Accounting Standards Bitesize

Plant and Equipment

Angus Kemp MA(Hons) CertAcc CA MBA Med
Island Consortium Limited

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The Financial Reporting Framework
Introduction

The importance of a conceptual framework

A conceptual framework is a set of theoretical principles and concepts that underlie the
preparation and presentation of financial statements.

If no conceptual framework existed, then accounting standards would be produced on a

haphazard basis as particular issues and circumstances arose. These accounting standards might
be inconsistent with one another, or perhaps even contradictory.

A strong conceptual framework means that there are principles in place from which all future
accounting standards draw. It also acts as a reference point for the preparers of financial
statements if no accounting standard governs a particular transaction (although this will be
extremely rare).

That is why The Conceptual Framework for Financial Reporting was issued.

Financial statements and the reporting entity

Financial statements

The Conceptual Framework notes that financial statements are a particular type of financial
report.

The purpose of financial statements is to provide information to users about an entity's:

• assets
• liabilities
• equity
• income
• expenses.

This information is provided in:

• a statement of financial position
• statements of financial performance
• other statements, such as statements of cash flows and notes.

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Financial statements are prepared on the assumption that the entity is a going concern. This
means that it will continue to operate for the foreseeable future. If this assumption is not
accurate, then the financial statements should be prepared on a different basis.

The elements of financial statements

The elements are the building blocks of financial statements:

• statements of financial position report assets, liabilities and equity
• statements of financial performance report income and expenses.

Definitions of the elements are as follows:

Asset – “A present economic resource controlled by an entity as a result of a past event”

Liability – “A present obligation of the entity to transfer an economic resource as a result of a

past event.”

Equity – “The residual interest in the net assets of an entity.”

Income – “Increases in assets or decreases in liabilities that result in an increase to equity

(excluding contributions from equity holders).”

Expenses - “Decreases in assets or increases in liabilities that result in decreases to equity

(excluding distributions to equity holders).”

Recognition and derecognition

Recognition

Items are only recognised in the financial statements if they meet the definition of one of the
elements.

Derecognition

Derecognition is the removal of some or all of an asset or liability from the statement of financial
position. This normally occurs when the entity:
• loses control of the asset, or
• has no present obligation for the liability

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Non-current assets
Property, Plant and Equipment
Definition

Property, plant and equipment as tangible items that:

• are held for use in the production or supply of goods or services, for rental to
others, or for administrative purposes.
• are expected to be used during more than one period.

Tangible items have physical substance.

Initial recognition

An item of property, plant and equipment should be recognised as an asset when:

• it is probable that the asset's future economic benefits will flow to the entity
• the cost of the asset can be measured reliably.

Property, plant and equipment should initially be measured at its cost. This comprises:
• the purchase price
• costs that are directly attributable to bringing the asset to the necessary location and
condition
• the estimated costs of dismantling and removing the asset, including any site restoration
costs. This might apply where, for example, an entity has to recognise a provision for the
cost of decommissioning an oil rig or a nuclear power station.

Measurement models

There are two models:

• the cost model
• the revaluation model.

Cost model

Under the cost model, property, plant and equipment is held at cost less any accumulated
depreciation and impairment losses.

Revaluation model

Under the revaluation model, property, plant and equipment is carried at fair value less any
subsequent accumulated depreciation and impairment losses.

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If the revaluation model is adopted, then the following rules apply:
• Revaluations must be made with 'sufficient regularity' to ensure that the carrying amount
does not differ materially from the fair value at each reporting date.
• If an item is revalued, the entire class of assets to which the item belongs must be
revalued.
• If a revaluation increases the value of an asset, the increase is presented as other
comprehensive income (and disclosed as an item that will not be recycled to profit or loss
in subsequent periods) and held in a 'revaluation surplus' within other components of
equity.
• If a revaluation decreases the value of the asset, the decrease should be recognised
immediately in profit or loss, unless there is a revaluation reserve representing a surplus
on the same asset.

Depreciation

The key principles with regards to depreciation are as follows:

• All property, plant and equipment with a finite useful life must be depreciated. The
depreciable amount of an asset is its cost less its residual value.
• Residual value is an estimate of the net selling proceeds received if the asset was at the
end of its useful life and was disposed of today.
• Depreciation is charged to the statement of profit or loss.
• Depreciation begins when the asset is available for use and continues until the asset is
derecognised.
• Depreciation must be allocated on a systematic basis, reflecting the pattern in which the
asset's future economic benefits are expected to be consumed.
• The depreciation method, residual value and the useful life of an asset should be
reviewed annually and revised if necessary. Any adjustments are accounted for as a
change in accounting estimate.

Derecognition

An asset should be derecognised when disposal occurs, or if no further economic benefits are
expected from the asset's use or disposal.
• The gain or loss on derecognition of an asset is the difference between the net disposal
proceeds, if any, and the carrying amount of the item.
• When a revalued asset is disposed of, any revaluation surplus may be transferred directly
to retained earnings, or it may be left in the revaluation surplus within other components
of equity.

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Disclosures

Entities are required to disclose:

• measurement bases used
• useful lives and depreciation rates
• a reconciliation of carrying amounts at the beginning and end of the period.

If items of property, plant and equipment are stated at revalued amounts, information about the
revaluation should also be disclosed.

Example 1 – Property, plant and equipment

Cap bought a building on 1 January 20X1. The purchase price was $2.9m, associated legal fees
were $0.1m and general administrative costs allocated to the purchase were $0.2m. Cap also paid
sales tax of $0.5m, which was recovered from the tax authorities. The building was attributed a
useful life of 50 years. It was revalued to $4.6m on 31 December 20X4 and was sold for $5m on
31 December 20X5.

Cap purchased a machine on 1 January 20X3 for $100,000 and attributed it with a useful life of
10 years. On 1 January 20X5, Cap reduced the estimated remaining useful life to 4 years.

Required:

Explain how the above items of property, plant and equipment would have been accounted
for in all relevant reporting periods up until 31 December 20X5.

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Government grants
Definitions

Government grants are transfers of resources to an entity in return for past or future compliance
with certain conditions.

Recognition

Government grants should not be recognised until the conditions for receipt have been
complied with and there is reasonable assurance that the grant will be received.

Grants should be matched with the expenditure towards which they are intended to contribute in
the statement of profit or loss:
• Income grants given to subsidise expenditure should be matched to the related costs.
• Income grants given to help achieve a non-financial goal (such as job creation) should be
matched to the costs incurred to meet that goal.

Grants related to assets

Grants for purchases of non-current assets should be recognised over the expected useful lives of
the related assets. There are two acceptable accounting policies for this:
• deduct the grant from the cost of the asset and depreciate the net cost
• treat the grant as deferred income and release to profit or loss over the life of the asset.

Disclosures

The following disclosures are required:

• the accounting policy and presentation methods adopted
• the nature of government grants recognised in the financial statements
• unfulfilled conditions relating to government grants that have been recognised.

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Borrowing Costs
Definition

Borrowing costs are defined as interest and other costs that an entity incurs in connection
with the borrowing of funds.

Recognition

Borrowing costs may be capitalised if they relate to the acquisition, construction or production of
a qualifying asset.

A qualifying asset is defined as one that takes a substantial period of time to get ready for its
intended use or sale.

Capitalisation period

Borrowing costs should only be capitalised while construction is in progress.

The requirements are that:

• Capitalisation of borrowing costs should commence when all of the following apply:
o expenditure for the asset is being incurred
o borrowing costs are being incurred
o activities that are necessary to get the asset ready for use are in progress.
• Capitalisation of borrowing costs should cease when substantially all the activities that
are necessary to get the asset ready for use are complete.
• Capitalisation of borrowing costs should be suspended during extended periods in which
active development is interrupted.

Disclosures

The following disclosures are required:

• the value of borrowing costs capitalised during the period
• the capitalisation rate

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Impairment of Assets
Definition

Impairment is a reduction in the recoverable amount of an asset or cash-generating unit below

its carrying amount.

An impairment review should be carried out where there is an indication that impairment may
have occurred.

Indications of impairment

The following are indications that an asset might be impaired:

• External sources of information:
o unexpected decreases in an asset's market value
o significant adverse changes have taken place, or are about to take place, in the
technological, market, economic or legal environment
o increased interest rates have decreased an asset's recoverable amount
o the entity's net assets are measured at more than its market capitalisation.
• Internal sources of information:
o evidence of obsolescence or damage
o there is, or is about to be, a material reduction in usage of an asset
o evidence that the economic performance of an asset has been, or will be, worse
than expected.

Calculating an impairment loss

An impairment occurs if the carrying amount of an asset is greater than its recoverable amount.

The recoverable amount is the higher of fair value less costs to sell and value in use.

Fair value is the price received when selling an asset in an orderly transaction between market
participants at the measurement date.

Costs to sell are incremental costs directly attributable to the disposal of an asset.

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Value in use is calculated by estimating future cash inflows and outflows from the use of the
asset and its ultimate disposal, and applying a suitable discount rate to these cash flows.

The discount rate used to calculate value in use should reflect:

• the time value of money, and
• the risks specific to the asset for which the future cash flow estimates have not been
adjusted.

Recognising impairment losses in the financial statements

An impairment loss is normally charged immediately in the statement of profit or loss and other
comprehensive income.
• If the asset has previously been revalued upwards, the impairment is recognised as a
component of other comprehensive income and is debited to the revaluation reserve until
the surplus relating to that asset has been reduced to nil. The remainder of the impairment
loss is recognised in profit or loss.
• The recoverable (impaired) amount of the asset is then depreciated/amortised over its
remaining useful life.

Disclosures

The following disclosures are required:

• impairment losses recognised during the period
• impairment reversals recognised during the period.

For each material loss or reversal:

• the amount of loss or reversal and the events causing it
• the recoverable amount of the asset (or cash generating unit)
• the discount rate(s) used.

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Example 1 – Impaired asset

On 31 December 20X1, an entity noticed that one of its items of plant and machinery is often left
idle. On this date, the asset had a carrying amount of $500,000 and a fair value of $325,000. The
estimated costs required to dispose of the asset are $25,000.

If the asset is not sold, the entity estimates that it would generate cash inflows of $200,000 in
each of the next two years. Assume that the cash flows occur at the end of each year. The
discount rate that reflects the risks specific to this asset is 10%.

Required:

(a) Discuss the accounting treatment of the above in the financial statements for the year
ended 31 December 20X1.

(b) How would the answer to part (a) be different if there was a balance of $10,000 in other
components of equity relating to the prior revaluation of this specific asset?

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Example 2 – Reversal of impairment loss

Boxer purchased a non-current asset on 1 January 20X1 at a cost of $30,000. At that date, the
asset had an estimated useful life of ten years. Boxer does not revalue this type of asset, but
accounts for it on the basis of depreciated historical cost. At 31 December 20X2, the asset was
subject to an impairment review and had a recoverable amount of $16,000.

At 31 December 20X5, the circumstances which caused the original impairment to be recognised
have reversed and are no longer applicable, with the result that recoverable amount is now
$40,000.

Required:

Explain, with supporting computations, the impact on the financial statements of the two
impairment revie

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Solutions to lecture examples

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Example 1 – Property, plant and equipment

The building would have been recognised on 1 January 20X1 at a cost of $3m ($2.9m purchase
price + $0.1m legal fees). Recoverable sales tax is excluded from the cost of property, plant and
equipment. General administrative costs of $0.2m will have been expensed to profit or loss as
incurred.

Depreciation of $0.06m ($3m/50 years) would have been charged to profit or loss in each of the
years ended 31 December 20X1, 20X2, 20X3 and 20X4.

Prior to the revaluation on 31 December 20X4, the carrying amount of the building was $2.76m
(46/50 × $3m). In the year ended 31 December 20X4, a gain on revaluation of $1.84m ($4.6m –
$2.76m) would have been recognised in other comprehensive income and held within equity.

In the year ended 31 December 20X5, the building would have been depreciated over its
remaining useful life of 46 (50 – 4) years. The depreciation charge in the year ended 31
December 20X5 would therefore have been $0.1m ($4.6m/46) leaving a carrying amount at the
disposal date of $4.5m ($4.6m – $0.1m).

On 31 December 20X5, a profit on disposal of $0.5m ($5m – $4.5m) would be recorded in the
statement of profit or loss.

The revaluation gains previously recognised within OCI and held within equity are not
reclassified to profit or loss on the disposal of the asset. However, Cap could do a transfer within
equity as follows:

The machine

The machine would be recognised on 1 January 20X3 at $100,000 and depreciated over 10 years.
Depreciation of $10,000 ($100,000/10) will be charged in the years ended 31 December 20X3
and December 20X4.

On 1 January 20X5, Cap changes its estimate of the machine's useful life. This is a change in
accounting estimate and therefore dealt with prospectively. The carrying amount of the asset at
the date of the estimate change is $80,000 (8/10 × $100,000). This remaining carrying amount
will be written off over the revised life of 4 years. This means that the depreciation charge is
$20,000 ($80,000/4) in the year ended 31 December 20X5.

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Example 1 – Impaired asset

(a) The value in use is calculated as the present value of the asset's future cash inflows and
outflows.

Cash flow Discount rate PV

Year 1 200,000 1/1.10 182,000

Year 2 200,000 1/1.102 165,000

347,000

The recoverable amount is the higher of the fair value less costs to sell of $300,000 ($325,000 –
$25,000) and the value in use of $347,000.

The carrying amount of the asset of $500,000 exceeds the recoverable amount of $347,000.
Therefore, the asset is impaired and must be written down by $153,000 ($500,000 – $347,000).
This impairment loss would be charged to the statement of profit or loss.

Dr Profit or loss 153,000

Cr PPE 153,000

(b) The asset must still be written down by $153,000. However, $10,000 of this would be
recognised in other comprehensive income and the remaining $143,000 ($153,000 – $10,000)
would be charged to profit or loss.

Dr Profit or loss 143,000

Dr Other comprehensive income 10,000

Cr PPE 153,000

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Example 2 – Reversal of impairment loss

Year ended 31 December 20X2

Asset carrying amount (30,000 x 8/10) 24,000

Recoverable amount 16,000

Impairment loss 8,000

The asset is written down to $16,000 and the loss of $8,000 is charged to profit or loss. The
depreciation charge per annum in future periods will be $2,000 ($16,000 × 1/8).

Year ended 31 December 20X5

Asset carrying amount (16,000 x 5/8) 10,000

Recoverable amount 40,000

Impairment loss Nil

There has been no impairment loss. In fact, there has been a complete reversal of the first
impairment loss. The asset can be reinstated to its depreciated historical cost i.e. to the carrying
amount at 31 December 20X5 if there never had been an earlier impairment loss.

Year 5 depreciated historical cost (30,000 × 5/10) = $15,000

Carrying amount: $10,000

Reversal of the loss: $5,000

The reversal of the loss is now recognised. The asset will be increased by $5,000 ($15,000 –
$10,000) and a gain of $5,000 will be recognised in profit or loss.

It should be noted that the whole $8,000 original impairment cannot be reversed. The impairment
can only be reversed to a maximum amount of depreciated historical cost, based upon the
original cost and estimated useful life of the asset.

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