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. 2

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;

10. implement the disclosure requirements of AASB 116. 3

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).

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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  Disclosure requirements 5

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

also special rules for investment property – AASB 140

 For some purposes, PPE is divided into classes, e.g.  land, buildings, machinery, ships, aircraft, motor vehicles, furniture and fixtures, office equipment. 6

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. 7

Initial measurement of PPE  PPE is initially measured at cost, which includes:  purchase price (at fair value); includes duties and taxes but excludes rebates and discounts

 directly attributable costs required to bring the asset to the location and condition necessary for it to operate; more details on next slide

 borrowing costs (AASB 123); interest paid to finance acquisition, construction or production until ready for use, if for a substantial period of time

 Initial estimate of costs of dismantling, removing the item or restoring the site. for example, an offshore oil platform 8

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); f)

professional fees. 9

Measurement subsequent to initial recognition  AASB 116 allows a choice of two possible measurement models:  cost model;  revaluation model.

Each model will be discussed in detail later

 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. Refer to section 7.6 of text for examples of what constitutes a 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. 10

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. 11

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 CR

Accumulated depreciation 12

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

 13

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  useful life

residual value cost or revalued amount 14

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  cost or revalued amt - residual value total expected production



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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  residual value) 

4 15 (=1+ 2 + 3 + 4 + 5)

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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.

discussed in week 6

 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.

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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.  Accounting performed on an asset-by-asset basis.

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The revaluation model – accounting on an asset-by-asset basis  A Ltd has decided to change from the cost model to the revaluation model to account for plant. class of  At 30 June 2013 A Ltd owned the following plants:

Cost

Accumulate d depreciation

Carrying value

Fair value

assets

Increment/(d ecrement)

Plant A

200,000

100,000

100,000

150,000

50,000

Plant B

140,000

40,000

100,000

80,000

(20,000)

TOTAL

340,000

140,000

200,000

230,000

30,000

 A revaluation increment will be recorded for Plant A and a revaluation decrement will be recorded for Plant B. 20

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 (200,000 – 150,000) = 50,000

*** Amount of increment

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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

Assumes that tax and acct. depn. rates are the same

Based on new FV of asset

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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) Cr Deferred tax liability

15,000 15,000

 Combined entry: Dr Accum. depreciation Dr Income tax expense (OCI) Cr Plant Cr Deferred tax liability Cr Gain on revaluation (OCI)

100,000 15,000 50,000 15,000 50,000

 At year end the OCI accounts are closed against the ARS: Dr Gain on revaluation (OCI) Cr Income tax expense (OCI) Cr Asset revaluation surplus (ARS)

50,000 15,000 35,000 23

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*** *Removal of existing accumulated depreciation

**Amount of decrement

***Cost - FV

(140,000 – 80,000) = 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). 24

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 increment of $10,000 had been made in 2011.

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The revaluation model: reversing previous increments (cont‟d)  The revaluation of plant B would be recorded as follows: Dr Dr Dr Dr

Accum. depreciation Deferred tax liability Loss on revaluation (OCI) Loss on revaluation (P&L) Cr Income tax expense (OCI) Cr Plant

40,000 3,000 10,000 10,000 3,000 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?

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The revaluation model: reversing previous increments (cont‟d)  At year end the OCI accounts are closed against ARS: Dr Income tax expense (OCI) Dr Asset revaluation surplus (ARS) Cr Loss on revaluation (OCI)

3,000 7,000 10,000

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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.

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The revaluation model: reversing previous decrements (cont‟d)  The revaluation of plant A would be recorded as follows: Dr Accum. depreciation Dr Income tax expense (OCI) Cr Plant Cr Gain on revaluation (P&L) Cr Gain on revaluation (OCI) Cr Deferred tax liability 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

100,000 10,500 50,000 15,000 35,000 10,500

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. 29

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) Cr Asset revaluation surplus (ARS)

10,500 24,500

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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 Accumulated depreciation - Building Plant Accumulated depreciation - Plant

$ 300,000 (100,000) 120,000 (40,000)

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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. 33

The revaluation model: comprehensive example (cont‟d) 1. 30/06/2011 Dr Dr Dr Dr

Accumulated depreciation – building Loss on revaluation (OCI) Deferred tax liability Loss on revaluation (P&L) Cr Income tax expense (OCI) Cr Building

Dr Income tax expense (OCI) Dr Asset revaluation surplus (ARS) – building Cr Loss on revaluation (OCI)

100 000 20 000 6 000 20 000 6 000 140 000 6 000 14 000 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 Cr Income Tax expense

6,000 34

The revaluation model: comprehensive example (cont‟d) 1. 30/06/2011 (cont‟d) Dr Accumulated depreciation – plant Dr Income tax expense (OCI) Cr Plant Cr Gain on revaluation (OCI) Cr Deferred tax liability

40 000 3 000

Dr Gain on revaluation (OCI) Cr Income tax expense (OCI) Cr Asset revaluation surplus (ARS) – plant

10 000

30 000 10 000 3 000

3 000 7 000

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The revaluation model: comprehensive example (cont‟d) 2. 30/06/2012 Dr Depreciation expense – building Cr Accumulated depreciation – building ($160 000/5)

32 000

Dr Depreciation expense – plant Cr Accumulated depreciation – plant ($90 000/ 4)

22 500

32 000

22 500

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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. DR ARS CR 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 Share capital 37

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.

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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 Cr Proceeds on sale Dr Carrying amount of asset Dr Accumulated depreciation Cr Machine

45,000 45,000 30,000 20,000

The gain on sale is $45,000 - $30,000 = $15,000

50,000 It is common to show this gain on sale net in the income statement 40

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.

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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.

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