Almost any type of companies engaged in various businesses need capital assets to use in the production or supply of goods or services, or for administrative purposes (e.g. building, warehouse, production line, vehicle, etc.). In the accounting world, capital assets refer to Property, Plant and Equipment (PPE). Property, Plant and Equipment are tangible assets and are expected to be used during more than one period (generally more than one year). The accounting standards that are relevant for PPE accounting are IAS 16 Property, Plant and Equipment for IFRS, ASC 360 Property, Plant and Equipment for US GAAP. IAS 16 Property, Plant and Equipment is one of oldest standard and its history goes back to 1980.
PPE is recognized as an asset in the Company’s Balance sheet if and only if the cost of the item can be measured reliably and it is probable that the item will generate future economic benefits for the Company. An item of PPE must be initially recognized at its cost (how much it costs to the Company to purchase or internally generate that item of PPE).
What goes into the cost of PPE
Expenditures that should be included in the cost of PPE comprise:
- its purchase price after deducting any trade discounts and rebates, import duties and non-refundable purchase taxes;
- any costs directly attributable to bringing the asset to the location and condition to operate;
- the estimated costs of dismantling and removing the item and restoring the site on which it is located;
- borrowing costs (interest costs of debts or loans) should also be added in the cost of internally generated PPE which requires substantial amount of time to bring the asset in a condition to use (e.g. a warehouse which requires 8 months to construct).
Subsequent measurement of PPE
There are two methods that Company may choose to measure the carrying amount of PPE in its Balance sheet statement:
Cost model* (This is the sole model acceptable under ASC 360 US GAAP)
PPE is carried at its historical cost minus any accumulated depreciation and impairment loss since its recognition.
PPE is carried at its fair value (at the date of the revaluation) less any subsequent accumulated depreciation and impairment loss. Revaluations must be made regularly so that the carrying amount of PPE does not differ materially from its fair value at the reporting date. If one item of PPE is revalued than all items in that class of asset should be revalued (examples of separate classes are land, machinery, aircraft, furniture and fixtures, etc.).
Revaluation increases are recognized in other comprehensive income and accumulated in equity unless they reverse a previous revaluation decrease. Revaluation decreases are recognized in profit or loss unless they reverse a previous revaluation increase.
Let’s assume ABC Company acquired a production line from an overseas supplier to manufacture a new-developed product. The purchase costs were $ 15,000, import duties and taxes $ 5,000, transportation expenses were $ 2,000, and the installation costs were $ 8,000. The fair value of this production line (with installation) is $ 50,000 in local market.
Under Cost model a production line of $ 30,000 should be recognized in ABC Company’s accounting, which will be depreciated over its estimated useful life.
Debit PPE 30,000
Credit Cash 30,000
Under Revaluation model a production line of $ 50,000 should be recognized in ABC Company’s accounting.
Debit PPE 50,000
Credit Cash 30,000
Credit Revaluation reserve 20,000
Realization of PPE
The cost of PPE can be allocated during a specific period of time through depreciation or impairment losses.
Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life. The depreciable amount is the difference between the initial cost and residual value of PPE (the amount that is expected to receive by selling the PPE at the end of its useful life), but in reality, residual value is often insignificant and are ignored in the calculation of depreciable amount.
The depreciation method used should reflect the pattern that best matches with the benefit generated by that PPE. There are various methods of calculating depreciation:
- Straight-line method (time)
- Diminishing balance method (applying % to outstanding balance)
- Units of production method (number of units produced)
To explain the different depreciation methods, let’s look at the following example. A company has the following PPE with $100 initial cost.
Under straight-line method, depreciation for each year will be (let’s assume the useful life is 5 year):
($100 initial cost is divided between these 5 years equally).
Under diminishing balance method, depreciation for each year will be (let’s assume 30% is relevant):
|Depreciation||30 (100*30%)||21 (70*30%)||15 (49*30%)||10 (34*30%)||7||17|
(depreciation for each year is calculated by applying X% on outstanding balance of prior year).
Under the units of production method, depreciation for each year will be (let’s assume that PPE is made for producing only 1,000 units, after which it becomes unusable):
|Number of goods produced||300||250||200||150||100||1000|
(b) Impairment loss
Impairment losses arise when the PPE’s recoverable amount is less than its carrying amount reflected in Balance sheet statement. This may happen for various reasons, such as: drop in market value of that PPE, previously applied incorrect depreciation rate, etc.
PPE should be removed from the balance sheet statement as an asset when it is disposed (sale, donation, etc.) or when it is withdrawn from use and no future outcome is expected from that PPE. Gain or loss from its disposal is the difference between the carrying amount of that PPE and the fair value of any benefits received from its disposal. This gain or loss should be recognized in profit and loss statement in the period when the sale occurred.