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PRACTICAL PROBLEMS ENCOUNTERED IN THE ACCOUNTING FOR PPE

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PRACTICAL PROBLEMS ENCOUNTERED IN THE ACCOUNTING FOR PROPERTY, PLANT AND EQUIPMENT (PPE)

During 2007, in presenting the SAICA workshops on PPE, it became apparent that although IAS 16(AC 123) – Property, Plant and Equipment, was effective for annual periods beginning on or after 1 January 2005, there were still difficulties being encountered in implementing the Standard. These primarily related to:

  • capitalising an item;
  • derecognising a replaced part;
  • splitting an asset into components; and
  • calculating residual values.

In this article, I outline the common practice in South Africa, what IAS 16(AC 123) requires and the implication for preparers.

 

Item Common practice IAS 16(AC 123) requirements Implications 
Capitalising an item 
  • Companies continue to capitalise only those items that were previously capitalised.
  • No ‘repairs or maintenance’ are capitalised.
  • The principle applied is that of ‘capitalise if the level of performance exceeds the original level’, i.e. almost never!
“The cost of an item of property, plant and equipment shall be recognised as an asset if, and only if:

  1. a) it is probable that future economic benefits associated with the item will flow to the entity; and
  2. b) the cost of the item can be measured reliably.”
  • Certain repairs or maintenance costs may need to be capitalised.
  • All costs should be measured against the principle at the time they are incurred.
  • These costs include costs incurred initially to acquire or construct an item of PPE and costs incurred subsequently to add to, replace part of, or service it.
  • However, it excludes the costs of the day-to-day servicing of the asset.
Derecognising a replaced part Companies do not remove parts from the fixed asset register that have been replaced (derecognise them), unless the part was recognised as a separate component. “If, under the recognition principle in paragraph 7, an entity recognises in the carrying amount of an item of property, plant and equipment the cost of a replacement for part of the item, then it derecognises the carrying amount of the replaced part regardless of whether the replaced part had been depreciated separately.” 
  • When a part of an asset is replaced and the new part is capitalised, the old part should be derecognised.
  • This applies irrespective of whether or not the part was recognised as a separate component.
Splitting an asset into components 
  • Very few companies split assets into components.
  • Alternatively, it is often only done for new assets or those where the component is able to be sold separately.
“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 shall be depreciated separately.An entity allocates the amount initially recognised in respect of an item of property, plant and equipment to its significant parts and depreciates separately each such part.”
  • Companies should split all assets into components if the useful life or depreciation method of that component is different to the remainder of the asset AND it has a cost that is significant in relation to the total cost of the asset.
  • This applies to existing assets, new assets and replacements.
  • The ability to separate a part should not affect whether or not it is accounted for as a component.
  • The history of repairs and maintenance can provide past information as to what parts are regularly replaced – this could indicate that the useful life might be different to the rest of the asset.
Calculating residual values 
  • Many companies do not attribute residual values to assets.
  • Those that do, often do not understand the concept of residual value (and use a future value).
  • Alternatively, they may mistakenly use market value instead of residual value.
“Depreciable amount is the cost of an asset, or other amount substituted for cost, less its residual value.Fair value is the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction.

The residual value of an asset is the estimated amount that an entity would currently obtain from disposal of the asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life.”

  • Residual value (RV) should be determined by firstly assessing the useful life (UL) compared to the economic life (EL).
  • If UL < EL, it is more likely that an asset should have a RV. However, if UL = EL, RV is likely to be insignificant.
  • RV focuses on the value at the balance sheet date (not a future value).
  • E.g if a building is new and has a UL of 15 years, the RV is the value of a 15 year old building at the balance sheet date (not the value in 15 years’ time).
  • RV is not the same as fair value or market value. Using the previous example, fair value at the end of year 1 would be the amount the 1 year old building would realise. RV is the amount a 1 year old building would realise.
  • Preparers or auditors should therefore explain the concept of RV to valuation experts – including the fact that the estimated costs of disposal should be deducted from the value.

 

Many people are of the opinion that the biggest area of change in IAS 16(AC123) is the fact that an asset should be split into components. They relax once they believe they have no assets that should be split into components. However, it is evident from the above, that IAS 16(AC123) has some areas that are more complicated than many initially thought.

The majority of these requirements are also in the South African Statement of GAAP for SMEs that was issued during September 2007 by SAICA. The only difference (other than certain disclosures) is that subsequent costs should only be capitalised if they provide incremental benefits, which is not a concept that is currently in IAS 16(AC 123). Therefore, all companies should carefully assess whether what they have been doing in practice complies with the relevant Standards.

Glynnis Carthy CA(SA) is an independent financial reporting consultant on IFRS/SA GAAP and SME GAAP issues.