ACCOUNTING FOR PROPERTY, PLANT AND EQUIPMENT- PART 2

Capitalizable Costs on Specific Items of PPE

Land
 Purchase price;
 Legal fees and other costs for establishing clean title;
 Broker or agent commission;
 Escrow fees;
 Fees for registration and transfer of title;
 Costs associated with relocating or reconstructing property owned by others in order acquire
possession;
 Mortgages, encumbrances and interest on such mortgages assumed by the buyer;
 Unpaid taxes up to date of acquisition assumed by the buyer;
 Cost of land survey;
 Payments to tenants to induce them to vacate the land in order to prepare the land for its intended
use but not to make room for the construction of new building;
 Cost of permanent improvements such as cost of clearing, cost of grading, levelling and landfill;
 Cost of option to buy the acquired land;
 Special assessments paid

Note:
 As a rule, the treatment for real property taxes is expensed outright.
 If the buyer assumes outstanding real property taxes as part of the purchase price, the
taxes are capitalized, but only up to the acquisition date.
 Real property taxes incurred after the date of acquisition are charged to expense.

 The cost of option is expensed outright if the land is not acquired.

 Special assessments are taxes paid by the landowner as a contribution to the cost of public
improvements.
 Because public improvements boost the value of the land, these are treated as part of the
land cost.

Land Improvements
 Land improvements that are not subject to depreciation are charged to the land account.
o Examples:
 Cost of surveying, clearing, grading, leveling, and landfill
 Cost of subdividing, and other costs or permanent improvements.

 Land improvements that are subject to depreciation are charged to the land improvements
account.
o Examples:
 Fences;
 Water systems
 Drainage systems,
 Sidewalks,
 Pavements, and the cost of trees, shrubs, bushes, and other landscaping.

 This type of land improvement should be depreciated over its useful life.
 Building
 Two ways of acquiring a building:
1. By purchase
2. By self-construction

 The following costs are associated in purchasing a building:

 Purchase price;
 Legal fees and other costs incurred in connection with the purchase;
 Unpaid taxes up to date of purchase assumed by the buyer;
 Interests, mortgage, liens and other encumbrances on the building assumed by the buyer;
 Payments to tenants to induce them to vacate the building;
 Any renovating or remodeling costs incurred to put the building purchased in a condition
suitable for its intended use, such as lighting installations, partitions, and repairs.

 The following costs are associated in constructing a building:

 Materials used, labor employed, and overhead incurred during the construction process;
 Building permit or license;
 Architect fee;
 Superintendent fee;
 Excavation cost;
 Cost of temporary structures used as construction offices and tool or material storage;
 Interest on construction loans and insurance premiums incurred during the construction
period;
 Service equipment and fixtures that were made a permanent part of the structure;
 Cost of temporary safety fence around construction site and cost of subsequent removal
thereof.

Note:
 Treatment of expenditures for sidewalks, pavements, parking lots, and driveways
 These expenditures are charged to the building account if they are part of the blueprint
for the construction of the new building.
 These expenditures are charged to the land improvements account if they are not related
to the construction of the new building.

 Cost of insurance
 The cost of insurance taken during the construction of the building forms part of the cost
of the building as it becomes necessary in bringing the building into existence.
 If the insurance was not taken, any payment for damages due to injuries sustained by
company personnel is recorded as outright expense as a result of management’s
negligence to ensure safety around the construction area.

 Cost of building fixtures (e.g., shelves, cabinets, and partitions)

 Such expenditures are charged to the building account if they are immovable in the sense
that they are attached to the building in such a way that their removal would destroy the
building.
 If such expenditures are movable, they are charged to furniture and fixtures and
depreciated over their useful life.

 Cost of ventilating system, lighting system and elevator

 If installed during the construction, they are charged to the building account.
 If not, then they are charged to building improvement and depreciated over their useful
life or remaining life of the building, whichever is shorter.
PIC Interpretations on Land and Building
 When land and an old building are purchased at a single cost:
 If the old structure/building is still usable, the single cost is split between land and
building, based on relative fair value.
 If the existing structure is no longer usable, the single cost is allocated solely to the land.

 When usable old building is demolished

 When the old building is demolished immediately to make way for the construction
of a new one
 If the new building is accounted for as property, plant, and equipment or
investment property, any allotted carrying amount of the usable old structure is
recognized as a loss.
 Whether the new structure is accounted for as property, plant, and equipment,
investment property, or inventory, the demolition cost is capitalized as the cost of
the new building.
 If the old building is demolished to prepare the land for the intended use but not
to make place for the construction of a new building, the demolition cost is
capitalized as cost of land.
 When the old building is demolished at a later period to make way for the
construction of a new one
 Whether the new building is property, plant, and equipment, investment
property, or inventory, the carrying amount of the previous structure is
recognized as loss.
 Whether the new building is accounted for as property, plant, and equipment,
investment property, or inventory, the demolition cost is capitalized as the cost of
the new building.
 If the old building is leased, any settlements made to tenants to induce them to
vacate the old building will be capitalized as cost of the new building.

Machinery
 The following are costs associated with machinery when purchased:
 Purchase price
 Freight, handling, storage, and other acquisition-related costs such as insurance while in
transit.
 Cost of installation, which includes site preparation and assembly.
 Cost of a safety rail and platform around the machine, as well as the cost of a water-
cooling system.
 Cost of testing and trial runs, as well as other costs associated with getting the machine
ready for its intended use.
 Fees paid to experts for advice on machinery acquisition.
 Initial cost estimate for dismantling and removing the machinery, as well as restoration of
the site where it is located and for which the business has a current obligation.

Note:
 The Value Added Tax (VAT) on machinery purchases is not capitalizable, but it is charged to
input tax and offset against output tax.

 Any purchase tax that is irrevocable or nonrefundable us capitalized as machinery cost.

 When a machinery is removed or retired to make place for a new one, the cost of the removed
item that was not previously recognized as a provision is charged as an expense.
  Machine tools and hand tools are two types of tools. Drills and punches are examples of machine
tools. Hammers and saws are examples of hand tools. The account for tools should be kept
separate from machinery account.

 Patterns and dies utilized for regular products forms part of the asset and depreciated over their
useful life, however, if patterns and dies are utilized under a special order, such cost forms part of
the special product out of that particular special order.

Equipment
 The cost of equipment is almost similar with machinery, the following are commonly associated
with equipment:
 Purchase price
 Freight, handling, storage, and other acquisition-related expenses such as insurance while
in transit.
 Cost of installation, which includes site preparation and assembly.
 Cost of testing and trial runs, as well as other costs associated with getting the machine
ready for its intended usage.

Note:
 Different types of equipment
 Furniture and fixtures
 Often includes store and office equipment such as tables and chairs, cabinets,
desks, computers, printers, and other related assets.
 Delivery equipment
 Cars, trucks, motorcycle, and other vehicles or related assets.
 Registration fees related to delivery equipment is expensed outright.

 Containers are classified in three ways:

 Classified as property, plant, and equipment if returnable and huge in size units such
as barrels, drums, or tanks with huge.
 Classified as other noncurrent asset if returnable and small in size units such as bottles
and boxes.
 Classified as outright expense if not returnable.

 An expenditure is considered as expense when the benefit derived from it affects only the current
period.
 If such expenditures affect current and future period, it is classified as asset.

Subsequent expenditures on PPE

 Subsequent expenditures on PPE shall be capitalized as part of the cost of the asset if there are
probable future economic benefits along with the cost that will flow to the entity and such
subsequent cost can be measured reliably.

 If subsequent expenditures do not increase the future service potential of an asset and merely
maintains the existing level of standard performance, such cost shall be expensed outright.

 The following are common measurement of future economic benefits:

 Extension of life of an asset as a result of the expenditure.

 Upgrade in the capacity of the property to produce number of outputs more than its usual
after incurring an expenditure.
  Adoption of new manufacturing scheme with less cost which improves effectiveness,
efficiency, and safety after incurring an expenditure.

 Repairs are the costs associated with restoring assets to working order following a breakdown or
the replacement of broken pieces.
o There are two types of repairs:
 Ordinary repairs
 Minor replacements.
 Also known as revenue expenditures.
 This cost shall be recorded as expensed outright.
 Extraordinary repairs
 Major replacement of parts which will significantly improve the
performance of an asset and will even extend its useful life.
 Also known as capital expenditures.
 This cost shall be capitalized.

 Rearrangement cost refers to the cost incurred in relocating the existing property, plant, and
equipment.
o Such cost should be expensed outright because it does not add value to the property.

Depreciation

Nature of Depreciation
Depreciation is the systematic allocation of the asset’s depreciable amount over its useful life.

Note:
 The term “allocation” refers to manner of spreading the assets’ cost over the period (useful life)
of its usage.
o This is to recognize the exhaustion of the life of a long-term asset.
 On the other hand, the term “systematic” refers to methods used in allocating the assets’ cost
over its useful life, in other words, it has basis in doing so, although mainly based on estimate,
but at least, there is relatively applied procedure.
 Each component of an item of PPE with a substantial cost in relation to the total cost of the item
must be depreciated separately.

Factors of Depreciation
 Useful life
o The amount of time the entity expects to use the asset.
o It could also mean the number of hours it is expected to work or the number of units it
can generate or manufacture.
o The following are the factors that should be considered in determining the useful life of
an asset are:
 Expected usage of the asset
 Expected physical wear and tear
 Technical obsolescence
 Legal limits for the use of the asset

 Residual value
o The amount expected to be recovered by an entity after the asset’s useful life.

Note:
  Usually, the value of the asset after its useful life is zero. If a third party is willing to acquire such
asset at a certain sum of money, then the amount is considered as the residual value, the value
that is left after its useful life.

 Depreciable amount
o Amount subject to depreciation.
o Formula:
Acquisition cost xx
Less: Residual value (xx)
Depreciable amount xx

Recognition of Depreciation
 Depreciation is recognized as an expense unless it is included in the cost of producing another
asset.

Note:
 If the PPE is used mainly in selling or administrative purposes, then the depreciation associated to
it forms part of the operating expenses since they are considered as period cost or cost that are
expensed outright when incurred.
 If the PPE is used mainly in manufacturing products, then the depreciation associated to it forms
part of the manufacturing overhead as indirect costs, thus, considered as inventoriable or product
cost.

Commencement and Cessation of Depreciation

 Depreciation starts when the asset is available for use and stops when the asset is:
 Derecognized (i.e., sold, or disposed of);
 Classified as held for sale; or
 Fully depreciated

Note:
 When we say “available for use”, the moment the company took possession of the property,
plant, and equipment and acquired its title, then that’s the time the depreciation will start even if
not yet used. The main basis is the time or aging or the asset. Again, even if the asset is being
used or not, it is depreciated.
 When we say “derecognized”, it pertains to manner of eliminating an asset from the record for
some reasons such as sale or retirement of the asset. Therefore, once an asset is derecognized, it is
already out from the books of the entity, thus, depreciation will now be stopped.
 When we say “held for sale”, a noncurrent asset is reclassified as current asset because the
company expects it to be sold within a short period of time.
o We only depreciate an asset if it is noncurrent asset, under property, plant, and equipment
section and the said asset is not land.
 A full depreciated asset is an asset whose carrying amount is zero or equal to its residual value.

 Depreciation does not cease when the asset becomes idle or is retired from active use.

Depreciation Methods

1. Straight-line method
2. Sum of the year’s digits (SYD) method
3. Double declining balance method
4. 150% declining balance method
5. Working hours method
6. Output method
7. Composite or group method
 8. Inventory method
9. Retirement method
10. Replacement method

Straight line method

Annual Depreciation = Cost – Residual Value
Estimated Useful life (in years)
Sum of the year’s (SYD) Digits Method
Annual Depreciation = Depreciable x Useful life as of the beginning of the period
Amount Sum of the year’s digits (SYD)
SYD = n(n+1)
2
Where: n is the useful life

Double Declining Balance Method

 Also known as 200% declining balance method.
Annual Depreciation = Carrying value, beginning x 2
n
Where: n is the useful life

Note: under this method, the residual value is not considered when computing the depreciation expense
per year (except for the final year of the asset’s useful life). This will only be considered in computing the
depreciation in the final year of the asset’s useful life.

Working Hours Method

 Under this method, the number of hours consumed in using the asset will be the basis of its
depreciation.

Annual depreciation = Actual hours worked during the year x Depreciation per hour

Depreciation per hour = Cost – Residual Value

Estimated Useful Life (in service hours)

Output Method
 Under this method, the number of units produced by using the asset will be the basis for its
depreciation. The depreciation rate per hour shall be determined and it is computed by dividing
the depreciable amount by the estimated useful life in terms of number of output or units
produced.

Annual Depreciation per unit = Cost – Residual Value

Estimated Useful life (in units)

Composite or Group Method

 When a company has a large number of assets, calculating asset depreciation one by one becomes
complex. Entities can use the composite technique or the group technique:
 Composite Method – A method wherein, dissimilar in nature items are depreciated as if
they were a single unit.
 Group Method – A method wherein, similar in nature items are depreciated as if they
were a single unit.
 Important formulas used in composite/group method of depreciation:

Composite Life = Total depreciable amount

Total annual depreciation
 Composite rate = Total annual depreciation
Total Cost

 Only one accumulated account is needed because depreciation is calculated on the entire group.
 When an asset in the group is derecognized, no gain or loss is recognized.
 The difference between original cost of the asset sold and any proceeds received from the sale is
debited or credited to accumulated depreciation.
o Journal entry:

Cash xx
Accumulated depreciation (balancing figure) xx
Asset xx
Accumulated depreciation (balancing figure) xx

 If an asset is retired but not sold, the asset’s original cost is deducted from the accumulated
depreciation.
o Journal entry:

Accumulated depreciation xx
Asset xx

 When the asset is replaced, the original cost of the replaced asset is deducted from accumulated
depreciation, and the cost of replacement is added to the group’s total cost.
o Journal entry:

Accumulated depreciation xx
Asset xx

Asset xx
Cash xx

Alternative entry:
Accumulated depreciation xx
Asset* xx
Cash xx
Asset** xx
*If cost of the replacement > cost of the replaced asset
** If cost of the replacement < cost of the replaced asset

Inventory Method
Asset balance, end of the year xx
Less: Asset balance, before adjustment (xx)
Depreciation expense- current year xx

Retirement Method
 No depreciation is recognized until the asset is retired.
 Formula:
Original cost of the asset retired xx
Less: Proceeds from disposal/retirement (xx)
Depreciation expense- current year* xx
*Applicable only when the asset is retired.

Replacement Method
 No depreciation is recognized until the asset is retired and replaced.
  Formula:
When the asset is retired and replaced
Replacement cost of the asset xx
Less: Proceeds from disposal/retirement (xx)
Depreciation expense- current year xx

When the asset is retired but not replaced

Original cost of the asset retired xx
Less: Proceeds from disposal/retirement (xx)
Depreciation expense- current year xx

Note:
 When depreciation is a function of time or driven by the passage of time rather than usage, time-
based depreciation approaches are acceptable.
 IAS 16 does not provide a particular method or approach in depreciating PPE.
o The method of depreciation to use depends on the judgement of the management.
IAS 16 requires management to select the method that best reflects the expected pattern
of consumption of the future economic benefits embodied in the asset when making the
judgement, and to apply that method consistently from period to period unless the
expected pattern of consumption of those future economic benefits changes.

 IAS 16 prohibits the use of a revenue-based depreciation approach.

 At each reporting period, IAS 16 requires a yearly assessment or review of the depreciation
method, as well as the estimations of useful life and residual value.
 Any adjustment is accounted for as change is accounting estimate.

 The amount after recording depreciation on an asset is referred to as the carrying amount. This is
the amount to be presented in the financial statements in respect of PPE items. This is computed
as follows:
Cost xx
Less: Accumulated depreciation (xx)
Less: Accumulated impairment losses (xx)
Carrying amount xx

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