In this session we shall continue our look at IAS 16 Property, Plant and Equipment. We shall look at how property, plant and equipment should be measured after it has been recorded initially and what information should be disclosed in the notes to the financial statements.
Subsequent valuation of property, plant and equipment
We have previously seen that property, plant and equipment should first be recorded at their cost. After that initial valuation the company has a choice and can value these assets using two methods
- The Cost Model
- The Revaluation Model
The same model should be applied to all assets within the same class of property, plant and equipment. For example, a company might decide to apply the Cost Model to all its machinery and the Revaluation Model to all its buildings.
1 The Cost Model
Under the Cost Model, the asset is recorded at its cost and is then depreciated over the asset’s useful life to its residual value.
The carrying value of an item of property, plant and equipment under this model is therefore the cost of the item less accumulated depreciation and accumulated impairment losses (impairment losses are unexpected falls in value and are explained in more detail is section 5.06).
2 The Revaluation Model
Under the Revaluation Model, the chosen asset will be revalued to its fair value. Fair value is the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction. Fair value is usually the same as the market value of the asset.
Once the asset has been recorded at its fair value, it will then be depreciated over the asset’s remaining useful life to its residual value. Once an asset has been revalued however, further valuations need to be made regularly. This is done to ensure that the carrying value of the asset does not differ materially from its year-end fair value.
The carrying value of a revalued asset is therefore calculated as its most recent valuation less accumulated depreciation and accumulated impairment losses since the date of the most recent valuation.
The most common types of property, plant and equipment to use the Revaluation Model are land and buildings as these types of assets tend to rise in value.
Note. The revaluation process can be seen in session 3.07 Common Adjustments – Revaluations
Depreciation is the way that a company spreads the depreciable amount of an item of property, plant and equipment over its useful life. The depreciable amount is the asset’s cost (or the latest fair value if the Revaluation Model is being used) less the asset’s residual value. Depreciation should be applied irrespective of whether the Cost Model or Revaluation Model is used.
All types of property, plant and equipment should be depreciated except for land as this (with a few exceptions) has an infinite useful life.
Depreciation of assets with separate components
Some assets have separate components and these can be depreciated separately; effectively we would treat them as separate assets. For example, the cost of a large jet plane can be split between the plane’s structure, its engines and its interior seats and fittings. Each separate component would be replaced or renewed at different times and would therefore be depreciated over a different period.
In order to calculate depreciation we should consider the asset’s useful life and its residual value.
To calculate or identify an asset’s useful life we would take into account a variety of factors:
- The assets expected usage and expected physical wear and tear
- Technical or commercial obsolescence
- Legal or regulatory limits
The useful life of an asset should be reviewed each year in case there has been a significant change. If there has been such a change then current and future depreciation charges should be recalculated to take the change into account.
Like useful life, the residual value of an asset should be reviewed each year and if there has been a significant change the current and future depreciation charges should be recalculated.
If as a result a review, the residual value exceeds the carrying value of the asset, the depreciation charge will be £nil (note that we would not record a negative depreciation charge).
IAS 16 does not stipulate that a particular method of depreciation should be used. It simply states that the method used should be appropriate for the particular asset and best reflect the use of the asset.
The most common methods used to depreciate assets in the UK are the Straight Line Method and the Diminishing Balance Method (also known as the Reducing Balance Method).
The straight-line method depreciates an asset evenly over its useful life. The charge is calculated as Cost less Residual Value divided by the assets’ Useful life in years. Where an asset has been revalued the charge would be the latest fair value less residual value, then divided by its remaining useful life in years.
The diminishing balance method depreciates an asset by applying a fixed percentage (or a fixed fraction) to the asset’s carrying value. Compared to the straight-line method the diminishing balance method results in higher depreciation charges at the start of the asset’s useful life and lower charges later on.
Some companies calculate depreciation based on a number of units. Under this method the depreciable amount would be divided by the total number of units that is expected to be processed by the asset over its useful life, to calculate a rate per unit. The depreciation charge for a period would then be calculated as the number of units processed multiplied by the rate per unit. This method is much less commonly seen in the UK.
A vehicle is purchased on 01/01/2020 for £12,000. The company expects to use the asset for two years at the end of which it will be disposed of for an estimated £6,750.
The depreciation charges and carrying values of the vehicle using the straight line method and the diminishing balance method are shown below.
A company has purchased an asset for £45,000. The company estimates that it has a useful life of 6 years at the end of which it will be worth an estimated £6,000. The asset is to be depreciated using the straight-line method.
a) Calculate the depreciation charge for the asset for the first year
b) Calculate the carrying value of the asset at the end of the first year
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A company owns a motor vehicle that originally cost £25,000 and the start of its most recent financial year, had accumulated depreciation charged against it of £10,938. The vehicle is being depreciated using the diminishing balance method at a rate of 25% per year. Calculate, to the nearest pound:
a) The depreciation to be charged for the most recent financial year
b) The carrying value of the vehicle at the end of the most recent financial year
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On 1st January 2018, a company purchased a piece of equipment for £15,000. This was then depreciated in the years ended 31st December 2018 and 31st December 2019 on a straight-line basis using an estimated useful life for the equipment of 4 years and a residual value of £1,000. In 2020 however, the company reviewed the equipment’s useful life and residual value and believes that the equipment will now be used until 31st December 2023 at which time its residual value is expected to be £500.
a) Calculate the depreciation to be charged for the year ended 31st December 2020
b) Calculate the equipment’s carrying value at 31st December 2020
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Gains or losses on disposal
When an item of property, plant or equipment is disposed of, the amount received on disposal is compared with the carrying value of the asset. This is on order to calculate whether a gain (or profit) or a loss was made on disposal.
If the disposal proceeds exceed the asset’s carrying value then a gain, or profit, has been made on disposal, if it is less than the carrying value, a loss was made.
A company owned a trailer with a carrying value of £14,961. The company then purchased a replacement trailer costing £46,250 which was paid for using a cheque for £31,250 plus the old trailer which was traded-in.
What gain or loss was made on the disposal of the trailer?
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Revalued property, plant and equipment
Additional depreciation and transfers to retained earnings
If an item of property, plant and equipment has been revalued upwards, its depreciation charges will be higher than if it had been valued at its cost. Where this happens, a company has the option of transferring an amount from the Revaluation Reserve to its Retained Earnings each year.
The amount that would be transferred would be the additional amount of depreciation caused by the revaluation and would have the effect of increasing Retained Earnings and reducing the Revaluation Reserve. This transfer would not be recorded in the Statement of Profit or Loss and Other Comprehensive Income but would be recorded in a separate line of the Statement of Changes in Equity.
A company charges depreciation of £7,500 each year on its revalued property. Had the property been recorded at its cost, the annual depreciation charge would have been £5,000. The depreciation charge of £7,500 would be included as an expense in the company’s Statement of Profit or Loss but the company would then have the option of transferring £2,500 from its Revaluation Reserve to its Retained Earnings each year. This transfer would be recorded in the company’s Statement of Changes in Equity.
Disposals of revalued assets
Where an item of property, plant and equipment is disposed of, any revaluation reserve associated with that item shall be transferred to the company’s Retained Earnings. This transfer will not be shown in the Statement of Profit or Loss and Other Comprehensive Income but will be recorded in a separate line of the Statement of Changes in Equity.
A company owned a building with a carrying value of £18m. The building had been valued using the Revaluation Model and there was a revaluation reserve associated with the building of £6m. The company then sold the building for £20m.
Included in the company’s Statement of Profit or Loss would be a gain made on disposal of £2m (i.e. disposal proceeds of £20m less the buildings carrying value of £18m).
Included in the company’s Statement of Changes in Equity would be a transfer of £6 from the Revaluation Reserve to the company’s Retained Earnings as shown below.
The notes to the financial statements will include a considerable amount of information about the company’s property, plant and equipment.
For each class of property, plant and equipment, the notes will specify
- The method used to measure the value of the assets (i.e. the cost or revaluation method)
- The depreciation methods that have been used (e.g. the straight line method)
- The depreciation rates used (or alternatively the useful lives used in calculating depreciation)
An example of these disclosures is given below.
“Property, plant and equipment is stated at cost net of accumulated depreciation and any provision for impairment. Depreciation is provided to write off the cost less the estimated residual value of the property, plant and equipment over their useful economic lives. The assets’ residual values and useful economic lives are reviewed and adjusted as appropriate at the end of each financial period. The following rates are applied:
- Plant & machinery: 10% p.a. on a straight line basis
- Motor vehicles: 25% p.a. on a diminishing balance basis
- Fixtures & fittings: 10% to 20% p.a. on a diminishing balance basis”
Included in the notes will be a breakdown of the company’s property, plant and equipment recording the main categories of these assets and detailing how their cost (or fair values where the revaluation method has been used), accumulated depreciation charges/impairment losses and carrying values have changed over the year. An example of a common layout used is given below.
Disclosures regarding revaluations
Where a company has assets valued under the Revaluation Model it will include a note to the financial statements that provides:
- The dates of the revaluations
- Whether or not an independent valuer was involved
- The carrying amounts had the assets been valued using the Cost Model
- The revaluation surplus
An example of the type of note that would be made is shown below:
“Property, plant and equipment includes land valued at its fair value less accumulated depreciation. The land was valued by Smith & Associates, Chartered Surveyors on 01/02/20X8. Had the land been valued at its cost the carrying value of property would have been £520,000. The revaluation surplus relating to this land is £265,000 and has not changed in the reporting period.”