An Update on International Accounting Standard (IAS) 16 ...An ...

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Published by the De La Salle University - Manila, College of Business and Economics (CHED Center of Development for Business and Management Education) Center for Business and Economics Research and Development (CBERD)

on business education

Volume 9 Issue No. 1 Jan - Feb 2006

An Update on International Accounting Standard (IAS) 16: Property, Plant and Equipment By Herminigilda E. Salendrez Assistant Professor I. Introduction Failure to apply the set of rules, principles, bases, conventions and standards distort the financial information reported in the financial statements. This article aims: (1) to discuss International Accounting Standard 16 as it relates to accounting for Property, Plant and Equipment; and (2) to provide coherent set of updates on accounting for tangible fixed assets which is commonly known as property, plant and equipment. Since January 2005, advocates of the new International Accounting Standard 16 Property, Plant and Equipment encourage entities to apply the principles of the Standard in lieu of its previous version, IAS 16 (1998). The advocacy, headed by the International Accounting Standards Board, was initiated due to questions and criticisms raised by securities regulators, professional accountants and interested parties. The Board undertook a project in order to develop this revised IAS 16 to reduce or eliminate alternatives, redundancies and conflicts within the standards, deal with some convergence issues and make other improvements. The revision, however, was not intended to overhaul nor to reconsider the fundamental approach to the accounting for property, plant and equipment

contained in IAS 16. This standard clarifies how an entity should apply the principles to items of property, plant and equipment that is used to develop or maintain: (a) biological assets; and (b) mineral rights and mineral reserves such as oil, natural gas and similar nonregenerative resources.

II. Major Changes The main changes introduced from the previous version of IAS 16 are the following: A.

Recognition - subsequent costs The old version states that, subsequent expenditure is added to the

Ms. Herminigilda Salendrez teaches financial accounting in the modular accountancy program of DLSU - Manila

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carrying amount of the asset only when it is probable that future economic benefits in excess of the originally assessed standard of performance of the existing asset will flow to the enterprise. Any other subsequent expenditure is simply recognized as an expense in the period in which it is incurred. In contrast to the new version, the cost of an item of property, plant and equipment shall be recognized as an asset if, and only if: a) it is probable that future economic benefits associated with the item will flow to the entity; and b) the cost of an item can be measured reliably. This is a general recognition principle, which guides the entity in the evaluation of all property, plant and equipment costs at the time they are incurred. Those costs include costs incurred initially from the time a property, plant and equipment is acquired or constructed and costs incurred subsequently to add to, replace part of, or service an item. To recognize a cost as an asset, the expenditure must give rise to the expectation of future economic benefits. Assets for which the cost cannot be reliably measured but whose initial fair value can be measured reliably cannot be recognized in the entity’s records. Table 1 shows the proper accounting for subsequent costs to acquisition of property, plant and equipment: B. Measurement at recognition asset dismantlement, removal and restoration costs. The previous version of IAS 16 covers only the costs incurred as a consequence of installing the item. The new version includes both the costs of an item of property, plant and equipment and the estimated cost of its dismantlement, removal or restoration. Such cost to dismantle or remove equipment or to restore property should be subjected to accurate determination and should constitute a legal or constructive commitment by the reporting entity. For example, when an


Table1. Accounting for costs incurred subsequent to acquisition of property, plant and equipment

Type of expenditure 1. Additions 2. Repairs & maintenance a. Ordinary b. Extraordinary

3. Replacement and betterments

Expense when incurred

Characteristics Extension, enlargements, or expansions made to an existing asset

Normal accounting treatment Capitalize - Accumulated Other + Asset Depreciation x

Recurring, relatively small amount • Maintain normal operating condition • Do not add materially to use value • Do not extend useful life Not recurring, relatively large amount • Primarily increase the use value • Primarily extend the useful life

x x x x x

Major component of the asset is removed and replaced with the same type of component with comparable performance capabilities or different type of component having superior performance capabilities

a. Book value of old component is known

b. Book value of old component is not known 4. Reinstallation and rearrangements

* Remove old asset cost & accumulated depreciation * Recognize gain or loss on old asset *Charge asset to replacement component 1. Primarily increase the use value 2. Primarily extend the useful life

x x

Provide general efficiency in production or reduce production costs 1. Material costs incurred: benefits extend into future accounting periods 2. No measurable future benefit

x x

Source: Wiley. IAS 2004. Interpretation and Application of International Accounting and Financial Reporting Standards

asset such as offshore oil platform is constructed, an entity knows that in the future it is required by law to dismantle and remove the platform in such manner that the environment is cared for. The construction of the platform gives rise to a liability for restoration under IAS 37 Provisions, Contingent Liabilities and Contingent Assets. The projected costs are measured on a discounted present value basis, capitalized into the construction of the platform and are depreciated over the life of the asset. Since the dismantling, removal and restoration costs are initially recorded at a discounted amount, each accounting period the provision (i.e. estimated

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liability) should be accreted, so that at the expected date on which the expenditure is to be incurred it will be appropriately stated. The offset of accretion1 should be reported as interest expense or a similar financing cost. It should not be added to the cost of the asset to which the estimated dismantlement costs are related. There may be restoration costs associated with the use of land, such as when it is used for mining or farming. These costs are capitalized into the cost of the land at acquisition date and are depreciated over the period in which the benefits from use of the land are received, although the land is not depreciated.

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Illustrative problem: restoration costs The company purchased a mining site that will have to be restored to certain specifications when the mining production ceases. The cost of the mining site is P15,000,000, and the restoration costs is expected to be P400,000. It is estimated that the mine will continue in operation for 12 years. The appropriate interest rate is 8%. The cost of the asset is computed as follows: Purchase price P15,000,000 Present value of restoration cost:P400,000 x 0.3971 155,840 Total cost P15,155,840 The acquisition is, then recorded as follows: Mine property Cash Provision for mine property retirement

15,155,840 15,000,000 155,840

The account Provision for Mine Property Retirement is presented in the balance sheet as liability in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets. Adjusting entries at year-end: Accretion expense Provision for mine property retirement (P155,840 x 8%) Depreciation expense Accumulated depreciation (P15,155,840 /12 yrs.)

12,467.20 12,647.20 1,262,987 1,262,987

Illustrative problem: renewals and replacements BEST Company recently replaced the outside corrugated wall of its administration building. The old wall cost P250,000, and was 50% depreciated. The new wall cost P400,000, which was paid in cash. The new wall will extend the life of the building by 3 years. Assume that the cost of the old wall is identifiable, and has been accounted as part of the building cost. The book value of the old component is known. The entries to record the removal of the old wall and the installation of the new wall are: 1.

To eliminate the original cost of the old corrugated wall: Loss on retirement of building Accumulated depreciation Building

2.

To record the replacement: Building Cash

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125,000 125,000 250,000 400,000 400,000

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The International Accounting Standards Board (IASB) concentrated on the initial estimate of costs of dismantling, removal and restoration. The IASB noted that regardless of whether the obligation is incurred when the item is acquired, the obligations underlying nature and its relationship with the asset are the same. Hence, the considerations for obligation for which an entity incurs as a result of installing the item and the costs incurred as a result of using it during a particular period are taken carefully. C. Measurement at recognition asset exchange transactions In terms of asset exchange transactions, the two versions differ in the manner how the fair value method is utilized. Under the previous version, if the exchanged assets were similar (similar asset that has a similar use in the same line of business and which has a similar fair value), resorting to measuring an item of property, plant and equipment at fair value is not strictly implemented. In the new version, unless the exchange transaction lacks commercial substance, an entity is required to measure an item of property, plant and equipment at fair value, whether such item of property is acquired in exchange for a non-monetary asset or assets, or a combination of monetary and non-monetary assets. Commercial substance is concerned with whether the transaction has a discernible effect on the economics of an entity. Paragraph 25 states that an exchange transaction has commercial substance if: a. the configuration of the cash flows of the asset received differs from the configuration of the cash flows transferred; b. the entity-specific value of the portion of the entity’s operations affected by the transaction changes as a result of the exchange; and c. the difference in (a) or (b) is significant relative to the fair value of the assets exchanged. Where the transaction lacks commercial substance, the asset acquired


is measured at the carrying amount of the asset given up. Paragraph 24 of IAS 16 states that, in an exchange of assets where neither the fair value of the assets given up nor the fair value of the asset acquired can be measured reliably, the acquirer should measure the costs of the asset acquired at the carrying amount of the asset given up. D. Measurement after recognition – revaluation model. IAS 16 establishes two alternative approaches to accounting for property, plant and equipment. First, the benchmark treatment, under which the acquisition or construction cost is used for initial recognition, subject to depreciation over the estimated economic life and to possible write-down in the event of a permanent impairment in value. Second, the allowed alternative treatment is to recognize upward revaluation. A revalued amount is that fair value of the items at the date of the revaluation less any subsequent accumulated depreciation and accumulated impairment losses. Under the previous version of IAS 16, the use of revalued amounts did not depend on whether or not the measuring of the fair values of an item can be relied upon. Under the new version, the use of revalued amounts depends on the reliability of the fair values of an item. The standard stipulates that fair value is the amount for which the asset could be exchanged between knowledgeable, willing parties in an arm’s-length transaction. The standard requires that once the entity undertakes revaluations, they must continue to be made with sufficient regularity that the carrying amounts in any subsequent balance sheet are materially at variance with its current fair values. According to paragraph 32, the fair value of the land and buildings is usually determined from market-based evidence by appraisal normally undertaken by professionally qualified valuers. The management should


Illustrative problem: acquisition through exchange Two independent companies, NES Company and KSE Company, are in the real estate business. Each owns a condominium building in Makati City. They agree to exchange their condominium building. An appraiser was hired, and from her report and the companies’ records, the following information was obtained: Cost Accumulated depreciation Fair value based upon appraisal

NES's Building P128,000,000 51,200,000 90,000,000

KSE's Building P80,000,000 32,000,000 70,000,000

The exchange was made, KSE Company paid P20,000,000 to NES Company. The exchange is regarded as with commercial substance. Journal entry to record the exchange follows: Books of KSE Company Building - new 90,000,000 Accumulated depreciation 32,000,000 Cash Building – old Gain on exchange Books of NES Company Cash Building – new Accumulated depreciation Building – old Gain on exchange determine whether there has been sufficient change in the market for the asset held at fair value to merit formal appraisal by professional valuers. With items of plant and equipment, the fair value is usually their market value determined by appraisal. In addition, IAS 16 conservatively requires that if assets are revalued, all other assets in those groupings or categories also have to be revalued to prevent the presentation of balance sheet that contains an incoherent mixture of historical cost and current values. Although the requirement of IAS 16 is to revalue all assets in a given class, the standard recognizes that it may be more practical to accomplish this on a rolling or cycle basis.

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20,000,000 80,000,000 22,000,000

20,000,000 70,000,000 51,200,000 128,000,000 13,200,000 The adjustments due to revaluation are to be shown directly in the stockholders’ equity as a revaluation surplus, if a downward adjustment had previously been made to the asset and was recognized as an expense, the latter upward revaluation would also be reported as an income. Any revaluation receiving this treatment would be limited to the amount of expenses recognized in the past. If the carrying amount of the revalued asset is decreased by the recognition of permanent impairment, the decline should be reported as a reduction of the revaluation surplus. The amount credited to revaluation surplus can either be amortized to retained earnings as the asset is being depreciated or it can be held in the surplus account until such time as the asset is disposed of or retired from service.

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E.

Illustrative problem: revaluation On December 31, 2005, the balance sheet of Henri See Company showed the following non-current assets: Building Accumulated Depreciation Machinery and Equipment Accumulated Depreciation

P9,000,000 (3,000,000) 360,000 (120,000)

P6,000,000 240,000

The company has adopted fair value for the valuation of property, plant and equipment. This has resulted in the recognition in prior periods of an asset revaluation surplus for the building of P420,000. On December 31, 2005, an independent valuer assessed the fair value of to be P4,800,000; and the machinery and equipment to be P270,000. Assume that the building and machinery and equipment had remaining useful lives of 15 years and 4 years respectively, with zero residual value. 1. To record the revaluation of building and machinery and equipment: Accumulated Depreciation – Building Revaluation Surplus Expense – Revaluation Decrement Building

3,000,000 420,000 780,000 4,200,000

Accumulated Depreciation – Mach. & Equipment120,000 Machinery & Equipment Revaluation Surplus

90,000 30,000

2. To record depreciation expense for the year ended December 31, 2005: Depreciation Expense – Building Accumulated depreciation – Building (P4, 800,000 / 15 years)

320,000 320,000

Depreciation Expense – Machinery & Equipment 67,500 Accumulated depreciation – Mach. & Equip (P270,000 / 4 years)

67,500

3. To record the piecemeal realization of revaluation increment: Revaluation Surplus Retained Earnings (P30,000 / 4 years)

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7,500 7,500

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Depreciation – unit of measure. The previous version of IAS 16 did not clearly set out a requirement to determine the depreciation charge separately for each significant part of an item of property, plant and equipment. The new version, however, provides that 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. F. Depreciation - depreciable amount. Under the old version, the basis for which the residual value of an item of property may be measured was not clearly specified. Hence, the residual value could be any amount or the amount, inclusive of the effects of inflation that an entity expects to receive in the future on the asset’s actual retirement date. In the new version, the residual value which an entity measures is treated as the same amount it would receive currently for the asset if the asset becomes obsolete or in the condition wherein an asset is expected to be unavailable for use by the entity. The depreciable amount of an asset shall be allocated on a systematic basis over its useful life. The residual value of an asset should be reviewed at least at each financial year-end and, if expectations differ from previous estimates. The change(s) shall be accounted for as a change in an accounting estimate in accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors. G. Depreciation - depreciation period. The previous version did not specify the period when depreciation of an item should begin, although it specifies that an entity should cease depreciating an item that it had retired from active use and was holding for disposal. Under the new version, an entity begins depreciating an item of


property, plant and equipment as soon as it is available for use. Depreciation continues until the item is derecognised or the cost of property, plant and equipment together with the related accumulated depreciation is removed from the accounts. The same is true even if during that period the item is idle and is no longer adopted for use in business. H. Derecognition - derecognition date. According to authorities, derecognition means the removal from the accounts of the cost of property, plant and equipment together with its related accumulated depreciation. Hence, the carrying amount of an item of property, plant and equipment is derecognized on disposal, such as the sale of the asset or when no future economic benefits are expected from its use or disposal (Valix & Peralta, 2006). Derecognition also implies the use of a particular date or period from which an entity may dispose a property or plant. Hence under the old version, an entity was not required to use a criteria, such as those provided under IAS 18 on Revenue, in the determination of the date on which an entity derecognizes the carrying amount of a disposed-of item of property, plant and equipment. Whereas under the new version, it requires an entity to observe the date for which a criteria for the sale of goods in IAS 18 on Revenue would be met when an entity derecognizes the carrying amount of an item of property, plant and equipment that it disposes. In the same manner, the old version limited the application of derecognition principle only to a property, plant and equipment and not to any of its parts. Also, its recognition principle for subsequent expenditures effectively disallowed the cost of a replacement from being included in the carrying amount of an item. Unlike in the new version, derecognition extends to the carrying amount of a part of an item of property, plant and equipment if that part has been replaced. An entity, likewise, includes the cost of the replacement in the carrying amount of the item.


I. Derecognition - gain classification The old version did not contain a provision on gain classification. The new version, on the other hand, when items of property, plant and equipment are sold, regardless of whether that are many or few remaining economic benefits, the selling entity will recognize a gain or loss on the asset, this being determined as the difference between the net proceeds from sale and the carrying amount of the asset at the time of sale. The gain or loss on sale is included in the profit or loss for the period.

III. Conclusion Businesses are increasingly conducted across the national borders. Entities must be able to make their financial statements understandable to users all over the world. The deviating or differing national accounting practices must converge to overall global standards. As to the various rules and principles set on accounting for property, plant and equipment under IAS 16, compliance of business entities are required to avoid any error or misstatement in financial reporting

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presentation that may result to the distortion of the account, and to conform to the international financial reporting standards.

References Epstein, Barry J., Mirza, Abbas Ali, John. Interpretation and Application of International Accounting and Financial Reporting Standards. Wiley & Sons, Inc. Hoboken, New Jersey, USA, 2004. International Accounting Standards (IAS) approved by the International Accounting Standards Board. 2003. Skousen, Stice and Stice. Intermediate Accounting (15th Edition). Thomson SouthWestern. 2004. Statement of Financial Accounting Standards (SFAS) approved by Accounting Standard Council, 1998 – 2002. Valix, Conrado T., Peralta, Jose F. Financial Accounting Volume. 2006 Edition. GIC Enterprises & Co., Inc., Manila. (Footnotes) 1 Accretion is an accumulation of finance cost over the life of the asset to increase the present value of the asset retirement obligation or provision for asset dismantlement, removal and restoration.

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is published by the De La Salle University - College of Business and Economics, Center for Business and Economics Research and Development (CBERD) Volume 9 No. 1 Jan - Feb 2006 Editorial Board Dr. Myrna S. Austria email: [email protected] Dr. Tereso S. Tullao, Jr. email: [email protected] Mr. Michael Angelo A. Cortez email: [email protected] Secretary: Liza Pajo For comments, suggestions and contributions, call (632)5244611 loc. 149 or telefax (632)3030869 or email: [email protected]

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