cost of the asset.

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Where it is not possible to determine the carrying amount of the replaced part, we must estimate its carrying amount. This could be done by using the cost of the new replacement part, adjusted for depreciation, impairment and time value of money.

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We would then derecognize this estimated amount and then capitalize the cost of the replacement part.

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Chapter 7: Page 5

Solutions to GAAP : Graded Questions

Property, plant and equipment: cost model

Solution 7.3 a) Residual value is defined as the estimated amount that the entity would currently obtain (at the financial reporting date) if the asset were already of the age and in the condition expected at the end of its useful life. IAS 16.6 The C100 000 is the amount the entity expects to receive when the plant is five years old in two years time. However, the residual value is the estimated amount the entity would receive today if the asset were already five years old. Therefore, C70 000, which is the amount that a similar five year old asset realised recently is used as the residual value. b) The cost of an item of property, plant and equipment is recognised as an asset if: • it is probable that future economic benefits associated with the item will flow to the entity; and • the cost of the item can be measured reliably. IAS 16.7 An entity evaluates under this recognition principle all its property, plant and equipment costs at the time they are incurred, including costs incurred initially to acquire the item or costs incurred subsequently to add to, replace part of or service it. IAS 16.10 The fact that the new ventilation system is only maintaining the existing level of ventilation in the factory is irrelevant. Probable future benefits will flow to the entity and the cost (C240 000) can be measured reliably. The carrying amount of the component that is replaced by the new component should be derecognised. c) Depreciation of an asset begins when it is available for use, that is, when it is in the location and condition necessary for it to be capable of operating in the manner intended by management. IAS 16.55 Depreciation must therefore commence from 1 August, when it was available for use. This is to reflect the consumption of the asset’s service potential that occurs while the asset is held. d) Depreciation is recognised even if the fair value of the asset exceeds its carrying amount. The future economic benefits are consumed irrespective if the fair value increases. Therefore, it is appropriate to depreciate the property in the current year. The purpose of depreciation is not the recognition of decreases in the value of property, plant and equipment; rather the purpose is to allocate the cost or revalued amount over its useful life.

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Chapter 7: Page 6

Solutions to GAAP : Graded Questions

Property, plant and equipment: cost model

Solution 7.3 continued . . . e) Each part of an item of property, plant and equipment with a cost that is significant in relation to the total cost of the item is required to be depreciated separately. It is therefore necessary to allocate the amount initially recognised in respect of an item of property, plant and equipment to its significant parts, including the inspection. The cost of the existing inspection component needs to be recognised even though it was not identified on initial acquisition. The current market price of an inspection for a three year old aircraft, estimated at C750 000 is used as an indication of what the cost of the existing inspection component was when the item was acquired. Additional comments (not required as part of answer) When a major inspection or overhaul cost is embedded in the cost of an item of property, plant and equipment, it is necessary to estimate the carrying amount of the component because the cost of the physical item itself should not include any amount attributable to the inspection or overhaul. The carrying amount of the component should be determined by reference to the current market price of such overhauls and not the expected future price. For example, entity P runs a merchant shipping business and has just acquired a new ship for C400. The useful life of the ship is 15 years, but it will be dry-docked every three years and a major overhaul carried out. At the date of acquisition the dry-docking costs for similar ships that are three years old is approximately C80. Therefore, the cost of the dry-docking component for accounting purposes is C80 and this amount would be depreciated over the three years to the next dry-docking. The remaining carrying amount, which may need to be split further into components, is C320. Any additional components would be depreciated over their own estimated useful lives. Component accounting for inspection or overhaul costs is intended to be used only for major expenditure that occurs at regular intervals over the life of an asset. Costs associated with routine repairs and maintenance should be expensed as incurred. The remaining portion of the component that is replaced by a new component should be derecognised. For example, P carries out the dry-docking of its ship after two years instead of three. The carrying amount of the overhaul at that date is C27 [80 – (80 / 3 X 2)]. The actual dry-docking costs are C100. The remaining carrying amount of the component that has been replaced should be written off immediately because the component effectively has been disposed of. However, it is submitted that the amount written off should be included in depreciation instead of being classified as a loss on disposal because the requirement is to depreciate each asset separately. The extra depreciation of C27 is in effect a revision of the estimated useful life of the dry-docking. The actual dry-docking costs of C100 will be capitalised to the cost of the ship and depreciated over the expected period until the next dry-docking.

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Chapter 7: Page 7

Solutions to GAAP : Graded Questions

Property, plant and equipment: cost model

Solution 7.4

SHAWSHANK LIMITED NOTES TO THE FINANCIAL STATEMENTS FOR THE YEAR ENDED 30 JUNE 20X 8 1 Statement of compliance (not required) The financial statements have been prepared in accordance with International Financial Reporting Standards. 2 Basis of preparation (not required) The financial statements are prepared in accordance with the historical cost convention. 3. Significant accounting policies The financial statements incorporate the following principle accounting policies, which are consistent in all material respects with those applied in the previous year. 3.1 Property, plant and equipment No depreciation is provided on land. Furniture is depreciated at 10% per annum using the reducing balance method. Buildings are depreciated at 2% per annum on the straight-line method. 10. Property, plant and equipment Land

Buildings

Furniture C

C

C

Cost Balance 1/7/20X7 Purchases Balance 30/6/20X8

116 000 116 000

72 500 72 500

87 000

Accumulated depreciation Balance 1/7/20X7 Current depreciation Balance 30/6/20X8

-

-** -

14 500 7 250* 21 750

116 000 116 000

72 500

72 500 65 250

Carrying amount 1/7/20X7 30/6/20X8

Total C 203 000 72 500 275 500

87 000

14 500 7 250 21 750

188 500 253 750

* Calculation of current depreciation: (87 000 – 14 500) x 10% = 7 250 ** No depreciation as the building was only available for use from the last day of the financial year.

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Chapter 7: Page 8

Solutions to GAAP : Graded Questions

Property, plant and equipment: cost model

Solution 7.5 1 Dance Street Partytown 1234 Phone: 082 123 4567 Attention: The Financial Director Rockstar Manufacturing Co. Limited 165 Universal Pictures Durban 4000 Dear Sir or Madam

Re: Query regarding the recognition and measurement of equipment Thank you for your query. There are two distinct issues that need addressing: recognition and measurement. Recognition of equipment as property, plant and equipment •

The items of equipment are correctly recognised as property, plant and equipment, if they are: a) held for use the production or supply of goods or services, for rental to others, or for administrative purposes; and b) are expected to be used during more than one period.

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If they are, for instance, intended to be sold, then they should be recognised, if they meet the requirements to be recognised as inventory per IAS 2, as inventory instead.

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From the information provided (e.g. the fact that staff have been trained how to use the amplifier) we have assumed that both items of equipment (the amplifier and the guitar stringer) are both intended to be used rather than sold as inventory and thus our advice is that we should apply IAS 16 Property, plant and equipment (i.e. rather than IAS 2 Inventory).

Measurement: Def-maker Amplifier •

The cost of a self-constructed asset is measured using the same principles as those applied to the cost of assets acquired via a purchase and therefore include the following: a) its p...