AF2101 – Intermediate Financial Accounting 1

LECTURE 4
Tangible Non-Current Assets

Dr Danielle Lyssimachou
What will we learn about this week?

1. What is PPE and what are the relevant accounting

standards? (pre-recorded video 1)

2. How is the initial cost of PPE determined? (pre-recorded

video 2)

3. Depreciation (pre-recorded videos 3 & 4 – revision from year 1)

4. How should PPE be measured after its initial

recognition? (Live online class)

5. Investment Property (pre-recorded video 5)

6. Non-current Assets held for Sale (pre-recorded video 6)

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 PART 1

Property, plant & equipment (PPE) and

the relevant accounting standards
 Reminder:
What is an ASSET?

A resource that has the following

characteristics:

◦ Controlled by the entity

◦ A result of past events
◦ Potential for future economic benefits
◦ Has a reliable monetary value

4
 What is PPE?
According to IAS 16:
PPE are tangible assets that are
◦ held (purchased or constructed) by an entity:
 For use in the production or supply of goods and
services,
 for rental to others, or
 for administrative purposes
AND
◦ expected to be used during more than one
period
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Accounting Treatment for PPE
How do we record the acquisition of
PPE?

Which accounting principle are we

following when recording the acquisition
of PPE?

Subsequent treatment of PPE?

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What do we mean by the carrying amount
of an asset?

Carrying Amount is also known as the Net

Book Value

Initial carrying amount = its cost

Subsequent carrying amount = the amount at

which an asset is recognised after deducting
any accumulated depreciation and accumulated
impairment losses 7
 Capitalisation of costs vs.
directly expensing them

What is the difference between

capitalising costs and expensing them?

Why does it matter?

If businesses could freely choose between

the 2 approaches, which one would they
choose and why?
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Relevant Accounting Standards

IAS 16: Property Plant Equipment

IAS 23: Borrowing Costs
IAS 40: Investment Property
IFRS 5: Non Current Assets Held for Sale
and Discontinued Operations

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 PART 2
How is the initial cost of PPE
determined?

Relevant accounting standards:

IAS 16: PPE
IAS 23: Borrowing Costs
The cost of an item of PPE
 On initial recognition, IAS 16 requires that items of
PPE should be measured AT COST.

 Cost of an item of PPE = Purchase Price (including

import duties + non-refundable purchase taxes – trade
discounts) + any directly attributable costs of bringing
the asset to working condition for its intended use

 Directly attributable costs include:

◦ Costs of site preparation
◦ Delivery and handling costs
◦ Installation costs
◦ Professional fees (for architects & engineers)
◦ Dismantling and restoring site 11
Example: Initial measurement of PPE
On 31st July 2020, a company with a 31st March year
end bought a machine for £648,000. This amount was
made up of:

Initial cost of PPE: £498,800 (= £470,000 + £4,300 + £24,500) 12

 What about self-constructed
items of PPE?
 Example of a self-constructed asset?

 The same principles apply as with acquired PPE

items for recognising them at their cost

 Ifthe constructed PPE item is one that is made

available by the business for sale in its normal
course of business, then the cost of the constructed
PPE is the same as the cost of producing the asset
for sale (i.e. without any profit element).

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 What IAS 23 (Borrowing Costs)
deals with

What if the business needs to take out a

loan in order to fund the purchase or
construction of PPE?

 Are the interest charges for this loan part

of the cost of the PPE (should they be
capitalised or expensed)?

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IAS 23 - Borrowing Costs
Borrowing costs are “interest and other costs
that an entity incurs in connection with the
borrowing of funds”.

Borrowing costs that are directly attributable to

the acquisition, construction or production of a
“qualifying asset” are to be capitalised.

The relevant costs are those borrowing costs that

would have been avoided if the expenditure on
the qualifying asset had not occurred.
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What is a “qualifying asset”?
Qualifying asset = an asset which takes a
substantial time to prepare for its intended use
or for sale.
Qualifying assets include:
◦ Construction work-in-process
◦ Manufacturing plants
◦ Investment Property
◦ Intangible assets

They do not include:

◦ Inventories produced over short time scales
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 For how long can a business
capitalise borrowing costs?

The capitalisation of borrowing costs should start

when:
Activities are taking place to prepare the asset for its
intended use or sale AND
Expenditure is being incurred on the asset AND
Borrowing costs are being incurred

The capitalisation of borrowing costs should stop

when substantially all the activities necessary to
prepare the asset for its intended use are complete.
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 Directly Attributable
Borrowing Costs
Borrowing may be specifically taken to fund the
purchase or construction of a qualifying asset –
accounting treatment of these costs is clear.

What happens when the business uses some of its

general purpose borrowings to obtain a qualifying asset?

Then the borrowing cost (i.e. the interest rate charge)

must be estimated for the qualifying asset. Take a
weighted average of the company’s borrowing costs for
the time that the asset counts as a qualifying asset.
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 Example: Borrowing costs when using general
purpose debt funding
 On 1 October 2018, the company
Company A has the began construction of a qualifying
following general asset and incurred expenditure of
borrowings outstanding £300,000. A further £240,000 was
throughout the year to 30 spent on 1 February 2019.
June 2019:  Both of these amounts were
financed out of general borrowings
£000
(i.e. no specific loan was taken out
7.5% bank loan 800 to finance the construction of the
9% bank loan 500 qualifying asset).
8.5% bank loan 1,200  Construction of the asset was still
2,500 underway at 30 June 2019.

TASK: Calculate the amount of borrowing costs that should be capitalised as part
of the cost of the qualifying asset during the year to 30 June 2019. 19
Solution to Example: Borrowing costs when
using general purpose debt funding

£000
7.5% bank loan 800
9% bank loan 500
8.5% bank loan 1,200
2,500

Step 1: Calculate the weighted average borrowing cost:

(7.5% x 800/2,500) + (9% x 500/2,500) + (8.5% x 1,200/2,500) = 8.28%

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 Solution to Example: Borrowing costs when
using general purpose debt funding

Data from the question:

 On 1 October 2018, the company began From Step 1:
construction of a qualifying asset and Weighted average
incurred expenditure of £300,000. A borrowing rate: 8.28%
further £240,000 was spent on 1
February 2019.
 Both of these amounts were financed out
of general borrowings (i.e. no specific Step 2: Calculate the borrowings
loan was taken out to finance the costs to be capitalised:
construction of the qualifying asset). (£300,000 x 8.28% x 9/12) +
 Construction of the asset was still
(£240,000 x 8.28% x 5/12) = £26,910
underway at 30 June 2019.

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Subsequent expenditure relating to an item of PPE

 Subsequent expenditure (e.g. routine servicing, repair

and maintenance) is normally expensed
 Capitalised if excess future economic benefits will flow
◦ Extend useful life & increase capacity
◦ Upgrade to improve quality of output
◦ Adopting new production processes to significantly
reduce costs
Example: A supermarket renovates a major store.
Management budgets show a 15% increase in sales as a
consequence of more / better display space. Since there is
some reliability about estimates, both the renovation and
any specifically allocated interest could be capitalised. 22
Part 3

Depreciation
Explaining what depreciation is
and what it isn’t

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 Depreciation & the Matching Principle

• Think about the following SCENARIO:

A delivery company buys a van to use for its
business. It pays for the van by cash.

• How do you record this transaction using the

Accounting Equation?

• Is this purchase an Expense to be shown on the I/S?

• Why did the company buy the van ?
• How do you match the use of the van to the Revenues
it helps generate?
2
4
 What is Depreciation?
• Depreciation is a NON-CASH (!) EXPENSE that is recorded
annually in the Income Statement.
• Depreciation is the gradual allocation of the purchase price of
the non-current asset into the Income Statement, to match the
use of the non-current asset with the revenues its help
generate.
• Depreciation is a good example of the matching principle.
• Depreciation applies only to non-current assets with finite
lives. For example, freehold land has an infinite life and thus
does not get depreciated.
• Tangible non-current assets (with finite lives) get depreciated
annually. Intangible non-current assets (with finite lives) get
25
amortised annually.
 What depreciation is NOT!
There are many common misconceptions about
what depreciation is. These are all incorrect.

Depreciation is:
• NOT a way of showing how non-current assets
lose value over time. We are not attempting to
track the asset’s second-hand market value on
the SOFP through depreciation.

• NOT an amount of money the business

safeguards every year in order to replace its
non-current assets.
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Depreciation

Computing and recording

depreciation

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 How to calculate the
Annual Depreciation Expense?
To calculate the Annual Depreciation Expense we
need to know:
1. The purchase cost of the asset
2. The useful life of the asset
3. The residual value of the asset
4. The depreciation method to be used
 Depreciation methods
 The business must select a suitable method of
allocating the amount to be depreciated (known as
the depreciable amount = cost minus residual
value) over the accounting periods covering the
non-current asset’s useful life.

 The two most commonly used depreciation

methods are:
 Straight line depreciation method
 Reducing balance depreciation method
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 Depreciation Methods (2)
• Most commonly used depreciation methods:
• Straight line method
• You deduct the same amount each year
• E.g. Cost of Van: 12,000, Useful life: 5 years, Residual Value:
2,000
• Depreciation Charge = (12,000 – 2,000) / 5 = 2,000 every year

• Reducing Balance method

• More complicated method
• You deduct the same % every year, but you deduct from a
reducing amount every year
• E.g. In Yr 1 you deduct 30% of 10,000, in Yr 2 you deduct 30%
of 7,000 etc.
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 Depreciation methods
Graphs of carrying amount against time

STRAIGHT LINE DEPRECIATION METHOD REDUCING BALANCE DEPRECIATION METHOD

40 40

Carrying amount (£000)

30 30
Carrying amount (£000)

20 20

10 10

0 1 2 3 4 0 1 2 3 4

Asset life (years) Asset life (years)

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Example -
Depreciation
 Westbrook Ltd buys a car for £10,000.
It expects to keep it for 4 years and
then sell it for £256.

 Calculate the depreciation expense

using:
(a) the straight line method
(b) the reducing balance method
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STRAIGHT LINE Depreciation
calculations
Straight line method
 Same amount is expensed each year

 Depreciation expense = (Cost - residual value)

Useful life

 In example: (10,000 – 256) /4 = £2,436 each year

 How is this shown in the financial statements?

33
 How Depreciation is shown
in the Income Statement

Income statement
 Show the depreciation expense calculated for
the year as one of the operating expenses

Operating Expenses £

Depreciation 2,436

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 How depreciation is shown
in the SOFP
Show the accumulated depreciation as a deduction from the value
at cost, resulting in the Net Book Value (also known as Carrying
amount)

SOFP (end of year 1)

Non current assets £
Motor vehicles At Cost 10,000
Less accumulated depreciation (2,436)
Net book value(NBV) 7,564

SOFP (end of year 2)

Non current assets £
Motor vehicles At Cost 10,000
Less accumulated depreciation (4,872) [2,436 + 2,436]
Net book value(NBV) 5,128
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REDUCING BALANCE Depreciation
calculations
 Reducing balance method
 Deducts a fixed percentage from the net book value
(NBV) each year (this is the cost in the first year and cost
less accumulated depreciation in subsequent years)
 This means higher depreciation charges in earlier years
and lower charges in later years

P = (1 - n√R/C) x 100%
Where P = depreciation percentage
n = useful life of asset in years
R = residual (scrap) value of asset
C = cost or fair value of asset
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REDUCING BALANCE Depreciation
calculations
 P = (1 - n√R/C) x 100% = (1 - 4√256/10,000)
= 1 – 4/10 = 0.6 or 60%
 Depreciation applied to each of the 4 years:
Cost £10,000
Year 1: Depreciation expense 60% x cost = (6,000)
NBV end of year 1 4,000
Year 2: Dep’n expense 60% x NBV (2,400)
NBV end of year 2 1,600
Year 3: Dep’n expense 60% x NBV ( 960)
NBV end of year 3 640
Year 4: Dep’n expense 60% x NBV ( 384)
NBV end of year 4 256 37
 PART 5
Investment Property

Relevant accounting standard:

IAS 40: Investment Property
 What is Investment Property?
 A propertyheld to earn rentals or capital
appreciation or both, as opposed to being used to
produce goods / services or for admin, or sale in the
ordinary course of business (i.e. inventory).

 Examples of investment property include:

◦ Land held for long-term capital appreciation
◦ Land held for undecided future use
◦ Building leased out as an operating lease
◦ Vacant building held to be leased out as an operating lease
◦ Property that is being constructed or developed for future
use as investment property
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What is NOT Investment Property?
The standard provides a list of items that are not
investment properties and are therefore outside
the scope of IAS 40:

◦ Property held for use in the production of goods or

services
◦ Property held for sale
◦ Owner occupied property
◦ Property occupied by employees

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 IAS 40: Investment Property
 IAS40 recognises that the characteristics of
investment properties differ from those of properties
recognised as PPE, under IAS 16. It is the market
values and changes to market values that are
deemed useful to investors.

 IAS40 can be applied by any company (e.g. not

only property investment companies)

Divergence from US GAAP, which doesn’t

recognise investment property separately
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Measurement of Investment Property

Initial Subsequent
Recognition Measurement

1. The Fair
At Cost Value
Model

2. The Cost
Model
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 Measurement of Investment Property
after initial recognition
 Themeasurement model chosen must normally apply to ALL
investment properties
 Investment property may be measured at fair value at the end
of each reporting period. Gains or losses arising from the
change in fair value are recognised in the income statement
directly (different to IAS 16!)
 Orthe company’s investment property may be measured at
cost as defined by IAS16 – in this case the fair value must also
be disclosed in the notes!
 Investment
property when measured under the fair value model
is NOT depreciated
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Investment Property on the SOFP

Disclosure on the face of the Statement of Financial Position

Plus additional disclosures in the notes with information about which

measurement model was adopted (fair value vs. cost model) and a table
describing the movements in Investment Property (including additions and
disposal) analogous to the note prepared for PPE.
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 PART 6
Non-current Assets Held for Sale

Relevant accounting standard:

IFRS 5: Non Current Assets Held for Sale and
Discontinued Operations
When can a non-current asset be classified
as “held for sale”?
It needs to meet 2 criteria:
◦ The asset must be available for Immediate Sale in
its Present condition AND
◦ Its sale must be Highly Probable
 Requires management commitment
 Actively seeking buyer (active marketing campaign)
 Expectation to complete the sale within a year
 Unlikely that the sale plan will change significantly or
be withdrawn
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 Measurement & Presentation of Non-
current Assets “Held for Sale”

These assets are NOT depreciated

They are measured at the lower value
between:
◦ Their carrying amount
◦ Their fair value less any selling costs
They are presented separately on the face
of the SoFP ( = balance sheet)
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