UNIT 3 : ACCOUNTING FOR TANGIBLE NON-CURRENT ASSETS
Key unit competence: To be able to measure and record tangible non current assets
Introductory activity
Observe the above picture and answer the following questions:
Based on International Accounting Standard (IAS) 16,
1) Why is it necessary to account for tangible fixed assets? Justify
your answer.
2) What is the meaning of carrying amount of fixed asset?3) What is Residual value of tangible fixed asset?.
3.1 Determination of the cost for non-current assetsLearning Activity 3.1
Required:
Is it necessary to recognize for this new asset in the books of ALLERUALTD? If yes, what is the meaning of recognition of intangible fixed asset?
3.1.1 International Accounting Standard (IAS) 16
IAS 16 covers keys aspect of accounting for property, plant and equipment.
This represents the bulk of items which are “tangible non-current assets”.
• Objective
IAS 16 Property, Plant and Equipment outlines the accounting treatment for
most types of property, plant and equipment. The Standard addresses the
recognition, measurement and disclose of all property, plant and equipment
pertaining to the entity.
• Scope
Property, plant and equipment are tangible assets that:
i. Are held for use in the production or supply of goods or services, for rental
to others, or for administrative purposes.
ii. Are expected to be used during more than one period
Carrying amount is the amount at which an asset is recognized in the
statement of financial position after deducting any accumulated depreciationand accumulated impairment losses.
IAS 16 should be followed when accounting for property, plant and equipment
unless another international accounting standard requires a different treatmentIAS 16 does not apply to the following:
a) Biological assets related to agricultural activity, apart from bearer
biological assets
b) Mineral rights and mineral reserves, such as oil, gas and non
regenerative resources
c) Property, plant and equipment classified as held for sale.
However, the standard applies to property, plant and equipment used to develop
these assets.
A bearer biological asset is living plant that:
a) Is used in the production or supply of agricultural produce
b) Is expected to bear produce for more than one period; and
c) Has a remote likelihood of being sold as agricultural produce, exceptfor incidental scrap sales?
• Recognition
In this context, recognition simply means incorporation of the item in the
business’s accounts, in this case as a non-current asset. The recognition of
property, plant and equipment depends on the two criteria:
i. It is probable that future economic benefits associated with the asset will
flow to the entity;
ii. The cost of the asset to the entity can be measured reliably.
Cost is the amount of cash or cash equivalents paid or the fair value of the
other consideration given to acquire an asset at the time of its acquisition orconstruction.
Property, plant and equipment can amount to substantial amounts in financial
statements, affecting the presentation of the company’s financial position and
the profitability of the entity, through depreciation and also if an asset is wronglyclassified as an expense and taken to profit or loss.
First criterion: Future economic benefits
The degree of certainty attached to flow of future of economic benefits must
be assessed. This should be based on the evidence available at the date of initial
recognition (usually the date of purchase). The entity should be assured that it
will receive the rewards attached to the asset and it will incur the associated
risks, which will only be the case when the rewards and risks have actuallypassed to the entity. Until then, the asset should not be recognized
Second criterion: cost measured reliably
It is generally easy to measure the cost of an asset as the transfer amount on
purchase, i.e what was paid for it. Self-constructed assets can also be measured
easily by adding together the purchase price of all the constituent parts (labor,material etc.) paid to external parties.
3.1.2 Measurement
• Initial measurement
Once an item of property, plant and equipment qualifies for recognition as anasset, it will initially be measured at cost
i. Components of cost
The standard lists the components of the cost of an item of Property, plant and
equipment.
a) Purchase price, less any trade discount or rebate
b) Import duties and non-refundable purchase taxes
c) Direct attributable costs of bringing the asset to working condition for
its intended use, eg:
– The cost of site preparation
– Initial delivery and handling costs
– Installation costs
– Testing (net of any proceeds on the sale of items produced)
– Professional fees (architects, engineers)
Initial estimate of unavoidable cost of dismantling and removing the asset
and restoring the site on which it is located
IAS 16 provides guidance on directly attributable costs included in the
cost of an item of property, plant and equipment.
a) The cost bringing the asset to the location and working conditions
necessary for it to be capable of operating in manner intended by
management, including those costs to test whether the asset is
functioning properly.
b) They are determined after deducting the net proceeds from selling any
items produced when bringing the asset to its location and condition.
Income and related expenses of operations that are incidental to the
construction or development of an item of property, plant and equipment should
be recognized in profit or loss.
The following costs will not be part of the cost of property, plant and
equipment unless they can be attributed directly to the asset’s acquisition, or
bringing it into its working condition:
– Administration and other general overhead costs
– Start-up and similar pre-production costs
– Initial operating losses before the asset reaches planned performance
All of these will be recognized as an expense rather than an asset.
In the case of self-constructed assets, the same principles are applied as
for acquired assets. If the entity’s normal course of business is to make these
assets and sell them externally, then the cost of the asset will be the cost of
its production. This also means that abnormal costs (wasted material, labor or
downtime costs) are excluded from the cost of the asset. An example of a selfconstructed asset is when a building company builds its own office.
ii. Subsequent expenditure
The recognition criteria apply to subsequent expenditure as well as costs
incurred initially. There are no separate criteria for recognizing subsequent
expenditure. For example, if a shop building is extended to include a new café
as revenue source, then this meets the criteria of probable future economic
benefits, and so should be recognized as property, plant and equipment.
However, if the shop building is maintained or repaired, it does not enhance the
future economic benefits, it merely sustains the existing economic benefits and
therefore the costs must be expensed.
iii. Exchanges of assets
IAS 16 specifies that exchange of items of property, plant and equipment,
regardless of whether the assets are similar, are measured at fair value, unless
the exchange transaction lacks commercial substance or the fair value
of neither of the assets exchanged can be measured reliably. If the acquired
item is not measured at fair value, its cost is measured at the carrying amountof the asset given up.
• Measurement subsequent to initial recognition
The standard offers two possible treatments here, essentially a choice between
keeping an asset recorded at cost of revaluing it to fair value
i. Cost model. Carry the asset at its cost less depreciation and any
accumulated impairment loss.
ii. Revaluation model. Carry the asset at a revalued amount, being its fair at
the date of the revaluation less any subsequent accumulated depreciation
and subsequent accumulated impairment losses. The revised IAS 16
makes clear that the revaluation model is available only if the fairvalue of the item can be measured reliably.
Revaluations
The market value of land and buildings usually represents fair value, assuming
existing use and line of business. Such valuations are usually carried out by
professionally qualified valuers
In the case of plant and equipment, fair value can also be taken as market
value. Where a market value is not available, however, depreciated replacement
cost should be used. There may be not market value where types of plant and
equipment are sold only rarely or because of their specialised nature (i.e they
would normally only be sold as part of an ongoing business).
The frequency of valuation depends on the volatility of the fair values of
individual items of property, plant and equipment, the more volatile the fair value,
the more frequently revaluations should be carried out. Where the current fair
value is very different from the carrying amount then a revaluation should be
carried out.
Most importantly, when an item of property, plant and equipment is revalued,
the whole class of assets to which it belongs should be revalued.
All the items within in class should be revalued at the same time, to prevent
selective revaluations of certain assets and avoid disclosing a mixture of costs
and values from different dates in the financial statements. A rolling basis of
revaluation is allowed if the revaluations are kept up to date and the revaluationof the whole class is completed in a short time.
Accounting for revaluations
How should any increase in value be treated when a revaluation takes place?
The debit will be the increase in value in the statement of financial position, but
what about the credit? IAS 16 requires the increase to be credited to other
comprehensive income and accumulated in a revaluation surplus (ie part of
owner’s equity), unless there was previously a decrease on the revaluation ofthe same asset.
DEBIT Carrying amount (statement of financial position)
CREDIT Other comprehensive income (revaluation Surplus)
Reversing a previous decrease in value
If the asset has previously suffered a decrease in value that was charged to profit
or loss, any increase in value on subsequent revaluation should be recognized
in profit or loss to the extent that it reverses the previous decrease. The amount
of the reversal is not necessarily the same as the amount of previous decrease-
the cumulative effect of differences in depreciation charged to profit or loss
as a result of the previous decrease must be considered. Any excess is then
recognized in other comprehensive income and accumulated in a revaluationsurplus.
Example
ABC Ltd has an item of land carried in its books at FRW 13 million as at 31
March 2018. Two years previously, at 31 March 2016, a slump in land values
led the company to reduce the carrying amount from FRW 15 million. This was
taken as an expense in profit or loss. There has been a surge in land prices in
the current year and the land is now worth FRW 20 million.Account for revaluation in the current year ending 31 March 2018.
Answer
The double entry is:
The case is similar for a Decrease in value on revaluation. Any decrease should
be recognized as an expense, except where it offsets a previous increase taken
as a revaluation surplus in owners’ equity. Any decease greater than the previousupwards increase in value must be taken as an expense in the profit or loss.
Example:
Let us simply swap round the example given above. The original cost was FRW
15 million, revalued upwards to FRW 20 million two years’ ego, for the period
ending 31 March 2016. The value has now fallen to FRW 13 million as of 31
March2018.Account for the decrease in value.
Remember that IAS 16 requires the initial increase here to be credited to other
comprehensive income and accumulated in a revaluation surplus (i.e part of
owners’ equity), therefore the increase in 31 march 2016 will be taken to other
comprehensive income and held in the revaluation surplus.
Once the value decreases, the original increase in value must be reversed
and any amounts over and above that should be taken to the statement of profit
or loss.
Revaluation of depreciated assets
There is a further complication when a revalued asset is being depreciated. As
we have seen, an upward revaluation means that the depreciation charge will
increase. Normally, a revaluation surplus is only realized when the asset is sold.
However, when it is being depreciated, part of that surplus is being realized as
the asset is used.
The amount of the surplus realized is the difference between depreciation
charged on the revalued amount and the (lower) depreciation which would have
been charged on the asset’s original cost. This amount can be transferred
to retained (realized) earnings but NOT through profit or loss.
Example:
KBG Ltd bought an asset for FRW 10 million at the beginning of 2016. It had
a useful life of 5 years. On January 2018 the asset was revalued to FRW 12
million. The expected useful life has remained uncharged (i.e three years remain).
Account for the revaluation and state the treatment for depreciation from 2018
onwards.
On 1st January 2018 the carrying amount of the asset has changed to FRW 12
million. Up to 1 January 2018, the company has depreciated the asset by FRW
4 million (FRW 10 million/5years*2) to reflect that the asset has been realized
through use. This means that the carrying amount was therefore FRW 6 million
(FRW 10 million- FRW 4 million), which is credited to other comprehensive income.
Due to the increased value, it appears that none of the asset’s original cost has
been used up in the past two years; therefore, we must also reverse theaccumulated depreciation:
The new depreciation is FRW 4 million compared to depreciation on the original
cost of 10m÷5= FRW 2m. So each year, the extra FRW 2 million can be treatedas part of the revaluation surplus that has become realized:
This is the movement on owners’ equity only and it will be shown in the statement
of changes in equity it is not an item in profit or loss.
Complex assets
For very large and specialized items, an apparently single asset should be
broken down into its composite parts. This occurs where the different parts
have different useful lives and different depreciation rates are applied to each
part, e.g an aircraft, where the body and engines are separated as they havedifferent useful lives.
Example
A company purchases an aircraft for FRW 330,000 million. Show how the asset
should be accounted for at the end of the first financial year if the following is alist of its component parts:
Answer
Depreciation at the end of the first year, in which 150 flights totaling 400 hourswere made, would then be:
Retirements and disposals
When an asset is permanently withdrawn from use, or sold or scrapped,
and no future benefits are expected from its disposal, it should be derecognized
from the statement of financial position.
Gain or losses are the difference between the estimated net disposal proceeds
and the carrying amount of the asset. They should be recognized as income orexpense in profit or loss.
Derecognition
An entity is required to derecognize the carrying amount of an item of
property, plant or equipment that it disposes of on the date the criteria for the
sale in IFRS 15 Revenue from contracts with customers would be met. Thisalso applies to parts of an asset.
Application activity 3.1
An equipment was purchased from England at CIF Mombasa value of
FRW 10,000,000. Transportation fees to Kigali Magerwa costs FRW
1,500,000; imports duties and fees amounted to FRW 1,900,000. The
installation cost was FRW 2,000,000 while trial runs and commissioning
amounted to FRW 2,600,000.
Required: Determine the original cost for that equipment
3.2 Compute depreciation charge and carrying amount
Learning Activity 3.2
A machine was bought at a cost of FRW 6,500,000; total non-refundable
taxes paid on the purchase transaction amounted to FRW 1,500,000 while
the installation cost was FRW 2,000,000. The scrap value is estimated atFRW 256,000 at the end of the estimated lifetime of 4 years.
Required: Based on the above information explain the following terms:
a) Capital expenditure
b) Depreciationc) Residual value
d) Useful life
Capital and Revenue Expenditure
Capital expenditure is money spent by a business on the purchase of fixed
assets for use in the business and not for immediate resale, or on their alteration
or improvement; it includes any costs of delivering or installing fixed assets, andthe legal costs of buying a non-current asset.
Revenue expenditure is money spent on the running expenses of a business:
that is, maintenance of fixed assets, the cost of administering the business and
selling and distributing goods, and the cost of stock of goods acquired withintention of resale.
Differences between capital and revenue expenditure
Depreciation
Depreciation accounting is governing by IAS 16 property, plant and equipment.These are some of IAS 16 definitions concerning depreciation.
Depreciation is the systematic allocation of the depreciable amount of an asset
over its estimated useful life. Depreciation for the accounting period is chargedas an expense to net profit or loss for the period either directly or indirectly.
Depreciable assets are assets which:
• Are expected to be used during more than one accounting period
• Have a limited useful life
• Are held by an entity for use in the production or supply of goods and
services, for rental to others, or administrative purposes.
Useful life is one of two things:
• The period over which a depreciable asset is expected to be used by
the entity; or
• The number of production or similar units expected to be obtained fromthe asset by the entity.
Depreciable amount of a depreciable asset is the historical cost or other
amount substituted for cost in the financial statement, less its estimated residual
value.
An amount substituted for cost’ will normally be a current market value after a
revaluation has taken place.
Residual value is the net amount which the entity expects to obtain for an
asset at the end of its useful life after deducting the expected costs of disposal.
If an asset’s life extends over more than one accounting period, it earns profits
over more than one period. It is a non-current asset.
With the exception of land, every non-current asset eventually wears out over
time. Machines, cars and other vehicles, fixtures and fittings, and even buildings
do not last forever. When a business acquires non-current asset, it will have
some idea about how long its useful life will be, and it might decide what to do
with it.
• Keep on using the non-current asset until becomes completely worn
out, useless and worthless.
• Sell off the non-current asset at the end of its useful life, either by
selling it as a second hand item or as scrap.
Since a non-current asset has a cost, and a limited useful life, and its value
eventually declines, it follows that a charge should be made in profit or loss to
reflect the use that is made of the asset by the business. This charge is calleddepreciation.
The need to depreciate non-current assets arises from the accruals
assumption. If money is expended in purchasing an asset, then the amount
expended must at some time be charged against profits. If the asset is one
which contributes to an entity’s revenue over a number of accounting periods it
would be inappropriate to charge any single period (e.g the period in which the
asset was acquired) with the whole of the expenditure. Instead, some method
must be found of spreading the cost of the asset over its estimated useful life.
It is worth mentioning here two common misconceptions about the purpose
and effects of depreciation:
• It is sometimes thought that the carrying amount of an asset is equal to
its net realizable value and that the object of charging depreciation is to
reflect the fall in value of an asset over its life. This misconception is the
basis of a common, but incorrect, argument which says that freehold
properties need not be depreciated in times when property values arearising.
It is true that historical cost statements of financial position often give a misleading
impression when a property’s carrying amount is much below its market value,
but in such a case it is open to a business to incorporate a revaluation into
its books, or even to prepare its accounts based on current costs. This is a
separate problem from that of allocating the property’s cost over successiveaccounting periods.
• Another misconception is that depreciation is provided so that an
asset can be replaced at the end of its useful life. This is not the
case :
– If there is no intention of replacing the asset, it could then be argued
that there is no need to provide for any depreciation at all.
– If prices are rising, the replacement cost of the asset will exceed theamount of depreciation provided.
There are situations where, over a period, an asset has increased in value, i.e its
current value is greater than the carrying amount in the financial statements. You
might think that in such situations it would not be necessary to depreciate the
asset. The standard states, however, that this is irrelevant, and that depreciation
should still be charged to each accounting period, based on the depreciableamount, irrespective of a rise in value.
An entity is required to begin depreciating an item of property, plant and
equipment when it is available for use and continue depreciating it until it isderecognized even if it is idle during the period.
Useful life
The following factors should be considered when estimating the useful life of
depreciable asset.
• Expected physical wear and tear
• Obsolescence
• Legal or other limits on the use of the assets
Once decided, the useful life should be reviewed at least every financial year end
and depreciation rates adjusted for the current and future periods if expectations
vary significantly from the original estimates. The effect of the changes shouldbe disclosed in the accounting period in which the change takes place.
The assessment of useful requires judgment based on previous experience with
similar assets or classes of asset. When a completely new type of asset is
required (through technological advancement or through use in producing a
brand new product or service) it is still necessary to estimate useful life, eventhough the exercise will be much difficult.
Land and buildings are dealt with separately when it comes to depreciation,
even when they are acquired together, because land normally has unlimited life
and is therefore not depreciated. In contrast buildings do have a limited life and
must be depreciated. Any increase in the value of land on which a building isstanding will have no impact on the determination of building; useful life.
Review of useful life
A review or the useful life of property, plant and equipment should be carried out
at least each financial year end and the depreciation charge for the current
and future periods should be adjusted if expectations have changed significantly
from previous estimates. Changes are changes in accounting estimates and areaccounted for prospectively as adjustments to future depreciation.
Example:
ABC Ltd acquired a non-current asset on 1 January 2002 for FRW 800,000.
It had no residual value and a useful life of ten years. On 1 January 2005, the
remaining useful life was reviewed and revised to 4 years.What will be the depreciation charge for 2005?
Residual value
In most cases the residual value of an asset is likely to be immaterial. If
it is likely to be of any significant value, that value must be estimated at the
date of purchase or any subsequent revaluation. The amount of residual value
estimated based on the current situation with other similar assets, used in the
same way, which are now at the end of their useful lives. Any expected costs ofdisposal should be offset against the gross residual value.
Depreciation methods
Consistent is important. The depreciation method selected should be applied
consistently from period to period unless altered circumstances justify a charge.
When the method is changed, the effect should be quantified and disclosedand the reason for the change should be stated.
Various methods of allocating depreciation to accounting periods are available,
but whichever is chosen must be applied consistently to ensure comparability
from period to period. Change of policy is not allowed simply because of theprofitability situation of the entity.
Depreciation methods were covered extensively in senior 5. The most common
accepted methods of allocating depreciation are straight-line method and
reducing balance method.
Under straight-line method, the depreciable amount is charged in equal
installments over the asset’s expected useful life. This method is best when
the business enjoys the benefits of the asset in equal measure over the asset’s
useful life. It is useful where there is an estimated realizable or scrap value after
a set period, for example, a van may be used by a business for four years, but
with the aim of selling it back to the motor company for an agreed amount of
money after that time.
Under the reducing balance method, the annual depreciation charge is a fixed
percentage of the carrying amount, as at the end of the accounting period.
Examples include machinery which has a higher productivity in the earlier years
of its usage.
The reducing balance method should be used when it is considered fair to
allocate a greater proportion of the total depreciable to the earlier years and a
lower amount in the later years, on the assumption that the benefits obtained by
the business from using the asset decline over time. Examples would includecomputer hardware or production machinery that gets less efficient as it ages.
Review of depreciation method
The depreciation method should also be reviewed at least at each financial
year end and, if there has been a significant change in the expected pattern of
economic benefits from the assets, the method should be changed to suit this
changed pattern. When such a change in depreciation method takes place the
change should be accounted for as a change in accounting estimate and the
depreciation charge for the current and future periods should be adjusted.
Impairment of carrying amounts of non-current assets
An impairment loss is the amount by which the carrying amount of an asset
exceeds its recoverable amount.
An impairment loss should be treated in the same way as revaluation
decrease i.e the decrease should be recognized as an expense. However, arevaluation decrease (impairment loss) should be charged directly against any
related revaluation surplus to the extent that the decrease does not exceed the
amount held in the revaluation surplus in respect of that same asset.
A reversal of an impairment loss should be treated in the same way as a
revaluation increase, i.e a revaluation increase should be recognized as an
income to the extent that it reverses a revaluation decrease or an impairment
loss of the same asset previously recognized as an expense.
Disclosure
The standard has a long list of disclosure requirements, for each class of
property, plant and equipment.
• Measurement bases for determining the gross carrying amount (if more
than one, the gross carrying amount for that basis in each category)
• Depreciation method used
• Useful lives or depreciation rates used
• Gross carrying amount and accumulated depreciation (aggregated
with accumulated impairment losses) at the beginning and end of the
period
• Reconciliation of the carrying amount at the beginning and end of the
period showing:
– Additions
– Disposals
– Acquisitions through business combinations
– Increases/decreases during the period from revaluations and from
impairment losses
– Impairment losses recognized in profit or loss
– Impairment losses reversed in profit or loss
– Depreciation
– Net exchange differences (from translation of statements of e foreign
entity)
– Any other movements
The financial statements should also disclose the following:
• Any recoverable amounts of property, plant and equipment
• Existence and amounts of restrictions on title, and items pledged as
security for liabilities
• Accounting policy for the estimated costs of restoring the site
• Amount of expenditures on account of items in the course of construction
• Amount of commitments to acquisitions
• Accounting policy disclosing the valuation bases used for determining
the amounts at which depreciable assets are stated.
IAS 16 also requires the following to be disclosed for major class of depreciable
asset:
Revalued assets require further disclosures:
• Basis used to revalue the assets
• Effective date of the revaluation
• Whether an independent valuer was involved
• Nature of any indices used to determine replacement cost
• Carrying amount of each class of property, plant and equipment that
would have been included in the financial statements had the assets
been carried at cost less accumulated depreciation and accumulated
impairment losses
• Revaluation surplus, indicating the movement for the period and any
restrictions on the distribution of the balance to shareholders.
The standard also encourages disclosure of additional information, which the
users of financial statements may find useful:
• The carrying amount of temporarily idle property, plant and equipment
• The gross carrying amount of any fully depreciated property, plant and
equipment that is still in use
• The carrying amount of property, plant and equipment retired from
active use and held for disposal
• The fair value of property, plant and equipment when this is materiallydifferent from the carrying amount
Application activity 3.2The following information relates to BGM LTD:
On Feb 2013, an additional equipment was bought at a cost of FRW
2,500,000. Due to expansion in the market for serviced plots, another
equipment, was bought on 24th June 2013 at a cost of FRW 3,750,000.
On Feb 2013, an additional equipment was bought at a cost of FRW
2,500,000. Due to expansion in the market for serviced plots, another
equipment, was bought on 24th June 2013 at a cost of FRW 3,750,000.
However, an equipment which had been acquired at a cost of FRW
2,000,000 on 7th April2010 and was expected to have a useful life of
5years and a scrap value of FRW 125,000 could not cope up with bigger
projects efficiently, as a result on 5 July 2013, management disposed it off
at FRW 750,000.
Another equipment which was bought on 20th May 2010 at a cost of FRW
4,000,000 and was expected to have a residual value of FRW 250,000 at
the end of tenth year broke down was disposed of at FRW 1,750,000 on3 September 2013.
The company’s policy is to charge full depreciation in the year of purchase
and none at all in the year of sale (disposal).
The company followed straight line method of depreciation but changed
to charge depreciation at rate of 10% on cost for the equipment which
was available by the end of 31 December 2013. All transactions were by
cheque.
Required:
Prepare the following accounts as at 31 December 2013:
a) Equipment A/C
b) Equipment disposal A/Cc) Accumulated depreciation-equipment A/C
End unit assessment
1) KABALISA Ltd acquired a building in KIGALI on 1st January 2011 for
FRW 200 million. The building was judged to have a useful life of 50
years. On 31 December 2013, the property was revalued at FRW 210
million. On January 2016 the property was independently valued atFRW 170 million, the useful life was unchanged.
Required
Calculated the effect of the property on the statement of profit or loss forthe year ended 31st December 2016.
2) The following information was got from the balance sheet of GASABOTOURS as at 31 December 2021
SOYDM: Sum of Years Digits method
All transactions were by cheque. It is the company’s policy to charge a full
year’s depreciation in the year of purchase and none in the year of disposal.
All motor vehicles that are not disposed by 31December 2022 should be
depreciated by 20% on cost. The company’s financial year runs from 1January to 31 December.
Required:
i. Motor vehicles A/C
ii. Motor vehicles Accumulated depreciation A/Ciii. Motor vehicles disposal A/C