Financial Accounting 2

ACC203 Financial Accounting 2

Workshop 9: Acquisition and Depreciation of Property, Plant

and Equipment

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Material adapted from Financial reporting in Australia / Janice Loftus, Ken Leo, Sorin Daniliuc, Noel Boys, Belinda Luke, Hong Ang, Karyn Byrnes. Second edition.

John Wiley & Sons Australia, Ltd

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Learning objectives

1. Discuss the nature of property, plant and equipment (PPE) and outline the recognition criteria

2. Explain how to measure PPE on initial recognition 3. Explain the alternative ways in which PPE can be

measured subsequent to initial recognition

Class Discussion • How would you assess the fair value of a piece of

property that you owned? How accurate could you be? How could you convince anyone else that your estimate was reasonable?

• If you apply for a bank loan, what value will you write on your application? The purchase price you paid when you bought the property 12 years ago or the current market value? Why?

Learning objectives

1. Discuss the nature of property, plant and equipment (PPE) and outline the recognition criteria

2. Explain how to measure PPE on initial recognition 3. Explain the alternative ways in which PPE can be

measured subsequent to initial recognition

Nature of PPE

• AASB 116/IAS 16 defines property, plant & equipment as:

Held for use in the production or supply of goods or services, for rental to others, or for

administrative purposes

They are expected to be used during more than

one period Assets with a specific use within the entity

Assets are non-current.

Normally divided into classes: • land, buildings, machinery,

motor vehicles.

Initial recognition of PPE

• Cost of an item is recognised as an asset if:

• The outlay must give rise to the expectation of future economic benefits.

1. • It is probable that economic benefits will flow to the entity; and

2. • The cost can be measured reliably.

Initial recognition of PPE

• The significant parts approach – The total PPE of an entity may be broken down into

separate assets. – To recognise both the value of the asset and the

expected benefits consumed by the entity during the period in which the benefits are received.

For example, an airplane can be separated as follows: • The engines; cockpit equipment,

including computers, navigation equipment and so on.

Class Activity

(a) What assets constitute property, plant and equipment? (b) What are the recognition criteria for property, plant and

equipment?

Class Activity

• Corella Ltd has acquired a new machine which it has had installed in its factory. Assess which of the following items should be capitalised into the cost of the building. Provide a reason for your conclusions.

1. Labour and travel costs for managers to inspect possible new machines and for negotiating for a new machine.

2. Freight costs and insurance to get the new machine to the factory.

3. Costs for renovating a section of the factory, in anticipation of the new machine’s arrival, to ensure that all the other parts of the factory will have easy access to the new machine.

4. Cost of cooling equipment to assist in the efficient operation of the new machine.

5. Costs of repairing the factory door, which was damaged by the installation of the new machine.

6. Training costs of workers who will use the machine.

Learning objectives

1. Discuss the nature of property, plant and equipment (PPE) and outline the recognition criteria

2. Explain how to measure PPE on initial recognition 3. Explain the alternative ways in which PPE can be

measured subsequent to initial recognition

Initial measurement of PPE

• Initially measured at cost which includes:

Purchase price (the basic cost of the asset)

Directly attributable costs (costs that are capitalized into the asset)

Initial estimate of the costs of dismantling and removing the item or restoring the location site.

Initial measurement of PPE

• Directly attributable costs: the costs are capitalised into the cost of the asset.

• Costs to be included:

Costs of employee benefits arising directly from the construction or

acquisition of the item of PPE

Costs of site preparation

Initial delivery and handling costs

Installation and assembly costs.

Initial measurement of PPE

• Costs NOT to be included:

Costs of opening a new facility

Costs of introducing a

new product or service

Costs of conducting

business in a new location

Costs incurred while an item

capable of operating

Initial operating losses

Costs of relocating or reorganising

parts

Initial measurement of PPE

• Acquisition for zero or nominal cost – An entity may acquire an asset for zero cost, or be

required to pay an amount substantially different from the fair value of the asset.

– The ‘cost’ is deemed to be its fair value at acquisition date.

Class Activity Darter Ltd has recently acquired a machine for an invoice price of $50 000. Various other costs relating to the acquisition and installation of the machine include transportation, electrical wiring, and preparing a platform for installation. These amounted to $7500. The machine has an estimated useful life of 10 years, with no residual value at the end of that period.

One of the accounting team has suggested that the incidental costs of $7500 be charged to expense immediately for the following reasons.

1. If the machine is sold, these costs cannot be recovered in the sales price. 2. The inclusion of the $7500 in the machinery account on the records will not necessarily result in a closer approximation of the market price of the asset over the years because of the possibility of changing demand and supply levels. 3. Charging the $7500 to expense immediately will lower the depreciation expense in future years.

Class Activity

Required Prepare a response to these arguments to be presented at the next meeting of the Darter Ltd accounting team.

Class Activity

• Pelican Ltd purchased land for use as its corporate headquarters. A small factory that was on the land when it was purchased was torn down before construction of the office building began.

• A substantial amount of rock blasting and removal of soil then had to be done to the site before construction of the foundations of the building.

• Because the office building was set back from the public road, Pelican Ltd had the construction company build a paved road that led from the public highway to the entrance of the office building.

• Required: Write a report to the group accountant of Pelican Ltd detailing which of the above expenditures should be capitalised.

Learning objectives

1. Discuss the nature of property, plant and equipment (PPE) and outline the recognition criteria

2. Explain how to measure PPE on initial recognition 3. Explain the alternative ways in which PPE can be

measured subsequent to initial recognition 4. Explain the cost model of measurement and understand the nature

and calculation of depreciation

Measurement subsequent to initial recognition

• AASB 116/IAS 16 allows a choice of two possible measurement models:

• The choice of model is an accounting policy decision. • It is not applied to individual assets but to an entire

class of PPE.

Cost model Revaluation model.

Cost Model

• The cost model requires that assets are carried at cost less any accumulated: – depreciation – impairment losses.

• The costs incurred at the time the capacity is changed must be able to be measured reliably.

Revaluation Model

• As an alternative to the cost model AASB 116/IAS 16 allows the revaluation model to be used for classes of assets: – Measurement basis is fair value (FV). – The principle for revaluation of the asset is that

revaluations must be made with sufficient regularity. – It limits the ability of management to ‘cherry‐pick’ or

selectively choose which assets to revalue.

Class Activity

Kingfisher Ltd has acquired a new building for $500 000. It has incurred incidental costs of $10 000 in the acquisition process for legal fees, real estate agent’s fees and stamp duties. Management believes that these costs should be expensed because they have not increased the value of the building and, if the building was immediately resold, these amounts would not be recouped. In other words, the fair value of the building is considered to still be $500 000.

Required Discuss how these costs should be accounted for.

Depreciation

– A systematic allocation • Depreciation is a process of allocation. • Depreciation is not a measure of change in value. • AASB 116/IAS 16 does not specify how this allocation process

should be undertaken.

– Methods of depreciation

Straight line method.

Diminishing- balance method.

Units-of- production method.

For the purpose of this course, the focus will be on straight line and diminishing balance method

Straight line Method of Depreciation

A firm purchased a motor vehicle for $25,000 on 1 July 2010. The vehicle had an estimated residual value of $2,000 at the end of its estimated useful life of 4 years. (Assume financial year, i.e. 1 July – 30 June) (a)How much depreciation would be shown on the Income Statement and Balance Sheet for each of the 4 years (straight line)?

Straight Line Method of Depreciation = [Cost – Residual Value]/Life = $23,000/4 years = $5,750 each year

Straight Line As at 30 June 2011 As at 30 June 2012 As at 30 June 2013 As at 30 June 2014 Motor Vehicle 25,000

Less Acc Dep 5,750 19,250

Motor Vehicle 25,000

Less Acc Dep 11,500

13,500

Motor Vehicle 25,000

Less Acc Dep 17,250

7,750

Motor Vehicle 25,000

Less Acc Dep 23,000 2,000

Diminishing Balance Method (b) How much depreciation would be shown on the income statement and

Balance Sheet for each year under the diminishing (reducing) balance method (Rate: 46.817%)

Year Bal. at beginning of year

Rate Yearly depreciation expense on Income Statement

Bal. at end of year

2011 25,000 .46817 11,704 13,296 2012 13,296 .46817 6,225 7,071 2013 7,071 .46817 3,310 3,761 2014 3,761 .46817 1,761 2,000

Diminishing Balance Method

Diminishing Balance As at 30 June 2011 As at 30 June 2012 As at 30 June 2013 As at 30 June 2014 Motor Vehicle 25,000

Less Acc Dep 11,704 13,296

Motor Vehicle 25,000

Less Acc Dep 17,929 7,071

Motor Vehicle 25,000

Less Acc Dep 21,239 3,761

Motor Vehicle 25,000

Less Acc Dep 23,000 2,000

Class Activity

What is meant by ‘depreciation expense’?

How is useful life determined?

Class Activity

What is meant by ‘residual value’ of an asset?

Class Activity

Class Activity

A new accountant has been appointed to Albatross Ltd and has implemented major changes in the calculation of depreciation. As a result, some parts of the factory are now subject to higher depreciation charges. This has incensed some operations managers who argue that they take particular care in the maintenance of their machines and, as a result, should not attract such large depreciation charges. They are concerned that these extra charges will reduce the profitability of their sections and may therefore lead to lower bonuses and maybe even the firing of some employees. These operations managers have complained to the group accountant.

Required: Write a report to these operations managers explaining the reasons for the depreciation policies adopted by Albatross Ltd.

References

Loftus, J. , Ken, L., Sorin D., Boys N., Luke B., Hong A. and Byrnes K., (2018) Financial Reporting, 2nd edn. Australia: John Wiley, pp.145-188

Australian Accounting Standard Board (2019) , AASB 116 Property Plant and Equipment . [Online] Available at: https://www.aasb.gov.au/admin/file/content105/c9/AASB116_08-15_COMPdec16_01- 19.pdf(Accessed 2 October 2019)

End of the Workshop