Manual of Accounting – IFRS Student Manual...

Manual of Accounting – IFRS Student Manual 2010

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Chapter 8

Property, plant and equipment

Page8.1 Introduction8.2 Recognition of initial and subsequent costs

Initial costsSubsequent costs

Replacement part and overhauls8.3 Initial measurement of property, plant and equipment

BasicsSelf-constructed assetsSoftware development costsDecommissioning costsCapitalisation of borrowing costsGovernment grantsExchanges of assets

8.4 Subsequent measurementIntroductionClass of assetsFrequency of revaluationsValuersBases of valuationTreatment of accumulated depreciation when PPE is revaluedRevaluation gains and losses

8.5 DepreciationIntroductionDetermining the useful life and residual valueMethods of depreciation

Straight-line methodDiminishing balance methodSum of the digits (or ‘rule of 78’)Sum of the units (unit of production) method

Depreciation of revalued assetsComponent depreciationNon-depreciation of certain assets

8.6 Derecognition of property, plant and equipmentIntended disposals of property, plant and equipment

8.7 Disclosures about PPE8.8 Investment property

Introduction and definitionMeasurement

Determining fair valueGains and losses on revaluation

TransfersPresentation and disclosure

SummaryReferences

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Chapter 8


8.1 Introduction

This chapter considers the accounting requirements affecting property, plant and equipment (PPE). With theexception of impairments, which are dealt with in detail in chapter 11, this chapter covers the followingmatters.

& Initial recognition and measurement.

& Measurement subsequent to initial recognition, which can be based on cost or fair value.

& The concept and methods of depreciation.

& Selling of other derecognition.

This chapter deals with IAS 16, ‘Property, plant and equipment’, IAS 40, ‘Investment property’, IAS 23,‘Borrowing costs’, IFRIC 1, ‘Changes in existing decommissioning, restoration and similar liabilities’, andparts of IAS 38, ‘Intangible assets’.

IAS 16 should be applied in accounting for property, plant and equipment, except where another IFRSrequires or permits a different accounting treatment. [IAS 16 para 2]. The standard does not apply to:

& Biological assets related to agricultural activity (dealt with by IAS 41, ‘Agriculture’).

& Recognising and measuring exploration and evaluation assets (dealt with by IFRS 6, ‘Exploration forand evaluation of mineral resources’).

& Mineral rights and mineral reserves such as oil, natural gas and similar non-regenerative resources.

& Property, plant and equipment classified as held for sale in accordance with IFRS 5 (dealt with byIFRS 5, ‘Non-current assets held-for-sale and discontinued operations’).

[IAS 16 para 3].

IAS 16 also does not deal with investment property, because IAS 40 does. In this chapter, we discuss IAS 40 insection 8.8, although many other parts of the chapter are also relevant because investment property can bemeasured on a cost basis.

8.2 Recognition of initial and subsequent costs

IAS 16 defines property, plant and equipment as:

‘‘. . .tangible items that:

(a) are held for use in the production or supply of goods or services, for rental to others, or foradministrative purposes; and

(b) are expected to be used during more than one period.’’

[IAS 16 para 6].

Cost is defined as ‘‘. . .the amount of cash or cash equivalents paid or the fair value of the other considerationgiven to acquire an asset at the time of its acquisition or construction’’. [IAS 16 para 6]. Other considerationcould, for example, include an asset given up in exchange.

The standard considers the question of how individual items may be identified and the extent to which itemsmay be aggregated. It does not prescribe the unit of measurement, but states that judgement is needed in

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applying the recognition criteria to an entity’s particular circumstances. [IAS 16 para 9]. Such judgements mayinclude whether individual items should be aggregated and treated as a single item of property, plant andequipment and whether large items should be broken down into significant component parts, which are thentreated as separate individual items (perhaps with different useful lives).

Disaggregation is the separation of an asset into its significant components. This is necessary because thestandard requires that each part of an item of PPE that has a cost that is significant in relation to the total costof the item, must be depreciated separately. [IAS 16 para 43]. This does not necessarily mean that thesesignificant components have different useful lives or provide a different pattern of benefits to the entity thanthe main asset. However, that will often be the case and different useful lives or different depreciation rates ormethods will then have to be used for the significant components. For example, an aircraft and its engines mayneed to be treated as separate depreciable assets and this will be required if they have different useful lives.Another example of a component might be the lining of a blast furnace, where the lining has to be replacedperiodically, and thus has a different useful life from the rest of the furnace. Examples of separate componentsare given in example 8.1.

On the other hand, it notes that it may be appropriate to aggregate individually insignificant items of property,plant and equipment, such as moulds, tools and dies and to apply the recognition criteria to the aggregatevalue. The standard also states that spare parts and servicing equipment are normally treated as inventory andexpensed as consumed. However, major spare parts and stand-by equipment should be treated as PPE whenthey are expected to be used during more than one period. In the same way, if the spare parts or servicingequipment can only be used in connection with an item of PPE they are accounted for as property, plant andequipment. [IAS 16 para 8]. Where this is the case, the spare parts or servicing equipment would bedepreciated over a period that does not exceed the useful life of the related asset. An example of such spareparts and their treatment as PPE is given in example 8.1.

Example 8.1 – Spare parts treated as property, plant and equipment

SAS AB – Report and Accounts – 31 December 2008

Accounting and valuation policies (extract)

Tangible fixed assets (extract)

Tangible fixed assets are carried at cost less accumulated depreciation and any impairment. These assets are

depreciated to their estimated residual values on a straight line basis over their estimated useful lives. As thecomponents of aircraft have varying useful lives, the Group has separated the components for depreciation purposes.

Costs for routine aircraft maintenance as well as repair costs are expensed as incurred. Extensive modifications,

including the required major overhauls of engines, and improvements to non-current assets are capitalized anddepreciated together with the asset to which the work is related over its remaining useful life. Investment in own andleased premises is amortized over their estimated useful lives, but not over a period exceeding the remaining leasingperiod for leased premises.

Income from the sale or disposal of a tangible fixed asset is calculated as the difference between the sales value andcarrying amount. The gain or loss that arises is recognized in the statement of income.

Depreciation is based on the following estimated periods of useful economic life:

Asset class

Aircraft 20*Spare equipment and spare parts 20*

Engine components (average) 8Workshop and aircraft servicing equipment 5Other equipment and vehicles 3-5

Buildings 5-50

* Estimated residual value after a useful economic life of 20 years is 10%.

The recognition principle above should be applied to all PPE costs at the time they are incurred. Such costsinclude the costs of acquiring or constructing the asset and costs incurred subsequently to add to, replace partof or service the asset. [IAS 16 para 10]. The standard also deals in detail with certain aspects of initial andsubsequent costs and these requirements of the standard are described in the following sections.

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Initial costs

IAS 16 considers the situation where items of PPE are acquired that, by themselves, may not generateeconomic benefits, but which are necessary to enable other assets to do so. Examples are assets necessary toensure safety or to comply with environmental regulations. The standard confirms that such assets should berecognised because they enable other assets to generate economic benefits in excess of the benefits that couldotherwise have been derived from those assets. However, the resultant carrying amount of those assets and therelated assets is reviewed for impairment to ensure that the combined carrying amount does not exceed theircombined recoverable amount. An example is given of a chemical manufacturer that has to install newchemical handling processes to comply with environmental requirements. Such related plant enhancements arecapitalised to the extent that they are recoverable (when taken together with the related chemical plant),because without them the entity is unable to manufacture and sell chemicals. [IAS 16 para 11]. A short casestudy relevant to this in shown as case 8.A

Case 8.A – Costs incurred before planning permission is granted

Entity A is developing a fixed asset property for its own use. It is incurring costs on the development prior to obtainingplanning permission.

IAS 16 states that the cost of an item of PPE should be recognised as an asset when it is probable that future economicbenefits associated with the item will flow to the entity and the cost of the item can be measured reliably. It can beargued that there are two phases to the development. First, a feasibility stage where all costs should be expensed;

second, a development phase where capitalisation is acceptable, subject to the IAS 16 criteria. Judgement needs to beexercised for each situation. In some cases, planning permission will be a formality; the feasibility stage might,therefore, be completed some time before the planning permission is given. If, for example, the company regularlyobtains planning permission, has been told informally that it will be granted, has experience of getting it and it will be

given in a short space of time, there may be sufficient evidence that there is access to and control over future economicbenefit such that the costs may be capitalised. However, in other situations where planning consent is not a formality(for example, if the company has been trying to get planning permission for some time and still has no indication of

whether it will be granted), it seems unlikely that the company can demonstrate access to future economic benefit. Ifthe costs do not meet the definition of an asset, they are an expense and should be written off to the income statementas incurred.

Although not specifically addressed in IAS 16, we consider that once such a cost has been classified as an expense, itcannot then be re-classified as an asset at a later date. This differs from the situation where a cost that was originallyrecognised as an asset has been written down for impairment and that impairment is subsequently reversed in

accordance with IAS 36.

Subsequent costs

Once an item of property, plant and equipment has been recognised and capitalised, a company may incurfurther costs on that asset at a later date. IAS 16 requires that subsequent costs should be capitalised, that isrecognised as an asset, only if they meet the recognition criteria in the standard. As explained above these arethat:

& It is probable that future economic benefits associated with the item will flow to the entity.

& The cost of the item can be measured reliably.

[IAS 16 para 7].

All other subsequent costs should be recognised as an expense in the period in which they are incurred. Forexample, the cost of adding a new wing to a hotel should be capitalised as it will meet the recognition criteriaof paragraph 7 of IAS 16. The additional rooms increase the revenue earning capacity of the hotel so it isprobable that future economic benefits will arise and the cost can be reliably measured. However, the cost ofcleaning the hotel, is a period cost of servicing the hotel and should be expensed as incurred.

Thus the standard explains that the costs of the day-to-day servicing of an item of PPE are not recognised asan asset. Instead such costs are recognised in profit or loss as incurred. Day-to-day servicing costs wouldinclude costs of labour and consumables and may include the cost of small replacement parts. The purpose ofthis type of expenditure is often known as ‘repairs and maintenance’. [IAS 16 para 12]. The reason why such




costs are expensed rather than capitalised is that they do not add to the future economic benefits of the item ofproperty, plant and equipment. Rather they maintain the asset’s potential to deliver the level of futureeconomic benefits that it was expected to provide when it was originally acquired. These subsequent repair andmaintenance costs do not, therefore, qualify for recognition as an asset in their own right.

Consider a newly purchased item of property, plant and equipment. Before the asset is depreciated, anassessment must be made of the appropriate useful life, residual value and depreciation method to use. As partof this assessment, it will be expected that there will be certain future costs associated with the asset in order tokeep the asset in a good enough condition to perform at expected levels over the expected useful life, such asroutine maintenance and repairs. Such costs will not meet the recognition criteria for property plant andequipment in IAS 16 paragraph 7, instead they are recognised in profit or loss as incurred.

By contrast an entity may acquire an asset at a price that reflects the entity’s obligation to incur expenditure inthe future that is necessary to bring the asset to the location and condition necessary for it to be capable ofoperating in the manner that management intends. A building might be acquired that requires substantialrepairs, or renovation, for example a new roof. In such circumstances the subsequent cost of replacing the roofis capitalised because the cost meets the asset recognition criteria in the standard. It increases the futureeconomic benefits expected to be obtained from the building and can be reliably measured. Case 8.Billustrates.

Case 8.B – Capitalising the cost of remodelling a supermarket

Entity A, a supermarket chain, is renovating one of its major stores. The store will have more available space for in-store promotion outlets after the renovation and will include a restaurant.

Management is preparing the budgets for the year after the store re-opens, which include the cost of remodelling and

the expectation of a 15% increase in sales resulting from the store renovations, which will attract new customers.

The expenditure in remodelling the store will create future economic benefits (in the form of 15% of increase in sales)and the cost of remodelling can be measured reliably, therefore it should be capitalised.

Replacement parts and overhauls

The standard requires that the costs of a replacement component be recognised as an asset if they meet therecognition criteria described above. If such costs meet those criteria and are capitalised the carrying amountof the part or parts that are replaced is derecognised, that is the accumulated cost and depreciation of thereplaced parts is eliminated. This applies whether or not the replaced part or component had been separatelydepreciated. If the cost and depreciation of the replaced part or component cannot be identified then it isacceptable to use the cost of the replacement as a proxy for the cost of the replaced part when it was acquiredor constructed. [IAS 16 paras 13, 70].

Examples of parts that may require replacement are the lining of a blast furnace that may require replacementafter a specified number of hours of use, or aircraft interiors such as seats and galleys that may requirereplacement several times during the airframe’s life. Other examples of parts that may require replacement lessfrequently are the interior walls of a building or a non-recurring replacement. [IAS 16 para 13]. A non-recurring replacement might be, for example, the replacement of a ventilation system with a new system thatmeets current health and safety requirements. Case 8.C illustrates.

Case 8.C – Depreciating an asset that requires periodic replacement

A small manufacturing company has recently acquired a new factory, which cost C1m for the freehold and has aresidual value of C100,000. This factory has a flat roof, which needs replacing every ten years at a cost of C100,000.

The company is considering two alternative approaches:

& To regard the item as one asset and, therefore, to depreciate the whole factory over its useful economic life of 30years, charging C30,000 per annum.

& To regard the roof as a significant part of the item and depreciate the cost of the roof of C100,000 over 10 years,giving a depreciation charge of C10,000 per annum and to depreciate the remainder of the factory of C900,000down to its residual value of C100,000 over 30 years, giving a depreciation charge of C26,667.




Whichever approach is adopted, in year 10 when the roof is replaced the carrying amount attributable to the replacedroof will be written off.

In the first accounting approach above the cost and accumulated depreciation of the old roof could be C100,000 andC33,333 respectively. Therefore, there would be a loss on disposal of C66,667 (the C100,000 replacement cost is used

as a proxy for the original cost of the old roof as the actual cost is not determinable. No residual value is assumed forthe old roof in calculating the accumulated depreciation).

If the second accounting treatment is adopted the carrying amount of the old roof in year 10 will be nil and the costand accumulated depreciation of C100,000 are written off, with no profit or loss on disposal arising.

The above alternative treatments have only been used to illustrate the principle. The second approach given is the

correct method to use under IFRS. Clearly, it more accurately reflects the company’s consumption of economicbenefits of the factory, resulting in an even charge to the income statement of C36,667 per annum, over the 30 years ofthe useful economic life of the factory. As the component in this case is significant this second approach is the one

required by paragraph 43 of IAS 16.

The standard notes that: ‘‘A condition of continuing to operate an item of property, plant and equipment (forexample an aircraft) may be performing regular major inspections for faults regardless of whether parts of theitem are replaced’’. [IAS 16 para 14]. This distinguishes pure inspection costs from costs of replacing parts,which are covered by the previous section above.

Overhaul costs typically include replacement of parts and major repairs and maintenance. As replacement ofparts is dealt with separately by the standard, the question which remains is whether major repairs andmaintenance costs are included under the term ‘inspection’. The answer to this is that it will depend onwhether or not repair and maintenance costs meet the standard’s criteria for recognition as an asset. As notedabove the standard states that the costs of ‘day-to-day servicing’ of an item do not meet the standard’s assetrecognition criteria. However, major repair and maintenance programmes carried out as part of a periodicinspection and overhaul and that result in future economic benefits may well qualify for recognition. The dry-docking of a ship would be another example of such an event.

Overhaul costs then may involve three elements, inspection, replacement of parts and major maintenance.Replacement of parts is dealt with separately by the standard and repairs and maintenance are also dealt withseparately under the general recognition principle. The standard requires that, when each major inspection iscarried out, the cost is recognised as part of the carrying amount of the item of PPE as a replacement if itmeets the asset recognition criteria in the standard. Any remaining carrying amount relating to the previousinspection is derecognised. This treatment is regardless of whether or not the cost of the previous inspectionwas separately identified and depreciated when the item was acquired or constructed. Where the cost of theprevious inspection was not separately identified, the estimated cost of a future similar inspection may be usedas a proxy for the cost of the previous inspection when calculating the carrying value of the previousinspection that needs to be derecognised. [IAS 16 para 14]. This treatment follows the same principles as applyto replacement parts or components, as above.

An aircraft, for example, may be required by law to be inspected/overhauled every three years. In such a case,IAS 16 requires a proportion of the cost of the asset equivalent to the expected overhaul cost to be identifiedand depreciated over the period to the next inspection/overhaul if it represents a significant part of the asset’scost. The actual cost of the overhaul or inspection is then capitalised, provided that it meets the recognitioncriteria, that is it is probable that future economic benefits will flow to the entity and the cost can be measuredreliably. This inspection/overhaul cost is then depreciated over the period to the next inspection/overhaul. Thecost and depreciation attributed to the overhaul originally should be removed from the balance sheet once thecost of the new overhaul has been capitalised to avoid double counting. The remainder of the asset isdepreciated over the full useful life of the asset, on the basis that the appropriate overhauls will be carried outas they are due.

8.3 Initial measurement

Basics

The basic principle in IAS 16 is that items of property, plant and equipment that qualify for recognitionshould be initially measured at cost. [IAS 16 para 15]. This is normally straightforward as it is generally the




price paid. Where an asset is self-constructed, the production cost will be ascertained by aggregating the pricepaid for material, labour and other inputs used in the construction.

IAS 16 states that cost of an item of property, plant and equipment comprises:

& The purchase price, including import duties and non-refundable purchase taxes less any trade discountsand rebates.

& Directly attributable costs of bringing the asset to the location and condition necessary for it to becapable of operating in the manner intended by management.

& The initial estimate of the costs of dismantling and removing the item and restoring the site on which it islocated. The obligation to incur these costs arises either when the item is acquired or as a result of usingthe item during a particular period other than for the purpose of producing inventories during thatperiod.

[IAS 16 para 16].

Examples of directly attributable costs are:

& The cost of employee benefits as defined in IAS 19, ‘Employee benefits’, that arise directly from theconstruction or acquisition of the item.

& The costs of site preparation.

& Initial delivery and handling costs.

& Installation and assembly costs.

& Professional fees.

& Costs of testing whether the asset is working properly (commissioning costs), after deducting the netproceeds of sale of any items produced while bringing the asset to the location and condition necessaryfor it to be capable of operating in the manner intended by management (such as samples producedduring testing).

[IAS 16 para 17].

Employee benefits are defined in IAS 19 as all forms of consideration given by an entity in exchange for servicerendered by employees. [IAS 19 para 7]. The types of benefit include:

& Short-term employee benefits such as wages, salaries and social security contributions, paid annual leaveand paid sick leave, profit sharing and annual bonuses and non-monetary benefits such as medical care,cars, housing and free or subsidised goods or services.

& Post-employment benefits such as pensions, other retirement benefits, post-employment life insuranceand post-employment medical care.

& Other long-term employment benefits, including long service leave or sabbatical leave, jubilee or otherlong-service benefits, long-term disability benefit and deferred bonuses or profit sharing and otherdeferred compensation.

& Termination benefits.

& Share-based payment.

[IAS 19 paras 1, 4 and IFRS 2].

Clearly, the above types of cost will normally be relevant only where an asset is being constructed, althoughcapitalisation may also be possible during the commissioning phase before an asset is capable of operating inthe manner intended by management. Not all of the above costs will be eligible or relevant even then. Forexample, termination benefits paid to employees who have left employment would not be relevant as theywould not be involved in constructing the asset. The list is useful, however, in answering some frequentlyasked questions, such as whether the costs of an employee share scheme, social security costs and companypension contributions may be considered to be directly attributable costs. The answer is that they may,




provided always that they are incurred in bringing an asset to the location and condition necessary for it tooperate in the manner intended by management.

Only costs that are directly attributable may be capitalised. Although it is tempting for management,particularly in start-up situations such as opening a new mine or a new manufacturing or retailing operation,to regard all the initial costs as capital to be carried forward and recovered (hopefully) when the operation isup and running successfully, this is forbidden by the standard. Only the costs that are directly attributable tothe item of property, plant and equipment, and not the general operating costs, may be capitalised. Thestandard lists types of costs that are not ‘directly attributable’ as follows:

& Costs of opening a new facility.

& Costs of introducing a new product or service (including costs of advertising and promotional activities).

& Costs of conducting business in a new location or with a new class of customer (including costs of stafftraining).

& Administration and other general overhead costs.

[IAS 16 para 19].

Case 8.D illustrates.

Case 8.D – Capitalisation of directly attributable costs

Entity A, which operates a major chain of supermarkets, has acquired a new store location. The new location requiressignificant renovation expenditure. Management expects that the renovations will last for three months during whichthe supermarket will be closed. Management has prepared the budget for this period including expenditure related toconstruction and remodelling costs, salaries of staff who will be preparing the store before its opening and related

utilities costs.

Management should capitalise the costs of construction and remodelling the supermarket, because they are necessaryto bring the store to the condition necessary for it to be capable of operating in the manner intended by management.The supermarket cannot be opened without incurring the remodelling expenditure, and thus the expenditure should be

considered part of the asset.

However, the cost of salaries, utilities and storage of goods are operating expenditures that would be incurred if thesupermarket was open. These costs are not necessary to bring the store to the condition necessary for it to be capableof operating in the manner intended by management and should be expensed.

Start-up costs

Start-up costs and similar pre-production costs do not form part of the cost of an asset. Initial operating lossesincurred prior to an asset achieving its planned performance are recognised as an expense. The same wouldapply to operating losses that occur because a revenue earning activity has been suspended during theconstruction of an item of property, plant and equipment. Such losses should also be expensed. An examplemight be where a hotel is being refurbished and is, therefore, closed for a period. The losses incurred in thatperiod (rents, wages etc) would be expensed as incurred as they would not form part of the cost ofimprovements.

An example of where costs should not be capitalised relates to a new hotel or bookshop, which could operateat normal levels almost as soon as it has been constructed or opened, but where demand usually builds upslowly and full use or sales levels will be reached only after several months. In such a case, initial operatinglosses in the start-up period are not costs that may be capitalised. Similarly, marketing and similar costsassociated with generating demand for the services of the item of property, plant and equipment may not becapitalised as part of the asset. Cases 8.E and 8.F illustrate.




Case 8.E – Operating costs incurred in the start-up period

An amusement park has a ‘soft’ opening to the public, to trial run its attractions. Tickets are sold at a 50% discount

during this period and the operating capacity is 80%. The official opening day of the amusement park is three monthslater.

Management claim that the soft opening is a trial run necessary for the amusement park to be in the condition capableof operating in the intended manner. Accordingly, the net operating costs incurred should be capitalised.

The net operating costs should not be capitalised, but should be recognised in the income statement. Running at 80%

operating capacity is sufficient evidence that the amusement park is capable of operating in the manner intended bymanagement.

Case 8.F – Pre-opening rentals

A new store is being developed on a rented site. Can the rentals incurred before the store is opened be capitalised andthen amortised over the period of the lease?

No. The rentals would not qualify for capitalisation as part of the cost of the store fixed assets, as they are not costsdirectly attributable to bringing the assets to the location and condition necessary for them to be capable of operating

in the manner intended by management. [IAS 16 para 16]. The rentals are in effect part of the start-up costs, whichshould be expensed. [IAS 16 para 19].

Self-constructed assets

An entity might obtain a non-current asset by constructing it, using its own labour and materials. In this case,the same principles as above are used for determining cost. Example 8.2 relates to this.

Example 8.2 – Accounting policy for self-constructed items of property, plant and equipment

Bayer AG – Report and Accounts – 31 December 2008

4. Basic principles, methods and critical accounting policies (extract)

Property, plant and equipment (extract)

The cost of acquisition comprises the acquisition price plus ancillary and subsequent acquisition costs, less anyreduction received on the acquisition price. The cost of self-constructed property, plant and equipment comprises thedirect cost of materials, direct manufacturing expenses and appropriate allocations of material and manufacturing

overheads. Where an obligation exists to dismantle or remove an asset or restore a site to its former condition at theend of its useful life, the present value of the related future payments is capitalized along with the cost of acquisitionor construction upon completion and a corresponding liability is recognized.

If the construction phase of property, plant or equipment extends over a long period, the interest incurred onborrowed capital up to the date of completion is capitalized as part of the cost of acquisition or construction inaccordance with IAS 23 (Borrowing Costs).

Software development costs

Computer software development costs may arise in several ways as discussed in more detail in chapter 9. Insome cases an asset comprises both tangible and intangible elements and judgement is needed to determinewhich element is more significant.

For example, computer software for a machine that cannot operate without that specific software is anintegral part of the machine and is treated as property, plant and equipment. The same applies to an operatingsystem of a computer. Where software is not an integral part of the related hardware, it is treated as anintangible asset. [IAS 38 para 4]. An example of capitalisation of software as property, plant and equipment,where it is an integral part of another tangible asset is given as example 8.3.




Example 8.3 – Capitalisation of software as property, plant and equipment

TeliaSonera AB – Report and Accounts – 31 December 2008

Note 4 (Consolidated) (extract)

Significant Accounting Policies (extract)

Property, plant and equipment are measured at cost, including directly attributable borrowing costs, less accumulateddepreciation and any impairment losses. Software used in the production process is considered to be an integral part

of the related hardware and is capitalized as plant and machinery.

Decommissioning costs

As mentioned above, the cost of an item of PPE includes the estimated costs of dismantling and removing theasset and restoring the site on which it is located (‘decommissioning costs’). However, this is only allowedwhen there is a corresponding obligation recognised as a provision under IAS 37, ‘Provisions, contingentliabilities and contingent assets’. This is consistent with example 3 in Appendix C to IAS 37, in which the costsrelating to an obligation to restore damage caused by the installation of an oil rig are set up as a provisionunder IAS 37 and the costs are also included as part of the cost of the oil rig.

Whilst IAS 16 does not apply to mineral rights or mineral resources such as oil, natural gas and similar non-regenerative resources (see ‘Scope’ above), it does apply to property, plant and equipment used to develop ormaintain those assets. Accordingly, in the above example IAS 16 applies to the capitalisation of cost and thedecommissioning provision in respect of the obligation to restore the damage caused by the installation of theoil rig, because the rig is an asset that is used to develop the oil resources.

At first glance, it seems odd to capitalise decommissioning costs that are not going to emerge until later in theasset’s life. However, where the entity has an obligation as a direct consequence of acquiring or constructingproperty, plant and equipment to incur further costs in the future that it cannot avoid, a provision isrecognised in accordance with IAS 37. Therefore, the decommissioning costs at the end of the asset’s life arejust as much a cost of acquiring or constructing the asset as the costs incurred at the start of the asset’s life.Example 8.4 illustrates capitalisation of the estimated cost of decommissioning.

Example 8.4 – Capitalisation of the estimated cost of decommissioning and restoration and changes in provisions

TeliaSonera AB – Report and Accounts – 31 December 2008

Note 4 (Consolidated) (extract)

Significant Accounting Policies (extract)

Intangible assets, and property, plant and equipment (extract)

Property, plant and equipment are measured at cost, including directly attributable borrowing costs, less accumulateddepreciation and any impairment losses. Software used in the production process is considered to be an integral partof the related hardware and is capitalized as plant and machinery. Property and plant under construction is valued at

the expense already incurred, including interest during the installation period. To the extent a legal or constructiveobligation to a third party exists, the acquisition cost includes estimated costs of dismantling and removing the assetand restoring the site. The cost of replacing a part of an item of property, plant and equipment is recognized in the

carrying value of the item if it is probable that the future economic benefits embodied within the item will flow toTeliaSonera and the cost of the item can be measured reliably. All other replacement costs are expensed as incurred.A change in estimated expenditures for dismantling, removal and restoration is added to and/or deducted from the

carrying value of the related asset. To the extent that the change would result in a negative carrying value, this effect isrecognized as income. The change in depreciation charge is recognized prospectively.

Examples of decommissioning costs that may be capitalised as part of the cost of the asset typically arise in oiland gas and electricity industries where environmental damage is caused by the construction andcommissioning of the facility (for example, an oil platform or nuclear plant). Similar costs are incurred inother industries, such as, abandonment costs in the mining and extractive industries, clean up and restorationcosts of landfill sites and environmental clean up costs in a number of industries.




Inevitably, there are likely to be significant changes in the initial (and subsequent) estimates ofdecommissioning costs of an asset, particularly where asset lives are long. These may be due to changes inlegislation, technology, timing of the decommissioning, management’s assumptions etc. The question is howthese changes in estimates should be reflected when such obligations had previously been recognised as aprovision and the cost capitalised as part of the cost of the asset. These issues together with the problemsassociated with discounting are dealt with by IFRIC 1, ‘Changes in existing decommissioning, restoration andsimilar liabilities’.

For assets measured using the cost model (which is used by most companies for most assets), changes in themeasurement of an existing decommissioning, restoration and similar liability and changes in the discount rateshould be accounted for as follows:

& Changes should be added to, or deducted from, the cost of the related asset in the current period, subjectto the following bullet point.

& The amount deducted from the cost of the asset must not be greater that the asset’s carrying amount(that is, the deduction must not give rise to a ‘negative asset’). If the decrease in the liability exceeds theasset’s carrying amount, the excess must be recognised immediately in profit or loss.

& If the adjustment results in an addition to the cost of the asset, for example where the liability hasincreased, the entity must consider whether the new carrying amount is fully recoverable or not. If thereis an indication that the asset may not be fully recoverable the entity should carry out an impairment testand account for any loss in accordance with IAS 36.

[IFRIC 1 para 5].

The interpretation adds that the adjusted depreciable amount of the asset is depreciated over its useful life.Once the asset has reached the end of its useful life (that is, when it is no longer being used by the entity)changes in the decommissioning or restoration liability are recognised in profit and loss as they occur. Inpractice, decommissioning often takes a considerable period after an asset has reached the end of its useful life,so this is an important and relevant requirement. [IFRIC 1 para 7].

The interpretation also deals with the periodic unwinding of the discount, IFRIC considered whether theunwinding of the discount was a borrowing cost for the purpose of IAS 23 (revised) and decided that it wasnot, because the provision for decommissioning was not a borrowing. Therefore, it decided that the unwindingof the discount would not qualify for capitalisation under IAS 23 (revised) and should be charged to profit orloss as a finance cost as it occurs. [IFRIC 1 paras 8, BC26, BC27].

An illustration of an accounting policy is given in example 8.4 above.

Capitalisation of borrowing costs

IAS 16 requires capitalisation of costs to take place only in respect of the period in which the activitiesnecessary to bring the asset to the location and condition necessary for it to be capable of operating in themanner intended by management are being undertaken. Thus, capitalisation should cease when substantiallyall the activities necessary to get the asset ready for use are complete, even if the asset has not yet been broughtinto use. [IAS 23 para 22]. IAS 23 states that ‘ready for use’ means when the physical construction of the assetis complete even though routine administrative work might still continue. For example, if minor decoration ofa property to a purchaser’s specification is all that is outstanding this indicates that the asset is substantiallycomplete. [IAS 23 para 23].

Examples of borrowing costs are:

& Interest expense calculated using the effective interested method (described in IAS 39, ‘Financialinstruments: Recognition and measurement’).

& Finance charges in respect of finance leases recognised in accordance with IAS 17, ‘Leases’.

& Exchange differences arising from foreign currency borrowings to the extent that they are regarded as anadjustment to interest costs.

[IAS 23 para 6].




The types of asset that may fall within the definition are not limited to PPE, but also include assets such asinventories that require a ‘substantial period of time’ to bring them to a saleable condition. IAS 23 does notdefine ‘substantial period of time’. Management exercises judgement when determining which assets arequalifying assets, taking into account the nature of the asset. An asset that normally takes more than a year tobe ready for use will usually be a qualifying asset. Once management chooses the criteria and type of assets, itapplies this consistently to those types of asset. Management discloses in the notes to the financial statements,when relevant, how the assessment was performed, which criteria were considered and which types of asset aresubject to capitalisation of borrowing costs. Property, plant and equipment that fall within the definitionmight include manufacturing plant, power generation facilities and construction of investment properties.Assets that are ready for their intended use or sale when acquired are not qualifying assets.

IAS 23 states that only directly attributable borrowing costs should be capitalised. ‘Directly attributable’means those borrowing costs that would have been avoided (for example, by avoiding additional borrowingsor by using the funds paid out for the asset to repay existing borrowings) if there had been no expenditure onthe asset. [IAS 23 paras 8, 10].

Where an entity borrows specifically for the purpose of obtaining a qualifying asset, the borrowing costsattributable to obtaining that asset are readily identifiable. However, where such specific borrowings are nottaken out and an entity funds the asset out of general borrowings, it may be difficult to identify a relationshipbetween particular borrowings and a qualifying asset and thus to determine the borrowings that could havebeen avoided had there been no expenditure on the asset.

Such a situation might occur where an entity has a centralised treasury function, which uses a range of debtinstruments carrying different rates of interest and lends funds to group companies, perhaps at differentinterest rates or even interest free. Other difficulties may arise where an entity uses foreign currency loans oroperates in a highly inflationary economy. In such situations, the standard states that determining the amountof borrowing costs that is directly attributable to obtaining a qualifying asset is difficult and that the exerciseof judgement is required. [IAS 23 (revised) para 11]. However, the standard helps by giving guidance forcapitalisation where funds are borrowed generally, as well as for the more straightforward situation wherefunds are borrowed specifically to obtain a qualifying asset.

IAS 23 gives guidance on how borrowing costs to be capitalised should be determined. If a particularborrowing can be specifically associated with expenditure on constructing or producing the asset, the amountof borrowing costs capitalised is limited to the actual borrowing costs incurred on that borrowing during theperiod less any investment income on the temporary investment of those borrowings. [IAS 23 para 12]. Case8.G illustrates this.

Case 8.G – Specific borrowing costs capitalised

An entity has borrowed C1m specifically to finance the cost of constructing a new head office. The loan is drawn on 1February 20X9 and during the year the entity pays interest on that loan at a rate of 12% until 1 November 20X9 when

the interest rate is increased to 13% due to a rise in LIBOR. Construction on the building does not begin until 1September 20X9 and continues without interruption until after the year end on 31 December 20X9. During the periodof construction the entity incurs directly attributable costs of C100,000 in September 20X9 and C250,000 in each

month from October 20X9 to December 20X9 (for simplicity it is assumed that these costs are incurred on the first dayof each month). Each month the borrowings, less any amount that is to be expended for the building works in thatmonth are re-invested and earn interest at a rate of 5% per annum.

During the year ended 31 December 20X9, the entity, therefore, incurs interest on the C1m loan totalling C111,667and earns interest on the re-invested portion of the loan of C37,917.


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The interest paid and received during the period of construction is as follows:C

Interest payable for September 20X9 at 12% 10,000

Interest payable for October 20X9 at 12% 10,000Interest payable for November 20X9 at 13% 10,833Interest payable for December 20X9 at 13% 10,834

Total interest payable during period of construction to end December 41,667Interest receivable on re-invested funds of C900,000 in September 20X9 3,750Interest receivable on re-invested funds of C650,000 in October 20X9 2,708

Interest receivable on re-invested funds of C400,000 in November 20X9 1,667Interest receivable on re-invested funds of C150,000 in December 20X9 625

Total interest receivable to end December 20X9 8,750

Net initial cost 32,917

As stated above, to the extent that borrowings are raised specifically for obtaining a qualifying asset the amount ofborrowing costs that may be capitalised is the actual costs during the period of construction less any investment

income on the temporary investment of the borrowings. Under IAS 23, the amount of borrowing costs that may becapitalised on specific borrowings is, therefore, C32,917, being interest paid of C41,667 from 1 September to 31December 20X9 less interest received of C8,750 from 1 September to 31 December 20X9.

It might be argued that IAS 23 could be interpreted to mean that all of the interest paid in the period, that is C111,667

less the interest received of C37,917, could be capitalised. The reason this is not so is that prior to 1 September 20X9,when construction commences, the borrowing costs cannot be said to be directly attributable to the construction ofthe asset, as no expenditure on the asset is being incurred. The standard sets out detailed rules on when capitalisationmay commence and these are described below under ‘Period of capitalisation of borrowing costs’.

Where funds are borrowed generally and used for financing the asset’s construction or production, the amountof borrowing costs eligible for capitalisation should be determined by applying a capitalisation rate to theexpenditure on that asset. The capitalisation rate should be the weighted average of the borrowing ratesapplicable to the borrowings of the entity that are outstanding during the period, other than borrowings madespecifically for the purpose of obtaining a qualifying asset. The amount of borrowing costs capitalised during aperiod should not exceed the amount of borrowing costs incurred during the period. [IAS 23 para 14].

IAS 23 does not define ‘expenditure on the asset’, to which the capitalisation rate should be applied. A suitablemethod of calculating such expenditure would be to calculate the weighted average carrying amount of theasset during the period (including borrowing costs previously capitalised) and apply the capitalisation rate tothe resultant figure.

In calculating which general borrowings to include in the weighted average in a group situation, judgement isneeded. It may be appropriate in some cases to include all borrowings of a parent and its subsidiaries whencalculating the weighted average borrowing costs, particularly where the treasury function is managedcentrally within the group or where the parent and the subsidiary are all within the same geographical area andtheir borrowings are generally at similar rates. In other cases, for example, where each subsidiary isresponsible for managing its own treasury function or where there are many overseas subsidiaries, whichborrow at different rates in different currencies to finance their capital expenditure, it may be appropriate foreach subsidiary to calculate the weighted average applicable to its own borrowings.

In consolidated financial statements the limitation applied is the consolidated amount of borrowing costs,because consolidated financial statements should be prepared so far as possible as if they were the financialstatements of a single entity. The limitation on capitalising borrowing costs, described above, is sometimesobjected to by companies that have little borrowing, but which are using cash resources to finance theconstruction of property, plant and equipment. The argument put forward is that cash being used to financethe construction could otherwise have been used to earn interest and it is, therefore, fair to attribute a notionalborrowing cost representing the opportunity cost of the cash employed in financing the asset’s construction.IAS 23 does not accept this argument limits the amount that can be capitalised to the actual borrowing costsincurred. [IAS 23 para 3]. General borrowings are illustrated in cases 8.H and 8.I.



Case 8.H – General borrowings used to finance qualifying assets

The entity uses general borrowings to finance its qualifying assets. However, cash flows from the operating activities

would be sufficient to finance the capital expenditures incurred during the period. Can management claim that thegeneral borrowings are used to finance working capital and other transactions (for example, merger and acquisitionactivity) but not to finance the qualifying assets, in which case no borrowing costs would be capitalised?

No. It is presumed that any general borrowings in the first instance are used to finance the qualifying assets (after any

funds specific to a qualifying asset). This is the case even where the cash flows from operating activities are sufficient tofinance the capital expenditure.

Case 8.I – General borrowing costs: weighted average capitalisation rate

As in the previous example, an entity constructs a new head office building commencing on 1 September 20X9, whichcontinues without interruption until after the year end on 31 December 20X9. Directly attributable expenditure onthis asset is C100,000 in September 20X9 and C250,000 in each of the months of October to December 20X9.

Therefore, the weighted average carrying amount of the asset during the period is C475,000((100,000+350,000+600,000+850,000)/4).

The entity has not taken out any specific borrowings to finance the construction of the asset, but has incurred financecosts on its general borrowings during the construction period. During the year the entity had 10% debentures in issue

with a face value of C2m and an overdraft of C500,000, which increased to C750,000 in December 20X9 on whichinterest was paid at 15% until 1 October 20X9, when the rate was increased to 16%. The capitalisation rate of thegeneral borrowings of the entity during the period of construction is calculated as follows:

CFinance cost on C2m 10% debentures during September – December 20X9 66,667Interest at 15% on overdraft of C500,000 in September 20X9 6,250

Interest at 16% on overdraft of C500,000 in October and November 20X9 13,333Interest at 16% on overdraft of C750,000 in December 20X9 10,000

Total finance costs in September – December 20X9 96,250

(2 million 6 4)+(500,000 6 3)+(750,000 6 1)

Weighted average borrowings during period = 4= C2,562,500

Capitalisation rate = total finance costs in period/weighted average borrowings during

period= 96,250/2,562,500

3.756%

The capitalisation rate, therefore, reflects the weighted average cost of borrowings for the 4 month period that theasset was under construction. On an annualised basis 3.756% gives a capitalisation rate of 11.268% per annum,

which is what would be expected on the borrowings profile.

Therefore, the total amount of borrowing costs to be capitalised

= weighted average carrying amount of asset 6 capitalisation rate= C475,000 6 11.268% 6 4/12= C17,841

Some groups of companies with little or no borrowing have subsidiaries that are engaged in constructingassets. In such circumstances, it is possible for the subsidiary to capitalise interest in its own financialstatements on finance provided by another group entity, even though at the consolidated financial statementslevel such intra-group interest must be eliminated, because the group as a whole has not incurred interest onthose borrowings. But where another group member borrows externally and lends to the constructionsubsidiary, any interest capitalised will remain on consolidation, subject to the overall limit that capitalisedborrowing costs cannot exceed the consolidated borrowing costs incurred.

IAS 23 gives quite specific rules regarding which period should be used to determine the finance costs to becapitalised. It states:



‘‘ The commencement date for capitalisation is the date when the entity first meets all of the followingconditions:

(a) it incurs expenditures for the asset;

(b) it incurs borrowing costs; and

(c) it undertakes activities that are necessary to prepare the asset for its intended use or sale.’’

[IAS 23 para 17].

Therefore, where borrowings have been incurred specifically to fund an asset’s construction, the costs of thoseborrowings cannot be capitalised in the period before the commencement of the activities necessary to get theasset ready for use. Whilst these activities would often coincide with the commencement of the asset’s physicalconstruction, they also encompass more than the asset’s physical construction. They include technical andadministrative work prior to the commencement of physical construction, for example drawing up site plansand obtaining planning permission. However, they exclude holding the asset when no production ordevelopment that changes the asset’s condition is being undertaken. For example, borrowing costs incurredwhile land acquired for building purposes is held without any development activity taking place do not qualifyfor capitalisation. [IAS 23 para 19]. Case 8.J relates to this.

Case 8.J – Period of capitalisation

Entity A has purchased a piece of land formerly used for agricultural purposes in order to construct a new factory.Entity A has applied to the local authorities for permission to change the use of the land from agricultural to

industrial. The process is expected to last six months, but entity A’s management are confident approval will be givenas the new factory will bring 1,000 new jobs to the area.

Entity A has financed the purchase of the land with a bank loan, which will be repaid over seven years.

The application to the local authorities for the change in use of the land is an activity necessary to prepare the asset forits intended use. Entity A, therefore, capitalises borrowing costs in respect of the loan used to finance the land’s

purchase while local authority approval is awaited.

This conclusion relies on the expectation that the local authorities will approve the change in use of the land. If entityA was to become aware during the approval process that approval is unlikely to be given, it should cease capitalisingborrowing costs and test the asset for impairment.

IAS 23 also states that ‘‘An entity shall suspend capitalisation of borrowing costs during extended periods inwhich it suspends active development of a qualifying asset’’. [IAS 23 para 20]. The standard explains thatborrowing costs may be incurred during an extended period in which activities necessary to prepare an assetfor its intended use are interrupted. It states that such costs do not qualify for capitalisation. However, it statesthat capitalisation is not normally suspended during a period when substantial technical and administrativework is being carried out. Capitalisation is also not suspended when a temporary delay is a necessary part ofthe process of getting an asset ready for its intended use. An example given in the standard is an extendedperiod during which high water levels delay construction of a bridge, where such high water levels are commonduring the construction period in the geographic region involved. [IAS 23 para 21].

Government grants

The carrying amount of assets may be reduced by the amount of government grants. [IAS 16 para 28].Government grants are dealt with in IAS 20, ‘Accounting for government grants and disclosure of governmentassistance’. IAS 20 is discussed in chapter 15.

Exchanges of assets

An item of PPE may be acquired in exchange for another non-monetary asset or for a combination of non-monetary and monetary assets. The cost of such an acquired item is measured at fair value unless:

& the exchange transaction has no commercial substance; or

& the fair value of neither the asset received nor the asset given up can be reliably measured.



This applies even if the entity cannot immediately derecognise the asset given up. ‘Fair value’ is defined inIAS 16 as ‘‘. . . the amount for which an asset could be exchanged between knowledgeable, willing parties in anarm’s length transaction’’ (see para 16.193). [IAS 16 para 6]. If the acquired item is not measured at fair value(because, for example, one or both of the two exceptions described above apply) it is measured at the carryingamount of the asset given up. [IAS 16 para 24]. ‘Carrying amount’ is defined in IAS 16 as ‘‘. . .the amount atwhich an asset is recognised after deducting any accumulated depreciation and accumulated impairment losses’’.[IAS 16 para 6].

The standard notes that the result of the above analysis may be clear without the entity having to performdetailed calculations. [IAS 16 para 25]. This will often be the situation where similar assets are exchanged or anasset is sold for an equity interest in a similar asset. If essentially the company is in the same position as it wasbefore the transaction and no material change has taken place in its net assets, no gain or loss is recognised onthe transaction and the cost of the new asset is the carrying amount of the asset given up. However, the fairvalue of the asset received may provide evidence of impairment in the asset given up and in such a case thevalue assigned to the new asset should be written down. Effectively in such a situation, the fair value of theasset received is used to identify a pre-existing impairment of the asset given up. But as the exchangetransaction itself lacks commercial substance, the new asset is recorded at the (adjusted) carrying amount ofthe asset given up, albeit that that amount is now the same as the fair value of the asset received. An example isgiven in case 8.K.

Case 8.K – Exchange of assets that lack commercial substance

Entity A exchanges car X with a book value of C13,000 and a fair value of C13,250 for cash of C150 and car Y which

has a fair value of C13,100. The transaction lacks commercial substance as the company’s cash flows are not expectedto change as a result of the exchange; it is in the same position as it was before the transaction.

The entity recognises the assets received at the book value of car X. Therefore, it recognises cash of C150 and car Y asproperty, plant and equipment with a carrying value of C12,850.

Where there are no comparable market transactions, the fair value of either the asset given up or the assetreceived can still be reliably measured if:

& the range of reasonable estimates of fair value does not vary significantly, that is if the range isreasonably narrow; or

& if the range itself is not narrow, the probabilities of the various estimates within the range can bereasonably assessed and used in estimating fair values.

Where both the fair value of the asset given up and the fair value of the asset received can be estimated withequal reliability, the fair value of the asset given up is used to measure the cost of the asset received. However,if the fair value of the asset received can be measured with more reliability, that value is used. [IAS 16 para 26].

8.4 Subsequent measurement

Introduction

After initial recognition IAS 16 permits an entity to adopt either the cost model or the revaluation model. Theadopted policy should be applied to the whole of a class of property, plant and equipment and not merely toindividual assets within a class. [IAS 16 para 29].

The cost model requires that PPE should be carried at cost less accumulated depreciation and accumulatedimpairment losses. [IAS 16 para 30]. The revaluation model requires that, subsequent to initial recognition,PPE whose fair value can be reliably measured should be carried at a revalued amount, being fair value at thedate of revaluation, less any subsequent accumulated depreciation and any subsequent accumulatedimpairment losses. Revaluations should be carried out with sufficient regularity that the carrying amount doesnot differ materially from that which would be determined using fair value at the end of the reporting period.[IAS 16 para 31].



Class of assets

IAS 16 requires that if a single item of PPE is revalued, then the entire class of PPE to which that item belongsshould be revalued, although the policy need not be applied to all classes of property, plant and equipment.[IAS 16 para 36]. This reduces the scope for picking out individual assets for revaluation, just because theyhappen to have significantly increased in value. However, this requirement means that adopting a policy ofrevaluation may be more onerous and involve more complex record keeping than before.

However, for valuation purposes, an entity may adopt classes of assets narrower than, say, land and buildingsand plant and machinery, provided that they meet the following definition: ‘‘. . .a grouping of assets of a similarnature and use in an entity’s operations’’. [IAS 16 para 37].

Other than ruling out classes of assets determined on a geographical basis, this definition is reasonably flexible,so that an entity can adopt meaningful classes that are appropriate to the type of business and assets held byan entity. However, separate disclosures must be made for each class of assets. For example, each class ofassets must be presented as a separate category in the table of movements in property, plant and equipment inthe notes to the financial statements. [IAS 16 para 73]. In practice, this effectively prevents the adoption ofmany narrowly defined classes of assets. Cases 8.L and 8.M illustrate.

Examples of classes of assets given in IAS 16 are:

& Land.

& Land and buildings.

& Machinery.

& Ships.

& Aircraft.

& Motor vehicles.

& Furniture and fittings.

& Office equipment.

[IAS 16 para 37].

Case 8.L – Revaluation on a class-by-class basis

Entity A is a large manufacturing group. It owns a considerable number of industrial buildings, such as factories andwarehouses and office buildings in several capital cities. The industrial buildings are located in industrial zones,

whereas the office buildings are in central business districts of the cities. Entity A’s management want to apply theIAS 16 revaluation model to the subsequent measurement of the office buildings but continue to apply the historicalcost model to the industrial buildings. Is this acceptable under IAS 16, ‘Property, plant and equipment’?

Entity A’s management can apply the revaluation model to just the office buildings. The office buildings can be clearly

distinguished from the industrial buildings in terms of their function, their nature and their general location. IAS 16permits assets to be revalued on a class-by-class basis. [IAS 16 para 36]. The different characteristics of the buildingsenable them to be classified as different PPE classes. The different measurement models can, therefore, be applied to

these classes for subsequent measurement. All properties within the class of office buildings must, therefore, be carriedat revalued amount. Separate disclosure of the two classes must be given. [IAS 16 para 73].

Case 8.M – Implications of valuing fixed assets on an acquisition

Entity A is acquiring entity B, which has fixed assets that are a similar class of fixed assets to those already owned byentity A. Generally, where fixed assets are revalued, all the assets of that class have to be revalued. Does this mean thatwhen the company fair values the acquired subsidiary’s fixed assets, it is required to revalue its own fixed assets that

are in the same class?

The fair value on acquisition is cost to the group of the fixed assets acquired, so no revaluation has taken place from agroup perspective. Therefore, the existing tangible fixed assets of the same class held by the group do not need to berevalued (assuming that the group does not have a policy of revaluing its fixed assets).



Frequency of revaluations

One of the requirements of IAS 16 is that valuations should remain up-to-date, as old valuations that do notreflect current values have little meaning. IAS 16 does not specifically require valuations to be performed everyyear. Instead, it lays down the general principle that revaluations should be made with sufficient regularity thatthe carrying amount does not differ materially from that which would be determined using fair value at theend of the reporting period. [IAS 16 para 31]. This imposes no specific time interval for valuations.

The frequency of revaluations, therefore, depends on movements in the fair value. Where the fair value of arevalued item of PPE at the balance sheet date differs materially from its carrying amount, a furtherrevaluation is necessary. Where fair values are volatile, such as is often the case with land and buildings,frequent revaluations may be necessary. The standard suggests that annual revaluations may be needed.Where movements in fair value are small, revaluations every three or five years may be sufficient. [IAS 16para 34].

A material change in value might be defined as one that would reasonably influence the decisions of a user ofthe financial statements. It is a matter of judgement, which is ultimately the responsibility of management.However, in making that judgement, management would probably consult their valuers and consider, amongother things, factors such as changes in the general market, the condition of the asset, changes to the asset andits location. In coming to their decision, management should consider the combined effect of all the relevantfactors, as it is possible that the effect of one factor may be offset by other factors.

Clearly, management needs to have a process by which it can monitor the movements in fair value each year,even if this does not amount to a full annual revaluation. This process may take the form of obtaininginformation on general fair value movements from, and consultation with, valuers on an annual basis. Assetsin a class may be revalued on a rolling basis, provided that the revaluation is completed within a short periodof time and that the revaluations are kept up to date. [IAS 16 para 38].

Valuers

Valuation of land and buildings is normally undertaken by a professionally qualified valuers. [IAS 16 para 32].That is, a person who:

& Holds a recognised and relevant professional qualification.

& Has recent relevant post-qualification experience.

& Has sufficient knowledge of the state of the market in the location and category of the asset being valued.

Normally, valuers would be independent of the entity (external valuers), but internal valuers might also beused. For example, an entity might have a policy of commissioning external valuations every three years, witha review by internal valuers each year. An internal valuer would normally be a director, officer or employee ofthe entity. By contrast an external valuer should not be a director, officer or employee of the entity, nor have asignificant financial interest in the entity.

Bases of valuation

Under IAS 16, if a policy of revaluation is adopted, the basis of valuation used is ‘fair value’. Fair value isdefined in IAS 16 as ‘‘. . .the amount for which an asset could be exchanged between knowledgeable, willingparties in an arm’s length transaction’’. [IAS 16 para 6]. The fair value of land and buildings is usuallydetermined from market-based evidence by an appraisal that is normally undertaken by a qualified valuer (seefurther para 16.196 onwards). The fair value of plant and equipment is usually the market value of the itemdetermined by appraisal (but see further para 16.194 below). [IAS 16 para 32]. The International ValuationStandards Committee (IVSC) is a leading international authority on valuation methods to be adopted inrelation to IFRS and its guidance is referred to in the paragraphs that follow.

Market value will reflect the highest and best use of the asset, which will usually be its existing use but may befor some other use. For example, if an entity owns a plot of land in a city centre on which it has a warehouse,the site may have potential for residential development, meaning that its market value could be significantly



higher than its value as an industrial site (although the entity would have to incur costs, such as relocation orclosure costs, in order to realise that value).

Where there is no market-based evidence of fair value, because of the specialised nature of items of PPE andbecause the items are rarely sold except as part of a continuing business, they are valued using an income or areplacement cost approach. [IAS 16 para 33]. Second hand plant and equipment is rarely sold, other than aspart of a continuing business. When it is sold, it is often as a result of, say, a business closure or insolvency andthe market value achieved for the plant and equipment is often far below what its value would be in acontinuing operation. Therefore, plant and equipment will often be valued on a depreciated replacement costbasis.

The depreciated replacement cost (DRC) basis of valuation is used for specialised items of property, plant andequipment, as there is no means of ascertaining a market value for such assets. Such assets are rarely, if ever,sold on the open market except as part of a continuing business.

Specialised properties might include:

& Oil refineries and chemical works where, usually, the buildings are no more than housings or claddingsfor highly specialised plant.

& Power stations and dock installations.

& Properties of such construction, arrangement, size or specification that there would be no market (forsale to a single owner occupier for continuation of existing use) for the properties.

& Standard properties of abnormal size in particular geographic areas that are isolated or remote frommain business centres and which are located there for business or operational reasons, such that there isno market there for the properties.

& Schools, colleges and research establishments where there is no market for such properties from othercompeting organisations in the area.

& Hospitals, health centres and leisure centres where there is no competing market demand in the area.

& Museums, libraries and other similar public sector properties.

The method of calculating DRC described above is consistent with the present guidance given by the IVSC,which defines DRC as follows: ‘‘The current cost of reproduction or replacement of an asset less deductions forphysical deterioration and all relevant forms of obsolescence and optimisation’’. [GN 8 para 3.1]. Example 8.5illustrates.

Example 8.5 — Depreciated replacement cost (DRC)

PetroChina Company Limited – Report and Accounts – 31 December 2008

3 Summary of principal accounting policies (extract)

(f) Property, plant and equipment (extract)

Property, plant and equipment, including oil and gas properties (Note 3(g)), are recorded at cost less accumulateddepreciation, depletion and amortization. Cost represents the purchase price of the asset and other costs incurred tobring the asset into existing use. Subsequent to their initial recognition, property, plant and equipment are carried at

revalued amounts. Revaluations are performed by independent qualified valuers on a periodic basis.

In the intervening years between independent revaluations, the directors review the carrying values of the property,plant and equipment and adjustments are made if the carrying values differ materially from their respective fairvalues.

Increases in the carrying values arising from revaluations are credited to the revaluation reserve. Decreases in the

carrying values arising from revaluations are first offset against increases from earlier revaluations in respect of thesame assets and are thereafter charged to the consolidated statements of income. All other decreases in carryingvalues are charged to the consolidated statements of income. Any subsequent increases are credited to the

consolidated statements of income up to the respective amounts previously charged.

Revaluation surpluses realised through the depreciation or disposal of revalued assets are retained in the revaluationreserve and will not be available for offsetting against future revaluation losses.



17 Property, plant and equipment (extract)

A valuation of all of the Group’s property, plant and equipment, excluding oil and gas reserves, was carried outduring 1999 by independent valuers on a depreciated replacement cost basis. As at September 30, 2003, a revaluation

of the Group’s refining and chemical production equipment was undertaken by a firm of independent valuers, ChinaUnited Assets Appraiser Co., Ltd., in the PRC on a depreciated replacement cost basis. The revaluation surplus netof applicable deferred income taxes was credited to reserves in shareholders’ equity.

As at March 31, 2006, a revaluation of the Group’s oil and gas properties was undertaken by independent valuers,

China United Assets Appraiser Co., Ltd and China Enterprise Appraisals, on a depreciated replacement cost basis.The revaluation did not result in significant differences from their carrying values.

Treatment of accumulated depreciation when PPE is revalued

When an item of property, plant and equipment is revalued, IAS 16 requires that accumulated depreciation istreated in one of two ways:

& Eliminated against the gross carrying amount of the asset with the net amount restated to equal therevalued amount. This method is normally used for buildings.

& Restated proportionately with the change in the gross carrying amount of the asset such that the netbook value of the asset after revaluation equals its revalued amount. This method is often used where anasset is revalued using an index to its depreciated replacement cost (DRC).

[IAS 16 para 35].

The amount of the adjustment to accumulated depreciation forms part of the revaluation increase or decrease,which is dealt with as described under ‘Revaluation gains and losses’ below. [IAS 16 para 35].

The first method described above is the simple one of comparing the revalued amount with the net bookamount immediately before revaluation and accounting for the difference as described below under‘Revaluation gains and losses’. This method is illustrated by the following simple example:

Revaluation gains and losses

Under IAS 16 a revaluation surplus is credited to other comprehensive income (OCI), unless it reverses arevaluation decrease on the same asset previously recognised as an expense, where it should first be credited toprofit or loss to that extent. [IAS 16 para 39].

IAS 16 does not specify that where an asset has previously been revalued downwards and is subsequentlyrevalued upwards, the credit to profit and loss should be reduced by depreciation that would have beencharged had the asset not been revalued downwards in the past. However, in our view this would beappropriate; as if this were not done it would amount to writing back that depreciation to profit and loss. Thiswould be against the principle of IAS 16, which requires that the reversal of depreciation on the occasion of arevaluation should be taken to the revaluation surplus in reserves. This is shown in case 8.N.

Case 8.N – Recognition of revaluation gains and losses

Entity A has a policy of revaluing its property, plant and equipment. An asset cost C1,000 at the start of year 1. It hasa useful life of 10 years and is being depreciated on a straight-line basis to nil residual value. It was revalued

downwards at the end of year 1 to C850, which was assumed to be the asset’s recoverable amount. The loss onrevaluation in year 1 is recognised in the profit and loss account, because it is a fall in value below depreciatedhistorical cost.

At the end of the following year (year 2) market values had risen to C1,050. The revaluation gain and loss arerecognised as follows:



Year 1 Year 2

Cost/valuation brought forward 1,000 850Depreciation charge (opening balance divided by remaining useful economic life) (100) (94)

900 756

(Loss)/gain on revaluation — profit and loss (50) 44

Gain on revaluation — to revaluation surplus (reserves) – 250

Carrying amount carried forward 850 1,050

Of the C294 gain on revaluation in year 2, C44 is recognised in profit and loss. This reverses the C50 loss previouslyrecognised in the profit and loss account, adjusted for depreciation of C6 (that is, C50 divided by 9), which is theadditional depreciation charge that would have been recognised in year 2 had the opening balance been C900, that is,if the C50 loss had not been recognised in year 1.

Note that the adjustment to depreciation of C6 is also the difference between depreciation that would have beencharged of C100 (that is, C1,000 divided by 10) on the original cost of C1,000, and the depreciation actually charged

for the year of C94.

IAS 16 states that the revaluation surplus included in OCI may be transferred directly to retained earningswhen the surplus is realised (that is, usually when the asset is derecognised). The transfer is made throughreserves and is not made through the profit and loss account. [IAS 16 para 41].

The standard explains that the whole of a surplus relating to an asset may be transferred when the asset isretired from use or disposed of or the surplus may also be transferred as the asset is used by the entity, that isas the surplus is realised. In that case the amount transferred is the difference between depreciation based onthe asset’s revalued carrying amount and depreciation based on the asset’s original cost. This amount may,therefore, be transferred from revaluation surplus to retained earnings each year, by means of a reservetransfer. [IAS 16 para 41].

Under IAS 16 a revaluation decrease should be charged against any related revaluation surplus to the extentthat the decrease does not exceed the amount held in the revaluation surplus (that is, in reserves) in respect ofthat same asset. Any balance of the decrease should then be recognised as an expense in the profit and lossaccount. As a result a negative revaluation reserve cannot be created. [IAS 16 para 40]. Case 8.O illustrates.

Case 8.O – Treatment of a revaluation decrease

An item of PPE cost C100 and is depreciated over 10 years on a straight-line basis, with nil residual value. At the endof year 1 the asset is revalued to C135. The revaluation gain of C45 (C135 less C90 (that is, C100 less C10depreciation)) is recognised in other comprehensive income and accumulated in equity.

At the end of year 2, the asset’s value has fallen to C50. After depreciation for the year of C15 (C135 divided by 9),there is a revaluation loss of C70 (C120 — C50).

Under IAS 16 the revaluation loss of C70 is first matched against the previous surplus on the same asset contained inthe revaluation surplus in reserves. This amount is C45 and so C45 of the revaluation loss is charged against therevaluation surplus in reserves, with the balance of C25 being charged to profit and loss.

CCarrying amount at beginning of year 2 135Depreciation for year (15)

Carrying amount at end of year 2 just before revaluation 120Fall in value charged to revaluation surplus (45)

75

Fall in value charged to profit and loss account (25)

Carrying amount (revalued amount) at end of year 2 50

However, as explained above, IAS 16 permits a transfer to be made from the revaluation surplus to retained earningsas the asset is used and the surplus is realised. The surplus may be realised as the asset is depreciated. In this exampleC5 of the surplus would have been realised in year 2 (depreciation for the year of C15 less depreciation on the

historical cost amount C10). If this amount had been transferred to retained earnings the balance left on therevaluation surplus would be only C40. In that case the amount of the revaluation loss of C70 that could be chargedagainst the revaluation surplus would be only C40 and C30 would be charged to profit and loss.



8.5 Depreciation

Introduction

The section deals with depreciation. Impairment is covered in chapter 11. The objective of IAS 16’srequirement to depreciate property, plant and equipment is to reflect in operating profit the cost of use of theproperty, plant and equipment in the period.

IAS 16 states that the depreciable amount of an asset should be allocated on a systematic basis over its usefullife. The method of depreciation that is used should reflect the pattern in which the asset’s future economicbenefits are expected to be consumed by the entity. Depreciation charges should be recognised as an expenseunless they are included in the carrying amount of another asset. [IAS 16 paras 48, 50, 60].

Depreciation applies to all property, plant and equipment, whether held at historical cost or revalued amount,with two exceptions:

& Investment properties carried as a matter of policy at fair value (as opposed to those carried as a matterof policy at cost, as IAS 40 gives a choice) in accordance with IAS 40, ‘Investment property’, which is notdepreciated.

& Property, plant and equipment such as most types of land, where it can be demonstrated that the assethas an unlimited useful life.

Depreciation is defined in IAS 16 as: ‘‘. . .the systematic allocation of the depreciable amount of an asset over itsuseful life’’. [IAS 16 para 6].

The depreciable amount is defined as: ‘‘. . .the cost of an asset, or other amount substituted for cost, less itsresidual value’’. [IAS 16 para 6].

IAS 16 explains that depreciation is charged even if an asset that is held at cost less depreciation has a fairvalue in excess of that carrying amount, so long as the asset’s residual value does not exceed its carryingamount. Repairs and maintenance do not remove the need to depreciate an asset. [IAS 16 para 52].

Economic benefits are consumed mainly through the use of an asset. However, other factors, such as technicalobsolescence and wear and tear whilst an asset remains idle may reduce the economic benefits that might havebeen obtained from the asset. [IAS 16 para 56]. Another factor that might reduce the expected economicbenefits is a fall in demand for, or price of, the product produced by the asset.

Further guidance is given in IAS 16 about the factors to be taken into account when determining thedepreciation of an item of PPE, as follows:

& The asset’s expected use by the entity. This is the principal factor and is generally assessed by reference tothe asset’s expected capacity or physical output.

& The asset’s expected physical deterioration through use or the passing of time (that is, ‘wear and tear’),when the asset is both in use and idle. This will depend upon operational factors, such as the number ofshifts for which the asset is to be used and on how well the asset is maintained and repaired throughoutits life.

& Technical or commercial obsolescence. The asset itself or the product or service generated by the assetmay become commercially or technically obsolete by being superseded by new or more advancedproducts or production techniques. Similarly, changes in market demand may render an assetcommercially obsolete, for example changes in trends or competitor actions.

& Legal or similar limits on the asset’s use, for example the expiry of a patent, licence or lease.

[IAS 16 para 56].

Notably, IAS 16 does not mention an asset’s financing as a factor that should be taken into account whendetermining its depreciation and hence annuity depreciation, the profile of which might match the profile ofborrowing costs financing an asset, is not allowed.



Determining the useful life and residual value

Depreciation charged in a period is recognised in profit and loss as part of operating profit, unless it ispermitted to be included in the carrying amount of another asset. This will only occur when depreciation isincluded in inventory or work-in-progress as part of an allocation of overheads, in accordance with IAS 2,‘Inventories’, or IAS 11, ‘Construction contracts’, or when it forms part of the cost of another item of PPE.For example, a mining company may purchase earth-moving equipment for the purpose of excavating a newmine. The equipment is, therefore, a directly attributable cost of digging the mine and the equipment’sdepreciation charge should be capitalised as part of the mine’s cost. IAS 16 also gives as an exampledepreciation of property, plant and equipment used for development activities that may be included in the costof an intangible fixed asset that is recognised under IAS 38. [IAS 16 para 49]. An example of an accountingpolicy for self constructed assets that includes depreciation as part of the cost is example 8.2 above. Case 8.Palso illustrates.

Case 8.P – Depreciation charge absorbed in the production of another asset

Entity A manufactures car components for the automotive industry and uses self-made tools in its production process,depending on the model of the car in which the component will be used. Entity A’s customers, the car manufacturers,continually introduce new models or redesign existing models. Entity A must, therefore, continually develop new tools

for use in its production processes.

The costs of the tools developed are capitalised and depreciated over three years, the expected useful life of the tools.

Entity A has one factory in which all of its production takes place. 10% of this factory is used for the development andconstruction of the tools. The building is depreciated using the straight-line method.

The entity should include 10% of the factory depreciation charge in the costs of the tools, which are capitalised anddepreciated. The factory’s depreciation charge is part of the cost of producing the tools.

Useful life is defined in IAS 16 as either:

‘‘(a) . . . the period over which an asset is expected to be available for use by an entity; or

(b) the number of production or similar units expected to be obtained from the asset by an entity.’’

[IAS 16 para 6].

Generally, the former of these two will apply, as in most cases it is more straightforward to assess useful livesby reference to time periods. However, for some types of asset, usage may be a more reliable measurement.For example, a machine may have the capacity to produce 100,000 units before it wears out. In that case theuseful life may be set at 100,000 units. However, if the same machine can produce 20,000 units per year and isexpected to operate at its full capacity, a useful life of five years might be used instead.

The definition includes the phrase ‘expected to be available for use’. Thus, it is clear that the useful life includesany period after acquisition when the asset is capable of operating in the manner intended by management,but has not yet been brought into use.

It is also clear from the definition that the end of the asset’s useful life is not necessarily the end of its physicallife. This is because the useful life is the period when the asset is used by the entity. If the entity buys an assetfor C100 that has a physical life of ten years, but the entity intends to use the asset for only six years, the usefullife that the entity assigns to the asset will be six years and not ten years.

If an entity intends to hold an asset for the asset’s whole physical life, then the asset would only be good forscrap, that is, it will have nil or a negligible residual value. However, as mentioned above, the useful life of atangible fixed asset to an entity may be less than the asset’s total physical life, in which case the value of theasset at the end of that life will reflect the asset’s remaining economic life. This may occur because the asset hasan alternative use at the end of the useful life to the entity, or because it is the entity’s policy to dispose of itsassets before they reach the end of their physical lives. The estimate of the useful life of an asset is a matter ofjudgement, based on experience with similar assets. [IAS 16 para 57].

For depreciation purposes land and buildings are treated as separate assets. With some exceptions, such asquarries and landfill sites, land normally has an unlimited useful life and is, therefore, not depreciated.



Buildings, however, have a limited useful life and are, therefore, depreciable assets. An increase in the value ofland does not affect the determination of the depreciable amount of a building nor remove the need fordepreciation to be charged on the building. [IAS 16 para 58].

Where a land asset includes the costs of site dismantling, removal and restoration, the restoration cost part ofthe land asset is depreciated over the period during which the economic benefits from incurring those costs areobtained. In some situations the land itself may have a limited useful life in which case it is depreciated overthat useful life. [IAS 16 para 59]. An example might be a landfill site that has to be restored. The costs of theobligation to restore the site might be depreciated over the period during which refuse is dumped in the site.The site itself might have a limited useful life to the landfill site operator and its residual value might beconsiderably less than its original cost. In that case the cost of the land would also be depreciated over the lifeof the site to its residual value. Cases 8.Q and 8.R illustrate the timing of depreciation.

Case 8.Q – Depreciation charged over useful life

Entity A has a policy of not providing for depreciation on property, plant and equipment capitalised in the year untilthe following year, but provides for a full year’s depreciation in the year of disposal of an asset. Is this acceptable?

This is not acceptable as the requirement of IAS 16 is to allocate the depreciable amount of a tangible fixed asset on a

systematic basis over its useful life. The depreciation method should reflect the pattern in which the asset’s futureeconomic benefits are expected to be consumed by the entity. Useful life means the period over which the asset isexpected to be available for use by the entity. This means that depreciation should commence as soon as the asset is

acquired and is available for use.

Case 8.R – Depreciation charged from when an asset is ready for use

Entity B constructs a machine for its own use. Construction is completed on 1 November 20X6 but the company does

not begin using the machine until 1 March 20X7.

The entity should begin charging depreciation from the date the machine is ready for use, that is 1 November 20X6.The fact that the machine was not used for a period after it was ready to be used is not relevant in considering when tobegin charging depreciation.

Depreciation ceases when an asset is derecognised. Therefore, depreciation does not stop when an asset is idle.[IAS 16 para 55]. However, depreciation will cease to be charged where the asset is classified as held-for-saleunder IFRS 5. This would be where the asset is available for immediate sale in its present condition and theother conditions in IFRS 5 have been complied with (see further chapter 3). The standard notes that if theunits of production method of depreciation is used the depreciation charge may be nil when there is noproduction (although consideration would still need to be given to other factors such as technical orcommercial obsolescence that might lead to a need for an impairment write down).

IAS 16 requires that the useful lives of property, plant and equipment should be reviewed at least at each yearend and, if expectations are different from previous estimates, the change should be accounted for as a changein estimate in accordance with IAS 8, ‘Accounting policies, changes in accounting estimates and errors’.[IAS 16 para 51]. IAS 8 requires that the effect of a change in estimated useful life should be accounted for byadjusting the depreciation charge for the current period insofar as the change affects the current period and byadjusting the charge for future periods to the extent that it affects the future periods. Case 8.S and example 8.6illustrate.

Case 8.S – Change in estimate of useful life

Entity A purchased an asset on 1 January 20X0 for C100,000 and the asset had an estimated useful life of 10 years and

a residual value of nil. The entity has charged depreciation using the straight-line method at C10,000 per annum. On 1January 20X4, when the asset’s net book value is C60,000, the directors review the estimated life and decide that theasset will probably be useful for a further four years and, therefore, the total life is revised to eight years. The company

should amend the annual provision for depreciation to charge the unamortised cost (namely, C60,000) over therevised remaining life of four years. Consequently, it should charge depreciation for the next four years at C15,000 perannum.



Example 8.6 – Change in estimate of useful life

British Airways plc – Annual report and Accounts – 31 March 2008

Notes (extract)

14 Property, plant and equipment

c Depreciation

Fleets are generally depreciated over periods ranging from 18 to 25 years after making allowance for estimated

residual values. Effective annual depreciation rates resulting from those methods are shown in the following table:

GroupPer cent 2008 2007

Boeing 747- 400 and 777 – 200 3.7 3.7Boeing 767 – 300 4.8 4.9Boeing 757 – 200 4.4 4.4

Airbus A321, A320, A319, Boeing 737 – 400 4.9 4.9

For engines maintained under ‘Power-by-the-hour’ contracts, the depreciation lives and residuals are the same as forthe aircraft fleets to which the engines relate. For all other engines, the engine core is depreciated to residual valueover the average remaining life of the related fleet.

Major overhaul expenditure is depreciated over periods ranging from 54 to 78 months, according to engine type.During the year, the Group changed the depreciation period for the RB211 engine, used on Boeing 747 and 767 fleets,from 54 months to 78 months. The change resulted in a £32.5 million decrease in annual depreciation charge for this

engine type.

Property, apart from freehold land, is depreciated over its expected useful life subject to a maximum of 50 years.Equipment is depreciated over periods ranging from four to 20 years, according to the type of equipment.

The entity’s repair and maintenance policy may also affect an asset’s useful life. Depending on the repairs andmaintenance policy, there may be subsequent costs being capitalised (as they meet the recognition criteria ofIAS 16) or components may be replaced, thus extending the asset’s useful life or increasing its residual value.The adoption of such a repairs and maintenance policy does not negate the need to charge depreciation.[IAS 16 para 52].

Residual value is defined in IAS 16 as ‘‘. . . the estimated amount that an entity would currently obtain fromdisposal of the asset, after deducting the estimated costs of disposal, if the asset were already of the age and in thecondition expected at the end of its useful life’’. [IAS 16 para 6]. IAS 16 requires residual values to be based onprices current at the balance sheet date, that is the residual value takes account of price changes up to that date(but not future expected price changes). The standard explains that the depreciable amount of an asset isdetermined after deducting its residual value and states that in practice the residual value is often insignificantand, therefore, is immaterial to the calculation of the depreciable amount. [IAS 16 para 53].

Residual values are estimated for an asset as if it were of the age and in the condition expected at the end of itsuseful life.

IAS 16 requires that residual values should be reviewed at least at each year end. [IAS 16 para 51]. Reviews ofresidual value would take account, for example, of reasonably expected technological changes, and of pricechanges and inflation since the last balance sheet date. If expectations differ from previous estimates thechanges should be accounted for in the same way as changes in useful lives, that is as a change in accountingestimate in accordance with IAS 8. IAS 8 requires that any change in the estimate of residual value should beaccounted for by adjusting the depreciation rate for current and future periods. However, if, and to the extentthat, the asset has been impaired at the balance sheet date the impairment should be charged to profit and lossaccount immediately. Revision of reidual value is illustrated as case 8.T An example of a company that haschanged both useful lives and residual values is given in example 8.7.



Example 8.7 – Change in residual value

TUI AG – Annual report and Accounts – 31 December 2008

Accounting principles (extract)

Moreover, the level of depreciation is determined by the residual amounts recoverable at the end of the useful life ofan asset. While the residual value of a container ship is determined in particular on the basis of its scrap value, theresidual value assumed for cruise ships and their hotel complexes amounts to 30% of the acquisition costs. The

determination of the depreciation of aircraft fuselages, aircraft engines and spare parts in first-time recognition isbased on a residual value of 20% of the cost of acquisition.

Both the useful lives and assumed residual values are reviewed on an annual basis in the framework of the

preparation of the annual financial statements. The review of the residual values is based on comparable assets at theend of their useful lives as at the current point in time. Any adjustments required are effected as a correction ofdepreciation over the remaining useful life of the asset. The restatement of depreciation is effected retrospectively forthe entire financial year in which the review has taken place. Where the review results in an increase in the residual

value so that it exceeds the remaining net carrying amount of the asset, depreciation is suspended. In this case, theamounts are not written back.

Any losses in value expected to be permanent and going beyond wear-and-tear depreciation are taken into account by

means of the recognition of impairment losses. If there are any indications of impairment, the carrying value of anasset is compared with the recoverable amount in the framework of the impairment test required in that case. Therecoverable amount is the higher of an asset’s fair value less costs to sell and the value of future payment flowsattributable to the asset (value in use).

Case 8.T – Revising the residual value of an asset

An asset is bought for C1,000. Its estimated useful life is 6 years. Its estimated residual value at the date of acquisition

was C70 and this estimate has not changed up to year 3, because there has been no significant inflationary or otherprice changes . However, the rate of inflation is now expected to increase and at the end of year 4 the estimatedresidual value, based on prices at the end of year 4 is C130. If future inflation is taken into account, the estimated

residual value at the end of the asset’s useful life is estimated at C400. At the end of year 3 the asset has a carryingamount of C535, calculated as follows:

C

Cost 1,000Residual value 70

Depreciable amount 930

Depreciation (465) (3 years at C155 per year)

Carrying amount 535

In year 4, the residual value is revised to C130. The depreciable amount of the asset becomes C870. Deducting the

depreciation charged to date of C465 leaves C405 to be depreciated over the remaining useful life of three years.Therefore, depreciation of C135 is charged in year 4.

If future inflation had been taken into account in year 4 the depreciable amount would have been C600 and after

deducting depreciation to date of C465 the charge would have been C45 only. However, this treatment is notpermitted by the standard.

The standard’s treatment will, however, ensure that by the end of the asset’s useful life the total depreciation chargedwill normally be the same as that which would have been charged had future inflation been taken into account. This is

because in years 5 and 6 the residual value will be revised so that at the end of year 6, if expectations hold true, therevised residual value will be C400. Assuming that all the future inflation effect occurs in year 5, for example, thecalculation of depreciation in year 5 will be.



CCost 1,000Residual value 400

Depreciable amount 600Depreciation to year 5 600

Depreciation in years 5 and 6 Nil

(The example has been deliberately exaggerated as it is unlikely that inflation between years 4 and 5 would be so highas to increase the residual value to C400, but the same effect may well occur over an extended period of time.)

As can be seen from this example the depreciation charged in years 1 to 4 has been adequate to write the asset down to

its residual value as expressed in terms of prices at the end of years 5 and 6. However the charge for depreciation hasnot been evenly spread because in each year residual values and, therefore, the depreciation charge is based on residualvalues expressed in C currency current at the balance sheet date. The charge for depreciation over the 6 years is,therefore, as follows. For comparison purposes the charge as it would have been had future inflation been taken into

account is also shown.

IAS 16 Future inflation assumed

C C

Year 1 155 100Year 2 155 100Year 3 155 100Year 4 135 100

Year 5 Nil 100Year 6 Nil 100

Total 600 600

As may be suspected from the above case 8.T there will be occasions where the depreciation charge in earlieryears will actually in aggregate exceed the depreciable amount of the asset in future years if the depreciableamount falls because residual value increases. IAS 16 foresees this possibility. It states that the residual valueof an asset may increase to an amount that is equal to or greater than the asset’s carrying amount. If it does,the depreciation charge on the asset is zero, unless the residual value of the asset subsequently falls below thecarrying amount of the asset. [IAS 16 para 54].

Methods of depreciation

IAS 16 notes that there is a variety of acceptable depreciation methods. Management should select the methodregarded as most appropriate, based on the expected pattern of consumption of future economic benefits, soas to allocate depreciation on a systematic basis over the asset’s useful life. [IAS 16 para 62]. This sectiondescribes some of the most common methods.

The method chosen should result in a depreciation charge throughout the asset’s useful life and not justtowards the end of its useful life or when the asset is falling in value. Therefore, it is not acceptable just todepreciate a leasehold property, mine or landfill site in, say, the last 20 years of its useful life. This is becausethe asset is being used throughout the whole useful life and the allocation of depreciation should reflect this.

Straight-line method

This is the most common method in practice. The cost (or revalued amount) less the estimated residual value isallocated over the useful life so as to charge each accounting period on a systematic basis over the asset’suseful life.

Diminishing balance method

This method is designed to charge higher amounts of depreciation in the earlier years of an asset’s use, as incase 8.U which assumes no residual value.



Case 8.U – Depreciation charged using the diminishing balance method

C

Cost 125Depreciation charge (20%) 25

Carrying amount at end of year 1 100

Depreciation charge (20% of 100) 20

Carrying amount at end of year 2 80Depreciation charge (20% of 80) 16

Carrying amount at end of year 3 64

and so on

This method is appropriate when the economic benefits of an asset decline as they become older, for examplebecause the asset becomes less reliable and more likely to break-down, less capable of producing a high-qualityproduct or less technologically advanced.

Sum of the digits (or ‘rule of 78’)

This method is not mentioned in IAS 16, but is similar in its effect to the reducing balance method althoughthe mechanics are different. If an asset is expected to last, say, 12 periods (years, months, etc), the digits 1 to 12are added (total 78); the first period is charged with 12/78, the next period with 11/78 and so on — hence thename ‘rule of 78’.

Sum of the units (unit of production) method

This method relates depreciation to the asset’s estimated use or output. The rate of depreciation per hour ofusage or unit of production is given by dividing the depreciable amount by the asset’s estimated total servicecapability, measured in terms of hours or units. This method is sometimes employed when the asset’s usagevaries considerably from period to period because, in these circumstances, it matches cost against revenuemore satisfactorily. Examples of the types of asset that are often depreciated in this way are: for hourly rates— airline engines; and for unit of production — landfill sites.

Case 8.V illustrates the determination of the appropriate method.

Case 8.V – Determining appropriate depreciation method

Entity B manufactures industrial chemicals and uses blending machines in the production process. The output of theblending machines is consistent from year to year and they can be used for different products. However, maintenance

costs increase from year to year and a new generation of machines with significant improvements over existingmachines is available every five years.

Management should determine the depreciation method based on production output. The straight-line depreciationmethod should be adopted, because the production output is consistent from year to year.

Factors such as maintenance costs or technical obsolescence should be considered in determining theblending machines’ useful life.

The depreciation method applied to an asset should be reviewed at least at each year end and, if there has beena significant change in the expected pattern of consumption of the asset’s future economic benefits, the methodshould be changed to reflect the changed pattern. Any such change in method should be accounted for as achange in accounting estimate in accordance with IAS 8. IAS 8 requires that the effect of a change in themethod of depreciation should be accounted for by adjusting the depreciation charge for the current periodinsofar as the change affects the current period and by adjusting the charge for future periods to the extent thatit affects the future periods. [IAS 16 para 61].

Consequently, in case 8.S (but assuming that the life remains as ten years) the company may decide that, from1 January 20X4, the sum-of-the-digits method of calculation would give a fairer presentation than the straight-line method. If so, the depreciation charge for 20X4 would be C17,143 (namely, C60,000 6 6/6+5+4+3+2+1), because the asset still has a remaining useful life of six years.



Depreciation of revalued assets

With the exception of investment properties, depreciation is required by IAS 16 to be charged on revaluedproperty, plant and equipment. How to apply the rules for revalued assets is described in the followingparagraphs.

Where an entity has revalued an item of property, plant and equipment that value (rather than the historicalcost) is the starting point for determining the amount at which it discloses that asset in its financial statements.Accordingly, in determining the amount to be written off systematically over an item of property, plant andequipment’s useful life, an entity must have regard to the asset’s value determined according to the latestvaluation rather than to its historical cost.

Ideally, the asset’s average value for the period should be used as the basis for calculating the year’sdepreciation charge, but in practice, as IAS 16 is silent on this issue, either the opening or closing balance maybe used instead, provided that it is used consistently in each period. It is common to use the opening balance,together with the cost of subsequent additions, for determining the current year’s depreciation charge, whichavoids the need to recalculate depreciation charged in the earlier part of the year, used, for example in interimreports. On this basis some might argue that until the year end valuation ‘the most recently determined value’would be the valuation carried out at the last year end and if depreciation is deemed to accrue evenly over theasset’s life, depreciation should be charged on that opening value plus additions throughout the year until thenext valuation at the year end. An issue would arise where there is a material change arising from therevaluation.

IAS 16 requires that where an entity revalues assets, and gives effect to the revaluation in its financialstatements, the depreciation charge should be recognised as an expense. [IAS 16 para 48]. No depreciationpreviously charged should be written back to profit and loss on revaluation of an asset. IAS 16 states also thata depreciation charge is made even if the value of an asset exceeds its carrying amount. [IAS 16 para 52].

Consequently, it is clear that IAS 16 requires an entity to charge depreciation based on the revalued amount tothe profit and loss account. Despite this, where a company properly charges the whole of the depreciationbased on the revalued assets to the profit and loss account, it may also transfer an amount equal to the excessdepreciation from the revaluation reserve to retained earnings.

Component depreciation

IAS 16 requires that each part of an item of property, plant and equipment that has a cost that is significantwhen compared to the total cost of the item, should be depreciated separately. [IAS 16 para 43]. As explainedin section 8.2, the standard requires the amount initially recognised for an item of PPE to be allocated to itssignificant parts, which must then be depreciated separately. (This may be contrasted with land and buildings,which the standard states are separate assets for depreciation purposes rather than separate parts of the sameasset. [IAS 16 para 58].) IAS 16 states that one example of parts of an asset that may be appropriate todepreciate separately might be the airframe and engines of an aircraft, whether owned or subject to a financelease. Another example in IAS 16 explains that where an entity is the lessor of property, plant and equipmentsubject to an operating lease, it may be appropriate to depreciate separately amounts reflected in the cost ofthat item that are attributable to favourable or unfavourable lease terms relative to market terms. [IAS 16para 44]. Another example of a significant part that may require separate identification for depreciationpurposes is the lining of a furnace that needs replacement at regular intervals such that the lining and thefurnace have substantially different lives. A further example might be the element of the cost of an asset that isattributed to periodic major inspection or overhaul costs. There is, therefore, a need for entities to reviewwhether or not an asset has significant parts. If it decides it has, then the significant parts should be depreciatedindividually, unless the exception described in the next paragraph applies.

Where significant parts of an item of property, plant and equipment have been separately identified inaccordance with the standard they should normally be depreciated separately. [IAS 16 para 43]. However,where one significant part has a useful life and a depreciation method that is the same as those of another partof that same item of property, plant and equipment, the two parts may be grouped together for depreciationpurposes. [IAS 16 para 45].

Given the size and complexity it is not clear how the infrastructure asset (that is, the underground network ofpipes) should be allocated to its significant parts. However, it is clear from IAS 16 that an infrastructure asset



cannot be accounted for as one asset. The asset must be allocated to its significant parts – even if thedepreciation charges for each part are the same. The factors below provide guidance on how to determine thesignificant parts of an infrastructure asset to arrive at a reasonable allocation.

& The cost of the asset and materiality – The allocation of the asset to its ‘significant’ parts – hencemateriality of the cost of a part to the cost of the asset as a whole should be a guiding factor whendetermining significant parts. For example, a small length of pipe is unlikely to form a significantproportion of the cost of the overall infrastructure asset, and is, therefore, unlikely to represent asignificant part of the infrastructure asset as a whole.

& Management’s operational decisions – The way in which management makes operational decisions overwhether to, for example, replace rather than repair certain sections of the network will give someguidance in determining how the infrastructure asset can be broken down to its significant parts.

& Physical location of the asset – Certain geographical areas have differing characteristics, such aspopulation and soil type, which will impact on the asset’s useful life. For example, the higher thepopulation of an area the greater the traffic vibration impact will be on the network in that area. Somesoils are more corrosive than others – shortening the relative useful life of the network in a geographicalarea.

& Design and flow characteristics – certain parts of the network may have been designed to work together ina particular way that is different from other parts.

It may be that the companies can use other reasonable means of defining the significant parts in combinationwith those factors above.

Due to the size and complexity of the infrastructure asset it is not clear how to apply IAS 16 when determiningwhether the costs of replacing a part of the infrastructure asset should be written off as repairs andmaintenance rather than capitalised as part of the infrastructure asset.

IAS 16 recognises that the standard does not prescribe a unit of measure for recognition and that judgement isrequired. However IAS 16 does infer that materiality is a factor in determining whether an asset should berecognised. It refers to ‘major’ spare parts as qualifying for recognition and refers to ‘major’ inspection costsas being those that should be recognised – providing the recognition criteria are met. (The recognition criteriaare that both the cost of the item can be measured reliably and that it is probable that future economic benefitsassociated with the item will flow to the entity.)

It seems logical that the significant parts making up the infrastructure asset, rather than the infrastructureasset as a whole, should be used as a basis for determining the materiality of costs incurred on that part of thenetwork. Costs that are material to the cost of the related significant part of the asset should be capitalised,providing of course the recognition criteria are fulfilled. For example the cost of replacing 100m of pipe maynot be material to the network as a whole, but if it is material to the related significant part of the asset, say alocal distribution system, then the costs of replacement should be capitalised. The resulting asset will then bedepreciated along with the significant part to which it relates.

Non-depreciation of certain assets

One issue that has caused debate and variations in practice over many years is whether, in some circumstances,it is appropriate to omit annual charges for depreciation in respect of certain assets. The issue is generallydiscussed in the context of buildings. Case 8.V illustrates.

Case 8.V – Depreciation where residual value is the same as or close to original cost

A property costing C1m is bought in 20X6. Its estimated total physical life is 50 years. However, the companyconsiders it likely that it will sell the property after 20 years. The estimated residual value in 20 years’ time, based on20X6 prices, is (a) C1m, (b) C900,000. A residual value that is the same as or close to original cost is likely to be rare,

as it assumes that in 20 years’ time potential purchasers would pay, for a 20 year old property, an amount similar towhat they would pay for a new property.

In case (a), the company considers that the residual value, based on prices prevailing at the balance sheet date, willequal the cost. There is, therefore, no depreciable amount and depreciation is correctly zero.



In case (b) the company considers that the residual value, based on prices prevailing at the balance sheet date, will beC900,000 and the depreciable amount is, therefore, C100,000. Annual depreciation (on a straight line basis) will beC5,000 (1,000,000-900,000/20). Depending on the context, the annual depreciation charge of C5,000 may be

immaterial and it may, therefore, be acceptable not to provide for depreciation of the property on those grounds.However, expectations of future inflation levels may not be taken into account in estimating the residual value andwhether the depreciation is or is not material. It is also necessary to consider the materiality of the cumulative

depreciation as well as the depreciation in the year.

This example demonstrates two points mentioned above.

& The useful life is defined in terms of the present owner; therefore, 20 years rather than 50 years is the relevantperiod.

& Residual value is defined as being based on prices prevailing at the balance sheet date, that is, excluding theeffects of future inflation.

In case 8.V, maintaining the asset to a high standard was not assumed. Maintenance is of course one of thefactors that determines the estimated residual value and in practice is almost invariably quoted as the reasonwhy the residual value of particular assets is expected to be at least as high, in terms of prices prevailing at thebalance sheet date as the present carrying value. As explained below consideration should also be given towhether the asset is likely to suffer from technical and commercial obsolescence and whether, in practice, suchassets have been sold in the past for at least the expected residual value, based on prices prevailing at thebalance sheet date.

The useful life of an item of PPE cannot be extended without limit by maintenance. This is because thephysical life of an item other than non-depreciable land cannot be unlimited. At some point it will be moreeconomic to scrap the physical asset and replace it with a new one. On the other hand, for some, exceptional,assets the useful life may be extended to such a degree that any depreciation charge would be immaterial (forexample, heritage properties).

Expenditure (for example, repairs and maintenance) does not remove the need to charge depreciation. [IAS 16para 52]. Where costs subsequent to an asset’s initial recognition are capitalised in accordance with thestandard’s recognition criteria the revised carrying amount is then depreciated over the asset’s remaininguseful life. The circumstances in which such subsequent costs are capitalised are described under ‘Subsequentcosts’ above (see section 8.2). Case 8.W illustrates.

Case 8.W – Depreciation when replacement expenditures equal annual amortisation charge

An entity operates several hotels. The total carrying amount of hotel equipment such as bed linen, dishes etc, remainsconsistent from year to year.

All equipment is replaced every few years to ensure that high standards are maintained. Management has introduced arolling replacement programme such that the cost of replacement assets remains at a consistent level from year to

year.

Management is keen to reduce administration and proposes that it no longer depreciates the hotel equipment, butexpenses the cost of replacements each year.

The entity should capitalise all assets with useful lives of more than 1 year and depreciate them over their useful lives.Management could, for efficiency purposes, capitalise groups of similar assets as a single asset and then calculate

depreciation for those assets as if it they were a single asset.

Management should not, however, follow the proposed policy of expensing all replacement assets purchased duringthe year and not providing depreciation on the asset capitalised.

An example of a company that has changed the useful lives and is depreciating the balance of the assets overthe remaining useful life is given in example 8.6.

8.6 Derecognition of property, plant and equipment

An item of PPE should be derecognised when:



& It is disposed of.

& No future economic benefits are expected from its use or disposal.

[IAS 16 para 67].

IAS 16 requires that the gain or loss on derecognition (that is, on disposal or retirement from use) of an itemof PPE is the difference between the estimated net disposal proceeds and the carrying amount. [IAS 16para 71]. The consideration receivable is recognised at fair value. Therefore, if payment is deferred theconsideration is recognised at the cash price equivalent. The difference between this figure and the actualamounts receivable is treated as interest receivable under IAS 18 over the period of credit given. [IAS 16para 72]. The gain or loss on derecognition should be recognised as profit or loss for the period in whichderecognition occurs. [IAS 16 para 68]. The only exception is where IAS 17, ‘Leases’, requires a differenttreatment on a sale and leaseback. Gains on disposal should not be recognised as revenue. However, if anentity routinely sells items of property, plant, and equipment held for rental to others in the course of itsordinary activities, it must transfer these assets to inventories at their carrying amount when renting is ceasedand the assets become held for sale. The proceeds from this sale should be recognised as revenue in accordancewith IAS 18. IFRS 5, ‘Non-current assets held for sale and discontinued operations’, does not apply in thiscircumstance. [IAS 16 para 68A]. Where items of income and expense are material, the nature and amount ofthe item should be disclosed separately. IAS 1 (revised), ‘Presentation of financial statements’, gives disposalsof items of property, plant and equipment as an example of circumstances that may give rise to separatedisclosure of profits or losses. [IAS 1 (revised) paras 97, 98].

Where PPE in a class for which an entity has a policy of revaluation is disposed of, there is no requirement forthe entity to revalue the asset at the date of disposal, provided that revaluations are reasonably frequent. Anygain or loss arising on disposal would, therefore, be recognised in the income statement.

Disposals of PPE may occur in a variety of ways and the standard cites as examples disposals by sale, enteringinto a finance lease (as lessor) and by donation. The date of disposal is determined by using the criteria inIAS 18, ‘Revenue’ for recognising the sale of goods. IAS 18 is dealt with in chapter 15. IAS 17 applies todisposals by sale and leaseback and is dealt with in chapter 10. [IAS 16 para 69].

A significant part of an asset may have been identified in accordance with the standard’s recognition principles(see section 8.2). When such a part is replaced the carrying amount of the old part is derecognised regardless ofwhether it has been depreciated separately. If it is not practicable to determine the carrying amount of thereplaced part, the cost of the replacement may be used as a proxy. [IAS 16 para 70]. This amount andaccumulated depreciation calculated by reference to that cost is then eliminated from the balance sheet andany resulting loss on disposal is recognised in profit and loss.

Intended disposals of property, plant and equipment

IAS 16 excludes from its scope property, plant and equipment that is classified as held-for-sale in accordancewith IFRS 5, ‘Non-current assets held-for-sale and discontinued operations’. IFRS 5 is dealt with in chapter 3and the following paragraphs are a summary only of that standard’s requirements.

It is important to note that classification as held-for-sale under IFRS 5 and the exclusion from the scope ofIAS 16 applies only to assets that are to be sold. It does not apply to assets that are to be abandoned orscrapped. IFRS 5 specifically states that assets that are to be abandoned may not be classified as held-for-sale.This is because the carrying amount of such assets will be recovered principally from continued use. Suchassets include assets that are to be used to the end of their economic lives and assets that are to be closed ratherthan sold.

The conditions that must be met before an asset can be classified as held-for-sale under IFRS 5 are restrictive.It is, therefore, quite possible for management to have taken a decision to sell an asset but to be unable toclassify it as held-for-sale under IFRS 5, because all the conditions have not been met. In such a situation,management must continue to account for the asset in accordance with IAS 16 until the conditions in IFRS 5have been met. However, the asset may need to be reviewed for impairment under IAS 36, as a plan to disposeof an asset before the previously expected date is an impairment indicator mentioned in that standard. [IAS 36para 12(f)]. Assets that are to be abandoned rather than sold would also continue to be accounted for inaccordance with IAS 16 and reviewed for impairment.



Where the conditions are satisfied an entity presents the asset that is held-for-sale separately from other assetsin the balance sheet. It must disclose, either on the face of the balance sheet or in the notes, the major classes ofassets held-for-sale, for example land and buildings or plant and machinery. The prior period classification,however, is not adjusted, that is the assets are not shown separately in the prior period figures as held-for-sale.[IFRS 5 paras 38, 40].

Assets classified as held-for-sale are measured at the lower of their carrying amount and fair value less costs tosell. Any impairment loss on a write down to fair value less costs to sell (if required) is recognised at the pointwhen the asset is reclassified. Depreciation is not charged on assets classified as held-for-sale.

The income statement effect of reclassification, for example, recognition of impairment losses and of any gainor loss on subsequent sale, will depend on whether the asset forms part of ‘continuing’ or ‘discontinued’operations under IFRS 5. Discontinued operations and the classification of gains and losses relating to suchoperations are fully discussed in chapter 3.

8.7 Disclosures about PPE

The disclosure requirements in IAS 16 require a table that explains the movements in cost, or revalued amountand depreciation. However, IAS 16 requires disclosures to be given for each class of property, plant andequipment adopted, which may result in a large volume of disclosures, particularly where a revaluation policyhas been adopted.

IAS 16 requires the following disclosures for each class of PPE:

& The measurement bases (for example cost or revaluation) used for determining the gross carryingamounts.

& The depreciation methods used (for example, straight-line method or declining balance method).

& The useful lives or the depreciation rates used.

& The gross carrying amount (cost or revalued amount) at both the beginning and end of the period.

& The cumulative amount of provisions for depreciation (aggregated with accumulated impairment losses)at the beginning and end of the period.

& The depreciation for the period, whether recognised in profit or loss or as part of the cost of other assets.

& A reconciliation of the carrying amount at the beginning and end of the period, separately disclosing:

(a) Additions.

(b) Assets (or assets included in a disposal group) classified as held-for-sale under IFRS 5 and otherdisposals.

(c) Acquisitions through business combinations.

(d) Revaluation increases or decreases.

(e) Impairment losses recognised or reversed in other comprehensive income.

(f) Impairment losses recognised in the profit and loss account.

(g) Reversals of past impairment losses written back to the profit and loss account.

(h) Depreciation.

(i) Exchange differences arising on the retranslation of the financial statements of a foreign operation.

(j) Other changes.

& The carrying amount (that is the net book amount) at the beginning and end of the period.

[IAS 16 paras 73, 75].

The disclosures for items (a) to (j) above are required to be given for the current period and also for the priorperiod.



The financial statements should also disclose:

& The existence and amounts of restrictions on title and property, plant and equipment pledged as securityfor liabilities. Example 8.8 illustrates this disclosure.

& The amount of expenditure included in the carrying amount of property, plant and equipment in thecourse of construction.

& The amount of contractual commitments for the acquisition of property, plant and equipment. Example8.9 illustrates this disclosure.

& If not separately disclosed on the face of the income statement, the amount of compensation from thirdparties for items of property, plant and equipment that were impaired, lost or given up that is included inprofit or loss.

[IAS 16 para 74].

Example 8.8 – Restrictions on title and PPE pledged as security

Barloworld Limited – Report and Accounts – 30 September 2008

2. Property, plant and equipment (extract)

Net book value2008 2007 2006

Rm Rm Rm

Other disclosures (extract)

Net book value of encumbered property, plant and equipment (note 15) 1 058 1 793 2 475

15. Interest-bearing liabilities (extract)

Liabilities secured Net book value of assets encumbered

2008 2007 2006 2008 2007 2006

Included above are secured liabilities as follows Rm Rm Rm Rm Rm Rm

Secured liabilities

Secured loans

South African rand 105 60 4 135 50 3

Foreign currencies 39 968 1 763 76 959 1 881Liabilities under capitalised finance leases (note 30)

South African rand 512 372 504 481 353 448

Foreign currencies 432 505 546 444 552 1 253

Total secured liabilities 1 088 1 905 2 817 1 136 1 914 3 585

Assets encumbered are made up as follows:

Property, plant and equipment (note 2) 1 058 1 793 2 475Finance lease receivables (note 6) 1 008

Trade receivables (note 10) 78 121 102

1 136 1 914 3 585

Included in secured liabilities for 2006 are loans in the United Kingdom and United States amounting to R720million, which were secured by a charge over specific lease receivables under a securitisation transaction. Repaymentof the loans would have been made from cash received from the specific receivables subject to the securitisationtransaction amounting to R1 008 million as at 30 September 2006.



Example 8.9 – Disclosure of contractual commitments for the acquisition of property, plant and equipment

Novartis AG – Report and Accounts – 31 December 2008

8. PROPERTY, PLANT & EQUIPMENT MOVEMENTS (extract)

Total

USD millions

2008

Commitments for purchases of property, plant & equipment 674

2007

Commitments for purchases of property, plant & equipment 690

Disclosure of contractual commitments for the acquisition of property, plant and equipment

SAS AB – Report and Accounts – 31 December 2008

Note 13 Tangible fixed assets (extract)

Contractual purchase commitments

On the closing date the Group had the following commitments relating to future acquisition of tangible fixed assets.

2008 2007

Aircraft 3,411 1,139Other purchase commitments 49 46

Total 3,460 1,185

On the basis of external valuations, the SAS Group is of the opinion that the contractual future acquisitions are inline with expected market values.

Details of the nature and amount of a change in accounting estimate that has an effect in the current period oris expected to have an effect in future periods should be disclosed in accordance with IAS 8. Examples of suchchanges given in IAS 16 are changes in respect of:

& Residual values.

& Estimated cost of dismantling, removing or restoring property, plant and equipment.

& Useful lives.

& Depreciation methods.

[IAS 16 para 76].

Where items of property, plant and equipment are stated at revalued amounts, the following should also bedisclosed:

& The effective date of the revaluation.

& Whether an independent valuer was involved.

& The methods and significant assumptions used in estimating fair values.

& The extent to which fair values were determined directly by reference to observable prices in an activemarket or recent market transactions on an arm’s length basis or were estimated using other valuationtechniques.

& The carrying amount of each class of property, plant and equipment determined under the cost model(historical cost less depreciation measurement basis).

& The revaluation surplus, showing the change for the period and any restrictions on the distribution of thebalance to shareholders.



& The change in the revaluation surplus arising from a change in the liability for decommissioning,restoration or similar liabilities.

[IAS 16 para 77, IFRIC 1 para 6(d)].

IAS 16 suggests that users of financial statements may also find the following disclosures relevant to theirneeds. These disclosures are not required by the standard, but disclosure is encouraged, when relevant.

& Carrying amount of temporarily idle property, plant and equipment.

& Gross carrying amount of any fully depreciated property, plant and equipment that is still in use.

& Carrying amount of property, plant and equipment retired from active use and not classified as held-for-sale in accordance with IFRS 5.

& Where the cost model is used, the fair value of property, plant and equipment where this is materiallydifferent from the carrying amount.

[IAS 16 para 79].

8.8 Investment property

Introduction and definition

The classification of certain properties as ‘investment properties’ for financial reporting purposes arisesbecause it is argued that the characteristics of investment properties differ sufficiently from the characteristicsof owner occupied property that there is a need for a separate standard on investment property. In particular,the IASB believes that it is the current value of such properties and changes to those values that are relevant tousers of financial statements. [IAS 40 para B6].

IAS 40 is relatively wide in terms of its scope, since it does not limit its application to companies such asinvestment trusts and property investment companies, whose main or sole activity is the holding ofinvestments. Rather it also brings into its scope any investment properties held by companies whose mainactivity is other than investment holding and management.

The scope includes property held for capital appreciation or to earn rentals, where the property is owned bythe entity or held by it under a lease accounted for as a finance lease (see below). Therefore, its scope includesproperty leased out by the entity under an operating lease. It does not deal with other aspects of leasedproperty that are dealt with in IAS 17, ‘Leases’.

Investment property is defined in IAS 40 as:

‘‘Property (land or a building – or part of a building – or both) held (by the owner or by the lessee undera finance lease) to earn rentals or for capital appreciation or both, rather than for:

(a) use in the production or supply of goods or services or for administrative purposes; or

(b) sale in the ordinary course of business’’.

[IAS 40 para 5].

In addition, a property interest that is held by a lessee under an operating lease may be treated as aninvestment property if, and only if:

& The rest of the definition of investment property is met.

& The lessee uses the fair value model in IAS 40 (see below).

& The initial cost of a property interest held under an operating lease and classified as an investmentproperty should be treated as for a finance lease (see chapter 10), that is, the asset should be recognised atthe lower of the fair value of the property and the present value of the minimum lease payments.

[IAS 40 para 6; IAS 17 para 19].



The reason for this last condition, prescribed by IAS 17, ‘Leases’, is so that the amount shown under the fairvalue model reflects the full value of the property interest. If the asset were not treated as a finance lease, onlythe premium or prepaid rental amount would be revalued, rather than the present value of the total futurerentals and the result might not reflect the fair value of the property interest. It would also ensure that suchleases are accounted for consistently in the same manner as those investment properties held under financeleases such that different measurement bases are not used. [IAS 40 para BC 7]. Case 8.X illustrates.

Case 8.X – Recognition of an operating lease as investment property

An entity owns a hotel that it leases out (as lessor) under an operating lease to a hotel management group. The hotel issituated on land leased by the government to the entity (as lessee) for a period of 999 years with no transfer of title tothe entity at the end of the lease. The hotel building’s useful life is expected to be approximately 40 years. There are noprovisions in the lease to return the land with the building intact at the end of the 999 year lease.

In this situation, the land should be accounted for as operating lease under IAS 17 and can be recognised as aninvestment property only if it meets the definition of investment property and the entity has chosen the fair valuemodel for investment property. [IAS 40 para 6]. The building, however, meets the definition of investment propertyand should be accounted for under IAS 40. A building is recognised as an investment property if the lease of land

extends beyond the building’s expected useful life and there are no provisions in the lease to return the land with thebuilding intact.

Classification as an investment property of a property interest held by a lessee under an operating lease isavailable on a property-by-property basis. However, once this classification alternative is selected for one suchproperty interest held under an operating lease, all property classified as investment property (including ownedproperty and property interests held under finance leases) must be accounted for using the fair value model.[IAS 40 para 6].

Owner-occupied property is defined as property held by the owner (or by a lessee under a finance lease) for usein the production or supply of goods or services or for administrative purposes. [IAS 40 para 5]. Investmentproperty is distinguished from owner-occupied property by the fact that it is held to earn rentals and forcapital appreciation and thus generates cash flows independently from the other assets of the entity. Bycontrast, owner-occupied property that is used for the production or supply of goods or services, is used forthat purpose in conjunction with the other assets of the entity, such as plant and machinery and inventory.Such owner-occupied property, including property held for administrative purposes, does not generate cashflows independently of the other assets of the entity. [IAS 40 para 7].

Examples of investment property include:

& Land held for long-term appreciation in value, rather than for short-term sale in the ordinary course ofbusiness.

& Land whose future use has not yet been determined. If the future use has not yet been determined, land isassumed to be held for capital appreciation.

& A building owned or held under a finance lease and leased out under an operating lease.

& A building that is vacant, but held to be leased out under an operating lease.

& Investment property being redeveloped for continued use as investment property.

[IAS 40 para 8].

Investment property does not include:

& Property intended for sale in the ordinary course of business or for development and resale.

& Property under construction for third parties.

& Owner-occupied property, including property held for such use or for redevelopment prior to such use.

& Property occupied by employees.

& Owner-occupied property awaiting disposal.

& Property that is leased to another entity under a finance lease.

[IAS 40 para 9].



However, property that is under construction or development for future use as investment property is withinIAS 40’s scope effective for annual periods beginning on or after 1 January 2009. Previously such property waswithin the scope of IAS 16. Where the fair value model under IAS 40 is applied, such a property is measured atfair value. However, where the fair value of the investment property under construction is not reliablymeasurable, the property is measured at cost until the earlier of the date construction is completed or the dateat which fair value becomes reliably measurable.

Although a property that is used and occupied by an entity for the purpose of producing or supplying goodsor services is not an investment property, there may be instances where a property is only partially owner-occupied, with the rest being held for rental income or capital appreciation. In such circumstances thestandard states that if the portions could be sold separately (or separately leased out under a finance lease) theentity should account for the portions separately. [IAS 40 para 10]. That is, the portion that is owner-occupiedis accounted for under IAS 16 and the portion that is held for rental income or capital appreciation or both istreated as investment property under IAS 40.

For example, an entity might own a four-storey block and use the bottom two storeys for its administrativefunction, whilst renting out the upper two floors. If the entity could sell floors separately or lease them out on afinance lease, it should treat the lower half of the property as owner-occupied property and the upper half asinvestment property. Case 8.Y illustrates.

Case 8.Y – Accounting for multi-purpose property

Entity A owns a hotel resort, which includes a casino, housed in a separate building that is part of the premises of theentire hotel resort. Its patrons would be largely limited to tourists and non-resident visitors only.

The owner operates the hotel and other facilities on the hotel resort, with the exception of the casino, which can be

sold or leased out under a finance lease. The casino will be leased to an independent operator. Entity A has no furtherinvolvement in the casino. The casino operator will not be prepared to operate it without the existence of the hotel andother facilities.

In this scenario, management should classify the hotel and other facilities as property, plant and equipment and the

casino as investment property. As explained in paragraph 17.23, the casino can be sold separately or leased out undera finance lease.

A particular area of controversy during the development of IAS 40 was the treatment of hotels. In thestandard, hotels are given as an example where the supply of ancillary services is significant. Because of this,an owner-managed hotel is regarded as an owner-occupied property rather than an investment property, asthe property is being used to a significant extent for the supply of goods and services. On the other hand, thestandard recognises that it may be difficult to determine whether ancillary services are so significant that theproperty does not qualify as investment property. It again uses the example of a hotel, but where themanagement function and provision of services is carried out, not by the owner, but by a third party to whomthe owner has transferred those responsibilities under a management contract. The standard notes that suchcontracts vary considerably and that at one extreme the owner may in substance be a passive investor, whilstat the other extreme the owner may have outsourced certain functions, but retained significant exposure tovariations in cash flows from the operation of the hotel. The implication of the standard is that in the formercase the hotel might be treated as an investment property, but in the latter case it would be treated as anowner-occupied property. [IAS 40 paras 12 and 13].

Within a group of companies one group entity may lease property to another group entity for its occupationand use. In the consolidated financial statements such property is not treated as investment property, becausefrom the group’s point of view the property is owner-occupied. In the financial statements of the entity thatowns the property or holds it under a lease accounted for as a finance lease, the property will be treated asinvestment property if it meets the conditions set out in the definition above. [IAS 40 para 15].

Measurement

Measurement at initial recognition is as for other PPE (see section 8.3). For subsequent measurement thestandard permits an entity to adopt either the fair value model or the cost model as its accounting policy andto apply that policy to all of its investment property. [IAS 40 para 30]. The exceptions to this rule are asfollows:



& Regardless of its choice of policy for all other investment property, an entity may choose either the fairvalue model or the cost model for all investment property backing liabilities that pay a return linkeddirectly to the fair value of, or returns from, specified assets including that investment property. [IAS 40para 32A].

& When a property interest held by a lessee under an operating lease is classified as an investment property(see above), the fair value model has to be applied to all investment property (other than those in theprevious bullet point). [IAS 40 para 34]. However, it is a property by property choice whether to accountfor the leasehold property as an investment property and under IAS 40 or as a lease under IAS 17.[IAS 40 para 6].

Where the cost model is chosen under IAS 40 an entity may not carry any of its investment property at fairvalue, but it may still adopt a policy of revaluation for its owner-occupied property if it wishes. [IAS 40para B51].

Where an entity has adopted the fair value model, the IASB considers that it should not subsequently changeto the cost model. This is because IAS 8, ‘Accounting policies, changes in accounting estimates and errors’,allows a change of policy only if the change will provide reliable and more relevant information about theeffects of transactions, other events or conditions. The IASB considers that this is highly unlikely to be the casefor a change from the fair value model to the cost model. [IAS 40 para 31]. The implications of the choice ofpolicy for first-time adopters of IFRS are considered in chapter 27.

Where an entity adopts the cost model, it is still required to make disclosure of the fair value of its investmentproperty. Thus, even though entities may adopt either the fair value or the cost model for measurement, thisadditional disclosure requirement for those that adopt the cost model ensures that fair value information isavailable for all investment property companies. [IAS 40 paras 32, 79(e)]. An example of a company thatcarries investment properties at cost less depreciation and discloses fair value in accordance with IAS 40 isexample 8.10.

Example 8.10 – disclosure of fair value of investment property carried at cost

Hochtief AG – Report and accounts – 31 December 2008

Accounting policies (extract)

Investment properties are stated at amortized cost. Transaction costs are included on initial measurement. The fair

values of investment properties are disclosed in the Notes. These are assessed using internationally accepted valuationmethods, such as taking comparable properties as a guide to current market prices or by applying the discounted cashflow method. Like property, plant and equipment, investment properties are depreciated using the straight-line

method.

13. Investment properties (extract)

The fair values of investment properties are measured using internationally accepted valuation procedures, such astaking comparable properties as a guide to current market prices or the discounted cash flow method, and came to

EUR 63,281,000 (2007: EUR 60,354,000) as of December 31, 2008. EUR 30,655,000 (2007: EUR 27,492,000) of thistotal is accounted for by fair value adjustments following independent external appraisals.

The standard encourages, but does not require, entities to have valuations carried out by independent,professionally qualified valuers with recent experience of the location and category of the properties beingvalued. This applies to all entities, whether they measure investment properties at fair value or measure themat cost with additional disclosure of fair value. The standard requires disclosure of the extent to which anindependent professional valuer, that holds a recognised and relevant professional qualification and has recentexperience in the location and category of the investment property being valued, has been involved. If therehas been no independent valuation that fact should be disclosed. An example of disclosure is given as example8.11.



Example 8.11 – disclosure of details of valuation of investment property

SEGRO – Report and accounts – 31 December 2007

15. Properties (extract)

The investment properties were externally valued as at 31 December 2007 by CB Richard Ellis, DTZ Debenham TieLeung, Colliers CRE and King Sturge. The valuation basis is market value, conforms to international valuationstandards and was arrived at by reference to market evidence of the transaction prices paid for similar properties. All

the valuers listed above are qualified independent valuers who hold a recognised and relevant professionalqualification and have recent experience in the relevant location and the category of properties being valued. All thevaluers have adopted policies for the regular rotation of the responsible valuer.

CB Richard Ellis, DTZ Debenham Tie Leung, Colliers CRE and King Sturge also undertake some professional andletting work on behalf of the Group, although this is limited in relation to the activities of the Group as a whole. Allfour firms advise us that the total fees paid by the Group represent less than 5 per cent of their total revenue in anyyear.

An entity can choose the fair value model as its accounting policy for investment property, but, if a propertyinterest held by the entity under an operating lease is classified as an investment property, there is no choiceand the fair value model must be applied to all the entity’s investment properties (other than investmentproperty linked to liabilities, for which there remains a choice). [IAS 40 paras 6, 34]. Otherwise, an entity thatadopts the fair value model should measure all its investment properties at fair value, subject only to theexception described below. [IAS 40 para 33].

There is a rebuttable presumption that fair value can be determined reliably on a continuous basis. [IAS 40para 53]. Excluded from the fair value measurement requirement are:

& investment properties under construction for which the fair value cannot be reliably determined atpresent, but for which the entity expects the fair value to be reliably measured at a later date during theconstruction or when the construction is completed; and

& investment properties for which, in exceptional cases and upon initial recognition only, the fair valuecannot be determined reliably on a continuing basis.

The fair value of the investment property cannot be determined reliably on a continuing basis when, and onlywhen, comparable market transactions are infrequent and alternative reliable estimates of fair value (that is,based on discounted cash flow projections) are not available. [IAS 40 para 53].

In such a circumstance the entity should use:

& The cost model for investment properties under construction for which the fair value cannot be reliablydetermined at present, but for which the entity expects the fair value to be reliably measured at a laterdate during the construction or when the construction is completed (that is, at cost less impairment).

& Cost model as required by IAS 16 for investment properties which, in exceptional cases and upon initialrecognition only, the fair value cannot be determined reliably on a continuing basis (that is, at cost lessdepreciation and impairment). The residual value of such investment properties is assumed to be zero.[IAS 40 para 53].

Once an entity becomes able to reliably measure the fair value of an investment property under constructionthat has previously been measured at cost, it should then measure that property at its fair value. Onceconstruction of that property is complete, it is presumed that fair value can be measured reliably. [IAS 40para 53A]. Case 8.Z illustrates

Case 8.Z – Inability to measure fair value reliably

Entity A owns several investment properties and has adopted the fair value model for measurement purposes. It has

completed the development of an investment property. Entity A’s management is not able to determine theentertainment complex’s fair value, as there is no active market for such a property. A sale of the complex would besubject to significant negotiations.



In this situation, entity A should measure the property at fair value even though there is no active market for theproperty. As management intends to lease the property to a third party, it should be able to approximate fair valuebased on the present value of the future lease rentals.

IAS 40 does not specify whether the requirement noted in the previous paragraph to assume a residual value ofnil applies to both land and buildings. However, paragraph 58 of IAS 16 notes that land normally has anunlimited life and, therefore, is not depreciated. For this reason we consider that the requirement to assume aresidual value of nil would not normally apply to freehold land, but would apply to buildings and land heldunder an operating lease.

When the entity uses the above exception for one or more investment properties, it should fair value all theremaining investment properties. [IAS 40 para 54].

The exception is not permitted for an investment property that the entity has previously measured at fairvalue. In the case of such property the entity should continue to measure it at fair value until disposal orchange of use (for example, to owner-occupied property or development for subsequent sale in the ordinarycourse of business), even if comparable market transactions become less frequent or market prices become lessreadily available. [IAS 40 para 55].

Determining fair value

Fair value is defined as ‘‘the amount for which an asset could be exchanged between knowledgeable, willingparties in an arm’s length transaction’’. [IAS 40 para 5]. This definition is similar to the definition of ‘marketvalue’ given by the International Valuation Standards Committee (IVSC). IVSC defines market value as: ‘‘Theestimated amount for which a property should exchange on the date of valuation between a willing buyer and awilling seller in an arm’s length transaction after proper marketing wherein the parties had each actedknowledgeably, prudently, and without compulsion’’.

The explanation and interpretation given below of the elements of the IAS 40 definition of fair value aresimilar or, in some cases, identical to the explanations given by the IVSC of equivalent terms in its definition ofmarket value.

‘Knowledgeable parties’ in the IAS 40 definition means that both buyer and seller are reasonably informedabout the nature and characteristics of the property, its actual and potential uses and the state of the market atthe balance sheet date. A willing buyer is one who is motivated, but not forced to buy, nor is such a buyerover-eager or determined to buy at any price. Such a buyer will not pay a higher price than a market made upof knowledgeable willing buyers and sellers would require. [IAS 40 para 42].

Similarly, a willing seller is not forced to sell nor over-eager to do so or prepared to sell at any price orprepared to hold out for a price that is not realistic in the current market. A willing seller is motivated to sellon market terms for the best price obtainable. The individual circumstances of the seller (for example, whetherits business is in difficulties or its tax position) are not relevant as part of this consideration because a willingseller is a hypothetical owner. [IAS 40 para 43].

The definition of fair value also refers to an arm’s length transaction. Such a transaction is one between partiesthat do not have a particular or special relationship that makes transaction prices unrepresentative of themarket. The arm’s length transaction is assumed to be between unrelated parties each of which actsindependently of the other, in its own interests. [IAS 40 para 44].

Fair value differs from value in use, which is defined in IAS 36, ‘Impairment of assets’, as ‘‘the present value ofthe future cash flows expected to be derived from an asset or cash-generating unit’’. [IAS 36 para 6]. Thedifference is that fair value reflects open market conditions and the knowledge and estimates of value of thoseknowledgeable willing buyers and sellers who participate in that market as well as general economic factorsthat affect the market. The market value of an investment property is determined on the basis of the highestvalue considering any use that is financially feasible, justifiable and reasonably probable. This ‘highest andbest use’ value may result in the fair value being determined on the basis of redevelopment of the site (asillustrated in the examples below). Value in use is more specific to the entity and reflects the entity’s ownknowledge and estimates (for example, of future cash flows) and conditions that are specific to the entity. Inaddition, any future capital expenditure that would be undertaken by the average market participant to get theinvestment property to its highest and best use should be reflected in the property’s fair value. However, if the



redevelopment would be undertaken by the existing owner only, then capital expenditure should not bereflected in the property’s fair value. Consider case 8.AA.

Case 8.AA – Use of ‘highest and best value’ approach

An entity owns an investment property, which comprises currently land with an old warehouse on it. It has beendetermined that the land could be redeveloped into a modern leisure park. The market value of the land would be

higher if redeveloped than the market value under its current use. Management is unclear about whether theinvestment property’s fair value should be based on the propery’s (land and warehouse) market value under its currentuse, or the potential market value of the land if the leisure park redevelopment occurred.

The fair value of the property should be based on the market value of the land for its potential use. The ‘highest and

best-use’ is used as the most appropriate model for fair value. Using this approach the existing use value of theproperty is not the only basis considered. Fair value is the highest value, determined from market evidence, byconsidering any other use that is financially feasible, justifiable and reasonably probable.

This approach is also confirmed in IAS 40 para Appendix paragraph B53. The highest and best valuation assumes

redevelopment of the site. This will involve demolishing the current warehouse and constructing a leisure park in itsplace. Therefore, none of the market value obtained for the land should be allocated to the building. The market valueof the current building on the highest and best use of the property (as a warehouse) is therefore zero, The building’scurrent carrying amount should, therefore, be written down to zero.

Fair value does not reflect the following factors to the extent that they would not be generally available toknowledgeable willing buyers and sellers:

& Additional value created by bringing together a number of properties in different locations andcombining them into a portfolio of properties.

& Synergies between investment properties and other assets.

& Legal rights and restrictions that are specific to the present owner only.

& Tax benefits or disadvantages that are specific to the present owner.

[IAS 40 para 49].

Fair value excludes any estimated price that is inflated or deflated by special terms such as unusual financing,sale and leaseback arrangements or special considerations or concessions granted by anyone associated withthe sale. [IAS 40 para 36]. Fair value is determined without deduction for transaction costs that might beincurred on sale or other disposal. [IAS 40 para 37]. This is because the fair value model is not intended as arepresentation that a sale could or should be made in the near future.

Fair value reflects rental income from current leases and reasonable and supportable assumptions thatknowledgeable, willing parties would make about future rental income, based on current conditions. [IAS 40para 40]. For example, if current rental agreements provided for increases at five-yearly intervals based oninflation plus a set percentage, it would be reasonable to make estimates of future rentals for the purpose ofthe valuation based on official projected inflation rates.

Fair value also reflects any cash outflows, including rentals and other outflows that may be expected in respectof the property. However, some of the outflows are reflected as a liability, rather than as part of the investmentproperty’s carrying amount. [IAS 40 para 40]. For example, a property that is leased by the entity on a financelease will require the entity to make future lease payments. The carrying amount is not shown net of thisliability for future lease payments, but instead the obligation for the future lease payments is shown as aliability.

A leased property interest is initially recognised at its fair value or, if lower, at the present value of theminimum lease payments. At acquisition and assuming that the lease has been negotiated at market rates, thefair value of such a leased property interest, net of all expected lease payments (including those relating torecognised liabilities), should be nil.This is because if the property interest is recorded at the present value ofthe minimum lease payments, the carrying amount of the property interest and of the related lease liability willbe the same and the net amount will be nil. [IAS 40 para 41]. Normally, the fair value of the property interestwill approximate to the present value of the minimum lease payments, since the minimum lease payments arediscounted to present value using the interest rate implicit in the lease. [IAS 17 para 20]. This rate is defined in



IAS 17 as the rate that, at inception of the lease, causes the present value of the minimum lease payments plusthe unguaranteed residual value to equal the sum of the fair value of the leased asset plus any initial directcosts of the lessor. [IAS 17 para 4].

Subsequent remeasurement of a leased asset from the amount initially recognised (cost) to fair value shouldnot result in a gain or loss initially, since the fair value on acquisition, net of the expected lease liabilities, isnormally nil. However, where remeasurement to fair value takes place at different times, a gain or loss mayarise, because after initial recognition the basis for determining fair value would take account of other factorsbesides the minimum lease payments and the interest rate implicit in the lease. For example, this could arisewhere an election to use the fair value model is made after initial recognition. [IAS 40 para 41].

The best evidence of fair value is usually provided by current prices in an active market for similar property inthe same location and condition and subject to the same lease terms and other conditions. Clearly, suchidentical conditions may not always be present and so an entity should take account of, and make allowancesfor, differences from the comparable properties in location, nature and condition of the property or incontractual terms of leases and other contracts relating to the property. [IAS 40 para 45]. For example, if theproperty is leased by the entity on a finance lease that contains restrictions on the uses to which a propertymay be put by present and future lessees, that could significantly affect its fair value, because it might restrictthe entity’s ability to obtain the optimum market rentals.

Where current prices on an active market are not available, entities should consider evidence from alternativesources, such as:

& Current prices on an active market for properties of a different nature, condition or location or which aresubject to different lease or other contractual terms, adjusted to reflect the differences.

& Recent prices from transactions on less active markets, adjusted to reflect changes in economicconditions since the date of those transactions.

& Discounted cash flow projections based on reliable estimates of future cash flows, supported by the termsof existing lease and other contracts. Where practicable, external evidence should also be used, such ascurrent market rents for properties of a similar nature, condition and location. Discount rates that reflectcurrent market assessments of uncertainty regarding the amount and timing of cash flows should be usedto discount the estimated future cash flows.

[IAS 40 para 46].

Gains and losses on revaluation

Gains and losses arising on revaluation to fair value should be recognised in profit or loss for the period inwhich they arise. [IAS 40 para 35].

IAS 40 requires disclosure of net gains or losses from fair value adjustments, but does not specify where suchgains and losses on revaluation should be shown in the income statement. They should, however, be shownseparately from rental income and direct operating expenses, which are required to be disclosed separately byIAS 40. IAS 1, ‘Presentation of financial statements’, was revised in 2003 and no longer requires disclosure of aline item for the results of operating activities. The Basis for conclusions section of IAS 1 notes that if an entityvoluntarily discloses a line item for the results of operating activities it should ensure that the amount disclosedis representative of activities that would normally be considered to be ‘operating’. [IAS 1 para BC13].Revaluation gains and losses would form part of the operating results of an investment property companyand, therefore, should be disclosed in arriving at operating profit, if such a line item is disclosed. If a line itemfor operating profit is not disclosed, we consider that gains and losses on revaluation should be shown beforethe line item for ‘finance costs’ that is required by IAS 1. This is because finance costs are generally not part ofoperating profits, unless the entity is a financial business.

IAS 1 stipulates the minimum information to be presented on the face of the income statement. This does notinclude gains or losses on revaluation, but IAS 1 states that additional line items, headings and subtotalsshould be presented on the face of the income statement when such presentation is relevant to anunderstanding of an entity’s financial performance. [IAS 1 para 83]. Accordingly, we consider that, wherematerial, gains or losses on revaluation should be shown as a net figure separately on the face of the incomestatement. Where such net figure comprises losses and gains that are individually of such significance that their



separate disclosure is relevant to explaining the performance of the entity for the period, we consider thatfurther analysis of the net figure between gains and losses should be given in the notes.

Example 8.12 illustrates disclosure on the face of the income statement. Note 1 has also been reproduced inthis example as it shows the presentation of rental income as part of total revenue. (Note that the company hasalso adopted IAS 1 (revised 2003), but has voluntarily disclosed an operating profit figure.)

Example 8.12 – Revaluation gains disclosed on the face of the profit and loss account

Hongkong Land Holdings Limited – Annual Report and Accounts – 31 December 2007

Consolidated Profit and Loss Account

for the year ended 31st December 20072007 2006Underlying Non – Underlying Non, business trading – business trading

performance items Total performance items Total

Note US$m US$m US$m US$m US$m US$m

Revenue 5 933.2 – 933.2 555.9 – 555.9

Cost of sales 6 (442.2) – (442.2) (197.5) – (197.5)

Gross profit 491.0 – 491.0 358.4 – 358.4Other income 0.6 – 0.6 23.0 – 23.0Administrative and other expenses (52.2) – (52.2) (33.7) – (33.7)

439.4 – 439.4 347.7 – 347.7Increase in fair value of investment

properties 12 – 2,588.9 2,588.9 – 1,952.6 1,952.6Asset impairment provisions,reversals and disposals 12 – 9.4 9.4 – (5.8) (5.8)

Operating profit 7 439.4 2,598.3 3,037.7 347.7 1,946.8 2,294.5

Notes to the Financial Statements (extract)

5 Revenue (extract)

2007 2006

US$m US$m

Rental income 440.5 348.7Service income 97.7 95.4

Sales of trading properties 395.0 111.8

933.2 555.9

Transfers

IAS 40 deals in detail with transfers to or from investment property. Transfers should be made when, and onlywhen, there is a change of use and the detailed rules are as follows:

& Investment property becomes owner-occupied property

A transfer should be made from investment property to owner-occupied property at the commencementof owner-occupation. [IAS 40 para 57(a)]. Where the investment property has been carried at fair value,the fair value at the date of transfer becomes the deemed cost for subsequent accounting under IAS 16.[IAS 40 para 60].

& Investment property is to be developed for sale

A transfer should be made from investment property to inventory at the date of commencement ofdevelopment with a view to sale. [IAS 40 para 57(b)]. Where the investment property has been carried atfair value, the fair value at the date of transfer becomes the deemed cost for subsequent accounting underIAS 2. [IAS 40 para 60].



& Owner-occupied property becomes investment property

A transfer should be made from owner-occupied property to investment property when owner-occupation ceases. [IAS 40 para 57(c)]. If the investment property is to be carried at fair value, IAS 16 isapplied up to the date of transfer. The property is fair valued at the date of transfer and any revaluationgain or loss, being the difference between fair value and the previous carrying amount, is accounted foras a revaluation surplus or deficit in equity in accordance with IAS 16. Increases are recognised directlyin equity, unless there was an impairment loss recognised for the same property in prior years and aportion of the increase is recognised in profit or loss to the extent of that impairment loss. Decreases arerecognised in profit or loss for any decrease in excess of the amount included in the revaluation surplusfor that property. The treatment of revaluation gains and losses under IAS 16 is discussed in section 8.4.[IAS 40 paras 61, 62].

& Property held as inventory becomes investment property

When an operating lease is granted to a third party on a property held as inventory and upon thecommencement of the lease, the property should be transferred to investment property as soon as theoperating lease commences. [IAS 40 para 57(d)]. If the investment property is to be held at fair value, anydifference between the fair value and the previous carrying amount at the date of transfer is recognised inprofit or loss. This is consistent with the treatment of sales of inventory. [IAS 40 paras 63, 64].

& Transfers under the cost model

Where an entity has a policy of carrying investment property at cost less depreciation (the cost model),properties are transferred in the same way and under the same circumstances as described above.However, such transfers do not change the carrying amount of the property transferred, that is, norevaluation gains or losses arise, nor do they change the cost of the property for measurement ordisclosure purposes. [IAS 40 para 59].

Presentation and disclosures

A further issue that arises with investment properties is how they should be presented in the balance sheet.IAS 1 paragraph 68 specifies items that, as a minimum, have to be included on the face of the balance sheet.This includes investment property. Therefore, investment property should be presented as a separate line itemon the face of the balance sheet within non-current assets. Example 8.13 illustrates disclosure on the face of thebalance sheet.

Example 8.13 – Investment property disclosure on face of balance sheet

SEGRO plc – Report and accounts – 31 December 2007

Balance sheets

As at 31 December 2007 (extract) Group Company

2007 2006 2007 2006

Note £m £m £m £m

AssetsNon-current assets

Goodwill 14 0.8 0.7 – –Investment properties 15 4,485.5 5,156.7 – –Development and owner occupied properties 15 289.5 469.7 – –

Plant and equipment 16 5.8 48.1 – –Investment in subsidiaries 18 – – 3,800.8 3,491.0Investments in joint ventures and associates 18 73.4 84.5 5.5 5.5Finance lease receivables 17 10.4 10.6 – –

Available-for-sale investments 19 39.5 44.1 – –Deferred tax asset 26 – – 4.3 5.3

Total non-current asset 4,904.9 5,814.4 3,810.6 3,501.8

Under IAS 40, the entity should disclose for all investment property, whether carried at fair value or at costless depreciation:



& Whether the entity uses the cost model or the fair value model.

& If the entity applies the fair value model, whether and in what circumstances it classifies, and accountsfor, property interests held under an operating lease as investment property.

& Basis of distinguishing investment property from owner-occupied property and property held for sale inthe ordinary course of business, where classification is difficult.

& Methods and significant assumptions for determining fair value, including a statement as to whether fairvalue was supported by market evidence or was more heavily based on other factors (which the entityshould disclose) because of the nature of the property and lack of comparable market data. (See example8.13.)

& Extent of involvement of independent professional valuers with recent experience in the location andcategory of investment property being valued (in determining fair value for measurement or disclosurepurposes) or, if there has been no independent valuation, disclosure of that fact. (See example 8.13.)

& Amounts included in profit or loss for rental income and direct operating expenses relating to investmentproperty (such as repairs and maintenance) giving amounts separately in the latter case for property thatgenerated rental income and property that did not.

& The cumulative change in fair value recognised in profit or loss on a sale of investment property from apool of assets in which the cost model is used into a pool in which the fair value model is used.

& Details of the existence and amount of restrictions on the realisability of investment property or onremittance of income and proceeds of disposal.

& Contractual obligations to purchase, construct or develop investment property or for repairs,maintenance or enhancements.

[IAS 40 para 75].

In addition, where an entity adopts the fair value model, it should disclose a reconciliation of the carryingamount at the beginning and end of the period showing:

& Additions from acquisitions.

& Additions from subsequent expenditure recognised in the carrying amount of an asset.

& Additions from business combinations.

& Assets classified as held for sale or included in a disposal group classified as held for sale in accordancewith IFRS 5, ‘Non-current assets held for sale and discontinued operations’, and other disposals.

& Net gains or losses from fair value adjustments.

& Net exchange differences arising from retranslation of the reporting entity’s financial statements into adifferent presentation currency (where applicable) and from retranslation of a foreign operation (forexample, an overseas subsidiary undertaking) into the reporting entity’s presentation currency.

& Transfers to and from inventory and owner-occupied property.

& Other changes.

Comparatives are required for these disclosures.

[IAS 40 para 76].

Where an entity carries investment property using the cost model, it should, make the following additionaldisclosures, which in particular include disclosure of the fair value of the investment property:

& The depreciation methods used.

& The useful lives or depreciation rates used.

& The gross carrying amount and the accumulated depreciation (combined with accumulated impairmentlosses) at the beginning and end of the period.



& A reconciliation of the carrying amount of investment property at the beginning and end of the periodshowing the following:

& Additions from acquisitions.

& Additions from subsequent expenditure recognised as an asset.

& Additions from business combinations.

& Assets classified as held for sale or included in a disposal group classified as held for sale in accordancewith IFRS 5, ‘Non-current assets held for sale and discontinued operations’, and other disposals.

& Depreciation.

& Amount of impairment losses recognised and the amount of impairment losses reversed during theperiod under IAS 36, ‘Impairment of assets’.

& Net exchange differences arising from retranslation of the reporting entity’s financial statements into adifferent presentation currency (where applicable) and from retranslation of a foreign operation (forexample, an overseas subsidiary undertaking) into the reporting entity’s presentation currency.

& Transfers to or from inventory and owner-occupied property.

& Other changes.

& Fair value of investment property. Where, in the same exceptional circumstances as are described earlier,an entity cannot reliably determine the fair value of an investment property it should disclose:

& A description of the property.

& An explanation of why fair value cannot be reliably determined.

& If possible, the range of estimates of fair value within which the fair value of the property is highly likelyto lie.

[IAS 40 para 79].

Summary

& Property, plant and equipment (PPE) is recognised when the cost of an asset can be reliably measuredand it is probable that the entity will obtain future economic benefits from the asset.

& PPE is measured initially at cost. Cost includes the fair value of the consideration given to acquire theasset (net of discounts and rebates) and any directly attributable cost of bringing the asset to workingcondition for its intended use (inclusive of import duties and non-refundable purchase taxes).

& Directly attributable costs include the cost of site preparation, delivery, installation costs, relevantprofessional fees and the estimated cost of dismantling and removing the asset and restoring the site (tothe extent that such a cost is recognised as a provision). Classes of PPE are carried at historical cost lessaccumulated depreciation and any accumulated impairment losses (the cost model), or at a revaluedamount less any accumulated depreciation and subsequent accumulated impairment losses (therevaluation model). The depreciable amount of PPE (being the gross carrying value less the estimatedresidual value) is depreciated on a systematic basis over its useful life.

& Subsequent expenditure relating to an item of PPE is capitalised if it meets the recognition criteria.

& PPE may comprise parts with different useful lives. Depreciation is calculated based on each individualpart’s life. In case of replacement of one part, the new part is capitalised to the extent that it meets therecognition criteria of an asset, and the carrying amount of the parts replaced is derecognised.

& The cost of a major inspection or overhaul of an item occurring at regular intervals over the useful life ofthe item is capitalised to the extent that it meets the recognition criteria of an asset. The carryingamounts of the parts replaced are derecognised.

& The IFRIC published IFRIC 18, ‘Transfer of assets from customers’, in January 2009. It clarifies theaccounting for arrangements where an item of PPE that is provided by the customer is used to providean ongoing service. The interpretation applies prospectively to transfers of assets from customersreceived on or after 1 July 2009; it is subject to EU endorsement.



& IAS 23, ‘Borrowing costs’, requires borrowing costs directly attributable to the acquisition, constructionor production of a qualifying asset to be capitalised.

& Certain properties are classified as investment properties for financial reporting purposes, as thecharacteristics of these properties differ significantly from owner-occupied properties. It is the currentvalue of such properties and changes to those values that are particularly relevant to users of financialstatements.

& Investment property is property (land or a building, or part of a building or both) held by an entity toearn rentals and/or for capital appreciation. Since 1 January 2009, this category includes such propertyin the course of construction or development. Any other properties are accounted for as property, plantand equipment (PPE) in accordance with IAS 16, ‘Property, plant and equipment’, if they are held foruse in the production or supply of goods or services; or as inventory in accordance with IAS 2,‘Inventories’, if they are held for sale in the ordinary course of business. Owner-occupied property doesnot meet the definition of investment property.

& Initial measurement of an investment property is the fair value of its purchase consideration plus anydirectly attributable costs. Subsequent to initial measurement, management may choose as itsaccounting policy either to carry investment properties at fair value or at cost. The policy chosen isapplied consistently to all the investment properties that the entity owns.

& If the fair value option is chosen, investment properties in the course of construction or development aremeasured at fair value if this can be reliably measured, otherwise they are measured at cost.

& Fair value is the price at which the property could be exchanged between knowledgeable, willing partiesin an arm’s length transaction. Changes in fair value are recognised in profit or loss in the period inwhich they arise.

& The cost model requires investment properties to be carried at cost less accumulated depreciation andany accumulated impairment losses consistent with the treatment of PPE; the fair values of theseproperties is disclosed in the notes.

References

& IAS 16, ‘Property, plant and equipment’

& IAS 23, ‘Borrowing costs’

& IAS 40, ‘Investment property’

& Annual improvements to IFRSs (IAS 16 and IAS 23)

& IFRIC 1, ‘Changes in existing decommissioning, restoration and similar liabilities’



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