Financial Accounting 1 by Valix NOTES Published by the De La Salle University

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Financial Accounting 1 by Valix NOTES Published by the De La Salle University Powered By Docstoc
                                                     Published by the De La Salle University - Manila, College of Business and Economics
                                                              (CHED Center of Development for Business and Management Education)
                                                                Center for Business and Economics Research and Development (CBERD)

on business education                                                                  Volume 9 Issue No. 1 Jan - Feb 2006

  An Update on International Accounting Standard
     (IAS) 16: Property, Plant and Equipment
By Herminigilda E. Salendrez
Assistant Professor

I. Introduction
          Failure to apply the set of rules,
principles, bases, conventions and
standards distort the financial
information reported in the financial
statements. This article aims: (1) to
discuss International Accounting
Standard 16 as it relates to accounting
for Property, Plant and Equipment; and
(2) to provide coherent set of updates
on accounting for tangible fixed assets
which is commonly known as property,
plant and equipment.
          Since January 2005, advocates
of the new International Accounting
Standard 16 Property, Plant and
Equipment encourage entities to apply
the principles of the Standard in lieu of
its previous version, IAS 16 (1998). The
advocacy, headed by the International
Accounting Standards Board, was
initiated due to questions and criticisms
raised by securities regulators,
professional accountants and interested
parties. The Board undertook a project
in order to develop this revised IAS 16
                                               contained in IAS 16. This standard            II. Major Changes
to reduce or eliminate alternatives,
                                               clarifies how an entity should apply the           The main changes introduced from
redundancies and conflicts within the
                                               principles to items of property, plant and    the previous version of IAS 16 are the
standards, deal with some convergence
                                               equipment that is used to develop or          following:
issues and make other improvements. The
                                               maintain: (a) biological assets; and (b)
revision, however, was not intended to
                                               mineral rights and mineral reserves such      A.      Recognition - subsequent costs
overhaul nor to reconsider the
                                               as oil, natural gas and similar non-               The old version states that,
fundamental approach to the accounting
                                               regenerative resources.                       subsequent expenditure is added to the
for property, plant and equipment

Ms. Herminigilda Salendrez teaches financial accounting in the modular accountancy program of DLSU - Manila
Jan - Feb 2006                                                  1                             Notes on Business Education
carrying amount of the asset only when          Table1. Accounting for costs incurred subsequent to acquisition of
it is probable that future economic
                                                property, plant and equipment
benefits in excess of the originally
assessed standard of performance of the
                                                                                                                                       Normal accounting treatment
existing asset will flow to the enterprise.                                                                         Expense                 Capitalize
Any other subsequent expenditure is                   Type of                                                         when             - Accumulated
                                                    expenditure                    Characteristics                  incurred   + Asset Depreciation     Other
simply recognized as an expense in the
period in which it is incurred. In contrast      1. Additions         Extension, enlargements, or expansions
                                                                      made to an existing asset                                   x
to the new version, the cost of an item of
property, plant and equipment shall be           2. Repairs &         Recurring, relatively small amount
                                                    maintenance       • Maintain normal operating condition            x
recognized as an asset if, and only if: a) it       a. Ordinary       • Do not add materially to use value             x
is probable that future economic benefits                             • Do not extend useful life                      x
                                                   b. Extraordinary   Not recurring, relatively large amount
associated with the item will flow to the                             • Primarily increase the use value                          x
entity; and b) the cost of an item can be                             • Primarily extend the useful life                                     x

measured reliably. This is a general             3. Replacement       Major component of the asset is removed
recognition principle, which guides the             and betterments   and replaced with the same type of
                                                                      component with comparable performance
entity in the evaluation of all property,                             capabilities or different type of
plant and equipment costs at the time                                 component having superior performance
they are incurred. Those costs include            a. Book value of                                                                                 * Remove old
costs incurred initially from the time a            old component                                                                                    asset cost &
                                                    is known                                                                                         accumulated
property, plant and equipment is                                                                                                                     depreciation
acquired or constructed and costs                                                                                                                  * Recognize
                                                                                                                                                     gain or loss
incurred subsequently to add to, replace                                                                                                             on old asset
part of, or service an item. To recognize a                                                                                                        *Charge asset
cost as an asset, the expenditure must                                                                                                               replacement
give rise to the expectation of future                                                                                                               component
                                                  b. Book value of    1. Primarily increase the use value                         x
economic benefits. Assets for which the            old component      2. Primarily extend the useful life                                    x
cost cannot be reliably measured but               is not known

whose initial fair value can be measured         4. Reinstallation    Provide general efficiency in production
reliably cannot be recognized in the                and               or reduce production costs
                                                    rearrangements    1. Material costs incurred: benefits extend                 x
entity’s records.                                                         into future accounting periods
       Table 1 shows the proper                                       2. No measurable future benefit                  x

accounting for subsequent costs to              Source: Wiley. IAS 2004. Interpretation and Application of International Accounting and
acquisition of property, plant and              Financial Reporting Standards
                                                asset such as offshore oil platform is                         liability) should be accreted, so that at
B.       Measurement at recognition -           constructed, an entity knows that in the                       the expected date on which the
asset dismantlement, removal and                future it is required by law to dismantle                      expenditure is to be incurred it will be
restoration costs.                              and remove the platform in such manner                         appropriately stated. The offset of
      The previous version of IAS 16            that the environment is cared for. The                         accretion1 should be reported as interest
covers only the costs incurred as a             construction of the platform gives rise                        expense or a similar financing cost. It
consequence of installing the item. The         to a liability for restoration under IAS 37                    should not be added to the cost of the
new version includes both the costs of          Provisions, Contingent Liabilities and                         asset to which the estimated
an item of property, plant and equipment        Contingent Assets. The projected costs                         dismantlement costs are related.
and the estimated cost of its                   are measured on a discounted present                                    There may be restoration costs
dismantlement, removal or restoration.          value basis, capitalized into the                              associated with the use of land, such as
Such cost to dismantle or remove                construction of the platform and are                           when it is used for mining or farming.
equipment or to restore property should         depreciated over the life of the asset.                        These costs are capitalized into the cost
be subjected to accurate determination          Since the dismantling, removal and                             of the land at acquisition date and are
and should constitute a legal or                restoration costs are initially recorded at                    depreciated over the period in which the
constructive commitment by the                  a discounted amount, each accounting                           benefits from use of the land are received,
reporting entity. For example, when an          period the provision (i.e. estimated                           although the land is not depreciated.

Notes on Business Education                                            2                                                                    Jan - Feb 2006
                                                                                                The International Accounting
                                                                                         Standards Board (IASB) concentrated on
 Illustrative problem: restoration costs
                                                                                         the initial estimate of costs of
 The company purchased a mining site that will have to be restored to certain
                                                                                         dismantling, removal and restoration. The
 specifications when the mining production ceases. The cost of the mining site
                                                                                         IASB noted that regardless of whether
 is P15,000,000, and the restoration costs is expected to be P400,000. It is estimated
                                                                                         the obligation is incurred when the item
 that the mine will continue in operation for 12 years. The appropriate interest
                                                                                         is acquired, the obligations underlying
 rate is 8%.
                                                                                         nature and its relationship with the asset
                                                                                         are the same. Hence, the considerations
 The cost of the asset is computed as follows:
                                                                                         for obligation for which an entity incurs
 Purchase price P15,000,000
                                                                                         as a result of installing the item and the
 Present value of restoration cost:P400,000 x 0.3971 155,840
                                                                                         costs incurred as a result of using it
 Total cost                                         P15,155,840
                                                                                         during a particular period are taken
 The acquisition is, then recorded as follows:
 Mine property                                           15,155,840
                                                                                         C.        Measurement at recognition -
      Cash                                                             15,000,000
                                                                                         asset exchange transactions
      Provision for mine property retirement                              155,840
                                                                                                 In terms of asset exchange
                                                                                         transactions, the two versions differ in
 The account Provision for Mine Property Retirement is presented in the balance
                                                                                         the manner how the fair value method is
 sheet as liability in accordance with IAS 37 Provisions, Contingent Liabilities
                                                                                         utilized. Under the previous version, if
 and Contingent Assets.
                                                                                         the exchanged assets were similar (similar
                                                                                         asset that has a similar use in the same
 Adjusting entries at year-end:
                                                                                         line of business and which has a similar
 Accretion expense                                         12,467.20
                                                                                         fair value), resorting to measuring an item
     Provision for mine property retirement                               12,647.20
                                                                                         of property, plant and equipment at fair
         (P155,840 x 8%)
                                                                                         value is not strictly implemented. In the
                                                                                         new version, unless the exchange
 Depreciation expense                                   1,262,987
                                                                                         transaction lacks commercial substance,
     Accumulated depreciation                                           1,262,987
                                                                                         an entity is required to measure an item
       (P15,155,840 /12 yrs.)
                                                                                         of property, plant and equipment at fair
                                                                                         value, whether such item of property is
                                                                                         acquired in exchange for a non-monetary
 Illustrative problem: renewals and replacements                                         asset or assets, or a combination of
 BEST Company recently replaced the outside corrugated wall of its administration        monetary and non-monetary assets.
 building. The old wall cost P250,000, and was 50% depreciated. The new wall cost        Commercial substance is concerned with
 P400,000, which was paid in cash. The new wall will extend the life of the building     whether the transaction has a discernible
 by 3 years. Assume that the cost of the old wall is identifiable, and has been          effect on the economics of an entity.
 accounted as part of the building cost.                                                 Paragraph 25 states that an exchange
                                                                                         transaction has commercial substance if:
 The book value of the old component is known. The entries to record the removal                a.       the configuration of the
 of the old wall and the installation of the new wall are:                               cash flows of the asset received differs
                                                                                         from the configuration of the cash flows
 1.       To eliminate the original cost of the old corrugated wall:                     transferred;
                                                                                                b.       the entity-specific value of
          Loss on retirement of building                   125,000                       the portion of the entity’s operations
          Accumulated depreciation                         125,000                       affected by the transaction changes as a
                   Building                                           250,000            result of the exchange; and
                                                                                                c.       the difference in (a) or (b)
 2.       To record the replacement:                                                     is significant relative to the fair value of
          Building                                         400,000                       the assets exchanged.
                   Cash                                               400,000                   Where the transaction lacks
                                                                                         commercial substance, the asset acquired

Jan - Feb 2006                                                 3                          Notes on Business Education
is measured at the carrying amount of
the asset given up. Paragraph 24 of IAS          Illustrative problem: acquisition through exchange
16 states that, in an exchange of assets
                                                 Two independent companies, NES Company and KSE Company, are in the real
where neither the fair value of the assets
                                                 estate business. Each owns a condominium building in Makati City. They
given up nor the fair value of the asset
                                                 agree to exchange their condominium building. An appraiser was hired, and
acquired can be measured reliably, the
                                                 from her report and the companies’ records, the following information was
acquirer should measure the costs of the
asset acquired at the carrying amount of
the asset given up.                                                                        NES's Building      KSE's Building
                                                    Cost                                    P128,000,000        P80,000,000
                                                    Accumulated depreciation                  51,200,000         32,000,000
D.        Measurement after recognition             Fair value based upon appraisal           90,000,000         70,000,000
– revaluation model.
       IAS 16 establishes two alternative        The exchange was made, KSE Company paid P20,000,000 to NES Company.
approaches to accounting for property,           The exchange is regarded as with commercial substance.
plant and equipment. First, the
benchmark treatment, under which the             Journal entry to record the exchange follows:
acquisition or construction cost is used         Books of KSE Company
for initial recognition, subject to                       Building - new                     90,000,000
depreciation over the estimated economic                  Accumulated depreciation           32,000,000
life and to possible write-down in the                              Cash                                           20,000,000
event of a permanent impairment in value.                           Building – old                                  80,000,000
Second, the allowed alternative treatment                           Gain on exchange                                22,000,000
is to recognize upward revaluation. A
revalued amount is that fair value of the        Books of NES Company
items at the date of the revaluation less                Cash                                    20,000,000
any      subsequent        accumulated                   Building – new                          70,000,000
depreciation and accumulated                             Accumulated depreciation                51,200,000
impairment losses. Under the previous                            Building – old                                      128,000,000
version of IAS 16, the use of revalued                           Gain on exchange                                     13,200,000
amounts did not depend on whether or
not the measuring of the fair values of an
item can be relied upon. Under the new         determine whether there has been                     The adjustments due to
version, the use of revalued amounts           sufficient change in the market for the       revaluation are to be shown directly in
depends on the reliability of the fair         asset held at fair value to merit formal      the stockholders’ equity as a revaluation
values of an item. The standard                appraisal by professional valuers. With       surplus, if a downward adjustment had
stipulates that fair value is the amount       items of plant and equipment, the fair        previously been made to the asset and
for which the asset could be exchanged         value is usually their market value           was recognized as an expense, the latter
between knowledgeable, willing parties         determined by appraisal. In addition,         upward revaluation would also be
in an arm’s-length transaction. The            IAS 16 conservatively requires that if        reported as an income. Any revaluation
standard requires that once the entity         assets are revalued, all other assets in      receiving this treatment would be limited
undertakes revaluations, they must             those groupings or categories also have       to the amount of expenses recognized in
continue to be made with sufficient            to be revalued to prevent the                 the past. If the carrying amount of the
regularity that the carrying amounts in        presentation of balance sheet that            revalued asset is decreased by the
any subsequent balance sheet are               contains an incoherent mixture of             recognition of permanent impairment, the
materially at variance with its current fair   historical cost and current values.           decline should be reported as a reduction
values. According to paragraph 32, the         Although the requirement of IAS 16 is to      of the revaluation surplus. The amount
fair value of the land and buildings is        revalue all assets in a given class, the      credited to revaluation surplus can either
usually determined from market-based           standard recognizes that it may be more       be amortized to retained earnings as the
evidence by appraisal normally                 practical to accomplish this on a rolling     asset is being depreciated or it can be
undertaken by professionally qualified         or cycle basis.                               held in the surplus account until such
valuers. The management should                                                               time as the asset is disposed of or retired
                                                                                             from service.

Notes on Business Education                                     4                                                   Jan - Feb 2006
                                                                                     E.       Depreciation – unit of measure.
                                                                                            The previous version of IAS 16 did
 Illustrative problem: revaluation
                                                                                     not clearly set out a requirement to
 On December 31, 2005, the balance sheet of Henri See Company showed the
                                                                                     determine the depreciation charge
 following non-current assets:
                                                                                     separately for each significant part of an
                                                                                     item of property, plant and equipment.
 Building                               P9,000,000
                                                                                     The new version, however, provides that
 Accumulated Depreciation               (3,000,000)       P6,000,000
                                                                                     each part of an item of property, plant
 Machinery and Equipment                360,000
                                                                                     and equipment with a cost that is
 Accumulated Depreciation                (120,000)        240,000
                                                                                     significant in relation to the total cost of
                                                                                     the item shall be depreciated separately.
 The company has adopted fair value for the valuation of property, plant and
 equipment. This has resulted in the recognition in prior periods of an asset
                                                                                     F.        Depreciation - depreciable
 revaluation surplus for the building of P420,000. On December 31, 2005, an
 independent valuer assessed the fair value of to be P4,800,000; and the machinery
                                                                                            Under the old version, the basis
 and equipment to be P270,000. Assume that the building and machinery and
                                                                                     for which the residual value of an item of
 equipment had remaining useful lives of 15 years and 4 years respectively, with
                                                                                     property may be measured was not
 zero residual value.
                                                                                     clearly specified. Hence, the residual
                                                                                     value could be any amount or the
     1. To record the revaluation of building and machinery and equipment:
                                                                                     amount, inclusive of the effects of
                                                                                     inflation that an entity expects to receive
       Accumulated Depreciation – Building              3,000,000
                                                                                     in the future on the asset’s actual
       Revaluation Surplus                                420,000
                                                                                     retirement date. In the new version, the
       Expense – Revaluation Decrement                    780,000
                                                                                     residual value which an entity measures
             Building                                                   4,200,000
                                                                                     is treated as the same amount it would
                                                                                     receive currently for the asset if the asset
       Accumulated Depreciation – Mach. & Equipment120,000
                                                                                     becomes obsolete or in the condition
            Machinery & Equipment                                          90,000
                                                                                     wherein an asset is expected to be
            Revaluation Surplus                                            30,000
                                                                                     unavailable for use by the entity. The
                                                                                     depreciable amount of an asset shall be
     2. To record depreciation expense for the year ended December 31, 2005:
                                                                                     allocated on a systematic basis over its
                                                                                     useful life. The residual value of an asset
       Depreciation Expense – Building                    320,000
                                                                                     should be reviewed at least at each
       Accumulated depreciation – Building                                320,000
                                                                                     financial year-end and, if expectations
             (P4, 800,000 / 15 years)
                                                                                     differ from previous estimates. The
                                                                                     change(s) shall be accounted for as a
       Depreciation Expense – Machinery & Equipment 67,500
                                                                                     change in an accounting estimate in
             Accumulated depreciation – Mach. & Equip                      67,500
                                                                                     accordance with IAS 8 Accounting
           (P270,000 / 4 years)
                                                                                     Policies, Changes in Accounting
                                                                                     Estimates and Errors.
     3. To record the piecemeal realization of revaluation increment:
                                                                                     G. Depreciation - depreciation period.
       Revaluation Surplus                                 7,500
                                                                                           The previous version did not
             Retained Earnings                                            7,500
                                                                                     specify the period when depreciation of
                 (P30,000 / 4 years)
                                                                                     an item should begin, although it
                                                                                     specifies that an entity should cease
                                                                                     depreciating an item that it had retired
                                                                                     from active use and was holding for
                                                                                     disposal. Under the new version, an
                                                                                     entity begins depreciating an item of

Jan - Feb 2006                                              5                         Notes on Business Education
property, plant and equipment as soon         I. Derecognition - gain classification         presentation that may result to the
as it is available for use. Depreciation             The old version did not contain a       distortion of the account, and to conform
continues until the item is derecognised      provision on gain classification. The new      to the international financial reporting
or the cost of property, plant and            version, on the other hand, when items         standards.
equipment together with the related           of property, plant and equipment are
accumulated depreciation is removed           sold, regardless of whether that are many      References
from the accounts. The same is true even      or few remaining economic benefits, the        Epstein, Barry J., Mirza, Abbas Ali, John.
if during that period the item is idle and    selling entity will recognize a gain or loss      Interpretation and Application of
is no longer adopted for use in business.     on the asset, this being determined as            International Accounting and Financial
                                                                                                Reporting Standards. Wiley & Sons, Inc.
                                              the difference between the net proceeds           Hoboken, New Jersey, USA, 2004.
H. Derecognition - derecognition date.        from sale and the carrying amount of the
       According to authorities,              asset at the time of sale. The gain or loss    International Accounting Standards (IAS)
derecognition means the removal from          on sale is included in the profit or loss          approved by the International Accounting
                                                                                                 Standards Board. 2003.
the accounts of the cost of property, plant   for the period.
and equipment together with its related                                                      Skousen, Stice and Stice. Intermediate
accumulated depreciation. Hence, the          III. Conclusion                                   Accounting (15th Edition). Thomson South-
carrying amount of an item of property,                                                         Western. 2004.
                                                     Businesses are increasingly
plant and equipment is derecognized on        conducted across the national borders.         Statement of Financial Accounting Standards
disposal, such as the sale of the asset or    Entities must be able to make their                (SFAS) approved by Accounting Standard
when no future economic benefits are          financial statements understandable to             Council, 1998 – 2002.
expected from its use or disposal (Valix      users all over the world. The deviating        Valix, Conrado T., Peralta, Jose F. Financial
& Peralta, 2006). Derecognition also          or differing national accounting practices         Accounting Volume. 2006 Edition. GIC
implies the use of a particular date or       must converge to overall global                    Enterprises & Co., Inc., Manila.
period from which an entity may dispose       standards.
a property or plant. Hence under the old             As to the various rules and             (Footnotes)
version, an entity was not required to use    principles set on accounting for property,
                                                                                               Accretion is an accumulation of finance cost
a criteria, such as those provided under                                                     over the life of the asset to increase the present
                                              plant and equipment under IAS 16,              value of the asset retirement obligation or
IAS 18 on Revenue, in the determination       compliance of business entities are            provision for asset dismantlement, removal
of the date on which an entity                required to avoid any error or                 and restoration.
derecognizes the carrying amount of a         misstatement in financial reporting
disposed-of item of property, plant and
equipment. Whereas under the new
version, it requires an entity to observe
the date for which a criteria for the sale
of goods in IAS 18 on Revenue would be
met when an entity derecognizes the
                                               NOTES                    on business education
carrying amount of an item of property,
                                                is published by the De La Salle University - College of Business and Econom-
plant and equipment that it disposes. In
                                                ics, Center for Business and Economics Research and Development (CBERD)
the same manner, the old version limited
                                                                            Volume 9 No. 1 Jan - Feb 2006
the application of derecognition principle
only to a property, plant and equipment
                                                                                   Editorial Board
and not to any of its parts. Also, its
recognition principle for subsequent
                                                              Dr. Myrna S. Austria email:
expenditures effectively disallowed the
cost of a replacement from being included
                                                              Dr. Tereso S. Tullao, Jr. email:
in the carrying amount of an item. Unlike
in the new version, derecognition extends
                                                          Mr. Michael Angelo A. Cortez email:
to the carrying amount of a part of an
item of property, plant and equipment if
                                                                           Secretary: Liza Pajo
that part has been replaced. An entity,
                                                  For comments, suggestions and contributions, call (632)5244611 loc. 149 or
likewise, includes the cost of the
                                                          telefax (632)3030869 or email:
replacement in the carrying amount of the

Notes on Business Education                                     6                                                       Jan - Feb 2006

Description: Financial Accounting 1 by Valix document sample