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Recognition and Measurement of Costs Under Property, Plant & Equipment

September 12, 2017[2017] 85 taxmann.com 139 (Article)
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Introduction

This article discusses recognition and measurement of costs under Property, Plant & Equipment as explained in Ind AS 16, Property, Plant & Equipment. It provides a bird's eye view wherein Measurement principles range from initial measurement when the asset is procured to subsequent measurement both under cost model and revaluation model. We have made an attempt to explain both the models with the help of examples including treatment of depreciation in both the models.

Recognition of non-current assets

Non-current asset has been defined in negative terminology i.e. it is an asset which is not classified as current. Let us quickly go back to the definition of current as per Ind AS 1, which is reproduced below.

An asset is classified as current
(a)   It is expected to be realised in, or is intended for sale or consumption in, the entity's normal operating cycle,
(b)   It is held primarily for the purpose of being traded,
(c)   It is expected to be realised within 12 months after the statement of financial position date, or
(d)   It is cash or a cash equivalent (as defined in IAS 7 Statement of Cash Flow), unless it is restricted from being exchanged or used to settle a liability for at least twelve months after the statement of financial position date.

All other assets which do not fall within the purview mentioned above is considered as non-current assets.

An asset is recognised as non-current assets:

(a)   It is a resource controlled based on past events
(b)   it is probable that future economic benefit will flow to the entity
(c)   cost of an item can be measured reliably.

This has been represented in the chart below for clarity.

image

Measurement principles

Property, Plant and equipment are initially recognized at historical cost. Thereafter subsequent measurement follows with the charge of depreciation based on useful life of the assets under consideration. This is summarized in the chart below.

image

Initial measurement of costs related to Property, Plant & Equipment

The elements under which the Property, Plant & Equipment are measured initially are highlighted in the chart below:

Purchase price Considered after deducting trade discounts and rebates and adding duties and non-refundable taxes

The price to be considered is the cash price equivalent at the recognition date. If the asset is acquired on deferred credit i.e. credit beyond the normal credit period, then the difference between the cash price and the total payment is treated as interest and recognised over the credit period

The cost of assets involved in the exchange is determined at fair value (of asset received or the asset given up) unless:

(a)   the transaction lacks commercial substance ; or
(b)   the fair value of neither of the two assets is reliably measured

In such a scenario the cost of the asset acquired is measured at the carrying amount of the asset given up.

Costs directly attributable to bringing the asset to its location and in the condition so as to make it available for its intended use
(a)   Costs of employee benefits (as per Ind AS 19 Employee benefits), arising from construction or acquisition of property, plant and equipment
(b)   Costs of preparing the site
(c)   Delivery and handling costs (freight and delivery charge)
(d)   Installation costs (e.g. wages to instal machinery)
(e)   Testing costs net of revenue generated, such as sale proceeds of material produced during a test run
(f)   Professional fees (architect's fees)
Initial estimate of the costs of dismantling and removing the item and restoration of site Either:
(a)   When the item is acquired or
(b)   As a consequence of having used the item during a particular period for purposes other than to produce inventories during that period.

The obligation for paying dismantling / restoration cost would arise at the time of capitalisation of the asset, but actual pay-out happens after a designated number of years when the asset is restored and handed over, say land taken for mining for example.

Hence the present value of restoration cost needs to be calculated and for capitalisation purposes. However, liability of paying out restoration cost is established in the financial statements by unwinding of discount and providing finance charges every year and crediting provision for restoration / dismantling. For further details please refer Chapter on Ind AS 37 , Provisions, contingent liabilities and contingent assets

Subsequent measurement of cost

Subsequent measurement of revenue and capital costs is explained in the chart below.

Subsequent costs – capital and revenue expenditure
(a)   Cost of day-to-day servicing of an asset is treated as revenue expenditure and charged to SOPL and not included in carrying amount of the asset
(b)   Cost of replacements:
-   at regular intervals
-   at less frequent intervals
-   at occasional intervals – i.e. non-recurring replacements

These are recognised as capital expenditure and added to carrying value of asset

Once the new parts are recognised, the old parts are replaced and de-recognised and removed from SOFP

Certain plant and equipments (e.g. aircraft, engines, turbines etc) are required to carry out major inspection and overhauling expenses on a periodic basis. The above principle would apply to these cases as well.

Cost model and revaluation model

Subsequent measurement of cost entails:

-   They are carried either at cost less accumulated depreciation and any accumulated impairment loss or
-   Revalued amount less subsequent accumulated depreciation and any accumulated impairment loss. Revaluation amount is the fair value at date of valuation.

Comparison of the two methods: Cost and revaluation model

Cost model Revaluation model

Valuation of carrying amount

Cost is taken as starting point

Valuation of carrying amount

Revalued amount is taken as starting point since it replaces cost

Accumulated depreciation and impairment losses are deducted from initial recognition of carrying value Accumulated depreciation and impairment losses are deducted subsequent to the revaluation date

Cost model

We are all familiar with cost model. As explained above it is simply:

Item   Amount
Original cost of the asset X
Less: Depreciation under Ind AS 16 X
Less: Impairment under Ind AS 36 X
Net book value of Asset X

Illustration 1

ABC Speciality gases plc set up a boiler unit near its manufacturing shed as at 1st of April 2016. The price paid for the equipment is INR 220,000 inclusive of VAT of INR 20,000. The entity gets a credit of VAT while calculating the tax payable on the finished goods sold.

Additional costs are freight INR 5,000, customs duty INR 10,000, installation expenses INR 4000. The estimate of dismantling and removing the item would be INR 5000. After the equipment was put to use INR 2500 was spent for maintenance. Calculate the initial cost of the asset in accordance with Ind AS 16.

As at 31st March 2017 it was found that one section of the boiler unit was damaged owing to waterlogging because of heavy rains and 20% of initial cost of the unit had to be impaired.

The useful life of the Boiler unit is 10 years.

Calculate carrying cost as at 31st March 2017.

Solution

Schedule 1: Statement of calculation of initial cost of asset as on 1st April 2016

Item INR
Purchase price (net of VAT of INR 20000) 200,000
Freight 5,000
Customs duty 10,000
Installation expenses 4,000
Initial estimate of dismantling and removing the item 5,000
Total initial cost of capitalisation as per Ind AS 16 224,000

Maintenance charges of INR 2500 was incurred post installation of the equipment and does not have any revenue generating capacity hence to be charged to Statement of Profit & Loss.

Schedule 2: Statement of calculation of subsequent cost of asset as on 31st March 2017

Item INR
Initial cost of capitalisation in Schedule I above 224,000

Less: Depreciation : (224000/10)

Impairment loss under Ind AS 36

22,400

44,800

Net book value (under Cost model) 156,800

Revaluation model

Capitalisation under revaluation model is explained in the table below.

Salient points of revaluation model are: The fair value of an asset is required to be determined under the revaluation model. Ind AS 16 provides guidance on how to determine the fair value:
(a)   If there is market based evidence:
  Land & Buildings – derived from market based values as appraised
  By professionally qualified valuers
  Plant & Equipment-based on market value determined by experts
(b)   If there is no market based evidence:

estimate fair value using an income or a depreciated replacement

cost method

Frequency of valuation should be annual in those class of assets where the fair value is materially different from carrying value based on volatile conditions – otherwise every three to five years would be sufficient.

Accounting for revaluation adjustment

(a)   If an asset's carrying amount is increased – it should be recognised in other comprehensive income and accumulated in equity under the heading revaluation surplus. However, if there is a revaluation decrease of the same asset earlier – which was recognised in SOPL as per Ind AS 16 – then the increase should be credited in SOPL to the extent it reverses the revaluation decrease
(b)   If an asset's carrying amount is decreased – it should be recognised in profit or loss (income statement). However, if there is a balance in the revaluation surplus under equity for the same asset based on revaluation performed earlier, such decrease is recognised in other comprehensive income.

If an item of property, plant and equipment is revalued, the entire class of assets to which the asset belongs should be revalued. A class is a group of assets of a similar nature and use in an entity's business operation.

Treatment of revaluation surplus and profit or loss on sale

When the assets is derecognized (sold), the revaluation surplus included in equity should be transferred directly to retained earnings. Profit or loss on sale will be calculated in the usual manner i.e. sale proceeds less carrying value (revalued)

This is explained clearly in the illustration below.

Illustration 2

XYZ Ltd purchased a building at the cost of INR 500,000 on 1st of April 2016. Professionally qualified and recognised experts value them at INR 750,000 as at 31st March 2017. Show treatment, ignore depreciation.

Solution

The revalued amounts will be recognised as under:

     
Building A/c Dr. INR 250,000
To Other comprehensive Income    
(Revaluation surplus)   INR 250,000
     

Extract from financial statements

XYZ Ltd: Other Comprehensive Income for the year ended 31st March 2017

Amount INR
Not reclassified subsequently  
Gains on property revaluation 250,000
Exchange differences on translating foreign operations X
Cash flow hedges X
Income tax related to components of other comprehensive income X
Total other comprehensive income 250,000
Total comprehensive income 250,000

XYZ Ltd: Statement of changes in equity for the year ended 31st March 2017

Share capital INR Retained earnings INR Revaluation surplus INR Cash flow hedges INR Total INR
Balance as on 1st April 2016 X X X X X
Issue of share capital X X X X X
Dividends X X X X X
Total comprehensive income X X 250,000 X 250,000
Transfer to retained earnings X X X X X
Balance as on 31st March 2017 X X 250,000 X  

XYZ Ltd: Balance Sheet extract as at 31st March 2017

INR INR
Assets    
Building as on 1st April 2016 500,000  
Add: Additions -  
Less: Deductions -  
Revaluation 250,000 750,000
TOTAL 750,000
Capital and Liabilities    
Share capital    
Retained earnings – Revaluation surplus 250,000  
TOTAL 250,000

Notes:

We must increase the value of the building by INR 250,000 to make it equal to the fair value. Hence we debit the Building.

Revaluation gain shall be recognised in other comprehensive income and will accumulate as revaluation surplus under equity. The accumulated revaluation surplus will be shown in the Balance Sheet under other components of equity.

Gain on revaluation surplus is an unrealized gain and hence it is recognised in other comprehensive income.

Depreciation methods

Standard depreciation methods prescribed under Ind AS 16 are highlighted as under:

  The straight line method: This result is a constant change over the useful life if the asset's residual value does not change
  The reducing (diminishing) balance method: This results in decreasing change over the useful life
  The units of production method: This results in a change based on expected use or output

As per Ind AS 16, each part of an item of property, plant and equipment with a cost that is significant in relation with the total cost of the item should be depreciated separately. This is also called "component" method of accounting.

Insignificant parts are depreciated together.

Depreciation under cost model

Depreciation under cost model is simple and straightforward, wherein we identify the estimated useful life of the asset and spread the capital cost into the number of years.

Depreciation under revaluation model

When an item is revalued, we get its present value, which is compared to its carrying value i.e. gross value minus depreciation. This leads to the treatment of accumulated depreciation as per Ind AS 16 guideline:

(a)   The accumulated depreciation needs to be restated proportionately so that the carrying amount of the asset after revaluation equals its revalued amount. The method is used normally when an asset is revalued by applying an index to its depreciated replacement cost. (Refer Illustration 3)
(b)   The accumulated depreciation is eliminated against the gross carrying amount of the asset, with the net amount restated to its revalued amount. This method is more in use. (Refer Illustration 4)

Illustration 3

The net book value of a building owned by Alpha is INR 50000. Its gross value is INR 60000 and accumulated depreciation is INR 10000.

There is 40% increase in the net book value (INR 50000 + 40% of INR 50000) = INR 70000.

Accordingly the gross book value and accumulated depreciation needs to be increased by 40% i.e. gross book value INR 84000 (INR 60000 + 40% of INR 60000) and accumulated depreciation INR 14000 (INR 10000 + 40% of INR 10000). The carrying amount works out to INR 70000 (INR 84000 – INR 14000) which is equal to the revalued amount.

Illustration 4

S Ltd needs to revalue a factory building that it has. The property was purchased for INR 600,000 and has been depreciated for the last 10 years on a straight line basis of 5%.

The revaluation report states that the building is worth INR 650,000 on 31st December 2011.

Solution

The carrying value of the factory building is as under: INR
Gross value (at cost)  600,000
Less: Depreciation (INR 600000 x 5% x 10) 300,000
Net book value 300,000

Journal entries are as under:

Particulars INR INR
Dr. Accumulated depreciation 300,000  
Cr. Factory building (asset)   300,000
(Being the removal of accumulated depreciation on a revalued property)    
Dr. Cost of Factory building 350,000  
Cr. Revaluation surplus   350,000
(Being the cost of factory building revalued)    

Note: Now the revalued building at INR 650,000 will be depreciated over the balance 10 years as 5% depreciation implies 20 years.

Depreciation calculation after revaluation

Depreciation will be based on revalued amount.

Full depreciation amount charged as expense to Statement of profit or loss.

Difference between depreciation on revalued amount and original cost may be transferred from revaluation reserve to retained earnings. This is further explained in the example below.

Illustration 5

An entity owns a building which originally costs INR 200,000. The property is depreciated over 50 years on a straight-line basis with no residual value. The entity follows revaluation model. At the start of year 2, the building was re-valued at INR 230,000. Show treatment.

Solution

Revaluation surplus at start Year 2 = INR 230,000 – INR 196,000 = INR 34,000.

(INR 196,000 = INR200,000 – INR 4000)

Depreciation charge for year 1 = INR 200,000 / 50 years = INR 4,000

Depreciation charge for year 2 = INR 230,000 / 49 years = INR 4,694

The amounts transferred from the revaluation surplus to retained earnings as the revaluation surplus is realised through depreciation are:

Year 1 – nil.

Year 2 – INR 4,694 – INR 4,000 = INR 694.

Depreciation under Companies Act 2013

The Companies Act, 2013 requires companies to compute the depreciation in accordance with the Schedule II to the Companies Act which provides useful lives to compute the depreciation. Accordingly, provisions governing charge of depreciation in the erstwhile Schedule XIV to the Companies Act, 1956 have been replaced with Schedule II to the Companies Act, 2013.

Some of the key changes in the Schedule II to the Companies Act, 2013 as compared to erstwhile Schedule XIV to the Companies Act, 1956 are summarised as under:

  Schedule II prescribes indicative useful lives of various assets instead of Straight Line Method (SLM)/ Written Down Value (WDV) rates for calculating depreciation
  Useful lives prescribed for tangible assets only
  No life prescribed for intangible assets. Notified accounting standard to govern the same
  Depreciation is systematic allocation of the depreciable amount of an asset over its useful life.
  The depreciable amount of an assets is the cost of an asset or other amount substituted for cost, less its residual value
  Useful life is the period over which an asset is expected to be available for use by an entity, or the number of production or similar units expected to be obtained from the asset by the entity.
  Companies are allowed to follow different useful lives/residual value if an appropriate justification is given supported by technical advice.
  Component accounting and useful life of a significant part of an asset to be determined Separately
  No separate rate for double/ triple shift; depreciation to be increased based on the double shift/triple shift use of the assets
  Useful lives of fixed assets prescribed under schedule II of the Act are different from those envisaged under Schedule XIV of the Companies Act, 1956.
  No reference to depreciation on low value assets.

Conclusion

As discussed in the paragraphs above, it is evident that recognition and measurement of Property, Plant and Equipment is always simple and straightforward under cost model. However, to ensure various kinds of possibilities are addressed, the Ind AS deals with revaluation model as well as explained above. In practical scenario where inflation grows beyond manageable levels revaluation model is adopted. However, this is quite complex to maintain and requires meticulous recording and accounting of each asset year on year.

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