ACCA F7 (INT) Financial Reporting - Study text - 2010 - Emile Woolf Publishing
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Chapter 7: Tangible non-current assets
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These ‘recognition criteria’ should be applied to expenditure on property, plant and
equipment as the expenditure is incurred. Expenditure on property, plant and
equipment might be:
initial expenditure (when the asset is first acquired), or
subsequent expenditure to add to the asset, or replace parts of the asset.
1.3 Measuring non-current assets: the cost model
There are two models for the measurement (valuation) of non-current assets:
the cost model
the revaluation model.
A measurement model must be chosen for each class of non-current assets. It is an
accounting policy choice. The chosen accounting policy for a class of assets should
be applied consistently to all the assets in that class. For example, an entity may
choose the revaluation model for all its land and buildings, and the cost model for
all its plant and equipment.
Under the cost model, an item of property, plant and equipment is carried at its cost
(initial cost plus subsequent expenditure) less accumulated depreciation and
impairment losses.
Cost consists of:
purchase price (less any trade discounts) plus import duties and any non-
refundable purchase taxes, plus
costs that are directly attributable to bringing the asset to its present location
and condition, necessary for the asset to operate in the manner intended by
management, plus
the initial estimate of any dismantling and site restoration/decontamination
costs. (This is an estimate that is made when the asset is initially acquired.)
In other words, when it is known when an asset is acquired that there will be costs
to incur when the asset is eventually dismantled, an estimate of these future costs
should be included in the cost of the asset from the time that it is first recognised.
Directly attributable costs might include:
professional fees
delivery costs
site preparation costs
assembly and testing costs.
Costs that should be capitalised and included in the cost of a non-current asset are
referred to as capital items. Costs that should not be capitalised are referred to as
revenue items.
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Example
Entity H has incurred the following costs prior to bringing a machine into full
production.
$
Purchasepricebeforetraderebateandtax 12,200
Traderebate 600
Refundablepurchasetaxes 1,200
Architects’fees 700
Installationcosts 100
Operatinglossespriortoachievingplannedperformance 250
Required
Calculate the amount at which the machine should be stated in the accounting
records of Entity H in accordance with IAS16.
Answer
The cost of the machine should be stated in the statement of financial position as:
$
Purchasepricelesstraderebate(12,200–600) 11,600
Architects’fees 700
Installationcosts 100
–
––––––
Totalcost 12,400
–
–
–––––
For self-constructed assets (non-current assets that are constructed by the entity
itself):
internal profits and abnormal costs should be excluded from cost
administrative expenses and other similar overheads should also be excluded
from cost
interest costs incurred in the course of construction may be included, in
accordance with IAS23 Borrowing costs (see below).
1.4 Subsequent expenditure
Subsequent expenditure relating to non-current assets, after their initial acquisition,
should be capitalised if it meets the criteria for recognising an asset. In practice, this
means that expenditure is capitalised if it:
improves the asset (for example, by enhancing its performance or extending its
useful life)
is for a replacement part (provided that the part that it replaces is treated as an
item that has been disposed of).
Chapter 7: Tangible non-current assets
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Repairs and maintenance expenditure is revenue expenditure. It is recognised as
an expense as it is incurred, because no additional future economic benefits will
arise from the expenditure.
Examples of subsequent expenditure on a building, for example, include:
constructing an extension to the building
replacing the elevators or the heating or air conditioning system.
1.5 Capitalisation of borrowing costs: IAS23
An entity may incur significant interest costs if it has to raise a loan to finance the
purchase or construction of an asset.
IAS23 Borrowing costs generally requires borrowing costs (interest costs) to be
written off to profit and loss in the financial period in which they are incurred.
However, borrowing costs must be capitalised as part of the cost of an asset
when they are directly attributable to the acquisition or construction of a
qualifying asset.
A qualifying asset is defined in IAS23 as ‘an asset that necessarily takes a substantial
period of time to get ready for its intended use or sale’.
Inventory is not a qualifying asset, because it is already in a condition for use or
sale. Similarly, purchased non-current assets are usually not qualifying assets,
because they should be ready for use as soon as or soon after they are purchased.
Qualifying assets are likely to include assets that are constructed by the entity itself,
where the construction takes a long time (and the cost of construction is financed by
borrowing).
Borrowing costs in relation to a qualifying asset such as a building or major
construction contract should therefore be capitalised and included in the cost of the
asset, provided that the borrowing costs can be directly related to it.
The cost of the asset will be more accurately stated by the inclusion of these
costs.
The borrowing costs will be more accurately matched to future revenues when
they are depreciated as part of the cost of the asset.
The amount of borrowing costs capitalised will be the finance cost of:
the funds borrowed to finance a specific asset, or
when it is not possible to identify specific borrowed funds with a specific
qualifying asset, a proportion of the funds borrowed by the entity for general
use, using a weighted average cost of finance.
Capitalisation of borrowing costs should start only when:
expenditures for the asset are being incurred
borrowing costs are being incurred, and
activities necessary to prepare the asset have started.
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Capitalisation of borrowing costs should be suspended if development of the asset
is suspended for an extended period of time.
Capitalisation of borrowing costs should cease when the asset is substantially
complete. The costs that have already been capitalised remain as a part of the asset’s
cost, but no additional borrowing costs may be capitalised.
Under IAS8 Accounting policies, changes in accounting estimates and errors, if an
entity chooses to capitalise borrowing costs then it should apply this policy
consistently to all qualifying borrowing costs.
1.6 Measuring non-current assets: the revaluation model
Instead of measuring non-current assets using the cost model, an entity may choose
to value them using the revaluation model. Under the revaluation model, an item of
property, plant and equipment is ‘carried’ in the statement of financial position at:
its revalued amount (its fair value)
less accumulated depreciation charges and impairment losses (since the
revaluation).
Fair value is normally open market value. If there is no reliable market value (for
example, because the asset is specialised or because sales are rare), depreciated
replacement cost can be used.
Valuation should normally be performed by a professionally qualified valuer.
If the revaluation model is adopted:
assets must be revalued regularly so that their carrying values do not differ
materially from their fair values
once an asset is revalued, all assets within that class must also be revalued
IAS 16 does not prescribe a time interval between revaluations. However it states
that revaluations should be made with ‘sufficient regularity’ to ensure that its
carrying value in the statement of financial position is not materially different from
its what its fair value would be.
Gains on revaluation
When an asset is revalued upwards from its carrying amount, there is a gain on
revaluation:
The gain on revaluation is included as other comprehensive income in the
statement of comprehensive income and is not included in profit or loss for the
period.
There is an exception to this rule. If the gain on revaluation reverses a previous
loss on revaluation, where the loss was recognised in profit or loss, the
revaluation gain should be recognised in profit or loss, not ‘other comprehensive
income’.
When a gain on revaluation is recognised in other comprehensive income, it is a
requirement of IAS1 and IAS12 that the tax associated with the revaluation should
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also be included in other comprehensive income. For example, if there is a gain on
revaluation of $500,000 before tax, and the rate of tax is 30%, other comprehensive
income will be $500,000 less tax of $150,000. There will be an increase of $500,000 in
the carrying value of the asset, and a matching increase of $350,000 in the
revaluation reserve for the asset and $150,000 in tax liability (deferred tax).
Losses on revaluation
When an asset is revalued down from its carrying value there is a loss on
revaluation.
The amount of the reduction in valuation should be recognised in profit or loss
(not in other comprehensive income).
There is an exception to this rule. If the loss on revaluation reverses a previous
gain on revaluation that was reported in other comprehensive income, the
decrease should be reported in other comprehensive income and not recognised
as a loss.
Example
Entity J has an asset in its statement of financial position at 31 December Year 1 as
follows.
$
Cost 450,000
Accumulated depreciation (300,000)
–
–––––––
Carrying amount 150,000
–
–––––––
On 31 December Year 1 the asset was revalued to its fair value of $600,000.
Required
(a) Set out the journal entry to record the revaluation, ignoring taxation.
(b) Explain how the revaluation would be reported in the financial statements for
the year to 31 December Year 1.
(c) Explain how the accounting treatment of the revaluation would differ if
$200,000 of the revaluation is a reversal of a revaluation loss that was
recognised as a loss in an earlier financial period.
(d) Explain how the accounting treatment of the revaluation in (a) and (b) would
differ allowing for tax at a rate of 30%.
Answer
(a) Ignoring taxation
Debit
Credit
$
$
Cost/valuation (600,000 – 450,000) 150,000
Accumulated depreciation 300,000
Revaluation reserve (600,000 – 150,000)
450,000
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(b) As a result of this revaluation, the asset will be stated in the statement of
financial position at a value of $600,000, with no accumulated depreciation.
There is an increase in the revaluation reserve of $450,000. There will be
$450,000 in the revaluation reserve that relates to that asset.
In the statement of comprehensive income for the year to 31 December Year 1,
‘other comprehensive income’ should include the revaluation surplus of
$450,000.
(c) If the revaluation of $450,000 in part reverses a revaluation loss of $200,000,
then $200,000 should be reported in profit for the period, and the balancing
$250,000 should be reported as other comprehensive income.
(d) Allowing for tax at 30%, other comprehensive income should report the
revaluation of $450,000 less tax at 30% ($135,000). The carrying amount of the
asset is increased by $450,000 to $600,000 with no accumulated depreciation.
There will be an increase in the revaluation reserve of $315,000 (= $450,000 less
tax of $135,000) and an increase in deferred tax of $135,000. Deferred tax is
explained in more detail in a later chapter.
Debit Credit
$ $
Cost/valuation (600,000 – 450,000) 150,000
Accumulated depreciation 300,000
Revaluation reserve (600,000 – 150,000) 315,000
Deferred tax 135,000
Example
Entity J had an asset in its statement of financial position at 31 December Year 1 as
follows.
$
Cost 450,000
Accumulated depreciation (300,000)
–
–––––––
Carrying amount 150,000
–
–––––––
On 31 December Year 1 the asset was revalued to its fair value of $600,000.
In Year 2, depreciation of $60,000 was charged on the asset. On 31 December Year 2,
the asset is revalued again and its fair value is now $500,000.
Required
Set out the amounts to be taken to the revaluation reserve in respect of this asset on
1 January Year 3. Ignore taxation.
Answer
On 31 December Year 2, the carrying amount of the asset is now $540,000 (=
$600,000 - $60,000).
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The asset is revalued to $500,000; therefore the revaluation reserve will be reduced
by $40,000.
The journal entries to record the adjustments will be as follows:
Dr Cr
$ $
Downward revaluation of asset (600,000 – 500,000) 100,000
Increase in accumulated depreciation 60,000
Revaluation reserve: reduction 40,000
The asset will now be valued at $500,000, the accumulated depreciation will be $0
again, and the revaluation reserve relating to the asset will be reduced from
$450,000 to $410,000.
The reduction of $40,000 in the revaluation reserve is reversing a gain that was
previously recognised in Year 1 as ‘other comprehensive income’. The reduction in
value should therefore be recognised in ‘other comprehensive income’ (as ‘negative’
income) for Year 2.
Note: Allowing for taxation, the other comprehensive income for Year 2 would be a
negative amount of $40,000 offset by an amount for taxation. For example if tax is at
the rate of 25%, other comprehensive income after tax would be $40,000 less 25% =
$30,000. The revaluation reserve would be reduced by $30,000 (not the $40,000
shown above) and deferred tax would be reduced by $10,000.
Calculating the gain or loss on revaluation
In an examination question, you might be given information that enables you to
calculate the amount of a gain or loss on revaluation. You need to remember that if a
revaluation is made at the end of a financial year, you should depreciate the asset
up to the time that the revaluation occurs. In other words, if revaluation occurs at
the year-end:
calculate depreciation for the asset for the year and then
calculate the revaluation gain as the difference between the new fair value of the
asset and the carrying amount of the asset after deducting depreciation for the
year.
Example
A company is preparing its financial statements for the year to 31 December.
A 25-year leasehold property had a carrying value of $69 million at the beginning of
the year, consisting of:
$m
At cost 75
Less: Accumulated depreciation as at 1 January (6)
–
––––
69
–
––––
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At 31 December the leasehold property is revalued to $70 million. The income tax
rate is 25%.
How should the revaluation be accounted for in the year to 31 December?
Answer
$m
Carrying value of leasehold property at 1 January 69
Depreciation for the year ($75 million/25 years) (3)
Carrying value at 31 December 66
Revalued amount 70
–
–––
Amount of revaluation of the asset 4
–
–––
The leasehold property should be revalued to $70 million in the statement of
financial position, with no accumulated depreciation.
The revaluation of $4 million before tax has an associated tax charge of $1 million (=
$4 million × 25%).
Other comprehensive income in the statement of comprehensive income for the year
will therefore show:
$m
Gain on asset revaluation 4
Less: Related tax (1)
–
–––
3
–
–––
Chapter 7: Tangible non-current assets
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The revaluation reserve should be increased by $3 million and
deferred tax by $1 million.Depreciating non-current assets
The objective of depreciation
Depreciation methods
A change in the method of measuring depreciation
A change in the asset’s useful life
2 Depreciating non-current assets
2.1 The objective of depreciation
IAS16 states that the objective of depreciation is to allocate the depreciable amount
of an asset on a systematic basis over its useful life. The depreciable amount of a
non-current asset is:
its cost minus its expected residual value, where the cost model of valuation is
used
the amount substituted for cost, less its expected residual value, where the
revaluation model is used.
The depreciation charge has the effect of spreading the cost/fair value of the asset
over the financial periods that will benefit from its use.
The depreciation charge for the year (whether based on cost or revalued amount) is
recognised in profit or loss in the statement of comprehensive income.
All tangible non-current assets must be depreciated. The only exception to this rule
is land, which normally has an indefinite useful life (unless the land is used in
mining or similar industries).
Each significant part of an item of property, plant and equipment must be
depreciated separately. This allows for assets that have two or more major
components with differing useful lives and where different depreciation methods
may be appropriate.
For example:
For an aircraft, the frame and engines may have different useful lives and
therefore should be depreciated separately.
Similarly, in a building, the external structure will be depreciated over a longer
life than the elevators or heating and air conditioning equipment installed in the
building. For example the structure of a building might be depreciated over a
useful life of 50 years, whereas the elevators might be depreciated over 10 years
and the heating system over 15 years.
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2.2 Depreciation methods
Methods of depreciation that may be used include:
the straight-line method
the reducing balance method
the units of production method.
The method chosen by an entity should:
most closely reflect the wearing out of the asset, and
be applied consistently.
Example
Entity K owns a machine which it purchased for $4,400 on 1 January Year 1. The
machine was estimated to have a residual value of $1,400.
Required
Calculate the depreciation charge for Year 1 and Year 2 using:
(a) the straight-line method (assuming that the machine has a useful life of four
years)
(b) the reducing balance method (using a rate of 25%)
(c) the units of production method (on the basis that the machine has a capacity
over its life of 100,000 units and in Year 1 has produced 28,000 units and in
Year 2 has produced 26,000 units.
Show the carrying amount of the asset at the end of Year 1 and at the end of
Year 2.
Answer
Year 1
Depreciable amount = $4,400 – $1,400 = $3,000
Depreciation rate:
Straight-line method: $3,000/4 years = $750 per year
Units of production method: $3,000/100,000 units = $0.03 per unit produced.
(a) Straight line method: $750
(b) Reducing balance method: $4,400 × 25% = $1,100 (carrying value at end of
Year 1 = $3,300)
(c) Units of production method: 28,000 × $0.03 = $840
Year 2
(a) Straight line method: $750